You Ain't Seen Nothing Yet
By Adrian Ash
October 15, 2007
High finance is suddenly hot for commodity
plays, and '70s-style inflation is sure to result...
DIG OUT YOUR burgundy bell-bottoms and dust off your Bachman
Turner Overdrive albums! This is where inflation stops hiding behind the
official CPI data...and starts instead to eat your cash savings and income
alive.
"More fund investment in agricultural markets in 2008,"
says Lehman Brothers, now launching a "Pure Beta Index" to buy
long-dated futures in 20 soft commodities...
"Funds' take-up of commodity indices to rise 20%," says
the Financial Times, quoting Eric Kolts at Standard & Poor's.
Global pension-fund investment in commodities will reach $160 billion, he
believes, in 2008...
"Energy and commodities may avoid banks' job axe," chips
in the San Diego Union-Tribune, adding that "commodities and
energy have been a massive push for everybody," as one investment bank
analyst says.
"Banks will look to retain expansion plans in commodities,
which is seen as a growth area," agrees a senior US executive...
Across the Pond here in London comes the Wessex Gold Fund, using
leverage to go long/short of gold-mining equities and give itself "an
additional edge versus long-only alternatives." That edge will cost anyone
making the minimum $500,000 investment – with a minimum 12-month lock-up –
some 1.5% in annual management fees, plus a 20% grab off any gains they might
make...
Over in Australia, Oceanic Asset Management is launching "a
stable" of commodity investment funds at the start of November, looking to
nab both retail and institutional money. It's starting with a $710 million
equity fund based in London, plus an offshore hedge fund in the Caymans...
And UBS, for good measure, just announced the launch of its
Commodities Portfolio Algorithmic Strategy System. Nicknamed the UBS Comm-PASS,
it's even more geeky than it sounds...running "a basket of strategies"
on 19 different commodity futures, exposing its clients 51% to energy, and going
both long/short yet again...
Simply put, "Burned subprime investors eye commodities for
growth," as Reuters explains. The impact on your cost of living should
prove as dramatic as the bubble in global real estate they're now fleeing.
Investment-fund interest in commodities isn't new, of course;
Merrill Lynch's World Mining fund, for instance, has grown nearly six times over
since 2002. It grew another 18% last month alone.
But the urgency of this autumn's switch into commodities – driven
by the flight from property and paper – is something else entirely. The PhDs
who cooked up the US housing bubble are now applying their haute finance
skills to gearing up the cost of natural resources.
Hence the complexity of the very latest commodity offerings. Expect
a side-order of inflation to reach your dining table as a result very soon!
"The reality is that there are still few options for investors
interested in gaining access to commodities through a fund," says John
Fearon, director of Oceanic in Sydney. "The thirst for some exposure to
commodities markets is growing all the time."
This sudden thirst for – and eager slaking of – schnapps-grade
commodity products begins, naturally enough, with the threat of inflation. Crude
oil has more than quadrupled in barely five years. Wheat prices have doubled
since April this year. Gold, that speechless seer of price-inflation ahead, has
shot 15% higher in the last eight weeks alone.
That bodes ill for the value of cash in the bank and pay-packet.
"Other commodities are major industry inputs, [so] their
relative prices change with the business cycle," found David Ranson of
H.C.Wainwright & Co. in a study for the World Gold Council of Nov. 2005.
"Gold is not subject to these distortions since it is not a major input to
industry. Changes in the Gold
Price are thus a good barometer of changes in currency values – and
ultimately in the absolute level of prices."
Comparing gold with oil, for instance, between 1951 and 2005,
Ranson found that gold's correlation with the Producer Price Index one year
later was 0.37. Crude, on the other hand, managed a mere 0.01.
For Consumer Price Inflation 12 months hence, moves in the Gold
Price averaged a 0.50 correlation, more than twice the correlation between oil
and the CPI.
The current move in the Gold
Market, leaping above $750 per ounce this week, was kick-started by the
world's biggest central bank – the US Fed – cutting the price of Dollars
borrowed by the world's biggest commercial banks. The Fed cut its
"discount" rate by 0.5% on August 20th, back when gold was trading
nearly $100 per ounce below current prices.
When unlimited money-supply growth crashes into rising demand for
limited-supply essentials – such as natural gas, copper, soybeans and cocoa
– the result is sure to be price inflation as violent as the monetary
inflation that preceded it.
Add a sudden wall of money from Wall Street, the City, Frankfurt,
Paris and Tokyo...all seeking a growth market to replace the can't-lose gamble
of home-loan trading and credit...and the surge in basic resource prices will
only accelerate.
Now add a little pixie dust...plus a dollop of leverage...and
voila! One '70s-style inflation – piping hot – cooked to order.
"There has been hedge fund interest" in cobalt, for
instance, says Nick French – a cobalt dealer at SFP Metals in London – but
not because the hedge funds foresee rising demand for hip replacements,
loudspeaker magnets, jet turbine engines or any other of the metal's major
end-uses.
Instead, "if you can push the price of cobalt up to $40 per
pound from $20," says French, "then the share price of a cobalt mining
company will double." Credit Suisse now offers a cobalt contract settled in
cash, but backed by physical metal. But futures contracts, based – like
everything else offered to investors by the high-finance industry – on credit,
are only the start of it.
"An army of structured credit experts is studying products
such as Collateralized Commodity Obligations – or CCOs," reports Reuters,
"tied to the performance of a portfolio of underlying commodities, such as
precious metals or energy prices.
In a CCO, "the issuer sells protection on the underlying
commodity portfolio to the counterparty under what is known as a 'trigger swap
agreement'. To fund its obligations under the swap, the issuer sells notes in
the amount of the protection sold, according to Fitch Ratings. Proceeds from the
notes then serve as collateral for the issuer's exposure under the swap until it
matures.
"At maturity the issuer liquidates the remaining asset and
returns the proceeds to noteholders."
With it so far? My guess is – and at least I'll confess it's just
guesswork – is that the Reuters journalist and most likely the bulk of
investors about to start buying CCOs have no idea quite what these products are,
either. All they'll see, instead, is a steady stream of potential income.
Provided, of course, that the CCOs pay-out at maturity.
The first CCO came from Barclays Capital back in 2004; in April
this year, Credit Suisse issued $190 million in "triple-A" rated CCO
debt, denominated in US Dollars, Euros and the Aussie. "This product has
opened up a new investment opportunity for investors who traditionally have not
had exposure in commodities as an asset class," reckons Bikram Chaudhury of
Credit Suisse's fixed-income desk.
In other words, bond managers and fixed-income traders whacked by
the collapse of mortgage-backed debt can now put commodities into their
portfolios – and just in time, too, for the runaway inflation about to hit
thanks to monetary over-supply and heavily-geared financial buying. The magic of
finance has turned consumable lumps of natural resources into a stream of
income...without the bother of digging the earth or planting a crop.
But you don't need to feel left out as the professionals start to
play natural resources in the same way they played mortgage-backed securities in
the housing market. The global finance industry is more than willing to help you
gear up, too. Morningstar, for example – the US mutual-fund rating service –
just launched a series of commodity indices applying basic momentum theory to go
long or short when prices break the 12-month average.
"It cannot be long before exchange-traded securities will
allow retail investors to take part in the action," says John Authers in
the Financial Times.
Macquarie Bank in Australia, meantime, is now advising you delay
making any commodity-stock purchases...lend your money to them on a "Hi
Note" instead for 30, 90 or 180 days...earn a "high yield" in the
meantime...but nominate now the purchase price you'll pay – of between 85-100%
of the current share value – when the note matures.
High income, eh, with a cut-price mining-stock future thrown in for
free? Sounds too good to be true. Right?
It may be worth recalling that when Refco, the US commodities and
derivatives brokerage, went bust in late 2005, Jim Rogers' Raw Material Fund was
owed more than $362 million according to court filings.
I'm not saying that any of the banks or brokerages now
brainstorming clever new ways to gear up commodity profits are acting
fraudulently or illegally today. Refco, on the other hand, was accused by Rogers
– certainly the most famous of natural-resources fund managers, if not the
most successful – of "brazenly violat[ing his] funds' instructions and
deceitfully divert[ing] the funds' assets to an insolvent, unregulated
entity."
But making the right call in commodities – and betting they're
only set to rise from here – won't guarantee you turn a profit. Not if you
rely on somebody else making the trades or making good on a credit-based
promise.
Simply buy and sell the physical asset yourself, and at least any
profits you make – and losses you suffer – will be yours to regret alone.
You can start today with your Gold
Bullion Investment, owning the physical asset outright with no
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metal in your hands.
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