It is a double whammy for commodities at the moment. On the one hand, they have to contend with falling global demand caused by shrinking credit. On the other, they have to see money being pulled out as funds under pressure must close positions to raise cash.
In the two years before the first signs of a derivative meltdown appeared, hedge funds are estimated to have invested up to $200 billion in commodities. The funds jumped on the commodities bandwagon when they found that the market for soft and hard commodities took off in a spirited way. The unprecedented fund flow into commodities was largely a result of a booming market, rather than a cause.
Fund managers were convinced that commodities in general had moved into a long bull cycle. Commodities looked a one-way bet to all and funds wanted to be part of the action. But so much speculative money coming in at such rapid pace could only have further fuelled the market that was already on fire.
The souring of home loans on an unprecedented scale in the US and the derivative meltdown created an economic crisis, which has come to be considered worst than the Great Depression of the 1930s.
We have been seeing the commodities market turning weak since the end of July. Experts now tell us the crisis of confidence this time is so strong that the bottom has not yet been reached.
As the rich countries face a deep recession and growth rates of yesterday’s booming economies such as China and India are being scaled down, the world demand for ferrous and base metals is falling sharply. Responding to the setback in demand and prices, world majors such as ArcelorMittal, Baosteel, Alcoa and Chalco have all effected big production cuts.
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Going beyond the shelving of capacity expansion programmes, metal groups consider it wise not to bring into stream the recently created extra capacity immediately. Here, we have the instance of JSW Steel, which after having added an extra 3-million-tonne (MT) capacity to the 3.8 MT plant at Vijaynagar is not going to use the new capacity now.
In order to cope with the market blues, JSW, like many of its peers, has cut production by 20 per cent and reduced steel prices by Rs 5,500 a tonne. A particular fear haunting the Indian steel industry is that taking advantage of our liberal trade regime, China, which due to deceleration in industrial activity has to contend with surplus steel, may dump the metal here.
As for base metals, the scene is becoming gloomier by the day. Aluminium cash settlement price on the London Metal Exchange (LME) peaked $3,291 a tonne on July 11. But as demand waned in the wake of slowdown in real estate and automobile industries and speculative positions got rapidly liquidated, the metal is now trading at around $1,860 a tonne.
JPMorgan Chase estimates that the world average aluminium cost ranges from $2,600 to $2,700 a tonne. No wonder then that we are seeing the closure of high-cost smelters across the world. In about four months, the value of copper is down from a record of $8,940 a tonne to $3,625 a tonne, basis three-month delivery.
LME nickel and zinc prices have retreated equally alarmingly for producers leaving the current prices below the average break-even cost, including depreciation and interest charges.
Real economy downturn must necessarily take its toll on the commodity market. At the same time, the continuous unwinding of futures positions by hedge funds is pushing prices lower and lower, perhaps more than what fundamentals warrant.
The reality is that in the current global economic environment, shifting out of commodities makes sense for fund managers. We have been seeing how disinvestments in commodity index-linked securities and derivatives based on AIG-Dow Jones Commodity Index have been gathering pace since July.
Around the same time, industrial commodities started getting the attention of speculators, banks saw an opportunity of making good money in commodity trade. A good number of banks opened desks for both trading in commodities and financing third-party transactions.