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Commodities: Great, Then Ugly (Year-End Review Of Markets & Finance 2008)

January 5, 2009 at 10:59 by Andriy Moraru

The wild gyrations in commodities last year were a brutal reminder of how volatile and dicey this market can be, especially when the economy turns sour.

It was a classic boom-to-bust cycle. Prices that seemed to defy gravity in the first half had trouble finding a floor later in the year. Public uproar over rising costs was damped. As demand dried up, suppliers were forced to make painful production cuts. Investment gains that took years to build disappeared in just a few weeks.

All this is expected to leave a profound mark on commodities markets for years to come, and 2009 is expected to be another difficult year. The Dow Jones-AIG Commodity Index, a broad benchmark, finished 2008 with a 37% loss, the worst year since the index was launched in 1998. Oil fell 54% for the year to $44.60 a barrel, down $100.69 from its record settlement in early July.

Commodities kicked off the year on a strong note: On Jan. 2, the first trading day of the year, crude-oil futures touched $100 a barrel — the first time it had surpassed the three-digit mark — before settling at $99.62. With stocks weighed down by uncertainties about financial institutions’ subprime exposure, commodities gained favor among investors as an asset class they believed would help their portfolios weather the storm.

A rosy outlook for emerging markets like China and India, the primary driver of the commodities run-up for several years, kept traders flooding into the market. Investments that track a variety of commodities indexes gained 37% in the first half to $200 billion, according to the Commodity Futures Trading Commission.
Precious metals soared in March, in a flight to quality as Bear Stearns Cos., the nation’s fifth-largest investment bank, collapsed. Gold, a traditional investor safe haven, hit all-time highs of $1,003.20 a troy ounce and silver rose to $20.685 a troy ounce. Both platinum and palladium reached records in March, fueled by a severe power outage in South Africa that hurt production.

Corn and soybeans reached their all-time highs around late June due to severe flooding in Midwest, the U.S.’s main producing area.

Oil continued to move higher amid expectations that emerging markets’ insatiable appetite for energy would counter the economic slowdown in the U.S. Wall Street firms argued that global production couldn’t keep pace and one-upped each other with sensational forecasts. Goldman Sachs Group analysts shocked the market in May with a prediction that oil could reach $200 a barrel within two years. In June, Morgan Stanley called for oil to spike at $150 a barrel by July 4.

Morgan Stanley was close. Crude oil reached $145.29 a barrel on July 3, a 51% gain from the beginning of the year — the pinnacle of commodities’ 2008 surge.

Then the tide turned. Soaring gasoline prices in the summer led to less driving and had an effect on consumer spending. Politicians proposed legislation to curb speculation in the oil markets, which became an issue in the presidential campaign. Some market players were spooked by the prospect of stricter regulation and stayed away.

Entering the fall, commodities took another hit as the credit crisis worsened after the failure of Lehman Brothers Holdings. Prices of all assets plunged as hedge funds and investment banks liquidated their positions to shore up capital and reduce leverage.

Demand for basic materials weakened as the financial crisis spread and tipped the world economy into recession, and commodities’ downward spiral gained speed. Oil hit its low for the year, $33.87 a barrel on Dec. 19. The International Energy Authority predicted that global oil demand would shrink this year, for the first time since 1983.

The second half’s decline was so brutal that it wiped out gains commodities had accumulated since 2002. Oil hasn’t been around these levels since 2004. But some still showed gains. Cocoa jumped 31% and rough rice gained 13%. Gold rose 5.8%, its eighth consecutive annual increase.

“It’s very typical for commodities to have a late-cycle rally,” said Lawrence Eagles, head of commodities research at J.P. Morgan Chase & Co., speaking of the first half of the year. Although the U.S. recession began in December 2007, commodities rose for months before weakening demand besieged the market.
Many investors were new to commodities and rushed for the exits when prices started to tumble. “Some of the hedge funds had never experienced any substantial corrections in commodities, and they got caught up here, badly,” said Richard Feltes, director of commodity research at MF Global.

The commodities markets are likely to be even tougher in the coming year. Liquidity is a major concern, with the prospect of fewer players and tighter credit.

“We may see increased interest from end users hedging against price swings,” said David Goodman, co-head of global commodities at Merrill Lynch & Co. “This will not offset the gap left from the exit of several financial players.”
Worries about credit risk will continue to have an impact as lenders may require counterparties to post more collateral to guarantee transactions, which in turn will utilize more capital, Mr. Goodman said.
While demand continues to decline, there is evidence now that supply is contracting, leading some players to hope that prices may be close to bottoming out. Oil-producing countries, mining companies and steel mills recently announced massive production cuts, which could put a floor on prices.
But nothing is certain. On Dec. 17, members of the Organization of the Petroleum Exporting Countries agreed to slash another 2.2 million barrels per day from oil markets, but oil prices continued to fall and earlier announced cuts weren’t fully implemented.
The latest cuts were scheduled to take effect at the start of this year. It might take longer for demand to pick up and have an effect on prices. “The answer now depends on how long this recession will last,” said J.P. Morgan’s Mr. Eagles.

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