Why commodity prices rise together with inventories?

Posted on 18. fév, 2010 by Jean Jacques Ohana in Weekly Focus | Commentaires fermés

In traditional commodity cycles, commodities prices tend to rise when inventories decrease and conversely drop when inventories increase. This mechanism is highly intuitive since when inventories are rising (resp. declining), we can infer that the supply is large (resp. low) in face of demand, which translates into a downward (resp. upward) pressure on prices.

The traditional commodity cycle decomposes into the following phases:

  1. Inventories are above average and commodities prices are lower than their long-term mean. The supply is gradually reduced by producers since producing is unprofitable, but there is still an excess of supply in the market, which can only be absorbed by further storage injections. The forward curve displays an increasing contango (contango refers to the spot price being below the forward prices for deferred delivery), a situation which reflects the increasing inventories and encourages further storage replenishments. We then get to an inventory peak and price bottom.
  2. As the supply is reduced and the demand boosted by the low spot prices, inventories deplete, reflecting an upward pressure on prices and progressively shifting the curve  from contango to backwardation (backwardation refers to the spot price being above the forward prices for deferred delivery). Increasing backwardation accompanies the depleting inventories and encourages the storage withdrawals which are required to absorb the excess of consumption.
  3. When prices get higher, the supply is gradullay increased as producing the raw material becomes more and more profitable. Then, the forward curve progressively flattens from backwardation to contango. Eventually, inventories rise again and the cycle resumes in phase 1.

This price process has been clearly observed on copper prices and inventories during the 1990’s,as shown by the chart below. Logically, speculators should buy raw materials when inventories are being depleted below their long-term average, i.e. when the forward curve enters in backwardation and should sell commodities when inventories are being piled up above their long-term average, i.e. when the forward curve enters in contango.

In the years 2000’s, China emerged as a major player in commodities markets. For instance, China produces in 2010 45% of worldwide steel production and still expands production by 10 to 20% per year. This new economic context has provoked unprecedented downward pressures on inventories and has triggered a change in the fundamental value of depletable commodities in the long run. The declining dollar, the replacement of the huge dollar reserves with gold and base metals by OPEC and other exporting countries and the massive arrival of long-only investors into commodities markets have finished  to break the traditional commodities price/inventory cycle.

The recent sharp prices increase went together with large inventory piling ups. The chart below highlights the broken relationship between prices and inventories:

And the inverted relation between inventories and prices is generalizing across all base metals, the relation being even more disrupted for Aluminium and Nickel.

How can we explain this unprecedented phenomenon? Many speculators have invested in the commodities complex by buying commodities futures and rolling to the following maturity contract before the previous expires so that there is no physical delivery. According to Riskelia’s estimates 200 Billions USD are presently managed through commodities indices and we can estimate the weekly cumulative net inflow to commodities indices (see the chart below representing the cumulated inflow):

These massive inflows distort the forward curve to contango, as they produce an excess of demand for forward contracts over prompt delivery contracts. In turn, this sharp contango prompts physical players to execute the cash and carry arbitrage which mechanically leads to increase in inventories. This massive contango has been observed in agricultural and energy markets since storage is costly and limited. Base metals markets have been more often in contango but the magnitude has been contained since storage capacity is not costly and virtually unlimited. Commodities investment has been strongly tilted toward base metals as they are the most related to Chinese growth and contango has been less penalizing for metals than for energy and agricultural commodities. This is corroborated by the massive increase in base metals dedicated ETFs and also by the sharp rise in Managed Money and Swap Dealers positions released by the CFTC for the Copper traded in New York (now accounting for 30% of the Open Interest):

Going one step further, a natural question is: who can sell against the massive long-only futures speculators while copper prices rose by 140% in 2009? Certainly not bearish speculators, who cannot maintain a short position for a very long time in such a bullish context.

Only physical players may have sold futures against index or ETF players. There are two types of such players: producers and storers. Producers may have an incentive to sell their production forward,  securing a high selling price and possibly rolling this short position to take advantage of the contango. On the other hand, storers may have stockpiled metals and executed the cash and carry arbitrage to benefit from the contango.

A new market equilibrium has settled since the emergence of commodities as a new investment class: stockpiling is not meant any more to absorb temporary excesses of supply but instead to physically back long speculative financial positions. As a result, simultaneous prices and inventories increases become a realistic scenario that can last much longer than people think.  But this new equilibrium is fragile: if speculative positions are quickly unwound, which has already occurred in fall 2008, the resulting supply overcapacity will automatically lead to a price collapse. In brief, this new generation of passive commodities “investors” has considerably enlarged the set of possibilities for commodities prices. Commodity investors, producers and buyers will have to learn how to navigate in these turbulent waters.

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