Watching investors as commodities slide

Commodities - the stuff that feeds us, runs our cars, heats our homes and provides the basic materials of everyday life - recently enjoyed one of the great bull runs of modern investment history, nearly doubling in price in the space of a year.

In the past month, though, prices of a wide range of commodities, from oil to corn to copper, have come back down with a vengeance as the global economy cools. We now know that the commodities boom was another bubble, not that much different from technology stocks in the 1990s and real estate earlier in this decade, market pros say.

"The recent bull run in commodities was based more on investment demand than the fundamentals of the world economy," said William Berg, president of Sigma Investment Management in Portland, Ore

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But there's one great difference. This was a bubble that picked the pockets of ordinary people around the world, be it a suburban mom in the United States paying $4.50 a gallon to fill her minivan or a laborer in Pakistan unable to buy rice or bread to feed his family.

Prices in the commodities markets are not just matters for investors. They quickly find their way into the retail cost of food, fuel and building materials. The United Nations has calculated that in recent months an additional 50 million people around the world joined the ranks of those whose health suffers because they can't afford food, notes Sophia Murphy, an analyst with the Institute for Agriculture and Trade Policy, a group critical of agribusiness.

The markets "have a very immediate and negative impact," Murphy said. "They exacerbate peaks and troughs. In the long run, they have less of an impact than in the short run. But in the short run, people die."

From the summer of 2007 through the beginning of July, the entire gamut of traded commodities, with few exceptions, shot up in price. Crude oil nearly touched $150 per barrel at the beginning of July, up from $70 the year before. Wheat soared 125 percent from August 2007 to March 2008. Natural gas, corn, copper and soybeans traced similar courses.

Supply and demand by themselves can't explain price jumps of those magnitudes, market pros say. They acknowledge that real-world factors are vital and usually are what set trends in motion. Yet despite talk of peak oil, global food shortages and China's growing appetite for raw materials, a significant portion, some argue a majority, of recent commodity price increases stemmed from investors searching for profit.

No huge jump in oil use

Take oil, for example. In recent years, world demand for petroleum has been growing by a few percentage points annually. But that incremental gain led to oversize movements in the marketplace.

"Did you see a huge increase in use of petroleum products? No," said Philip Gotthelf, president of Equidex, a New Jersey commodities trading firm. "Did peak oil happen? No. We didn't have a crisis that warranted this $150 oil."

All the same, if the commodity investment markets are behind much of the price run-ups, the story can't be boiled down merely to one of greedy speculators. The matter is more complicated than that, both technically and morally. It's not just super-rich hedge fund traders who play in commodities. Pension funds, universities, foundations and other conservative, long-term institutional investors have jumped into the market in a big way.

By March 2008, investors worldwide had sunk more than $400 billion into commodities, up $70 billion from the beginning of the year and twice as much as in late 2005, according to the International Food Policy Research Institute, a nonpartisan Washington think tank.

Specialized funds

Changes in the market encouraged the trend. Traditionally, commodities changed hands in what are called futures markets where participants buy and sell contracts to take delivery of bulk quantities of heating oil or aluminum or pork bellies months or even years in advance. These contracts, sold in exchanges that are home to the familiar clamoring, wildly gesticulating traders, are highly volatile and risky.

Historically, the main participants in the market were farmers and businesses that produced or consumed commodities and wanted to control the prices at which they bought or sold. In addition, speculative investors, such as hedge funds, made bets on which way prices would go

.

To make commodities palatable to a broader range of investors, brokerage firms created specialized funds in recent years that allowed investors to buy shares in a range of commodities. That opened the market to nontraditional investors

For example, the California Public Employees' Retirement System, the largest public pension fund in the United States, started a pilot program to invest in commodities in 2007. It says commodities now make up less than 1 percent of its portfolio.

All that new money pouring into the market put intense upward pressure on prices. "The impact of those folks coming onto the scene was greater than the effect of speculative investors," said James Greenleaf, a finance professor at Lehigh University in Bethlehem, Pa.

What really jolted the market though was the subprime mortgage crisis that erupted last summer. It slammed stocks and devastated the vast market for securities backed by home loans. The trading desks of major banks and hedge funds saw salvation in commodities.

"People in the know saw that paper assets stocks and bonds would get into serious trouble," Gotthelf said. "They figured the only safe haven was tangible assets. There was a complete panic out of paper and into physical assets. They moved not for speculation, but for protection."

As the months wore on, investors threw ever-larger sums into commodities, even as evidence accumulated that the global economy was slowing and demand for fuel, food and metals was slackening. The inevitable result was the crash of recent weeks, after worldwide economic weakness became too overwhelming to ignore.

"These things always run their course," said Edward Meir, an analyst with MF Global, a commodities brokerage firm. "After a while, the trend stops going one way. This time, it turned around with particular vengeance."

The shift will bring some relief to consumers, who are already seeing gas prices fall. Food prices should ease as well.

"I wouldn't be surprised if this commodity effect lowers food prices, maybe in the fourth quarter," said Daniel Sumner, director of the University of California Agricultural Issues Center at UC Davis.

Now a political issue

No one knows where commodity prices will settle. But even the most optimistic forecasts predict that prices will stay above historic levels, suggesting that $2.50 per gallon gas and cheap grain aren't in the cards.

But the wild ride of commodities has had one clear result - it's made the markets a political issue. Democrats in Congress have called for controls on commodity trading as a way of easing gas prices. Critics say it's far from clear that such regulation is workable and could interfere with the important economic role commodities trading plays for farmers, airlines and other traditional market participants.

As for the real speculators, most will live to trade another day.

"They're all momentum players," Greenleaf said. "Those people do not like to stand in front of steamrollers that are running downhill. They all can turn on a dime."