Bubbles and Supply Shocks at the Commodity Investment World Conference

I spent the last two days at the Commodity Investment World Conference in New York. The general theme and tone of the conference was that the world has changed dramatically and unprecedented market "anomalies" were occurring. In fact most of the presentations were compiled three weeks ago and were grossly out of date, so most presenters went off the cuff.
A simple look at the Dow Jones AIG commodity index illustrates the massive dislocations in the market.

The index peaked in July of 2008 and has since fallen 53%- the largest move in the shortest amount of time since the index began. If you have not looked at the news in 6 months this chart is a surprise, however, even a casual glance at the front page of any newspaper tells you the financial world is in turmoil. Deleveraging resulted in unprecedented correlations occurring between all asset classes, while institutional investors were making irrational decisions to pull money out of well performing funds.

As the conference got through the "Chicken Little" stage there was some blue sky. Thierry Wizman of Fortis spoke about hedge fund withdrawals coming to an end. I asked him for some detail and he told me that the numbers he has seen suggest that hedge funds have raised upwards of 80% of the cash they will need for year end redemptions . This follows the anecdotal evidence that I have gathered from friends and colleagues at large funds. Almost all have gone to cash and are waiting for the new year before they start to re-invest. In fact, many have told me that after this week they are done for the year.

I also chatted with one of the conference organizers and asked him how conference attendance has been overall. He told me that they had seen a surge in interest over the last few weeks as institutional investors were looking for opportunities for the new year.

Supply Shocks

The second general theme was that sometime in the next 6 months to 2 years there will be a substantial supply shock in many commodities, especially oil. The credit crunch has caused rigs to shut down, infrastructure improvements to stop and high cost supply to be unprofitable. The two examples examined were the tar sands of Canada and crack spreads.

In western Canada, the cost to pull a barrel of oil out the tar sands is roughly $70, the highest of all production methods. This does not include deep water Brazil which has yet to begin. In this environment, any company that is perceived to have exposure to oil is being punished and cut backs will lead to supply shortages.

Further, the refiners are losing money from negative gas crack spreads. The gas crack spread is a measure of how much money per barrel a refiner makes by "cracking"oil and producing gasoline.

Currently the gas crack spread is negative and has been that way since the end of October. Obviously refiners will not be able to stay in business for too long if they continue to lose money on the products they produce. This unsustainable trend will likely cause refiners to shut down production and lead to a supply shock.

All in, the take away from the conference was that while the world has changed rapidly, ultimately it will begin to normalize. Eventually, the unsustainable trends will be recognized by market participants and fundamentals will once again become relevant. However, as long as the credit crunch continues look for the insanity to continue.

Disclosure: I am short SLV.