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Saturday, June 06, 2009

How easy money feuled another round of commmodities speculation

WSJ reports:

With oil inventories high and demand down year on year, yet prices surging, "fundamentalists" are puzzled. Market participants, however, always have an eye on the future and locking in a profit.

Recently, commodities bulls have been aided by the Federal Reserve keeping rates low and banks' short-term funding flowing. This facilitates commodities trading and stokes fears of inflation. As cash flows into oil futures, their prices rise relative to spot prices. That makes it profitable to buy physical oil, store it and sell it forward.

Energy economist Phil Verleger demonstrates how lucrative this can be. On March 1, the cash price of light, sweet crude was $40.15 a barrel, while the 12-month forward contract sold for $50.26. Assume an investor bought the physical barrel borrowing 80% of the money at a rate of 3%, sold it forward, and paid 50 cents a month for storage. The resulting profit of $3.15 a barrel equates to a 39% return on investment.


[crude oil chart]

In reality, financing and storage costs aren't static. As spot prices have risen faster than futures, the spread has narrowed and the volatile trade recently turned unprofitable: On Friday, the return was zero.

Rapid liquidation of inventories could crash prices. Financial-services provider GaveKal puts global commercial inventories at six billion barrels. Crudely calculated, that is more than $400 billion of precious working capital tied up.

Yet oil has held up. Inflation fears aside, the "green shoots" thesis also lends support, although this is self-reinforcing: The more optimism on the economy, the more oil prices rise, fueling more optimism. On that reading, last July's $145 a barrel should have betokened eternal prosperity.

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