Commodities: Investment funds get back to basics

INVESTMENT funds have been moving selectively into commodities this year, encouraged by the many prophecies that the only way for prices to go is up. And true enough, half a dozen or so markets have hit their highest levels for several years within the past few weeks.

At the beginning of 1994, when so many raw materials were seen as ridiculously cheap after a long period of sluggish global consumption growth and over-production, the potential for profits from a stake in commodities was reckoned to be huge.

Not only were other economies forecast to follow the US recovery, which would be good for demand, but production was also turning down after being reined in following years of barely profitable prices, or hit by bad weather.

At the same time, other investments, such as stocks and bonds, were losing their attraction and interest rates were falling.

After years of neglect, commodities are enjoying a revival. 'This is one of the most bullish periods we have seen for some considerable time, even better than the late Eighties,' says Lawrence Eagles, commodities analyst at futures brokers GNI. 'The outlook for pretty much the whole complex is bullish.'

It is a view shared by Alec Gordon, senior commodities analyst at the Economist Intelligence Unit, a private business consultancy. 'Broadly speaking', he says, 'the cyclical downturn is over, although there are exceptions'- as crude oil's and wheat's recent poor performances show.

Opec's failure to cut production last week sent Brent blend tumbling to just a whisker away from February's five-year low of dollars 12.90 a barrel.

In many markets, the growing involvement of speculators and investors is making for increasingly volatile trading. A herd instinct can quickly develop as they follow the trend, often making investment decisions on computer-based trading systems that have little to do with the fundamental supply-and-demand picture.

This can take a market dramatically up, and just as sharply down, all in a matters of days. The recent gyrations of some metals reveal just this.

But it is not only 'outsiders' that have been buying. Traders and manufacturers are also more active today, seeing sense in stocking up a little after years of hand-to-mouth market operations.

For them, fundamentals are what count and almost everywhere they look they see that stocks available to the market are falling.

Yet for many commodities - especially base metals, coffee, cocoa, rubber, wool, sugar and cotton - the drop is from very high levels. And existing inventories still provide a nice cushion against the developing production shortfalls. There is also a risk that further price gains may reverse the trend to lower output, while structural changes - such as the planting of high-yielding hybrids and new technologies that have cut the use of metals in many applications - are also a check on upward price momentum.

Patchy demand growth and prevailing high stocks explain why many analysts do not foresee the potential in 1994 for an across-the- board boom in commodities on a par with the surges of the early 1970s and early 1950s. Prices of base metals may be up by about 20 per cent on average, but from a very deep trough. Last autumn, copper, aluminium, nickel, tin and zinc were at their cheapest for some decades, and all are still well down on past peaks. The outlook is also less than brilliant.

'The disproportionate demand- side boost evident during the early stages of an economic recovery has already occurred in the US. And while demand will continue to grow, the rates experienced in 1992 and 1993 are simply unsustainable,' says Angus MacMillan, analyst at Billiton-Enthoven Metals.

Meanwhile, Japan, Germany and most of the rest of Western Europe have yet to show an improvement in industrial output - the main driving force behind metal consumption.

The key to base metals, many argue, is held by the producers. But will the production cutbacks on the scale already planned really materialise for aluminium and will zinc smelters likewise introduce the restraint that the experts say is needed?

On the demand side, textile activity is picking up from last year's very low operating rates. Meanwhile, the US motor industry has been stepping up purchases of rubber - 70 per cent of world output in rubber is now used to make tyres. Yet much more influential in recent price gains - which have seen rubber at a five-year peak and wool and cotton at their best levels for several years - has been the prospect of market deficits this year because of production setbacks.

Conversely, a downturn in output after many years of over-production is behind the highest wholesale coffee, cocoa and sugar prices for about four years. Sporadic buying by investment funds has helped give these markets a leg-up, with coffee separately boosted by the producing countries' successful export retention scheme.

Rising raw material costs are inevitably stoking fears of inflation, which have encouraged some buying of gold - the traditional hedge. But falling oil prices have taken the edge off gold's rise, with the metal yet to break above last August's three-year high of dollars 407 an ounce.

In contrast, other precious metals are doing noticeably better, with platinum up on worries about South African supply lines and silver jumping a week ago to a five- year high of dollars 5.75 an ounce. It is traditionally the investors' favourite, because its low unit cost - one-sixtieth of gold's - makes it a relatively cheap way into commodities.

'In the US if you think commodities and inflation are going to take off, you buy silver,' says one dealer. Investment funds have been doing just that, encouraged by the fact that the use of silver - which, like platinum, is much more an industrial metal than gold - has begun to exceed newly mined supplies.

But silver stocks are huge and some of the more extravagant price forecasts for it are beginning to look a little dubious - something that may be true for commodities generally.

(Photograph omitted)