Supply and Demand

Here's a quote from today's WinterWatch blog written by Russ Winter. Russ, in turn, got his quote from Michael Masters' testimony on commodity speculation before the U.S. Senate.

In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion to 2.8 billion barrels, and increase of 920 million barrels. Over the same five-year period, Index Speculators demand for petroleum futures has increases by 848 billion barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

So, there goes the lie that commodity prices are a result of demand. I believe that this bubble will continue to get bigger and bigger as long as the US dollar is weak and real interest rates are negative. This is an extremely vicious cycle, because negative real interest rates are an almost worldwide phenomena. Real rates are negative in the US, Russia, China, India, Japan, and most of the developing world. I believe that the rapid flight into commodities is a result of CB money printing that has been out of control for at least the last five years.

However, bubbles make me uneasy, because they always implode at some point. My first thought is that the bubble implodes when the dollar strengthens. My second thought is that this bubble is getting so big that it will actually contribute to the dollar's plunge, as the crack-up boom further affects the US economy, contributes to a psychology of dollar worthlessness, etc., etc.

So, how do I play this? I believe that the most basic goods have the most potential, as price inflation in other basic resources will raise the costs of production of all goods. The only way to win is to invest in goods whose price rises faster than the price of production. This leads me to companies like RIO, POT, the commodity indexes themselves, coal companies, copper, etc. If congress acts to crush speculators, the short-term panic they cause will be a golden opportunity to find a few bargains in this trend.

In related news, Mish shows how PPI shows Enormous Squeeze On Profits. A picture being worth a thousand words, here's a chart illustrating this:

Here's the data in numerical form. For 2007, raw materials rose 13.1% while finished goods only rose 4.2%. So far in 2008, raw materials prices have risen 18%, vastly outrunning the 2.7% pace of finished goods. Mish sees a huge profit crunch coming.

Also, as a general rule of thumb, any ETF should contribute to its own success.