<<Does supply/demand as seen in production/consumption figures matter as much as we think?>>
The real rock bottom issue in setting commodities prices is inventory/consumption (I/C) ratio measured against the desired "normal working stock." Purchasing agents must provide sufficient inventory cushion to protect against various supply interruptions, e.g. mine strikes, smelter outages, shipping interruptions. etc. There's nothing quite so bad as shutting down the Mercedes production line for want of a radiator (brass).
The above has important seasonal variation so analysis must be seasonally adjusted - this takes out some of the mystery of short-run commodity price oscillation.
A declining trend in inventory quantity, by itself, does not lead to price increase. Its the difference between desired I/C ratio and the actual I/C ratio that counts. There are thresholds below which purchasing agents get really concerned and will accept, even offer, higher prices.
Against this "real world" there is the huge "paper market" such as COMEX, which is not a delivery market as is LME. The paper volume does provide a highly liquid market for industrial hedging but the paper, being a very public market price, will often reveal turning points driven by the buying patterns of the real industrial user as the latter is dictated by the I/C ratio. So, prices in the two markets may closely relate.
However, both markets can diverge for a variety of reasons such as poorly planned forward selling. Example; Newmont Gold desired to get off a 1 million oz. gold forward sale. They shopped it all around which had the effect of traders repeatedly hearing of a 1 mil. oz. offer. It seemed to traders that many mil. oz. were being offered and the gold price sank deeply out of proportion to the mere 1 mil. oz. sale.
Probably the biggest consideration with the paper market is the potential to build a major, retail investor short position at such time as supply/demand tightness has reduced the I/C ratio to the point of dipping below the threshold. Then, as the physical market price moves up, driving the paper market price up, the shorts are driven to buy in. Its the large size of the short position enable by the almost unlimited volumes in the paper market that can then yield a short covering-driven price advance far out of proportion to the long run equilibrium price of the commodity.
This creates the "spikes" such as $50 silver in Feb. 1980 or $1.50+ copper recently or $0.85 zinc just a few months ago.
Full understanding of the interplay between these two "markets" of any commodity can position us to catch the spikes for wild profits vs limited and readily defined risks, e.g. buying long calls on COMEX silver last winter to play the prospects that seasonal strength would move silver's price higher, knowing the supply/demand situation might also attract major hedge fund buying.
The situation jelled. WB (I thought it might be Soros) stepped in and, bingo, $6.00 COMEX options, bought at 15 cents, yielded a 10-fold gain a few weeks.
The silver play is just beginning because the I/C ratio isn't really critical yet - and might not be for a couple of years more. Imagine, though, what the price might do as silver users begin to experience actual shortages, hedge funds temporarily remove several hundred million ounces from the available supply and a large non-professional short position must be unwound. For some silver applications users will be willing to pay $50 - $100 per oz. because silver content is a small part of the cost of the finished product like an air-to-air missile and working out substitutes takes months or years so demand won't instantly evaporate.
The wild card will be the question of the timing of unwinding of hedge fund positions.
RH |
