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Inventories, not other markets, drive commodities
August 22, 2007 / 4:17 PM / 10 years ago

Inventories, not other markets, drive commodities

NEW YORK (Reuters) - Commodity investors hit by last week’s tumble in oil and metals prices as equity markets plunged should take heart that the asset class follows its own fundamentals in the long run, a market researcher said Wednesday.

“It is usual to see occasional periods where markets do move together,” said Gary Gorton, a professor at the University of Pennsylvania’s Wharton School and a member of the National Bureau of Economic Research.

“But when you look at the longer-term cycles, that’s when you really see the negative correlation between equities and commodities,” he said.

Gorton, who co-wrote “Facts and Fantasies about Commodity Futures” with Yale University’s Geert Rouwenhorst three years ago, said supply-demand over the long term matter more to commodities than short-term moves caused by financial markets.

Investors sold commodity futures across the board last week to help cover losses in equities and fixed income markets.

Gorton said these were just short-term measure.

“What our research shows is that inventory levels drive commodity futures returns. When inventory levels go down, long investors earn more,” he said.

After gaining almost 50 percent between February and early July, copper futures in London and New York gave back more than 10 percent over the last two weeks as a crisis in U.S. subprime mortgage loans ballooned into a global credit crunch.

U.S. crude oil, which hit a record of almost $79 a barrel at the start of August, is also down by more than 10 percent.

“One of the problems now is fear...fear that the subprime problems are worse than we know,” Gorton said. “We don’t know how big the problems are because we don’t know where the problems are. When there’s fear, markets can all go down, as in the Asian crisis for example.”

“But historically, in commodities markets, I’ve hardly seen a situation where all commodities futures were moving in the same direction at the same time,” he said. “The whole stock market can go down at a time, but we would not expect to see that happening to commodities as a whole asset class over an extended period.”

Gorton said institutional funds invested in commodities -- such as multibillion-dollar pension funds, mutual funds and endowments -- are seldom moved by the type of volatility seen over the last fortnight in the energy and metals markets.

“Generally, their concern is about understanding commodity futures as an asset class in order to make a decision about making a long-term allocation to this asset class,” he said. “They sort of think of it in the same terms as ‘should I make an allocation to private equity or should I make an allocation to emerging market equities?'”

“If they decide to make the allocation, then their decision about when to enter and how to enter as sort of a tactical question comes into play.”

Gorton said his research with Rouwenhorst showed one of the simplest ways of making money in commodities was to go long, or buy up front, when inventories are seasonally low, and go short, or sell forward, when stocks are high.

“If you do this as a portfolio and diversify it away to a large extent, our academic study indicates you would have made almost a free lunch, so to speak.”

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