Commodities Bubble Will Burst Soon

04/08/2008 12:00 am EST

Focus: MARKETS

Knight Kiplinger

Editor-in-Chief, The Kiplinger Letter, Kiplinger's Personal Finance, and Kiplinger.com

Knight Kiplinger, editor-in-chief of The Kiplinger Letter, says that commodities prices have been driven up in a speculative mania, and what goes up must come down.

Another bubble will burst soon. But this time, it’s all for the better.

Commodities are unsustainably high—way out of whack with supply/demand dynamics. And the day of reckoning isn’t far off. The froth in oil—about one-quarter of its current $105-a-barrel price on the futures market. Copper is a good 35% above logical levels; platinum, 30%; tin, 50%; nickel, 25%; zinc, 20%, and corn, 15%-20%.

What’s behind the commodity bubble? Mainly investors chasing high returns. They’re pouring cash into commodity futures, because other choices seem less attractive. The Standard & Poor’s 500 lost 10% in the first quarter, its worst quarterly performance since 2002. Interest rates keep falling, and the dollar is hitting record lows. And no one can guess when home prices might hit bottom and rebound.

Commodity gains add to herd behavior. With every price spike, more investors jump in, afraid they’ll miss the score of a lifetime. Hedge funds and other big investors do most of the speculating. But more little guys are also getting in on the act by buying exchange traded funds. ETFs trim the risk some by diversifying, are easy to get into and out of and have a much lower admission price.

Our best estimate is that the balloon will deflate by midsummer. A number of factors could do it in: A cut in worldwide commodity demand, big stock market gains, a more stable dollar, or tame inflation signals. Prices will drop by about 30% if all these factors come into play at once, but declines will be smaller and gradual if signals are mixed.       

Oil will slide to $85 a barrel, with a smaller reduction at the pump, because risk is still a factor. In any case, the bottom isn’t going to fall out of the commodities market. Supplies are tight, and demand for many products will remain high, particularly with growth in China and elsewhere.

One glaring exception to the commodity bubble: natural gas. Industrial, heating, and other demand is sure to remain strong, and prices, currently around $9 per million British thermal units, may top $10 per MM Btu next winter. Natural gas supplies are roughly adequate for normal weather, but harsh conditions are likely to cause real stress. Fading quickly: Hopes that liquefied natural gas (LNG) will increase supplies. LNG is going to Asian and European buyers, who are outbidding US ones.

The bubble’s pop will be good for businesses and for other regular buyers of commodities. So, put off major purchases if you can. The pain will be limited to big speculators and small investors who failed to diversify—plus producers who’ll lose outsize profits.

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