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Thoughts On Commodity Bubble

Oil Demand

Are commodities in a bubble? Surprisingly the Street is starting to question whether oil is in a bubble or not (most analysts are still bullish with some with short-erm crude oil targets in the $150+ range and long-term targets in the $80+ range). From an economic point of view, my view is that commodity prices are rising due to prices set at the margin. The price is being set by growing emerging markets and this is why some are bullish on commodities. Interestingly, I'm bearish because of the same reason. My view differs from the rest because I don't think the long-term demand projections make any sense. On top of environmental problems, a lot of people fail to realize that oil is heavily subsidized in precisely these developing countries that are used to justify higher long-term prices.

Today's Globe & Mail had a good news article today, picked up from Reuters, comparing government subsidies in developing countries. Let me quote the summary of who is bearing the cost:

(source: Pump pain hits drivers in Malaysia, India, by HIMANGSHU WATTS. June 5, 2008. The Globe & Mail (from Reuters))

COST OF SUBSIDY: About $500-million in January-May period.

GASOLINE PRICE: $1.50/litre
DIESEL PRICE: $1.22/litre
SUBSIDY BORNE BY: State-run oil firm Petroleo Brasileiro SA (Petrobras)

SUBSIDY BORNE BY: State oil company Petroleos de Venezuela SA (PDVSA)
COST OF SUBSIDY: No official figure. Estimates range from $10-billion a year to more than $20-billion a year. Government estimates 27,000 barrels per day lost to smuggling, costing some $1-billion a year.

GASOLINE PRICE: $0.69/litre
DIESEL PRICE: $0.59/litre
SUBSIDY BORNE BY: The government

GASOLINE PRICE: $0.67/litre
DIESEL PRICE: $0.70/litre
SUBSIDY BORNE BY: Top refiner Sinopec Corp., and upstream heavyweight PetroChina.
COST OF SUBSIDY: $1.37-billion payout to Sinopec in 2005; $685-million payout to Sinopec in 2006; Sinopec received about 4.9 billion yuan ($706-million) for losses in 2007, and 7.4 billion yuan for the first quarter of 2008.

GASOLINE PRICE: $0.645/litre.
DIESEL PRICE: $0.591/litre
SUBSIDY BORNE BY: The central government
COST OF SUBSIDY: $9.31-billion in 2007; $13.5-billion in 2008

GASOLINE PRICE: $0.833/litre
DIESEL PRICE: $0.796/litre
COST OF SUBSIDY: Malaysia is a net oil exporter and earns 250 million ringgit ($77.6-million) a year in revenue for every $1 rise in a barrel of crude. Domestic Trade Minister Shahrir Samad said earlier this year that fuel subsidy would cost the government as much as 56 billion ringgit this year, or about a third of government expenditure in 2008.

GASOLINE PRICE: $1.19/litre
DIESEL PRICE: $0.81/litre
SUBSIDY BORNE BY: Government, state-run upstream companies, and state-run retailers
COST OF SUBSIDY: not immediately available

Some of these, like Venezuela and Malaysia, are oil producers so we should just ignore them (it's sustainable to increase government spending on oil subsidies when your main industry is doing well). A lot of these countries are going to end up removing their subsidies. I can't see Vietnam, for example, spending 6% of goverment budget on subsidies (this estimate is mentioned in the full article). Unfortunately, although that is the right thing, it can potentially worsen inflation in the short term. I remember reading an article recently where it started off by saying that the Asian Tigers collapsed in 1998 due to an external problem (current account deficits and overvalued currencies), and now they may be done in by an internal problem. That internal problem is none other than inflation. If investors start discounting inflation then a lot of stocks and bonds in those countries are going to get crushed. So far nothing has happened and the bonds, which are very sensitive and less speculative than stocks, haven't shown any signs (although I will note that some illiquid stock exchanges like Vietnam are off almost 50%). If prices do collapse, foreigners may get a good buying opportunity. As Marc Faber has pointed out in the past, if you went into Argentina during its crisis in 2001, you could have bought assets at a very low price in US$ terms.

Sign of A Potential Commodities Bubble?

I may end up being wrong but how can I not be skeptical when I read something like this:

(source: Tiny miner swept up by potash frenzy, by ANDY HOFFMAN. June 5, 2008. The Globe & Mail)

What's a potash permit worth? About $38-million, judging by the stunning share price increase posted by Potash North Resource Corp. yesterday.

The junior miner, which was previously a shell company called Timer Explorations Inc., saw its stock climb 670 per cent on the TSX Venture Exchange in its debut as a potash play after disclosing it had won an exploration permit from the Saskatchewan Mines Branch.

Either the investment bankers severely underpriced this offering... or we are really in a mania stage. I wasn't around back then but one of the signs of the dot-com bubble was the performance of IPOs of no-name companies. Isn't this potash miner, which doesn't even have a mine and doesn't have the $2.5 billion supposedly required to build a mine, similiar to the unknown technology companies that rose sharply on their first day of trading without even having a viable business?

One thing that seperates commodities from other bubbles, such as residential real estate, technology stocks, biotech stocks, and so on, is that there isn't one single commodity and they have differing trends. Uranium was really hot a few years ago but it seems to have fizzled and may have entered a long-term correction judging from the price graph (but note that well-run corporations can do well even if prices are weak eg. Barrick Gold throughout the last 20 years.) Soft commodities are very popular right now, and related beneficiaries like fertilizer are popular.

I am pretty sure that when it's all said and done, Potash Corporation of Saskatchewan (POT) will end up being the poster-child (at least in Canada) for the commodities bubble. Potash Corp is battling to become the largest Canadian company (by market cap) and it doesn't make any sense to me. I don't know much about it but from what little I do know, my impression is that it is a well-run company with good assets. However, its valuation is based on extremely rosy scenarios and I don't think a $60 billion fertilizer company makes any more sense than what Nortel was worth (poster boy of dot-com bubble in Canada). It's a world leader but it's such a niche cyclical market. It's worth more than almost any Canadian oil&gas company, including the largest natural gas company in North America, Encana (ECA). However, momentum is on its side.

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