Will Bin Laden’s Death Burst The Commodity Bubble?

by Peter Cohan | May 2, 2011 1:40 pm

News of Osama bin Laden’s death is driving investors to sell commodities like oil and gold. And if it speeds up a political consensus that it’s time to withdraw American troops from Iraq and Afghanistan, it could be the trigger that bursts the commodity bubble.

To profit from that bursting commodity bubble, consider shorting three commodities exchange traded funds (ETFs). Why? With near 16:1 rates of borrowing to buy over-priced commodities, the peace dividend that could result from bin Laden’s death would boost confidence in the dollar and send commodities prices plunging driven by traders who sell to repay all the debt they took on to inflate the bubble.

Commodity prices are trading far above their historical averages. For example, the average price of barrel of oil between 1946 and 2011 was $18.94[1] a barrel and between 2001 and 2011, oil averaged $57.02 – it now stands at $112 — nearly twice the decade average. And the average price of gold between 1900 and 2010 was $157.07[2] an ounce — it’s now $1,576, ten times that long-term average.

Thanks to ETFs, a massive volume of retail cash has flowed into these commodities. As I wrote last December[3], for example, the SPDR Gold Trust (NYSE: SPDR[4]) has piled up $57 billion in consumer assets since it was founded in November 2004. That despite weak long-term returns. Wharton professor, Jeremy Siegel, notes that gold has total annual real returns of just 0.6% since 1802 — stocks, at 6.6% are much better investment performers, as are bonds at 3.6% and bills at 2.8%.

Despite price increases in many commodities, the supply and demand for many seem to be in balance. For example, in April 2011, the global demand for oil was about the same as it was in 2010 — at 87.8 million[5] barrels a day while supply fell a slight 700,000 barrels per day, or 1%, to 88.3 million barrels/day — hardly enough to justify the $30 a barrel rise in prices since February.

However, with demand down a million barrels a day due to Japan’s shuttering of 29% of its oil refining capacity since the March 2011 earthquake, while Saudi Arabia makes up for the loss of supply from Libya, all it would take is a withdrawal of Wall Street cash from the oil trade to get those commodity prices heading downhill fast.

This recognition could spur more warnings from Wall Street banks that it’s time to sell. After all, on April 11, Goldman Sachs (NYSE: GS[6]) called for traders to pull out of a long position in oil. This call came as hedge funds and other financial traders held “a total net-long positions in U.S. crude contracts equivalent to a near record 267.5 million barrels,” according to Reuters[7].

The rise in gasoline prices towards $5 a gallon is destroying demand. For example, in Michigan, despite limited public transportation, interest in carpooling through a local agency is up 25% and bus ridership through its SMART public transportation system is up 4%, according to The Detroit Free Press[8].

If hedge funds decide that the resulting drop in oil demand is a sufficient reason to take Goldman’s advice, the result could be a wave of institutional cash outflow from the commodity trade. After all, oil speculators who control 81%[9] of trading on the commodities exchanges only have to put up 6%[10] of their own money to control an oil contract, they borrow the other 94%.

This 15.7:1 ratio is short of the 30:1 that typified Wall Street bets on mortgage-backed securities that led to the financial crisis. But it still means that a small decline in the value of an oil traders’ position would trigger a margin call which would require the trader to raise cash fast to repay the debt. And that commodity selling could make those retail commodity ETF holders head for the exits as well.

Three commodity ETFs that could lose ground are United States Oil Fund (NYSE: USO[11]), SPDR Gold Trust, and iShares Silver ETF (NYSE: SLV[12]). The common theme underlying the rise in these funds is the use of borrowed money to buy commodities and to sell the dollar short, creating a powerful upward momentum in the prices of these ETFs. One of the popular sales pitches for these trades is the debasing of the dollar thanks to Federal budget deficits and rising national debt. But the peace dividend from bin Laden’s death should make a big dent in that deficit.

And when traders start selling commodities to repay their high levels of debt, there could be an earth-shattering sonic boom that drives down the prices of those ETFs.

Peter Cohan has no financial interest in the securities mentioned.

Endnotes:
  1. $18.94: http://forecastchart.com/forecast-crude-oil.html
  2. $157.07: http://www.gold.org/investment/statistics/prices/
  3. wrote last December: http://srph.it/gAPGay
  4. SPDR: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPDR
  5. 87.8 million: http://omrpublic.iea.org/
  6. GS: http://studio-5.financialcontent.com/investplace/quote?Symbol=GS
  7. Reuters: http://ca.reuters.com/article/businessNews/idCATRE73A7YN20110411
  8. The Detroit Free Press: http://www.freep.com/article/20110501/BUSINESS06/105010455/Is-5-gallon-coming-soon-?odyssey=mod%7Cnewswell%7Ctext%7CFRONTPAGE%7Cs
  9. 81%: http://www.dailyfinance.com/2011/03/04/high-oil-prices-regulate-speculators-spr/
  10. 6%: http://www.americanprogress.org/issues/2011/04/oil_roulette.html
  11. USO: http://studio-5.financialcontent.com/investplace/quote?Symbol=USO
  12. SLV: http://studio-5.financialcontent.com/investplace/quote?Symbol=SLV

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