The year 2006 proved to be yet another memorable one for the commodity markets. Now the question is: Are commodities still a favorable option? Well, for starters, if you analyze net inflows data to U.S. commodity-linked mutual funds in the year to August 2006—a mere $107 million compared with $3.8 billion in the same period of 2005—then get out! If you believe there are more troubled hedge funds (yes, Amaranth Advisors) and that a number of major investment and pension funds are thought to have lost big money thanks to Amaranth’s bad bet, then indeed, stay away from commodities.

Many agree (though not everyone, including yours truly. But I’ll get to that later in the article) that the commodities bull market has landed upon difficult times and is suffering an arduous demise. Admittedly, gone is the chatter of $100 a barrel for oil. And now the $64,000 question is: Will $50 even provide a floor or will momentum carry it through there too?

What’s On Tap Next?
So what’s going to happen in 2007? At this writing in late October 2006, most commodity sectors are very oversold and due for a moderate recovery. The CRB Index itself is probably no exception, as it has already fully realized a bearish price objective below 300 (currently back above it) following momentum readings that had been negative for seven weeks. (The average time a chart displays negative momentum is eight weeks.) Therefore, some buying has indeed emerged but the negatives outweigh the positives from a multi-month technical standpoint, suggesting that another trip below 300 is likely.

We’ll begin with crude oil. The news in August 2006 that British Petroleum was going to have to shut down its Prudhoe Bay operations caused oil to jump $2 in one day to $77 per barrel. Yes, that was a big move but the news was not enough to push oil to a new high. In fact, the price of oil actually turned lower the next day, and has since fallen nearly 25 percent from its high. If world oil supplies are as tight as they say they are, and if demand is as strong as they say it is, one would have expected news of the shutdown (remember, this is four percent of America’s output) to have caused the price to really start to run away. Moreover, the BP news came at the time of peak tensions in the Middle East, yet oil still could not manage a decent rally. From a bullish standpoint, something here is not right. Remember in 2005 the price of oil peaked just when the news looked the worst, right when Katrina hit. But here we are again, almost 18 months later and prices are down sharply. At this writing, winter is still some months away but it looks as if no major price hikes will be seen. This being said, for the last few bulls left in the bullring, I must warn you that forecast prices are suddenly dropping. Some oil projections have slid from an average of $73 a barrel to $68.50 to $65.50 in 2007. We are in the camp that crude oil will carve out an average price of $62 in 2007. See Figure 1.


click image for larger view

A Look at Copper
We are all aware that as the economy starts to overheat, the price of copper goes up and puts a damper on economic activity. Copper is used extensively in building. We do not need to be reminded of where the U.S. housing market is going. When we see copper topping out, the end of the expansion is near. Commodities cannot rise on speculation alone. The boom relies on a continued economic expansion to make it real. Technically, however, copper does not look as unhealthy as many other commodities (which also puts a question mark over recent recession fears), so it can be given a little more rope. This theory, however, would be enhanced only if it can manage an upside break at $4.16. Barring such a performance, we would use a weak rally that falls below that level to lighten up on copper exposure during at least the early part of 2007. In fact, copper broke down and violated a trendline that saw the price move from $.60 to over $4.00, a bullish trend that had been in place since October 2001. After copper reached its $4.16 peak in May 2006, it sold off more than 25 percent in June to $2.97. The subsequent bounce up to the $3.40-$3.60 range was never able to regain the momentum it had earlier in the spring of 2006. With such moves, consolidation around the mid-point of a trading range is typical action, but if we don’t see a meaningful push from here—preferably to new highs—then any bounce from here is likely to fail. That said, we are likely to see an average price for copper around $2.80.


click image for larger view

All That Glitters…
What about gold? Gold peaked in May at $732, in the heart of the commodity boom pricing that saw no shortage of predictions for $1,000/ounce by the end of 2006. Commodities have a long history of moving up and down dramatically, something investors were reminded of in the summer of 2006. Certainly, a slowing economy and thus reduced inflation expectations have played a part in gold’s recent pattern of lower highs and lower lows but its recent move to $563 should be considered particularly bothersome. Gold’s move below $600 violated a bullish support line, which is an important signal to keep in mind. This same trendline had been in place since October of 2001. In addition, the relative strength of gold versus the S&P 500 weakened significantly in early September of 2006. Further declines in gold or strength in that broad U.S. stock market index would suggest that a more aggressive move out of gold might be in order. While gold is deeply oversold on a shorter-term basis and a bounce could occur anytime, a move into the $625-$650 range would likely amount to a timely opportunity to roll out of some gold exposure. Look for gold to average $575 in 2007.

Is It Sweet?
Let’s take a look at sugar because it is an interesting story among softs. It has performed very well, hitting a 25-year high of $20.10 in March 2006 because of the huge increase in ethanol demand. Indeed, the market has been viewing sugar as an energy play. (By using sugar to produce ethanol, Brazil, for example, has been able to wean itself off imported oil, and is completely energy independent). But move forward to October 2006 and see that sugar is down nearly $10 from its peak. Why? Well, because the price of oil is under control. It’s high, yes, but it is not running away to $100 per barrel and beyond. Sugar prices began their collapse in early July. If the market has been viewing sugar as an oil substitute, then we should not be expecting $100 oil anytime soon, and the rally in sugar is clearly finished. We look for sugar to carve out an average price of $15 in 2007. See Figure 3.


click image for larger view

The Big Picture
So it appears that for the most part many commodity sectors (i.e. energy, metals and softs) are likely to put in poor performances in 2007. But I would be remiss if I did not opine on the outlook going beyond 2007. This is where I quickly break from the bear camp and venture into the woods on my own.

It’s not too late to continue to profit from commodities in the years ahead. We are still likely in the first half of a long-term bull market. To this day, commodities of all sorts are still in the midst of major economic imbalances. Global demand for both soft and hard commodities is on the rise and supply is struggling to keep up. It is the prudent investor or speculator who is able to recognize this pattern before it corrects itself and is able to leverage his/her capital to take advantage of the upside. Prices have been slipping recently, but the commodity bull market relies primarily upon powerful secular trends, one of which remains very much intact: Strong global demand. This trend is very different from the trend that depressed commodity prices throughout the 1980s and ’90s. But the new millennium has seen a complete reversal of fortunes for stocks and commodities, thanks to a complete reversal of underlying trends. In other words, the most important secular trend influencing the commodity markets has increased dramatically.

The current volatility in commodity prices raises the question of whether this is indeed a bear market or just a correction in a very long-term bullish trend. Historically commodity bull markets last up to 10-15 years and the odds are good that the bull market that began in 2001 has not yet run its full course. The important thing to remember is that no great bull market has been immune to such corrections. Even the NASDAQ in the 1990s and gold in the 1970s saw corrections of as much as 30 percent in the context of a longer-term trend higher. Brazil, Russia, India and China’s industrialization alongside rapid growth in the entire developing world will act as key forces to sustain structural demand for commodities, from steel to platinum and gold reserves to oil.

There are a number of factors driving the record gains in world commodities and materials prices but probably no factor is greater than the demand from China. Asia’s most populous country accounts for a rising percentage of worldwide demand in all commodities. To meet its growing consumer and industrial demand, China imports large quantities of gold, platinum, nickel, silver, oil, copper and iron ore. Now is the time to take advantage of the growth opportunities provided by China’s insatiable demand for these commodities and basic materials. For example, in 2003, Asia, with a population of about 3 billion, consumed 19 million barrels of oil daily. By contrast, 285 million Americans (now over 300 million) consumed 22 million barrels of oil a day, a per capita consumption more than 10 times higher. Led by China, which overtook Japan to become the world’s second-largest oil consumer after the United States, Asia’s demand for oil is growing steadily and should result in higher energy prices in the future.

Is There Really An Oil Top In Place?
Therefore, I ask you: Have oil prices really peaked? A 20 percent fall in the stock market or a 20 percent decline in house prices would be described as a crash or a meltdown. But for the oil market, such moves are more commonplace and should be viewed as corrections. In the spring of 2003, the oil price fell by 37 percent. In the period of September 2005 to December 2005 oil prices came off 22 percent. In both instances the prospect or reality of major supply disruptions caused feverish speculation in the oil markets, resulting in an oil price spike. The corrections occurred when these fears of supply disruption abated. The same thing happened in third quarter 2006; the markets were extremely nervous about prospective supply disruptions, only to find the imminent risks recede.

Moreover, China’s demand for precious metals continues to gain momentum with the opening of its gold market to retail investors. China’s culture has an acute affinity for secular and religious precious metal jewelry, which, when combined with increasing per capita consumption, will be a powerful engine for growth. Not only are gold and silver experiencing increasing demand, China now accounts for more than 50 percent of platinum demand worldwide, up from 30 percent in 2000. This growth largely comes from the popularity of platinum jewelry.

Meanwhile, in the Gulf of Mexico oil and gas production still has not fully recovered from hurricanes Katrina and Rita. And supplies were severely interrupted for months after the storms in 2005. If another major storm were to affect drilling operations in the region, supplies of oil and gas could be cut off once again, causing another shortage and spike in energy commodity pricing. Furthermore, real commodity prices are still low relative to their long-term trend, despite rapid increases in recent years. One example would be natural gas, which is selling roughly around 59 percent of Mexico’s crude equivalent value. Bottom line: The secular bull market in commodities remains intact.

Looking Across the Commodity Spectrum
Just some afterthoughts on the various major energy commodities such as uranium, crude oil, natural gas, coal, sugar and corn. Long-term technical trendlines and other long-term technical indicators for these commodities are still overall bullish, and there are some additional fundamental supply and demand considerations worthy of attention. Should the U.S. head into a recession due to a slowing housing market correlated to slowing consumer spending, which could likely translate into a slowing demand for energy commodities, energy commodity prices could still go up if the decline rate in supply exceeds the decline rate of slowing demand.

This scenario in which prices rise even in a recessionary environment happened during the 1970s. In today’s environment, rising prices also reflect continued world growth as non-U.S. consumer consumption and spending continues to develop worldwide.

And if that scenario does occur, the supply of uranium, crude oil, natural gas and sugar will probably remain tight while demand continues to rise. Sugar is a common compound in ethanol production, and well over 50 percent of the global ethanol supply comes from it. Ethanol consumption has significantly increased over the years and demand is expected to continue to rise sharply in the years to come. As more and more countries are implementing ethanol as an alternate energy source, we are now faced with a likely supply deficit in sugar. And corn is not being used as extensively as sugar in the production of ethanol yet, largely because of such issues as bird flu concerns and large overproduction yields, but this is also likely to change.

Just Taking A Rest?
The commodity market’s worst enemy at the moment seems to be sheer momentum. Anxieties remain. Still, prudent investors must ask themselves whether the three-year-old commodity bull market has exhausted itself or whether it is merely taking a well-deserved rest. We favor the latter interpretation, knowing full well that we are entering a period of heightened volatility.