Consumer Demand Destruction

It’s Labor Day weekend, and yes, I’m thinking about stocks. Actually, not that much, because I’ve been thinking about this month’s topic for several weeks now.

Back in early- to mid-July, the market for commodities turned. Up until that time, the predominant trade had been sell the financials, buy commodities. And suddenly, the commodities rolled over. Take a look at the following ETFs (Exchange Traded Funds) that track various commodities. You’ll see that on July 1, 2008, all the ETFs were close to their year highs. By closing on Friday, 8/29/08, all had dropped at least 10%, and the natural gas ETF was down more than 40%.

If you own these, or rather if you still own these, you’re not a happy camper. I don’t mind telling you I had no idea when the top in commodities would be, or when this “great unwind” would occur. I have voiced concern in previous articles, and expected a turn, but really couldn’t tell you when. That’s because I don’t really have a background in commodities.

All the more reason, then, to ask the question that all investors should ask – “ is there a way we could have known? If you look at the charts of these ETF’s, many had started declining before July 1st. So obviously, somebody knew (sadly, nobody I know).

I believe that a large part of investing is knowing what signs to look for. So I couldn’t resist compiling a list (for the next time, of course). Now, this is by no means a comprehensive list, and it is by no means a guaranteed list. These are just ideas of potential red flags that signal changes in commodities markets.

Consumer Demand Destruction

Let’s start with one of the most basic indicators – “ demand destruction, especially in oil. As we rolled further into summer this year, statistics were showing that consumers were beginning to pull back on oil consumption. According to the Energy Information Administration (EIA), American oil consumption had decreased a mere 0.5% in 2007 vs. 2008. For the first five months of 2008, American oil consumption fell 4.1% compared to the first five months of 2009. In May 2008, Americans drove 9.6 billion miles, or 3.7% less, than the year before.

International and Corporate Demand Destruction

International demand was beginning to taper off as well, although for different reasons. For the moment, let’s use China as an example of the issues facing international demand.

Oil consumption around the world has been growing, especially in emerging countries. But in many cases, domestic oil prices have not increased as much because of government subsidies. According to www.optionsellers.com, in June 2008, the retail price of gasoline was 5.34 yuan, or about $2.60 per gallon – an increase of 9% since January 2007. In the same time period, the average retail price of gasoline in the United States rose nearly 80% to $4.00 per gallon. In China, and in other emerging countries such as India, Indonesia and Malaysia, gasoline is subsidized. Profits at Petrochina, the Chinese oil conglomerate, were actually down because their costs were rising but their revenue was limited by domestic price controls on gasoline. In June, China announced that domestic gas prices would be raised 16% to 6.20 yuan. Other countries have also announced reduced subsidies for domestic gasoline.

There were reports also regarding pricing pressure for other commodities. By early July, word was that the automakers – “ including GM, Ford and Toyota – “ were fighting steel price increases being implemented by companies such as Arcelor Mittal. By the end of July, steel was trading off its historic highs reached earlier in the year. Many thought that indicated steelmakers had overplayed their hand.

Global Slowdown

And then there’s the world economic slowdown. Much of Europe has had the same problems that the United States has had over the last year – “ high levels of borrowing, falling housing prices and problems in the financial sector. Still, for much of the last year, the dollar has been falling against the pound and the euro. That means problems in Europe were not being recognized (because if they were, the British and the continental Europeans would be lowering interest rates, just as the US has been doing, to deal with these problems). Many traders have been saying it’s just a matter of time before the shoe drops in Europe, and in August, their prognostications turned out to be correct. Statistics released in August showed that the British economy contracted in the second quarter, ending fifteen years of growth. This last month, Germany also confirmed that its economy had contracted in the second quarter.

Add Japan to the near-recession crowd, and you have four of the world’s five biggest economies – the United States, England, the Eurozone and Japan in trouble. China, India and the emerging markets are still growing strongly, but remember that their biggest customers are the developed countries. So emerging economy growth will continue, but not at the level of the recent past.

The Dollar, the Pound, the Yen and the Euro

For most of the last year, the dollar has been falling relative to other currencies. That’s because the Fed lowered rates and pumped money into the economy to deal with the financial problems. Given that England, Europe and Japan are having problems as well, it’s only a matter of time before other countries lower their interest rates as well.

Once those rates are lowered – “ or once the market expected rates to be lowered – “ the dollar would rise and the other currencies would fall. On July 3rd, Europe raised rates to 4.25% to deal with inflation problems there, but also indicated that further rate increases were unlikely, or were at least a long way off. Of course, the market listened more to the forecast than anything else, and that help strengthen the dollar versus other countries.

Even going into July, traders were ready to put their money where their mouths were. Many were either long the dollar, short the pound, or short the Euro. Since that time, those traders have been well rewarded. Since mid-July, the dollar is up 8% vs. the euro, 9% vs. the pound and 5% vs. the yen.

And here’s the bottom line, the effect on commodities. Keep in mind that many commodities are denominated in dollars. So when the dollar fell, that helped drive up the price of oil and other commodities. As the dollar strengthens, that helps push down the price of dollar-denominated assets. Ergo, the drop in commodities stocks.

Seasons and Cycles

One thing I learned this summer is that the beginning of July is a key time for commodities. For example, at that time farmers have to start deciding what they will plant for the next year, and that will help determine what inputs they buy. This year, they’re facing a tricky situation. The cost of fertilizer has been rising, but that’s not a problem for farmers as long as the price of crops – “ such as corn – “ keep rising as well. Still, they don’t know if the price of corn will continue to increase next year. If the price of corn drops, then the farmers have a real problem, because they’ve invested in very expensive fertilizer to create that corn. So what do farmers do? They reduce their risk by – “ you guessed it – “ planting less corn, and more of products that do not require expensive fertilizer. Knowing this, are we surprised that agribusiness stocks are down? Take a look sometime at the chart for Potash (POT), a fertilizer maker, and you’ll see what I mean.

I also learned that early July is when seasonal demand for natural gas falls off. Now, many expect seasonal demand to pick up in September, and it remains to be seen if that past pattern will continue, but that helps explain the fall in natural gas prices.

It Kinda Makes Sense

As I said earlier, this is by no means an exhaustive or perfectly accurate predictor of stock prices. But I think it does help to make sense of what we’ve seen in the last couple months. In July, we had a convergence of all of the factors mentioned above. Demand destruction in the United States alone may not have been enough to cause a turn in the commodities trade, and changes in seasonal demand by itself might not have been enough to dampen the enthusiasm for commodities. But add international demand destruction, a global slowdown and an expected turn in currencies, and you have a powerful argument for getting out of commodities.

And now you ask, what happens going forward? Many still believe in the global growth story and many think that seasonal demand for oil and natural will pick up in the fall. These bulls are calling for a rally in oil and gas when that happens. They may very well be right, but I’m still cautious. For commodities to reach the heights that they have, a lot of traders and investors have to jump in. Now the picture is not as copasetic as it used to be, and the global slowdown is expected to continue for several quarters. That’s enough to keep some investors away. That means there might be a rally, but it would be hard for me to bet on a return to previous commodities price levels. And for me, investing is always a question of how certain are you about a trend. If you can’t assign a high degree of probability to something, I wouldn’t recommend investing in it.

Until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.