Commodities lesson for silly pension fund managers

By Neil Behrmann

February 2007:- A year ago, Hermes Pensions Management, the advisor of British Telecom's Pension scheme, proudly announced that it had invested £1billion ($2 billion) in commodities.

The pension's investment was the "largest single allocation to commodities of any institutional investor in the UK", Hermes boasted. Hermes had "in house expertise in commodities" which would "result in a significant reduction in volatility across a portfolio of investments".

Unfortunately for BT's present and future pensioners, the scheme bought near the top of the raw materials cycle, although a few commodities such as corn and nickel have continued to surge to new heights. BT's commodity investments are linked to Goldman Sachs' GSCI index, which is heavily weighted towards crude oil and other energy contracts. It has tumbled about 25 per cent from its 2006 bubble peak. This partly reflects a 31 per cent slide in crude oil prices, a 54 per cent slump in natural gas quotes and a 37 per cent fall in copper quotes.

Giant Dutch pension funds ABP and PGGM, were hit by a decline of around 20 per cent in their commodity holdings last year to a combined total of around $10 billion. ABP and PGGM, which are more experienced in commodities than BT, had gains on their commodity holdings in 2005. But they have since given back a sizeable proportion of their profits. BT Pension and the two Dutch pensions are huge and the investment in commodities is only about 3 per cent of their total portfolios. But their liabilities are also sizeable, so they can't afford to throw away billions.

Commodity traders laughed when Hermes' claimed that commodities reduced the volatility of portfolios. Commodity prices gyrate wildly and are a speculative punt rather than an investment or so called "asset class" as some pension fund managers and bankers describe them.

Forecasts were hopeless

Now that air is fizzing out the commodities bubble, pension funds and other investors who bought commodities recently, are in danger of losing a lot more. The scale of the commodities boom from the low point in 2001 to the second quarter of 2006 was exceptional. Commodities were ignored by the investment community when prices were depressed and outstanding value in the early part of this decade. They only became seriously popular after substantial price gains, a danger sign in any market.

Traders can't recall a a single commodities analyst who consistently read the market correctly in the past five years. Forecasts have been hopeless. Those who bought oil and copper when they were languishing around $17 a barrel and around $1300 a metric ton in 2001, became nervous or bearish when prices doubled. By the time oil was surging towards its peak of $78 a barrel and copper $8,800 a ton, commodities had become the investment nirvana of professional investment lemmings.

Market manipulation

All sorts of predictions were made about never ending growth in demand from China, India and other nations. Producers would never meet the demand and any surplus would be purchased by investors who would hold the materials for the long term, maintained the bulls. Several hedge funds became dominant forces in the commodity markets which are relatively illiquid compared with currencies, government bonds and large capitalisation equities. Prices of metals such as copper, aluminium, lead, zinc, tin, nickel tended to rise on unexceptional volumes of trade. These metals have thus been open to manipulation claim traders. In recent weeks hedge funds have created an artificial shortage of aluminium when in fact there are sizeable stocks around. Copper inventories are understated, because thousands of tons have not been reported to the London and New York exchanges, contend traders such as David Threlkeld of Resolved Inc and Steven Spencer of Traderight, the commodities specialist hedge fund.

Regulators and central banks have become increasingly concerned about hedge fund speculation following a $6,400 million loss of a trader at Amaranth Advisors a few months ago.

Bulls hope and pray

In the next year or two the investment crowd will be tested. Oil could well gyrate to higher levels if there is a confrontation with Iran. But if that happens at a time of world economic slow down, it will be bad news for other commodities. Indeed the US construction industry and other US manufacturers have already lowered orders of metals and similar trends are apparent in China. Higher prices have encouraged mines and refineries to boost output.

As a result, hedge funds, pension funds and other investors and speculators have been forced to purchase growing surpluses of commodities. With industrial consumers reluctant to buy, investors must play the greater fool game and pass around a parcel that is growing heavier and heavier. The risk is that attempted sales could take place in a virtual vacuum, leading to a collapse in prices.

The hope for commodity bulls is that the world economy will rebound and the factories of America, Europe, Japan, India and China will buy. But these consumers are fed up with over priced raw materials and are likely to wait until prices fall.


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