Oil Surges 10%, But Commodities are Still In a Rut

Just last week, oil made the biggest two day move in more than seven years. Oil was trading near 12 year lows when investors finally decided it was time to buy. Some analysts believe the rally has momentum to continue. But the rally will need to work hard to make up for this year’s losses.

Oil is still down around 13% this year. Why? Because of lacking confidence in the global market place. Adding to oil’s decline is oversupply. US inventories are overflowing and there are still more prospects of additional Iranian barrels.

Even Australian motorist are seeing the impact of oils decline this year. Petrol was below a dollar just last week at the pump. I personally thought it would never happen again but I was happily proven wrong. So will oil start its climb to US$40? Or just dance around US$30?

It could all depends on the views of hedge funds.

Commodities suffer because of hedge fund speculations

A hedge fund typically makes speculative trades. It might speculate based on the confidence or sentiment of the market.

For example, China’s growth is slowing and their major imports are commodities. Not only do they need commodities, but they are one of the biggest commodity buyers.

Now that China is slowing, speculators could draw a conclusion that commodities might suffer as well. Now what would you do with this information? You would most likely sell the physical commodities and the companies that produce them.

And according to Arrium director, Doug Ritchie, this is exactly what hedge funds are doing:

There hasn’t been a huge drop in demand in fact some commodities it has been higher. But it is becoming so much more sophisticated in terms of the paper that is traded. I wouldn’t be surprised if it’s ten times the amount of the physical commodities that are being traded.

But Ritchie believes hedge funds are unnecessarily selling off commodities. He believes mining companies are suffering because hedge funds are keeping prices down. Ritchie is right in a sense. Even with minor increases in some commodities, the market has savagely ripped down Australian commodities.

Iron ore, thermal coal and copper are all down. And who does this affect? Companies like BHP Billiton [ASX:BHP] and Rio Tinto [ASX:RIO]. But whether hedge funds are actually leading the selloff in commodities is a difficult question to answer.

But it does seem hedge funds have been increasing their bearish views on commodities. According to Bloomberg ‘volumes have held up well’, and ‘it’s just not the cyclical nature of the mining industry sending prices lower, put it that way’. In layman’s terms, Bloomberg believes commodity price are being held down by traders. And there are strong suspicions that hedge funds are causing most of the damage.

Mr Ritchie has spent 27 year with Rio. Like Mr Buffett he’s uncomfortable with the amount of derivatives out there.

With derivatives, when sentiment is upwards it’s going to have the impact of pushing commodity prices higher. And when sentiment is negative it is going to have a big impact pulling prices lower.’ Ritchie said.

What to do about Australian Big Miners

First we must keep in mind that commodity prices aren’t the only factor that can affect the share prices of BHP and Rio. The Brazilian dam disaster is a good example of this.

But bearing this in mind BHP and Rio performance for 2016 is just like that of last year. It leaves a lot to be desired. Even after BHP and Rio’s small rallies on Friday. Yet they’re still down more than 10% for the year.

BHP Rio ASX

Source: Yahoo finance

For the short term, BHP and Rio could be continually hammered down by fears coming out of China. China’s slowing growth is a big reason why so much negativity is surrounding the mining and resource sector.

But if you believe that hedge fund managers are going to keep commodities down into the foreseeable future, it might not be the best time to buy Australia’s biggest miners.

Härje Ronngard,

Junior Analyst, Money Morning

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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