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OUTLOOK 05: Hedge Funds To Be Picky In Commodities
After impressive gains, the appeal of commodities may be reduced in view of increased output and the slow down of China's economy in 2005.

4 Jan 2005
NEW YORK (Dow Jones)--After racking up impressive gains through general commodity investing over the past two years, hedge and commodity funds may need to be more specific in asset selection going forward in order to keep their streams of rising returns intact.

The pronounced decline in the U.S. dollar set against the backdrop of explosive industrial expansion in China sent industrially exposed dollar-priced commodities such as crude oil and copper surging to historic price highs over the past year.

Large Money Inflow Into Commodities in 2004
At the same time, the rather anemic performances across equity markets prompted many money managers to seek out assets offering diversification, higher rates of return or a defined price trend in which to invest.

The net result was the largest inflow of speculative and investor money into the commodities arena in several years, and the emergence of the raw materials sector as one of the most popular destinations for money in 2004.


Hedge Funds Anticipated Supply Shortage Earlier
Hedge funds correctly anticipated that, following several years of infrastructure underinvestment through the 1990s as the technology sector garnered most investor attention, any surge in industrial expansion would leave several commodities such as base metals and energy products in short supply.

Further, they surmised that increasingly stringent environmental standards and regulations would result in longer ramp-up periods between locating a viable ore body or oil reserve and actual development.

As a result, several commodity and hedge funds began amassing exposure to certain industrial commodities from early 2003 in a bid to front-run any widespread demand pick-up.

China Consumes Large Amounts Of Materials
This foreseen demand surge began that year as China's drive toward development gained momentum and generated an estimated 14%-16% jump in annual industrial production for 2003. The country's economy followed that up with an estimated 18% rise in industrial growth in 2004, according to CIBC World Markets.

With base metals such as copper, nickel and aluminum in particular required for effective industrial expansion, those inventories dropped sharply over the course of 2003 and 2004 as China voraciously consumed most major commodities.

The fall in copper inventories on the London Metal Exchange from over 800,000 metric tons in early 2003 to less than 60,000 tons in late 2004 highlighted how clearly demand outstripped supply over the past 24 months. Copper prices rose commensurably during the same period, climbing from around 80 cents a pound in early 2003 to over $1.40 a pound in late 2004.

In addition to copper and crude oil, which hit a lifetime price high of over $50 a barrel in 2004, nickel, gold, soybeans and cotton all pushed to multiyear highs within the past 12 months.

Impressive Returns From Commodities
This largely uniform progress of commodity prices consequently made it possible for large investors to place pan-market bets in the form of baskets of commodities and secure impressive year-on-year returns.

One of the most popular gauges of the commodity sector's general performance is the Commodity Research Bureau Futures Index, which tracks the prices of more than 20 commodities and is designed to provide a dynamic representation of broad commodity price trends. The index scaled all-time highs in 2004 of 291.50, after having peaked at around 263.50 in December 2003.

U.S. fund manager PIMCO's Commodity Real Return Strategy Fund, made of commodity-linked derivative instruments and with over $5 billion in assets, is another popular vehicle and recorded a 19% year-on-year return by the end of the third quarter of 2004.

Reducing Appeal Of Commodities

However, concerns now arise that a potential slowdown in Chinese economic growth in 2005, combined with increased output of many industrial commodities will reduce the appeal of the commodities sector to hedge fund players.

Market watchers are fearful that without the hedge fund community driving commodities broadly higher, there will be less follow-through investment backing the markets up and deepening the liquidity pool to keep the sector a popular place to be.

"The hedge funds participated strongly in commodities over the past two years and correctly anticipated the strong demand, low inventory situation we have now in many commodities," said Jim Steel, director of research at major futures commission house Refco LLC.

"But it could be argued now that the low hanging fruit has now been removed so they're going to have to be more selective going forward," he said.

Huge Price Gains in 2005 Unlikely

"It's not that demand is suddenly going to fall away or that we'll have a sudden huge supply surge, but it's hard to argue that we're going to see another 50% rise in copper prices within the next year," he said.

Ingrid Sternby, base metals analyst at Barclays Capital in London, agreed. "I think it's safe to say that the bulk of copper's tightness is behind us and that most of the price gains may have been seen," Sternby said.

While she and other market analysts agree copper prices will nevertheless remain strong and prone to further price spikes higher, the fact that the rate of ascent is expected to slow may diminish the hedge fund appetite for the metal, Sternby argued.

"The risk/reward ratio of investing a lot of money in a market that may be topping out could decline, so the funds may have to or want to look elsewhere in due course," she said.

The macroeconomic outlook may also spur hedge funds to alter or adjust strategies, according to Bart Melek, senior analyst and manager at CIBC World Markets in Toronto.

Mixed Views On Fund Inflow Into Commodities In 2005

He argued should global industrial growth slow in 2005 to around 3.1% after having peaked at around 5.1% in 2004 as CIBC expects, fund flow into industrially exposed commodities could slow.

However, a senior commodities strategist at a major macro hedge fund said despite the potential for a global slowdown, hedge funds will likely remain active participants in many commodity markets.

"Chinese industrial expansion will continue, and the U.S. dollar will remain under pressure so those two factors alone will keep many markets attractive," he said.

"And we've seen some markets that have registered fewer gains than others over the past year so we'll be looking into rotating into some of them from potentially overextended markets. For instance, while it's hard to see copper prices repeating their 2004 performance, I quite like the look of aluminum and zinc. And there's some agricultural commodities that could do better.

"So while the commodity price gains may be less uniform next year, I don't think that means we'll be less active in commodities. Just a bit pickier perhaps,"

he said.

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