At time of writing, crude oil is hitting new highs daily. Having already reached the previously inconceivable level of $135 per barrel, some analysts now see $200 oil as a real possibility, as do we now as well. Meanwhile, bloody food riots have broken out across the globe as millions of people have effectively been pulled back below the poverty line due to soaring costs for basic necessities.

The commodity bubble is something that HS Dent has commented on extensively since 2006 when it became a critical factor again for the first time since the 1970s. Commodities go through typical boom and bust cycles every 29 – 30 years as our research has shown, and investor interest reaches extremes in the late stages of this cycle. But today, we see something truly extraordinary: the rise of long-only commodity indexing has created an enormous source of new demand from large institutional investors that has absorbed virtually all of the market’s liquidity. It is this new breed of broad commodity index funds that allocate blindly to all sectors – as well as the popular gold, oil, and other specialized ETFs – that have increasingly fueled this bubble as much as the industrialization of China and the developing world.

In testimony before the United States Senate in May, hedge fund manager Michael Masters offers perhaps the best commentary on the commodities bubble that we have seen to date. We have copied excerpts from his testimony below, and we highly recommend reading the full transcript though at least the first seven pages:

Excerpts from Michael Master’s testimony before the Senate Committee on Homeland Security and Government Affairs, May 20, 2008:

Commodities prices have increased more in the aggregate over the last five years than at any other time in U.S. history. We have seen commodity price spikes occur in the past as a result of supply crises, such as during the 1973 Arab Oil Embargo. But today, unlike previous episodes, supply is ample: there are no lines at the gas pump and there is plenty of food on the shelves…. [Emphasis Added]

What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant…. [Emphasis Added]

Index Speculator demand is distinctly different from Traditional Speculator demand; it arises purely from portfolio allocation decisions. When an Institutional Investor decides to allocate 2% to commodities futures, for example, they come to the market with a set amount of money. They are not concerned with the price per unit; they will buy as many futures contracts as they need, at whatever price is necessary, until all of their money has been “put to work.” Their insensitivity to price multiplies their impact on commodity markets…[and provides the perfect recipe for a bubble. Just as during the final stages of the tech boom, for these investors price and supply/demand does not matter – HS Dent].

There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets…. [Emphasis Added]

In the early part of this decade, some institutional investors who suffered as a result of the severe equity bear market of 2000-2002, began to look to the commodity futures market as a potential new “asset class” suitable for institutional investment. [Emphasis Added] While the commodities markets have always had some speculators, never before had major investment institutions seriously considered the commodities futures markets as viable for larger scale investment programs. Commodities looked attractive because they have historically been “uncorrelated,” meaning they trade inversely to fixed income and equity portfolios. Mainline financial industry consultants, who advised large institutions on portfolio allocations, suggested for the first time that investors could “buy and hold” commodities futures, just like investors previously had done with stocks and bonds….

According to the CFTC and spot market participants, commodities futures prices are the benchmark for the prices of actual physical commodities, so when Index Speculators drive futures prices higher, the effects are felt immediately in spot prices and the real economy. So there is a direct link between commodities futures prices and the prices your constituents are paying for essential goods.... [Emphasis Added]

In the popular press the explanation given most often for rising oil prices is the increased demand for oil from China. According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculators’ demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China! [Emphasis Added]

In fact, Index Speculators have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over the last five years. [Emphasis Added]

Let’s turn our attention to food prices, which have skyrocketed in the last six months. When asked to explain this dramatic increase, economists’ replies typically focus on the diversion of a significant portion of the U.S. corn crop to ethanol production. What they overlook is the fact that Institutional Investors have purchased over 2 billion bushels of corn futures in the last five years. Right now, Index Speculators have stockpiled enough corn futures to potentially fuel the entire United States ethanol industry at full capacity for a year. That’s equivalent to producing 5.3 billion gallons of ethanol, which would make America the world’s largest ethanol producer….

Furthermore, commodities futures markets are much smaller than the capital markets, so multi-billion-dollar allocations to commodities markets will have a far greater impact on prices. In 2004, the total value of futures contracts outstanding for all 25 index commodities amounted to only about $180 billion. Compare that with worldwide equity markets which totaled $44 trillion, or over 240 times bigger. [Emphasis Added] That year, Index Speculators poured $25 billion into these markets, an amount equivalent to 14% of the total market….

Index Speculators’ trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.

Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged. [Emphasis Added]

Why is there not outrage over the fact that Americans must pay drastically more to feed their families, fuel their cars, and heat their homes?

Index Speculators provide no benefit to the futures markets and they inflict a tremendous cost upon society. Individually, these participants are not acting with malicious intent; collectively, however, their impact reaches into the wallets of every American consumer.

Masters makes a very compelling argument that the recent surge in commodity prices is both substantially and increasingly the result of passive index investment, not real demand from consumers (which is also rising) and not even from traditional hedgers and speculators. Traditional speculators go both long and short and sometimes take physical possession in the end, thus providing liquidity to the real commercial users of the commodities and providing a useful service. The indexers do just the opposite. Rather than provide liquidity, they compete for it. And their insensitivity to price and supply/demand factors compounds the problem.

This has clearly fueled the commodity bubble, but it does not mean that we should expect an imminent crash. As Lord Keynes said and we have often repeated, markets can stay irrational longer than you can stay solvent. This level of speculation, greater than in the 1970s, almost guarantees that this bubble will become more parabolic in the next year or so and will create extremes that will ultimately force both a major correction in the US and global equity markets and a global downturn.

The next great depression and extended downturn ahead will be caused by a decline in demographic and technology cycles. But the trigger for the next great crash will likely be runaway commodity prices that accelerate the downturn.

The commodity bubble has already become the primary factor in the present short term correction starting in late May that is likely to continue into June. It will almost certainly become the most important trigger for the next great crash we have been predicting between mid to late 2009 and late 2010, in line with the peak in our 29 – 30-year Commodity Cycle. When this bull market in commodities finally cracks, look out below.