Thursday, September 11, 2008

Why are commodity prices dropping?

It’s the heat of hurricane season in the United States, and three named storms—Gustav, Hanna and Ike—have already threatened its southern borders. And there's still two and half months left in the season.

What's unusual about this year's hurricane season, though, is that oil prices are tumbling, not moving higher. Over the years, we've typically watched crude oil per barrel skyrocket as hurricanes threatened oilrigs in the Gulf of Mexico.

But right now, even as Hurricane Ike is strengthening and moving towards refineries and offshore drilling operations in the Gulf, crude oil continues to drop. From its high of $147 per barrel in mid-July, crude oil has declined to $101 per barrel today. That's a 31% decline in about seven weeks!

What's Causing the Decline in Oil Prices?

For the past four years, high energy and commodity prices have been huge long-term investment themes that investors relied on to build their wealth. But this year, the tides unexpectedly turned, surprising investors and causing the global markets to sell off.

What's interesting, though, is that while commodities as a whole have sold off 30% this year, the fundamental picture has changed very little. The long-term supply and demand equation has not changed—it will take years to correct the underinvestment in production for oil and mines, while demand from emerging market economies continues to increase.

However, there have been some changes to the technical picture. When the trends in commodities and oil matured this year, their resulting liquidation broke the momentum in these stocks—which of course dampened investor sentiment.

So investors panicked and started selling their commodity-related stocks this summer, and a number of large hedge funds that have closed or are facing huge redemptions have only pushed commodities down even more. Many of these hedge funds held long heavy positions in commodities, and their liquidation into cash led to sharp sell-offs in the commodity markets.

Also the strengthening U.S. dollar is curbing demand for commodities as a hedge. In fact, commodity index investors sold about $40 billion worth of oil futures between the July record and last week, which, as you might have guessed, caused crude oil to plunge.

All of these factors have aided in the plunge of crude oil and commodity prices this year. And because the downward spirals, like these, tend to feed on themselves, it is difficult to predict how far these moves can go.

What Does It All Mean?

Predicting a bottom in oil prices right now is next to impossible. Just last week, indexes of commodity and energy producers skidded more than 7% amid expectations that slowing growth will curb demand for oil and metal.

Now, while it's hard to pick a bottom, I do think that $105 a barrel should be close to the low end of the range. And we're sitting at those levels right now. But as the commodity sell-off feeds on itself, commodity markets will likely overextend to the downside by the time they bottom.

Short-Term Profit Strategy

Are you more of a short-term investor and looking for ways to use the current market volatility to your advantage? Then you must check out Asia where I scour all of Asia looking for the most profitable short-term trades to make money fast.

Just look at the two trades recommended recently:

Trade #1: The U.S. dollar is showing some short-term strength—a trend that we need to respect since the dollar has the potential to rally in the near term. An ETF that that tracks the U.S. dollar’s performance against the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. This ETF is already gaining strength—up 11% since mid-July.

Trade #2: Biotech is a booming industry in Asia where governments like China, Singapore and Taiwan sponsor biotech research. This sector has been showing significant strength this year which is why one of the world's leading biotech companies was introduced to my friends. It's up more than 23%.

So, what should you be doing?

Right now, I think it's a good idea to remain slightly conservative and cautious. It's a tough time for the global markets and global economies. But I still think that the Chinese economy is strong enough to continue growing despite the global economic slowdown.

With commodity prices dropping worldwide, inflation in China has dropped significantly this year—after hitting a high of 8.5% in April, China's CPI was at 4.9% in July. And I think the Chinese government will start to aggressively stimulate the economy in the coming months.

But that doesn't mean that you should just dive into any Chinese investments. It's a difficult times right now, and while I'm expecting the Chinese market to be higher in six to nine months, the near term could be very volatile for Chinese stocks.

That's why you need to only invest in fundamentally strong companies with the potential to earn you money over the long-term. Try to carefully determine where to put your money today in preparation for the coming surge in the next three months.