What a Week: Commodity Matters

Weakness in oil, gold and other basic materials drags the indices.
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Talk of the "bursting of the commodities bubble" was swirling around Wall Street this week, putting pressure on the broad stock market.

Indeed, a big drop in the prices of most commodities, from crude oil to copper and gold was evident throughout the week, especially on Tuesday. The Commodity Research Bureau (CRB) index dropped 4% this week.

On Friday, crude oil dropped another 1.25% to $61.84 a barrel, capping a week in which it fell 5%, and gold dropped 2.6% to $553 an ounce. Lower crude prices tend to relieve anxiety about energy's impact on inflation and on growth. But given the huge market capitalization of energy stocks, the Amex Oil index's 5.5% drop this week kept a lid on the broad market.

The

Dow Jones Industrial Average

advanced 1.1% for the week, but the energy-heavy

S&P 500

rose just 0.02%. The

Nasdaq

barely moved at all, advancing only fractionally.

Notably, major stock indices turned positive Friday after most commodity markets settled at 3 p.m. EST. The Dow rose 35.70 points, or 0.33%, to 10,919.05, rebounding from a session low of 10,820.

The S&P 500 advanced 3.21 points, or 0.25%, to 1266.99, after sinking earlier to 1255, and the Comp gained 6 points, or 0.27%, to 2261, off its low of 2235.

Copper-mining giant

Phelps Dodge

(PD) - Get Report

, one of the highflying stocks of the commodity boom -- which has risen nearly 80% since August 2004 -- dropped 4% after Prudential downgraded it, citing waning U.S. and Asian demand for copper.

Bubble Talk

It's not surprising to hear talk of a bubble in regard to commodities. Most visibly, the price of oil went from an average $23 per barrel in 2003 to above $60 currently. But other commodities, such as gold -- which reached 25-year highs last week -- copper and even sugar have also been the subject of what many have called "speculative fever" in recent years.

Not all the stocks of the companies that produce these commodities have seen similarly stellar increases. But consider this: One of the few stocks that has matched

Google's

(GOOG) - Get Report

200% surge over the past two years is

Valero Energy

(VLO) - Get Report

, an oil refining and marketing company.

And the "double-digit earnings growth" many Wall Street strategists keep using as a sales pitch to attract retail investors to the market evaporates if one removes the energy sector.

According to Thomson Financial, earnings growth of 14.6% in the fourth-quarter results reported so far turns to 9% if one removes energy's contribution. Estimates that earnings will grow 10.8% in the first quarter turn to 6.2% excluding energy. That means energy earnings make up 38% of the growth in the fourth quarter and 43% in the first quarter.

Not surprisingly, as the CRB index dropped 4% this week, the broad market was under pressure.

Now to the big question: what caused the drop in commodities this week?

It's hard, if not impossible, to put all commodities in the same basket. While many -- from oil to copper -- have been surging along with demand from the likes of China and India, individual commodities still represent different markets, which respond to different factors.

Crude oil and the energy sector at large, for example, are notoriously rocked by geopolitical tensions. In recent weeks, these have centered around Iran's nuclear ambitions. A drop in crude prices was evident since last week after Iran, the world's fourth-largest oil producer, signaled that oil supplies would not be disrupted amid the tensions.

Oil weakness on Friday was attributed to the International Energy Agency forecasting that the Organization of Petroleum Exporting Countries will boost production this year. Yet crude oil may well make a comeback if OPEC goes ahead with a cut in production next month, says Jason Schenker, economist and energy analyst at Wachovia.

Gold had also benefited from tensions over Iran lately, and gold's steep drop on Tuesday came after China, a permanent member of the United Nations Security Council, said it hopes to resolve the issue through diplomacy.

Many observers also noted that speculation in many commodities had reached fever pitch in recent weeks and that a pullback was overdue.

But there's a big factor that didn't seems to receive half of the attention. Pressure on commodities this week took place just ahead of a key event next week.

Ben Bernanke, the new chairman of the

Federal Reserve

will testify to Congress on Wednesday and Thursday, laying out his vision of monetary policy and of the U.S. economy for the next six months.

What do Bernanke, interest rates and commodity prices have to do with one another? Quite a lot, according to Jeffrey Frankel, economics professor at Harvard's Kennedy School of Government, who has done extensive studies on the link between interest rates and commodities.

While prices of consumer goods tend to fluctuate slowly, commodity prices, which are traded in fast auction-style markets across the globe, are much more responsive to changes in interest rates, which after all represent the cost of money.

Rate Sensitive
Spikes in commodity prices tend to occur during and after periods of low interest rates

Source: Jeffrey Frankel

The correlation identified by Frankel has three different factors.

First, firms that build up inventories in any commodities pay a price for holding these inventories. It's the opportunity cost of keeping a valued commodity in storage in anticipation of demand vs. using the money for something else. When interest rates rise, so does the opportunity cost. This lasts until it's more profitable for firms to liquidate inventories at higher prices and to use their money elsewhere.

Second, along the same line of logic, commodity producers, be they oil or mining firms, have to weigh the cost of investing in new capacity to benefit from higher prices. "When interest rates are high, instead of pushing for new capacity, it's an incentive to pump the oil today and use the money to earn interest," Frankel says.

Third, when rates rise, it becomes more profitable for speculators to invest in safe assets such as U.S. Treasuries, instead of commodities, which are more risky and volatile.

Spikes in commodity prices, Frankel's research shows, have indeed tended to occur during and after periods of low interest rates, such as the past few years.

The Fed took down the Fed funds rate to 1% in 2003 and kept it at this historically low level until June 2004, when it started ratcheting it up only gradually. With the Fed hiking to 4.50% on Jan.31, rates are believed to have returned to a "neutral" level, where they neither stimulate nor restrain growth.

As the Fed took down interest rates over the past few years, this fueled not only the prices of assets such as homes but also of commodities, Frankel says. Home prices started cooling last summer, and now it might commodities' turn -- especially if the Fed continues to hike rates.

"I would say that high interest rates would be able to eventually burst the bubble of commodities in general," Frankel says.

Frankel's detractors may point out that Asian growth and limited capacity have as much, if not more, to do, with the surge in commodities. But if the Fed raises rates too much and pushes the U.S. economy into a recession, U.S. consumers won't be buying Asian products at the same rate, and Asian demand for commodities would take a hit.

It will be interesting to see what Bernanke's thoughts are on all of this. If commodity prices have indeed been fueled by U.S. interest rates that -- by the Fed's own admission -- are still not restrictive, the new Fed chairman will likely sound hawkish.