Brokerage execs can't say enough lately about commodities trading. On the various firms' third-quarter earnings conference calls over the past two months, executives heralded commodities trading as the one business they have that's totally untainted by the credit crunch -- and promising from a growth point of view. Outifts such as JPMorgan ( JPM), Lehman Brothers ( LEH), Merrill Lynch ( MER) and Morgan Stanley ( MS) -- which have otherwise been reeling from turmoil in the credit markets tied to the collapse of subprime mortgage securities -- have added substantially to their trading desks this year. But with signs of waning economic growth both in the U.S. and Europe, there's the danger that Wall Street is building up this business just as the commodities boom may be hitting a plateau. Commodities markets are small, and prices of energy, metals and agricultural products such as wheat have already come quite far over the past several years. The Goldman Sachs commodities research team made this very point Tuesday, when it warned in a note to clients that it is "time to take profits." The team said it is closing its long oil and related agriculture and gold recommendations. As if on cue, oil fell nearly 4% from its record high Tuesday o close at $89.90 per barrel. Stocks in that sector such as Exxon ( XOM), Chevron ( CVX) and Schlumberger ( SLB) likewise fell.
"We are six years into the current investment phase," and production capacity is not growing, says Goldman in the note. This "underscores how much longer this investment phase will likely last. We believe it has at least another 5 - 10 years left and has run into significant road blocks." Goldman's team says the balance of prices relative to the risk of decline has become more balanced in commodities. The firm cites downsides like a weakening U.S. economy, growing exports and global political tensions. The firm added that its target for oil in 2008 of $80 per barrel still stands, even though a weakening dollar typically means commodities prices, which are mostly denominated in dollars, go higher. "Wall Street hiring and firing is always a lagging indicator," says Howard Simons, analyst at Bianco Research and contributor to RealMoney.com, TheStreet.com's investing-ideas sister site. JPMorgan, which benefitted to the tune of nearly $750 million from taking on busted hedge fund Amaranth's natural gas positions in 2006, announced Tuesday it has hired 50 people for its global commodities business this year. The firm said it will add positions in power and gas trading, oil trading and carbon and environmental markets. Even Merrill Lynch, whose chief executive Stanley O'Neal was forced out after the firm took an $8.4 billion writedown mostly on asset-backed securities and related structured products called collateralized debt obligations, claims to be expanding its commodities business. On its earnings conference call earlier this month, O'Neal said commodities was an area where the firm "successfully and profitably managed risk, both for our clients and ourselves." He added that the firm plans to expand into asset classes such as coal, oil, metals and markets such as the Pacific Rim.
Citigroup ( C) and Lehman Brothers also said on their conference calls they would be expanding their commodities businesses. Citigroup's chief financial officer, Gary Crittenden, said the firm wants to invest in the space because it's a "competitive gap." Lehman says it will continue to expand in the space to capitalize on its acquisition of Houston-based natural gas and power company Eagle Energy Partners. On its third-quarter call, Lehman said it is working on "the next phase" of its buildout of metals trading as well. Whether one believes that developing economies like China and India can carry the commodities bull market farther or not, commodities markets are also much smaller than the $10 trillion mortgage-backed securities market. There is more mortgage debt in the marketplace than there are U.S. government bonds, which amount to about $8.5 trillion. According to Simons' research, all the lead produced in the world in 2005 amounted to just $5 billion, and $27 billion would have bought you all the corn made in the U.S. Simons also notes also that these markets can never match the profit potential of mortgages because speculation in commodities is not as easy as paper asset trading. Simons also adds that while there's lots of money to be made in a bear market for paper assets, commodities bear markets are not as lucrative. There is a floor for commodities prices, he says, adding that usually some base of buyers needs the commodity at some price.
"There is physical delivery involved here," says Simons. "Those who think of this as speculation are in for a rude surprise. At the end of the day, they are left with the responsibility of transporting a physical asset from one place to another." Financial sector analyst Richard Bove of Punk Ziegel & Co. agrees. "When you get away from energy and metals, it's just not that relevant," he says of commodities trading. Moreover, he worries that relying on the global economy is dangerous because its strength may begin to wane with what he expects to be a deeper retrenchment by U.S. consumers and businesses.