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Barrons

CHINA, AS EVERYONE KNOWS, IS A BIG FORCE IN THE extraordinary boom in commodities. Its voracious appetite for everything from corn and wheat to copper and oil has helped push up U.S. commodities prices by some 50% over the past 12 months.

But China is by no means the whole story. Speculators -- including small investors -- are also playing a huge role. Thanks to the proliferation of mutual funds and exchange-traded funds tied to commodities indexes, speculative buying has gone way beyond anything the domestic commodities markets have ever seen. By one estimate, index funds right now account for 40% of all bullish bets on commodities. The speculative juices are even more plentiful -- nearly 60% of bullish positions -- if you count the bets placed by traditional commodity "pools."


Index funds with buy-only strategies have had outsized influences on the market.
Here's the problem: The speculators' bullishness may be way overdone, in the process lifting prices far above fair value. If the speculators were to follow the commercial players -- the farmers, the food processors, the energy producers and others who trade daily in the physical commodities -- they'd be heading for the exits. For right now, the commercial players are betting on price declines more heavily than ever before, says independent analyst Steve Briese.

For example, in the 17 commodities that make up the Continuous Commodity Index, net short positions by the commercials have been running more than 30% higher than their previous net-short record, in March 2004.

Briese, author of the recent book The Commitments of Traders Bible and editor of the Website CommitmentsOfTraders.org, was one of the first to recognize that information on the bets made by the commercials could provide rare insights into how the "smart money" views the price outlook. These days, the data suggest, the smart money clearly believes that the market's exuberance has turned irrational.

Indeed, the great commodities bubble started springing its first leaks two weeks ago: Oil, gold and other major commodities posted their steepest weekly drop in half a century. Though prices have since firmed, they could eventually drop 30% as speculators retreat. The only real question is when.

[edit - shortened link - markl]