Market Matters Blog

Last summer a hedge fund trader told me he wasn't sure there was real money to be made trading grain. It didn't make sense to me then -- how could a smart speculator not make a few pennies during the great short-supply run-up? He argued down days cancelled the up days and a few other things along that line, but I'm starting to realize the full picture is much more complicated.

Commodity hedge funds like his trade more than just grains -- many are more heavily focused on metals and fuels -- and they've been losing money for years. His gains were probably more than cancelled out by losses in other sectors. A recent article in the Financial Times cited an index compiled by brokerage firm Newedge that showed the average commodity hedge fund lost 0.8% in the first quarter of the year.

That's on the heels of a 3.7% loss in 2012 and a 1.4% loss in 2011. From 2000 to 2008, gains ranged from 20% to 40% each year.

Investors pulled roughly $5 billion out of commodity hedge funds last year, at least 20% of the assets these funds held, according to the Financial Times. That's a substantial chunk of change that won't be used in any commodity market, let alone grains or livestock. And the fund managers the Financial Times spoke with said that liquidation is likely to continue.

Commodities have been in a long-term bull market, which some call a super cycle, fueled by surging demand for raw materials in emerging countries like China and typically low prices that, in the case of oil and other mined commodities, discouraged new investment and kept supplies reasonably tight.

"We are witnessing the implosion of a large chunk of the commodities hedge fund industry," a chief executive of one of the world's largest commodities trading house told the Financial Times, echoing a widely held view across the natural resources sector. "The sector is, on average, performing badly and investors are taking notice."

Stanley Druckenmiller, a well-known hedge fund manager, told an investing conference in New York on Wednesday that he thinks the super cycle is over. China's GDP has slowed as exports declined to large but financially troubled buyers like the European Union. The Chinese government is trying to transition the economy to one driven by consumption more than investment in fixed assets like buildings, which require a lot of raw material.

Add to it that the U.S. economy is starting to see stronger growth, and it's generally accepted that the Federal Reserve will raise rates by late 2013 or early 2014. "This is supporting the U.S. dollar index and throwing water on any idea of long-term inflation," DTN Senior Analyst Darin Newsom said. Commodities are often viewed as a hedge against inflation, and with the Dow Jones Industrial Average and S&P 500 inking new highs with seeming regularity it's not surprising noncommercial positions across the commodity sector have declined.

Druckenmiller's focus when he discusses the super cycle is on industrial metals and fuels, and that probably plays a large role in decline of commodity-trading hedge funds. But what does that mean for agriculture commodity markets?

China and other developing nations that fueled the commodities boom will still have growing populations, a steadily increasing middle class and rising demand for meat. That's a pillar of support for ag commodities that oil and copper fundamentally don't have, but it doesn't mean ag is exempt from the broader downturn.

Noncommercial investors like hedge funds play an increasingly large role in the direction of ag markets, as Newsom has pointed out many times over the past few years. If they're not buying, it's hard for a market to rally.

"Unless we return to a drought, the high prices posted in 2012 are probably THE high prices we will see" for a while, Newsom said. Profitability in grains will likely come down, farmland could start to look overpriced and the Midwestern economy could take a turn for the worse.

Bloomberg article on Drunkenmiller: http://bloom.bg/…

Financial Times on the decline of commodity hedge funds: http://on.ft.com/…