El Nino... (Investment Opp?)

Not that I really want to become a weather forecaster, but one of the things that commodity funds keep a close eye on, and I do too, is El Nino/La Nina events and their impact on commodity supply, prices and related equity performance.

Over the past few months there have been signs of a developing El Nino event in the Pacific and this could have important implications for supply and prices for several commodities over the next 12-18 months. The US National Oceanic and Atmospheric Administration expects the current event to last throughout the Northern Hemisphere winter and into 2010.

What is El Nino? It is an abnormal warming of surface ocean waters in the eastern Pacific which causes an oscillation of pressure patterns impacting weather conditions.

What are El Nino impacts?

• Reduction in rainfall in eastern and northern Australia, as well as parts of South East Asia causing drought conditions. A strong El Nino could result in drought in India, Indonesia and Malaysia. Very hot summer weather in northern China, flooding in southern China.

• Warmer winters in the northern part of North America and cooler in the southern parts. Wetter summers in the intermountain regions of the US. Depressed hurricane activity in the Gulf of Mexico.

• Warm and wet summers in western parts of Latin America (Peru and Ecuador) likely causing flooding. Higher winter rainfall in Chile. Dryer and hotter weather in the Amazon, Colombia and Central America with wetter spring and summer conditions in southern Brazil and northern Argentina.

Why is this relevant to commodities?

El Nino/La Nina trends generally impact supply of commodities, be that oil and gas, coal, wheat, soybeans, rice, etc

What are potential commodity impacts?

Oil & gas: El Nino generally results in depressed GoM hurricane activity which could mean limited supply curtailments this hurricane season, keeping gas prices depressed if demand doesn’t pick up.

Wheat: The last two major El-Nino events have resulted in significant increases in wheat prices during and after the event. This has come in no small measure due to impact of drought conditions in Australia on wheat production and yields.

Soybean: The last two major El-Nino events have resulted in significant increases in wheat prices during and after the event. Brazilian and Argentinean production of soybean has been impacted by drought and flooding in previous events.

Rice: The last three major El-Nino events have resulted in increases in rice prices during and after the event. Chinese and Indian rice production may be impacted by an El Nino event.

A Great Answer To A Great Question.

There seems to be something wrong with the way oil is trading these days -- at least wrong if you believe it should trade based on supply and demand. Obviously, the fundamentals aren't changing as fast as the wild price swings. Much of this seems to be because the trading pits are dominated by trades of paper (financial) barrels of oil and not real barrels of oil.

Yet, you seem to be generally opposed to limitations on oil speculation. Why? And is the current method of pricing oil the best one we can come up with? Can't we come up with a better system? When I go to the store to buy other goods, the price doesn't fluctuate so wildly. Why do we have to price oil this way?

Stephen Schork (The Globe & Mail 13/07/09): I certainly agree that oil speculators impact the pricing of oil (and other commodities) in the short-run. Therefore, at times the price path does indeed decouple from the underlying fundamentals. However, in the long-run, markets will regress to the fundamentals. hence the Wall Street adage. markets fall faster than they rise.

I do favor certain new regs on speculative trading in commodities. For instance, there is a tremendous amount of derivative contracts linked to U.S. markets that are traded on the ICE exchange in London that do not come under the purview of U.S. regulators. For price transparency reasons I think that ought to change.

On the other hand, I do not like the idea of limiting oil speculation. Why?

The most important reason is that speculators provide an outlet for producers to sell risk. If you hamper the speculators ability to buy that risk then all you are really doing is forcing this systemic risk back onto the books of the producers.

Therefore, they will in turn become apprehensive when it comes to increasing their risk exposure to the market, i.e. it will retard their ability to increase their plant and equipment or said another way. it will hamper their ability to increase supply when demand warrants.

Thus, in the long-run, limiting speculation might decreased short-run volatility in the market. But it will only serve to increase it for all of us in the long run.