What Caused this Gangbusters Commodity Boom?

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    NEW YORK (TheStreet) - Commodities have been the story of 2010, having been much more robust than any other capital market this year.

    Oil is up a relatively weak 22%, a paltry move in comparison to metals like copper, up more than 30%, or silver, up 70%. Soft commodities have shown even greater strength, with corn, wheat and coffee up around 50% for the year while cotton has nearly doubled in price.

    What the heck is going on here? I've been following and trading commodities for most of my adult life and while I have seen moves like these in the past, this universal commodity boom, where virtually every commodity runs at once, is a brand new phenomenon.

    A virtual chorus of analysts, economists and mainstream media are explaining this massive upswing in prices using all the same buzz words about recovering economies, emerging market demand growth, and a sliding dollar.

    All of these trends are undoubtedly true, but not even the combined effect of all three of these can explain the insanely powerful inflation we've seen in commodities this year (and are likely to see in the coming year).

    Has there been a devastating drought in any of the three largest cotton producing countries: China, the U.S. and India? Only such a natural disaster would have accounted for a doubling of prices that we have seen, at least in the last 25 years that I have followed cotton trading. Has such a natural disaster accompanied the 50% rise in corn, wheat or coffee?

    No. None of these commodities are being moved by disasters, nor are they being moved by intense industrial growth projections for the last year or the next that are still well under even average historic levels and appropriate for a global economy just now beginning to recover from the worst slowdown since 1932.

    Indeed, if any commodities contracts were to rise with vigor today, we should see these massive rises deep in the back ends of the curves, where the markets were designed to discover forward prices and help long-term planning - and where, supposedly, the full effects of a recovery and 6% to 10% growth are supposed to actually happen. We call them commodity futures for a reason, after all.

    Instead, the price curves for most of these commodities, including corn, wheat and oil have begun to flatten significantly this year. That is, the prices for futures contracts pricing in the next 30 days are relatively not that much different from those pricing six, 12, 18 or even more months out in the future. Indeed, the commodity curves don't even keep pace with a moderate rate of inflation, never mind the rampant inflation that a $1,400 dollar gold price would imply.

    So what is going on here? What is clear to me, and as I outline in my coming book, Oil's Endless Bid, due out from John Wiley and Sons in March of 2011, is that the perceptions of a recovering global economy, emerging market demand and declining greenback are all causing investor capital to flood the tiny and delicate commodity markets, none of which were ever designed or intended to accept the kind of investor interest they are now receiving.

    Passive investor money coming into index funds, managed futures, ETF's and personal futures accounts continue to flood the commodity markets. In indexes alone, another $70 billion of passive, long-only money has been added in the last six months, raising the amount of passive index money to an estimated $320 billion. These are commodity buyers that are completely price-insensitive -- and never sell.

    Supercharging these funds into an ever greater whirlwind of increasing prices are the trading desks at the largest investment banks and independent commodity traders (like the Irish-based Glencore, for example), making massive profits on the backs of this flood of "dumb money" from passive investors.

    Commodities, remember, are not like stocks: They are not capital creation tools. In the end, all commodities are a zero-sum game. Any money that traders make in the trading of commodities necessarily must come out of the pockets of someone else. Inevitably, that pocket is that of the consumer's through increasing prices both at the supermarket and the gas pumps.

    Understanding that investor interest has been a major factor fueling the commodity rally goes a long way to figuring out how to make money from it.

    In my book, I make it clear just how new commodity investment is and how much more potential money there is yet to "discover" commodity investment and join in.

    Indeed, rising prices in commodities inspires ever more investors to pour into indexes and ETF's since no one wants to be left out of a hot investment "opportunity." It is a self-fulfilling prophecy: 2011 promises to see even higher prices for commodities across the board.

    In oil, the best proxies for a rising price are the integrated oil companies, which is the main reason I have made Exxon-Mobil(XOM), a sector underperformer, my top energy stock pick for 2011. Aluminum, despite sharp fundamental support, hasn't participated much in the commodity boom so far and my bet is it will be a hot one next year. For that prediction, I've gone old school with Alcoa(AA), which is certain to benefit from a rising aluminum price next year.

    And for those still playing the momentum trade in copper, nothing has been a better proxy than Freeport-McMoran(FCX), even though it has already run almost 50% this year, keeping pace with the metal.

    In commodities, the way to play the trend is easy: Just follow the money.

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