Traders drive commodities to record highs

Raw materials are on a roll. The CRB Index, a broad basket of commodities, has hit a two-year high. Oil is 8% up on last month, while the recovery in base metals prices "has been extraordinary", says Javier Blas in the FT. The LME index, which tracks the main base metals, is at a two-year high. Aluminium has gained almost 30% over the summer; copper has risen almost 40% since early June, leaving it less than 10% shy of its 2008 record high of $8,940 a tonne.

Tin, now around $27,000 a tonne, has become the first industrial metal to regain its pre-crunch highs. Tin and copper highlight why analysts are "almost universally bullish" about metals, says Blas. Supply has been struggling to keep up with strong demand in emerging economies, especially China. Goldman Sachs reckons copper could rise as high as $11,000 a tonne next year.

Speculators race into the market

"People are getting a bit too bullish," says Raymond Key of Deutsche Bank. The rally has gone beyond the fundamentals, with speculators behind the latest rises, says Eugen Weinberg of Commerzbank. Aluminium's supply is plentiful. Meanwhile, global oil demand is anaemic and there is a supply glut, notes Longview Economics. Copper certainly looks tighter, but even here higher prices appear to be tempering demand, with Chinese stockpiles back up to a seven-week high. Copper's "good prospects are already in the price", says HSBC.

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Yet investors are pouring into the market, with 40% more speculative bets on rising oil prices than when oil hit $145 two years ago, says Gluskin Sheff's David Rosenberg. "Talk about danger levels of speculative activity." Bets on copper have rocketed and palladium and platinum are also "off the charts". Chalk this up to quantitative easing (QE) round two expectations of more money printing by the Fed. It would weaken the dollar, bolstering dollar-denominated raw materials, and fuel fears of inflation, which is increasing demand for hard assets. It also implies more liquidity flowing into commodities.

QE is the key

QE alone "suggests a number of downside risks" for commodity prices, says Capital Economics. For starters, the dose of printed money could fall short of expectations. An accompanying rebound in the dollar would put raw materials prices under pressure.

Higher commodity prices would undermine demand in the economy. So "higher prices contain the seeds of their own reversal", says Lex in the FT. Studies suggest that the $10 jump in oil prices within a month will cut US output by a few tenths of a percentage point; China's more energy-intensive economy could be hit harder.

Global growth is slowing in any case. Europe, Japan and America, the next most important sources of commodity demand after China, all look set for a long period of sluggish growth, says Capital Economics. Nor can a double-dip recession be ruled out.

And China, where growth is also set to slow, is not "immune to what happens in the West", especially if protectionism increases. Asia's dependence on the West is decreasing, but the region has not yet decoupled.

Given all this, "it's anything but obvious" that raw materials should be rising in a "straight line", says Key.

Since speculators can pour out as easily as they pour in, "you have a recipe for further erratic fluctuations in prices", says Mark Robinson on InvestorsChronicle.co.uk with prices looking more likely to fall than rise.