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By Ben Johnson, CFA | 09-01-2010 11:04 AM

The 'Financialization' of Commodities

Ben Johnson: Hi. I am Ben Johnson, ETF Strategist with Morningstar. I am at the first ETF Invest Conference here in Chicago--fresh out of the hot commodities panel. And I am joined today by one of the participants from that panel, John Snell, who is the managing director of Risk Management Incorporated here in Chicago.

John's firm deals primarily in the energy markets and more specifically in the natural gas markets, and he is here today to share some insights with us on the commodity markets.

John, thanks for joining me.

John Snell: Thank you for having me.

Johnson: So, one of the things we addressed in the panel was something that's taken place over the past number of years, which is really sort of the "financialization" of the commodity markets, and I am wondering if you could share some insights into how that's affected some of the markets you've dealt in in the energy space?

Snell: To be sure, the last 10 years have seen a significant amount of speculative money flow into commodities, specifically natural gas and crude oil, which are my specialties.

I do think that on any given day or week or month, there has been evidence that you could see that inflow of money come in and affect the market on a short-term basis, but for the most part, I think it's been a positive experience, and the speculative money that has flown into the marketplace has provided liquidity and made for a deeper market with regards to, not only investment vehicles, but also for the users of the commodity and producers of commodity, which are our customers.

Johnson: To what extent do you think that this new interest in the commodities markets has served to affect commodities prices? There has been a lot of talk in the media about how speculators maybe in some ways driving up the price of oil, and consumers are ultimately paying for that when they go to fill up their gas tanks?

Snell: Sure. And many of our customers have had the same issues or concerns about the marketplace. However, I think, having been in the commodities for 30 years and seen the speculative participation, to be sure on any given day or moment or circumstance, they may have been an effect in the marketplace on a short-term basis, but over the period of time, again, in 30 years of my experience, I still see the markets coming back to their supply/demand fundamentals, and should I say, working out these shortages, be it through high prices or for that matter the surpluses through creating low prices.

Johnson: Fair enough. Give us an outlook, right now, where it is the situation in the U.S. that we are awash in oil and gas, inventories are very high. What's sort of the near- to medium-term outlook for these markets? What are some of the fundamental factors behind that?

Snell: Sure. Natural gas, of course, we are still dominantly a domestic market, 98% of our supply roughly still comes from North America, and of course, the recent discovery of the technology to extract gas from shale has allowed for a production capacity in the United States that, frankly, is a blessing to the economy. That is, we have a cheap, relatively clean-burning fossil fuel that is domestic, a source of energy that we seem to be capitalizing on.

Now, price-wise that has obviously created lower values for natural gas, but at these levels natural gas has become very competitive with coal as a source for generating electricity. It's obviously cheaper to heat our homes now than it ever has been. Likewise, we are starting to look at ways in which to use natural gas to fuel cars or trucks, and the technologies that take place that would let that happen--to make natural gas and natural substitutes for maybe even diesel or unleaded. All those are good news stories in what is relatively a seasonal low right now for natural gas.

As we look forward to the next couple of months, in fact, the price of gas had probably got a little bit too cheap. Probably getting to a level where we are starting to see the marginal cost of production affect–the marginal cost of production, actually, should I say, be higher than where we are right now. And I think you are probably going to start to see some production decreases that may allow for, given the fact that we have a tendency to rally into the fall, may allow for natural gas prices to increase in the next couple of months.

Johnson: So, the fact that some supply could at the margin potentially come out of the market may further boost that seasonal uptick that we see?

Snell: Yes. The reduction in supply due to lower price along with the fact that, obviously, we do have inevitably surprises in the weather as we start to move into the early part of the winter.

Johnson: And what about the oil markets?

Snell: Oil market is a little bit of different animal, and it is a world commodity affected by many, many other variables. And of course, one of the biggest variables has been the demand that has helped to keep oil prices relatively high compared to natural gas--has been the demand out of Asia with many commodities that they have been in great demand for.

...We've seen a continued increase in demand from crude oil for China particularly. That has obviously helped to hold up the price of crude oil. However, crude oil has a very, very strong correlation to the stock market, and frankly as you look ahead to the next 12 months, I suspect that the direction of the crude oil will be heavily dependent on the recovery or lack of recovery in our economic situation.

Johnson: So, if you want crude oil exposure, maybe the S&P 500 is a good proxy.

Snell: They almost might be one and the same, yes.

Johnson: Well, John, thanks again for joining us today, sharing your insights.

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