02/06/2008 (The Star Online) - HUGE investment funds are driving up prices of commodities, said US Senator Joseph Lieberman, chairman of the Senate Homeland Security and Government Affairs Committee recently.

Having formed this view after listening to testimony from experts, he said he might draft legislation to limit the participation of institutional investors in commodity markets.

This was the debate in the US. Fund managers might have added fuel to the prices of commodities – food, oil and metals – that were already rising due to demand from the billion over population of China and India.

A hedge fund manager, Michael Masters, told the Senate Committee that on its question of whether institutional investors are contributing to food and energy inflation, “my unequivocal answer is yes.”

He listed pension funds, sovereign wealth funds and university endowment funds as a new category of participants in the commodity futures markets.

He offered some data to support his viewpoint – institutional investors' allocation for commodity futures rose from US$13bil at end-2003 to US$260bil at the end of March.

Over the same five-year period, the increase in demand for oil futures from institutional investors was almost as much as the increase in demand from China. The institutional investors had similarly bought massive amounts of futures contracts for corn and wheat, he said.

Masters absolves traditional speculators from any fault, drawing a distinction between them and institutional investors. Traditional speculators buy and sell futures contracts, and provide liquidity for the markets.

In contrast, institutional investors buy the contracts and later roll over their positions. They don't sell. Hence, they consume liquidity and bring no benefit to the functioning of the markets.

In a widely reported plan, California Public Employees' Retirement System (CalPERS) said in February it might increase its investments in commodities to US$7.2bil by 2010.

It had seemed harmless when fund managers ploughed long-term capital into commodities. In fact, it seemed to be a new but profitable asset class for them. Now, with too much money chasing commodities, including food, the US may impose limits to their purchases.

That would lead commodity prices to decline further from record levels but prices would likely remain moderately high.

Commodity gains
All the steel milling companies reported a surge in earnings in the first quarter (Q1) of this year. Their profit margins from the conversion of scrap iron into billets and steel bars widened as China's exports declined, which led to a rise in steel prices.

Some of the steel profits came from stocking up scrap when management anticipated costs would soar. There could thus be substantial “inventory gains,” as most analysts have noted. The quantum of such gains, however, is not unclear.

As such “inventory gains” could be hefty, it is helpful for investors if the companies could provide an estimate of it. If not, a sharp drop in earnings, when the cheap inventory has run out, would surprise investors. A clear picture would help investors to prepare a more accurate valuation of the steel companies.

Two industries – plantations and airlines – offer clearer guidance, although it also differs among companies.

In plantations, some companies disclose in their quarterly results the average selling price obtained for their fresh fruit bunches (FFB). That is helpful for investors to gain a better understanding of the results.

Output, another important figure, is provided monthly by all the companies that produce commodities – FFB and logs – which is a useful legacy of an age-old requirement by Bursa Malaysia.

There is a shortfall in useful disclosure even in this industry. Some of the plantation companies aggressively or “conservatively” sell forward their FFB, and as palm oil prices surged, the effect was millions of ringgit of foregone profits.

These involve substantial sums of more than 5% or even 50% of their profits. The companies should be required to announce such forward selling and the prices involved as soon as the combined contracts form more than 5% of a year's output. This would be helpful in the analysis of earnings forecasts as well as reassure cynical investors that there were no backdated contracts.

Airline companies provide a more detailed account of their results than most manufacturing companies. A factor in this could be that most airline companies interact with analysts whereas some of the manufacturers, especially the smaller ones, have no interaction with them.

Even among airline companies, however, some offer information on their fuel hedging commitments and some do not, while others offer that only to analysts at a chosen time. Fuel hedging affects airline profitability substantially and therefore is useful information for the investing public.

In its results statement last week, AirAsia Bhd detailed its performance indicators such as sales volume (passengers carried), average fares, passenger load factor, unit cost and even non-fuel unit cost.

AirAsia also indicated a large foreign exchange (forex) gain of RM86.2mil in its Q1, which some analysts took issue with as they stripped that off its net profit. The gain arose from the US dollar loans taken for the airline's fleet purchase when the dollar was much stronger.

The forex gain will probably be recurring, although fluctuating, in the same way that importers are likely to enjoy forex gains.

While analysts were focused on the forex, AirAsia also showed steady gains in revenue and passenger traffic. While times are hard for airlines, AirAsia could eventually emerge even stronger if the regional budget airline industry consolidates.

Other than some sectors like steel, flour and palm oil, companies in most other sectors reported a narrowing of profit margins last week. Those that grew their profits did so with gains in sales volume.

Mah Sing Group Bhd in property and Kossan Rubber Industries Bhd, for instance, were consistent with earnings growth of 24.6% and 22.4% in their Q1 respectively.

In subsequent quarters, the results of companies will depend on how well they pass on the higher costs of raw materials to consumers – it's either a margin squeeze for them or inflation for the consumers.

It would be a relief for everyone if Senator Lieberman could vastly reduce the purchases of commodities by long-term investment funds, and commodity prices could ease back a bit.