Veneroso Frank-World Bank Presentation Commodity Bubble Metals Manipulation-6!14!2007

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DRAFT 6/14/2007 2:31 PMWorld Bank Presentation

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Reserve ManagementThe Commodity Bubble, The Metals Manipulation, The Contagion Risk To GoldAnd The Threat Of The Great Hedge Fund Unwind To Spread ProductTo: Global Central Bankers at the World Bank Executive ForumFrom: Frank VenerosoApril 17, 2007Revised as of today July 19, 2007

Introduction

Thank you for this second invitation to speak at your treasury management conference.Last year I was asked to speak only because Larry Summers, who was scheduled tospeak, could not make it at the last moment and I was asked to fill in. I chose to speak onthe subject of the global commodity bubble as well as the U.S. housing and housingfinance bubble and their eventual bursting. My presentation was a bit on the histrionicside, and I know it was greeted with a certain amount of amusement. But I certainly didnot expect that it was of enough interest to warrant a second invitation to speak on thesame topic – particularly with the more august speakers available such as LarrySummers.Perhaps I am reading more into this invitation than I should, but it seems to me that theevents that have transpired over the last year must have intrigued some of you with thethesis that we have had a commodity and a housing bubble, that they may be in the process of bursting, and that this may have some relevance to central bankers and toreserve management.Last year, I did not really focus on central bank reserve management, but I thought thatthis year I might direct my train of thought to some reserve management issues. So, inwhat I have to say today, I will try to work towards two assessments: first, the outlook for gold as a reserve asset, and second, the outlook for spreads and the yield curve, which isobviously very relevant to reserve management.The following paper is very long. So let me give a road map of where I will be going.In the first part of this paper on the “Commodity Bubble”, I make the case that, in realterms, we have had an unprecedented commodity bubble in this decade. This bubble hasoccurred because of unprecedented investment and speculation in commodities, largely by way of derivatives. The far more important engine of this bubble has been leveragedspeculation by hedge funds. Over the last two years prices have climbed even though themicroeconomic fundamentals of commodities have deteriorated. There lies ahead a bursting of this commodity bubble. It is now being triggered by deterioratingfundamentals and it will be exacerbated by eventual investor revulsion which will reversethe extraordinary fund flows that have created this bubble.

DRAFT 6/14/2007 2:31 PMWorld Bank Presentation

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In part two, “Metals: A Speculation to the Point of Manipulation”, I turn to the leadingedge of this cycle’s commodity mania – metals. In base metals and to some degree inwhite metals hedge fund speculation has extended beyond derivatives to purchases of the physical. This has resulted in several variants of classic market “squeezes” across themetals sector. These squeezes in the context of a runaway speculative fervor haveresulted in increases in real prices for some metals that are far in excess of anything thathas ever occurred before for these metals, in particular, and almost all commodities ingeneral. Because of the extraordinary amplitude and duration of these price moves, themicroeconomic responses will be stronger than ever before, generating record surplusesthat will ultimately lead to reversion to the mean or marginal cost. Investor revulsiontoward this commodity subsector should prove to be greater than for other commodities.A consequent reversal of fund flows and the eventual liquidation of physical stocks held by hedge funds should lead to severe undershooting of marginal cost in the years tocome.In the third part of this paper, I consider gold. Gold’s fundamentals are far better thanthose of base and white metals. Unlike other commodities, there is zero mine supplygrowth in gold. Unfortunately, growth in physical demands for gold in jewelry, small bar and official coin has been surprisingly negative over the last decade plus, especially informer gold loving Asia. The net flow of gold from official stock liquidation in all itsforms, which had been depressing the gold price, has now disappeared, eliminating aformer potentially bullish factor for gold. The last advance in the price of gold since mid2005 has been driven by funds. Gold and other metals have been especially closelycorrelated in this cycle, perhaps because funds have similar portfolios driven by a similar psychology toward all metals. Therefore, a revulsion by institutional holders fromcommodities in general and the metals sector in particular constitutes a serious contagionrisk to the gold price.

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Part I: The Commodity BubbleMicroeconomic Dynamics Dictate Commodity Cycles

Let us first consider the bull market in commodities in this cycle. That is a first steptoward drawing some implications regarding the outlook for gold as a reserve asset.I will start with a recap of my thesis from last year.Commodity prices move in cycles. Their cycle tends to be strongly correlated with the business cycle. However, since the end of the 1970s our business cycle expansions, inthe United States at least, have been longer than in the past. The expansion of the 1980slasted eight years. The expansion of the 1990s lasted ten years. Commodity cycles havenot tended to be this long.

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