Fund flows pushing commodities prices higher, but at what cost?

Citigroup’s Metals and Mining team issued a note Monday talking about how fund flows—not global economic growth—are driving commodities prices higher. While copper’s skyhigh price makes sense because inventories are so low, the other industrial metals don’t have the same problem. Still, prices are rising.

The Citi report—brought to the market’s attention compliments of a story on the FT’s Alphaville site—says: “Aluminium, zinc, lead and nickel are ‘aping’ copper, even though their credentials are far inferior to copper.”

There’s an explanation, of course:

Funds buy baskets which have fixed components. Those baskets consist of commodities that have genuine claims to superior performance along with lower quality ‘pretenders.’ All live happily ever after side by side in the baskets. Until Economics 101 emerges from the cupboard. At the moment the ‘financing deals’ that have temporarily sanitised mountains of aluminium inventory are conspiring against 101. An unattractive contango and high carrying costs are threatening this sanitisation.

Citi says ‘people committing those fund flows do so in anticipation of the fact that the market will eventually wise-up to the ‘ongoing supercycle’, and will justify the current seemingly unjustifiable rises…’

All of this is similar to that little problem the U.S. faced with its sub-prime lending crisis, it said, where lending 120% of a property’s value to sub-prime borrowers was scientifically explained away by lumping them into ‘baskets’ with better-quality borrowers.

Watch this space.