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'We create our own reality.' The words are attributed to one of President George W. Bush's aides speaking a few years ago. But they could just as easily describe Washington's and Beijing's impact on the commodities market now.

With oil inventories high and demand down year on year, yet prices surging, 'fundamentalists' are puzzled. Market participants, however, always have an eye on the future and locking in a profit.

Recently, commodities bulls have been aided by the Federal Reserve keeping rates low and banks' short-term funding flowing. This facilitates commodities trading and stokes fears of inflation. As cash flows into oil futures, their prices rise relative to spot prices. That makes it profitable to buy physical oil, store it and sell it forward.

Energy economist Phil Verleger demonstrates how lucrative this can be. On March 1, the cash price of light, sweet crude was $40.15 a barrel, while the 12-month forward contract sold for $50.26. Assume an investor bought the physical barrel borrowing 80% of the money at a rate of 3%, sold it forward, and paid 50 cents a month for storage. The resulting profit of $3.15 a barrel equates to a 39% return on investment.

In reality, financing and storage costs aren't static. As spot prices have risen faster than futures, the spread has narrowed and the volatile trade recently turned unprofitable: On Friday, the return was zero.

Rapid liquidation of inventories could crash prices. Financial-services provider GaveKal puts global commercial inventories at six billion barrels. Crudely calculated, that is more than $400 billion of precious working capital tied up.

Yet oil has held up. Inflation fears aside, the 'green shoots' thesis also lends support, although this is self-reinforcing: The more optimism on the economy, the more oil prices rise, fueling more optimism. On that reading, last July's $145 a barrel should have betokened eternal prosperity.

Recently, the 'decoupling' thesis has resurfaced. China's official growth figures, while bowed, remain positive. Imports of crude oil rose by almost a third between January and March. In the first quarter, China took 75% of the world's seaborne iron ore, according to Macquarie Bank.

China's appetite for commodities is well-established, but the card looks overplayed this time. First, China is big, but not that big. In the first quarter, it accounted for 9% of global oil demand, compared with 55% for the largely recessionary industrialized world.

As for iron ore, Chinese consumption is growing fast, but its market share is flattered by collapsing demand elsewhere. Iron-ore prices have fallen.

Most of the surge in apparent consumption also reflects Beijing's stimulus efforts and likely stockpiling of resources. Sanford C. Bernstein estimates the first phase of China's new strategic petroleum reserve may have boosted imports by 400,000 barrels a day in March and April. Inventories likely will be worked off and apparent consumption growth will wane in coming months.

The elusive ingredient, with both short- and long-term implications, is much higher domestic consumption in China. Stimulus dollars helped push up fixed-asset investment by almost one-third in the first quarter, but consumer spending rose less than 10%.

Stephen Roach, chairman of Morgan Stanley Asia, says China remains too weighted to foreign trade, with private consumption accounting for only 36% of gross domestic product.

Unlike in previous economic crises, such as 1998, current infrastructure-focused stimulus efforts are unlikely to segue neatly into a rebound in export markets, as recovery elsewhere will be slow. Beijing's coffers are large and will likely offer a brake on sudden falls in commodities prices. Ultimately, however, the danger for China, and commodities bulls, is that Beijing's efforts fail to fully offset the harsh realities afflicting the world economy as a whole.

Liam Denning


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