Commodity prices are coming under a lot of scrutiny lately since they are largely being held responsible for the inflationary threat to the economy. Commodities are a great lesson in supply and demand but the massive price increases in this group over the past 7 months has very little to do with supply part of the equation. If you pull up a chart of almost any of the most commonly traded Commodity ETFs (DBC, GSG, MOO, DBA, GLD, IAU, SLV, USO, OIL, etc.) you will see approximately 50% gains since the beginning of August 2007. In the year from August 2006 to August 2007, these ETFs were flat with some up marginally and others down marginally. So if you want to know why commodities and their related ETFs are spiking higher, you just need to evaluate what changed. Obviously, since supply factors are not causing a shock to prices, it’s all about demand. But what kind of demand?

Is it natural demand from consumption? China and the global growth stories are providing real consumption demand. It’s undeniable, but prices are growing much faster than the natural demand is rising.

In fact, world oil demand is expected to have very moderate growth and the International Energy Agency (IEA) recently cut their forecast to 87.6 million barrels per day, which is only 2.1% higher than last year’s consumption.

We know that agricultural commodities have increased demand due to the ethanol fiasco and the improving diets of emerging countries, however I suspect on a global basis it’s probably not much more than the expected economic growth of approximately 3%. Anecdotally, ask yourself how much you think the average person is consuming more than last year? Are you eating 5% more, 10% more, 25% more???? Did any of that change rapidly since August? I doubt it.

Regarding an increase in consumption demand for metallic commodities - as much as you hear about the massive increase due to China, it is not so dramatic on a global scale. I looked up the forecasts for 2008 demand growth and other than steel (+6%) and aluminum (+10%), the other key metals such as zinc, lead, copper, gold and silver all come in between 2% and 4% higher. Furthermore, there is no surge in incremental demand as most of these growth percentages have been relatively constant for years.

In summary, global demand for almost every commodity is not growing much faster this year than it grew last year and there has been no significant increase in demand forecasts since August 2007 when the price spikes started.

There are tight inventories in some areas, but there have been only minimal supply problems and we know that consumption demand has not risen unexpectedly or dramatically. So what is causing the prices to spike 50% in the past 7 months? What is causing all this commodity inflation?

Many politicians and investors love to blame the traders in the commodity pits for running up the prices. As I have written here before, I think that blaming traders for speculating is odd. That’s what they do and they take both sides of the trade. Hedge funds? Same goes for them - they are traders. Without a doubt, they are contributing to the higher prices, but they do not have the power to move things so far so fast.

In my opinion, the real cause of this problem is easy to identify. It is a combination of monetary and fiscal policy of the United States Government coupled with investment demand, much of which is a result of those failed policies. The reality is the main thing that has dramatically changed since August is the credit crisis and now, the stock market declines.

Commodities is the last main asset class that is not declining so it gets a massive increase in demand for hard assets. Capital leaving fixed income and the stock market have to go somewhere. As long as the Fed and the Treasury devalue the dollar, it will continue. As long as bond markets are in disarray and stocks slide, it will continue. This asset allocation demand is a very powerful force. Just remember it works in both directions. When it reverses, I expect that 33% declines will be common.

We’ve had commodity prices rise before, but when that happened in the past, most commodity ETFs did not exist. Increasingly since 2005, retail investors and their advisors now have a convenient choice to park capital and in my opinion, the existence of the commodity ETFs traded in the US and on the LSE are having a significant impact on prices. Just look at the assets in the Gold ETFs - they have increased approximately 100% from about $10 billion of the yellow metal last year to almost $20 billion now.

Some commentators expect the final thumping in financial markets will come from a decline in the commodities (the last hope for capital appreciation and preservation).  If margin calls and forced deleveraging require that commodities are sold to generate capital, I agree that could be a catalyst for their demise.

If any or all of the following happens, I would be looking to exit commodities: the economy stabilizes, the credit crisis abates, the stock market bottoms and the dollar appreciates. Until then, I think the commodity ETFs will feed on themselves and head higher.

I like Commodity ETFs as an investing and hedging option, but they are contributing to the inflation that Bernanke is ignoring (maybe because he is largely responsible for causing it.)  I am watching for divergences in underlying price growth and the asset values in the ETFs to figure out when the run is ending. When investors decide to pull money out of commodities to reallocate to stocks and bonds, these commodity ETFs will get whacked.