London, 9 May 2011: Reuters

Over the next few days, once they recover from shock, analysts and investors will try to seize control of the market and fashion a new narrative for commodity prices in the wake of Thursday's brutal sell off. At banks and hedge funds around the world, the telephones will be working hard as traders, sales staff and portfolio managers make contact with clients and one another and try to work out where commodity prices go from here (and to ask for more margin in the nicest possible terms).

Two big narratives will be battling it out. In the bullish camp, this is no more than a temporary setback. Markets had become overheated -- moving too far too soon. But the fundamental forces driving prices upward over the last six months, and indeed over the last six years, have not changed. Prices are likely to resume their climb once the current wave of panic-driven liquidation has been completed.

For the bears, the events of the last 24 hours signal the top of the market. Investors had become caught up in a speculative mania. Like other manias, this started with some fundamental justification, but price increases far outstripped the level that could be sustained. Markets carried on rising on a cycle of self-validating buying. But like all bubbles this one burst when the prospect of further gains no longer outweighed the growing risk of a setback.

As usual the truth lies somewhere between these extremes.

STRATEGY AND OPPORTUNISM

The record speculative net length that had built up over the last six months in crude oil futures and options seems to have some from a mix of structuralists and opportunists. Structuralists believe continued increases in commodity prices are inevitable owing to fast-growing demand from China and other emerging markets, continued supply bottlenecks, and the inflationary implications of low interest rates and quantitative easing in the United States and some of the other advanced economies.

Opportunists are agnostic about fundamentals but spotted a good narrative that would draw in more investors and could lead to self-reinforcing price increases. Billionaire financier George Soros last year described gold as the "ultimate bubble". But as he has explained before bubbles are there to be embraced and exploited rather than avoided.

Opportunists are not invested for the long haul. They are behaviouralists and momentum traders. They want to ride the bubble, then get out when the narrative starts to change or lose traction with investors.

As former Citigroup CEO Charles Prince explained "As long as the music is playing, you've got to get up and dance." As with the game of musical chairs, the trick is to have an exit strategy before the music changes.

To the extent the rally was driven by structuralist money -- much of which is committed to the market for the medium to long term -- prices should be well supported. But to the extent rising prices were underpinned by opportunistic investors who may now be looking to exit the market, a deeper pullback is possible.

FROTH AND FUNDAMENTALS

The two most notable developments in the oil markets in recent weeks were (1) the increasing chatter about demand destruction which had displaced the previous emphasis on geopolitical risks and supply constraints as the dominant narrative; and (2) reports that Soros' fund had started to trim its gold holdings.

For opportunists, mounting talk about demand destruction, and perhaps the first "nascent signs" of it in oil consumption data, was the signal that the narrative was about to shift.

Soros reportedly starting to exit gold -- and talk of other investors quitting silver or going short -- was a sign the biggest and most sophisticated opportunists were starting to get out. If Soros was beginning to exit gold, it raised the question of whether he and other big opportunists were also starting to liquidate long positions in oil and other commodities.

There is no doubt that Thursday's sell off has removed some of the speculative "froth" from the top of the market. But as Alan Greenspan found out in the American housing market, once the froth has blown away, the underlying fundamentals do not always look pretty. U.S. home prices are still falling nearly five years after the market started to turn down.

In the case of oil, the narrative about strong demand growth from China and other emerging economies remains intact. Geopolitical risks have receded but have not gone away. Supply growth remains uncertain and potentially costly.

But demand restraint and destruction is occurring, and will accelerate the higher prices go and the long they stay there. As the short-term spike of 2006-2008 becomes a medium-term "permanently high plateau" (to misquote U.S. economist Irving Fisher) alternative sources of supply and new technologies become viable and pose an increasing threat to oil.

Just because some of the froth has blown off does not mean the outlook for prices has become any more certain. The only thing that is reasonably clear is that even after Thursday's sell off, crude remains very expensive in real terms.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed here are his own.