Commodities bubble burns big investment funds

The deflating commodities bubble is claiming its first casualties as large investment funds absorb staggering losses from bad bets that prices for oil, precious metals and grains would keep going up.

Hedge fund operator Ospraie Management LLC notified investors Tuesday that it's closing its flagship fund after it suffered losses in August on positions in energy, mining and other natural resource-related stocks that left the fund down nearly 40 percent year-to-date. It's believed to be the first hedge fund to go bust in this latest commodities boom as prices come crashing down after a historic bull-run earlier this year.

And the bloodletting may have only begun. Wall Street analysts say similar trouble looms for other funds that got caught up in the exuberance of the boom but were too late in getting out.

They say Ospraie's misfortunes illustrate one of the hard lessons emerging from the commodities bubble: Many money managers have never been through a commodities boom and so were ill-prepared for the hyper-volatility associated with hard assets.

"You're always going to have victims when a market comes down this fast. People stayed at the party for too long," said Phil Flynn, energy analyst at Alaron Trading Corp. in Chicago.

As commodities prices soared into the stratosphere in the first half of the year, hedge funds and other big institutional investors plowed money not only into oil, gold, copper and corn, but also into more obscure assets like cocoa, lead and pork bellies.

That, analysts say, helped drive a wedge between commodities' trading price and their real price as reflected by actual supply and demand - foreshadowing the violent correction of recent weeks. Since July 1, crude oil prices has fallen 22 percent, gold 15 percent and corn prices 9 percent.

At the same time, companies heavily reliant on commodities have seen their stock prices hammered. Oil and gas explorer XTO Energy Inc. has fallen 32 percent in the past eight weeks, Potash Corp. of Saskatchewan Inc. has dropped 27 percent and aluminum producer Alcoa Inc. has shed 11 percent.

The pullbacks have been exacerbated by a widening global economic slowdown that has dented demand for energy and raw materials.

For funds like Ospraie that invested heavily in commodities-related stocks, the whiplash of the market's reversal was stunning.

By early August, Ospraie's flagship fund had $2.8 billion invested, but it had a negative return of 26.72 percent after commodities and related equities fell into a six-week tailspin "characterized by some of the sharpest declines in these sectors in the past 20 years," the fund's founder, Dwight W. Anderson, said in a letter to investors that was obtained by The Associated Press.

The losses left the fund down 38.59 percent so far in 2008.

"As the fund's performance deteriorated, we made the decision - despite continued confidence in the fund's positions - to reduce risk and de-lever the portfolio significantly due to concern of incurring even greater potential loses," Anderson told investors.

The fund, of which embattled investment bank Lehman Brothers Holdings Inc. owns a 20 percent stake, was closed after the losses exceeded a threshold which would have allowed investors to pull out money without restriction, Anderson said. Hedge funds are pools of capital that cater to institutional investors and wealthy individuals.

Spokesmen for both Ospraie and Lehman declined to comment.

The fund's collapse has fed speculation that it was liquidating large positions in recent weeks, possibly adding to the severe downward pressure weighing on commodities in recent days.

Peter Holst, managing director at Delta Global Advisors in Huntington Beach, Calif., expressed surprise at the rapid demise of the highly regarded fund but said it serves as a cautionary tale about the too high, too fast commodities cycle.

"It's disturbing to see the smartest guys in the room losing so much money in commodities," Holst said. "The problem is when your holdings are in a momentum sector, your stocks aren't based on fundamentals, so you need to be one of the first ones out, not the last."

Ultimately, unfamiliarity with the white-hot volatility of commodities may have played a factor. It's been over 20 years since the last commodities boom ended, long before the time of many of today's money managers.

"Unfortunately, a lot of people managing vast sums of money haven't lived through this (cycle) and don't know. It hurts," Holst said.

More bad news could be ahead for other hedge funds. Jon Nadler, analyst with Kitco Bullion Dealers Montreal, said large investors have been dumping positions in commodities since Ospraie's failure, suggesting other funds could be in trouble.

"One ... has to extrapolate that this failure is not going to be a 'one-off' event," Nadler said in a note. "Not when considering the tens of billions that have been thrown at the commodities sector over the past several years."

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Associated Press writer Joe Bel Bruno contributed to this report from New York.