China Behind Chilling Drop in Commodity Prices

China is the real culprit behind the chilling effect that has hit the hot commodities sector over the last few days.

Gold coins and bar
Gazimal | Iconica | Getty Images
Gold coins and bar

After the Bank of Korea boosted interest rates for the second time this year and the China Securities Journal said the Chinese government will take further steps to control price increases, China's key stock index, the Shanghai Index, plunged 4 percent overnight. Commodity prices have followed suit in today's U.S. session.

Gold prices, trading below $1,330 an ounce intradayTuesday, have plunged nearly $100 in five days. U.S. oil futures have fallen 7 percent from the 2010 high over $88 a barrel reached last Thursday. Copper prices are now at a one-month low, down over 5 percent so far this session.

And while the peripheral debt issues surrounding Ireland and Greece have compounded the selloff in commodities, it's the tightening of liquidity, exacerbated by talk of China attempting to cool down its economy, that has caused this sharp pullback in commodities, traders say.

"It's been the rising economic growth story in China and the belief that quantitative easing would make the dollar weak that boosted the attractiveness of oil and commodities to two-year highs," says Gene McGillian, an analyst and broker at Tradition Energy. "Now that it appears China is trying to put a brake on its economic growth and European problems are resurfacing. It's boosting the dollar and forcing liquidation in commodities."

The dollar index has risen above its 50-day moving average, the first time it has done so since early September.

Market sentiment has changed dramatically in just a few trading sessions. "If all of a sudden central banks—namely China—don't have the same fervor for commodities, then the first assets that spec traders will dump are precious metals and natural resources," says independent trader John Netto of M3 Capital. "The real issue is the perceived tightening of central banks out there."

So how low could commodities prices go?

Gold prices, already down $35 today, broke a key area of support at $1,350 and could test $1,320 an ounce as traders continue "cautious selling ahead of next week's option expiration for Comex metals" and the large rollover from December to 2011 contracts in precious and base metals, says George Gero, precious metals analyst at RBC Capital Markets.

McGillian says oil prices, which have been trading between $70-$90 a barrel all year, could face further pressure the more futures approach the $80 mark. Expectations for an increase in U.S. crude oil supplies last week could also add to the weakness in oil prices—Platts' survey of analysts estimates U.S. crude oil supplies rose by 1.2 million barrels in the past week.

Many traders say this market was due for a correction. Now the CRB Index—representing 19 commodities—has given up nearly all of its November gains. Still, that index has risen over 15% in the past 6 months, led by even greater gains industrial commodities, including oil, copper, silver and palladium.

"When traders sniff even a subtle change in sentiment, these pullbacks happen," Netto says. "But we are still very much entrenched in a secular bull market in energy and commodities."