Every day thousands of new cars hit the roads in China and they all travel on rubber tires. The four wheels on your car, or the 14 wheels on the trucks hurtling between Beijing and Shandong and beyond are the most obvious evidence of the importance of the rubber industry.

This increasing demand is distorting rubber pricing in the same way that other commodity prices are also distorted. The price behavior moves beyond the simple relationship between supply and demand and is influenced by derivative price behavior.

The basics of this market are simple economics. Rubber is extracted from trees using methods, which have not changed significantly in the last 100 years.

It's labor intensive and suitable for small farmers and larger plantations. When demand is high there is a push to increase the cultivation area for rubber.

This supply lags demand because it takes around 7 years before a rubber tree starts to produce rubber but the tree continues production for around 25 years.

The alternative to natural rubber is synthetic rubber, which is a by-product of the oil industry. When oil prices are high the demand for cheaper natural rubber increases.

When oil prices are low synthetic rubber becomes cheaper and the demand for natural rubber falls. Traditionally the analysis of future rubber price movements has been closely tied to the future price of oil.

At the recent ASEAN Rubber Conference in Malaysia I examined the three features that dominate the rubber 2010 outlook. The first feature is market and trend volatility and trend divergence. The second is currency volatility.

The third is the recent confirmation of a head and shoulders pattern in the Japanese Tokyo Commodity Exchange rubber market. This pattern is a very reliable indication of significant downtrend pressure. The first two features affect many commodity prices.

Combined, they have a substantial impact on the price objectives for rubber. They also have a very large impact on the stability and continuity of the trend. Trend instability is a feature of global financial and commodity markets after the global financial crisis.

The first feature is the divergence in price trend behavior between oil and rubber. The rubber price has continued to move strongly upwards at a time when the oil price remained relatively stable.

This is an unsustainable bubble and it leads to longer term price corrections in the rubber price as the normal oil and rubber price relationship is re-established.

This bubble is influenced by the second feature, the currency volatility in the dollar index. In the past year the behavior of the rubber price closely follows the behavior of the dollar index.

This is a new behavioral relationship. The recent trend in the dollar index is defined with a parabolic curve, which suggests a significant correction will develop. This dollar index volatility transfers to the rubber pricing. The third feature is the recent confirmation of the strong head and shoulder pattern in the Japanese rubber market. This supports the bubble analysis derived from the first two features.

The head and shoulder pattern is not as strong in the Shanghai Rubber Futures market but it gives a downside target near 19,200 yuan. The pattern is invalidated with a move above 24,500 yuan.

Commodity pricing behavior is no longer a simple matter of seasonal supply and demand. Commodity investment funds have moved into this area. They are using a variety of financial methods and derivatives to 'invest' in commodities by using futures on a long-term basis.

The development of commodity funds that use exchanged traded notes based on holding futures positions for long-term investment has an impact on the market.

This reduces the efficiency of the commodity futures markets by reducing day-to-day liquidity.

This lack of liquidity helps to create price bubbles that are not related to underlying demand and supply of the commodity.

These pricing anomalies are further exaggerated by currency volatility. Commodity traders need to develop currency-hedging skills to manage the new commodity trend instability.

The author is a well-known international financial technical analysis expert.

(China Daily 06/21/2010 page14)