Perhaps We’ve Gotten Ahead of Ourselves

Commodity Prices have been on a tear. No question about it. Gold has traded over $1,300 per ounce and silver is over $21 an ounce. The grain markets have seen huge gains in corn, beans, rice and oats. Even markets like coffee, orange juice and cotton have participated in the broad commodity rally. Does this mean it’s a good time to put more money in commodities? Not necessarily. This is where our philosophy diverges from stockbrokers. We don’t generate revenues for the firm based on equity under management. Therefore, our best business practice is to provide our individual traders with information that will help them be successful over the long term.

The commodity markets as a whole, have built this rally on the economically sound principals of inflation, which include a declining dollar and low interest rates. However, according to the data that I’ve been watching, it’s quite possible that we’ve gotten a bit ahead of ourselves in the economic cycle. At this point, the anticipation may be greater than the event.

Starting with the big picture. There is a third component to inflation that hasn’t gotten much press over the last year and that is, velocity. Velocity in economics is how quickly money is changing hands. The higher the velocity of a dollar and the more it circulates, the more action there is in the economy and the closer we are to potential inflation. What we’ve seen since the economic crisis began and the housing bubble collapsed is that the Federal Reserve Board has flooded the economic system with Dollars.

The adjusted monetary base of the United States has increased nearly 25% since September of 2008. Broadly speaking, this means there are 25% more dollars in our pockets and in our checking, savings and cd accounts at the bank. However, as I wrote last week, Americans are finally starting to save their money. This is why the velocity of money has declined by more than 17% since the economic crisis began in 2008. This is in spite of the Federal Reserve Boards attempts to stimulate spending.

The United States is the financial trading center of the world. We have the most mature stock and commodity exchanges. They are the most highly regulated and also the most liquid. Therefore, we are the hub of the global financial network. The commodity markets here in the U.S. service 40% of all traded commodities. Therefore, the prices of commodities traded here in the U.S. actually reflect a global view of fair value. The decline in the U.S. Dollar has made trading prices in the U.S. seem like the latest sale at Kroger, just bring in your Treasury coupon for double points.

Finally, in the weekly Commitments of Traders Reports, we have seen a very large build up of large speculator and commodity index trader long positions with the commercial traders increasing their short positions as the markets have climbed. The fact that many of these markets are significantly below their pre financial market collapse highs of early 2008 is a telltale sign that the current market rallies may be over extended. It’s important to note that the two groups supporting the commodity markets have no ties to fundamental value. The large traders are simply trend followers. They are willing to be long or short any market at any time. The commodity index traders are only allowed to purchase commodity contracts to keep their portfolios properly weighted. They will add positions as the market climbs and offset positions as needed on a market decline.

Commercial traders are the producers or, end line consumers of the actual commodities themselves. They are keyed into the entire production mechanism and have a keen understanding of the issues affecting their markets. The general theme I see building is that they believe many of these markets are substantially overbought and inflation is further away than we think. While they do believe there is inflation coming down the pipeline, they believe it is further off than the commodity markets are making it look. They have bought up large positions in short term Treasuries while taking a decidedly more bearish tone towards the long end of the yield curve. In fact, the commercial trader net position in the 30 year bond is the most bearish it’s been since 2005, prompting me to consider taking profits in our bond trade from several weeks ago.

The combination of an economy flooded with cash led many investors to anticipate inflation down the road, which makes commodities a very sensible place to put money. However, given America’s newfound desire to save, the flood of cash hasn’t quite had the textbook multiplier effect that was expected to increase GDP 50% for every dollar spent by the government. Given the over extended state of some markets combined with fundamental data supporting declining velocity, it may be a good time to adjust risk in the commodity markets.  Velocity will increase and repurchasing commodities on a pullback could be an effective strategy once the actual race finally gets going.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

Economic Recovery or, Shell Game?

The National Bureau of Economic Research, the ones in charge of official business cycle dating, said Monday that the recession officially ended in June of 2009. Their statement allowed that although economic conditions may not have been favorable since then and that the economy has not returned to normal operating capacity, the recession ended and a recovery began in June 2009. This is good press for the incumbent party heading into election season. However, this is also a brightly burning example of why we shouldn’t trust a sound bite.

 

The bursting of the domestic consumption based economic bubble has left the politicians scrambling to secure their next terms in office. The best way to guarantee re-election is to make everything seem all right to the general voting public. I’m not taking sides in this. The problem is more systemic than it is partisan. The issue starts at the top with former Federal Reserve Chairman Alan Greenspan and the torch has been passed to Ben Bernanke, another Federal Reserve Chairman bound and determined to keep the money flowing. My sincere fear is that the day of reckoning will come when the people who buy our Treasuries to service, and grow, our debt will say, “This is a bad deal. We need to be paid a higher interest rate to take on your credit risk.”

 

The United States as a country has become an unfortunate reflection of the consumer society that our politicians have sought for generations to instill in their constituents. We are now facing the same economic problems at the national level that used to be handled at the dining room table by the family. We are simply over extended. We have spent too much for too long. We must admit that the budget surplus of the Clinton era had more to do with fortuitous timing than sustainable growth and that our projections were wrong. The paradox is that the same legal/governmental system that is all too ready to jump in and save the individual from their own bad decisions fails to acknowledge their own fallibility. The institution of government is being failed by the hubris of the individuals running it.

 

Enough hyperbole. The shell game is being played out in the transfer of private debt to governmental debt. This has enabled business and personal consumption to carry on with as little personal or, corporate lifestyle adjustment as possible. The United States’ personal rate of savings has climbed from 0% in June of 2004 to 6% currently. Over the last 50 years, 6% is much closer to the average. As individuals began to save, governmental spending increased 82% and our deficit grew from 7.35 trillion in 2004 to an estimated 13.4 trillion this year. It is estimated that the gross federal debt will approach 90% of gross domestic product. That leaves 10% of GDP to make the interest payments on existing debt and cover all national expenditures. For example, if your take home pay were $50,000, $45,000 of it would cover your minimum monthly interest payments. The leftover $5,000 would have to cover a year’s worth of basic living expenses like food, clothes, gas, entertainment, etc. The Congressional Budget Office estimates that gross federal debt will exceed gross domestic product by 2012.

 

The government, just like us, has run deficits going back to the Civil War. The issues are size and accountability. Deficits were designed to allow for the purchase of goods and services based on future earnings. This is how we buy houses and cars. The concern is the overextension and lack of self or, governmental control. It is the inability, “Just say no,” that gets all of us into trouble. A politician who stands up and suggests we all tighten our belts will have $0 funding for his election campaign. Businesses won’t contribute, banks won’t contribute, special interest groups won’t contribute and if the politician’s constituents listen, they won’t contribute either. Therefore, the plan to get us out of this mess is by spending more money while devaluing the U.S. Dollar.

 

The plan goes something like this. The government sells more Treasuries on the open market to generate stimulus funds to be spent on domestic programs to placate the people, domestic businesses and special interest groups.  The more Treasuries the government sells, the more U.S. Dollars it places in circulation. The more Dollars in circulation, the less they’re worth. The less the Dollar is worth, the more expensive it becomes to purchase foreign goods and services. This encourages more people to, “buy American.” This also makes domestically produced goods and services cheaper to purchase for foreign countries, therefore, increasing U.S. exports. The hope is that this will allow U.S. businesses to gain traction and begin hiring again.

 

In normal times, this has kept the balance of things moving forwards. I would suggest that these are not normal times. First of all, we are starting this process from a much higher debt ratio than ever before. Assume that you’re very nearly maxed out when an unexpected major medical expense or car repair comes up. Secondly, the U.S. has been able to grow its debt periodically through the sale of Treasuries when needed because we have, more or less, managed our expenses, which made the U.S. a safe credit risk. This is like being able to make at least the minimum monthly payments to your creditors in the roughest of financial times. Third, the Dollars we are borrowing will not be worth as much as the Dollars we are repaying. Typically, this difference is made up in the interest that we have to pay back with the principal. Finally, this is the same path being sought out by the entire Euro zone, England, and Japan, which puts us in the middle of a global competitive devaluation.

 

The end result is that it won’t take long for the countries that are lending us money to decide that they can do better lending to someone else, perhaps another country or, their own populations. Keep in mind that we are talking about the creation of new debt or, extending more credit on top of the current debt we will be struggling to pay the interest on. Essentially, following the path of increasing deficits in an attempt to grow our way out of societal gluttony and the misguided actions of elected representatives will only continue the downward debt spiral until someone has the courage to stand up and yell, STOP! As we approach this election season, I’ll cast my ballot for the candidate that simply states, “We’re going to have to learn to do more, with less.”

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

 

Crude Oil vs. Natural Gas Ratio Spread

This week’s trade has been all about the spread between natural gas and crude oil. Using inter-market analysis allows us to compare the value of substitute goods. In this case, we can compare the price of crude oil to the price of natural gas to determine what price levels it becomes cost efficient for the markets’ participants to shift their energy needs from crude oil to natural gas and vice versa. The key to this type of analysis is using the proper pricing methodology. The calculation of the crude oil vs. natural gas spread is done using a ratio spread. Dividing the price of natural gas, currently around $4 per million metric BTU’s into the price of a barrel of crude oil at $77 gives us a ratio of 19.25. This ratio peaked at an all time high of 22.7 in April of this year.  A spread ratio closer to 12 would represent an average relationship over the last few years.

 

The trick to trading this ratio is to try and create equal dollar movement in both contracts. We want the trade’s profit or loss to be accurately reflected by the ratio’s movement. If we were to simply do a one to one spread, buying natural gas and selling crude oil, we would end up with an imbalance on the side of the trade that has the largest daily dollar movement.

 

This problem is solved by using the average daily range multiplied by the market’s point value to provide us with the average daily dollar fluctuation of the individual markets. Crude oil’s nine day average range is exactly $2 per barrel. There are two sizes of crude oil contracts, the full size and the half size. The full size is $1 per point, which means an average daily range of $2,000. The half size obviously yields an average daily cash fluctuation of $1,000. The natural gas market has an nine day average range of .1563. This market also has two contract sizes. The full size contract which, has a daily cash fluctuation of $1,563 and a quarter size mini contract which, fluctuates about $390 per day.

 

Now, we have the pieces to construct a trade that is dollar value neutral and will accurately reflect our natural gas to crude oil ratio spread. Ideally, we would sell one full size crude oil contract with a daily fluctuation of $2,000 and buy one full size natural gas contract with a fluctuation of $1,563 plus an additional purchase of one mini natural gas with a daily fluctuation of $390. This gives us an average of $2,000 daily movement in the crude oil and $1,953 daily fluctuation in the natural gas.

More information on crude oil and natural gas can be found at NY Energy Futures.com

 

This type of ratio spread can also be used in grain markets when trying to spread corn or wheat against beans or even the corn to cattle spread. Please call with any questions regarding this trade or, spread trading in general.

 

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

Natural Gas Bottoming?

November natural gas may very well be forming a tradable bottom at these levels. There are several reasons for this.

1) Seasonal patterns in November natural gas tend from the last week of August through the first week of September.

November Natural Gas Seasonal Chart

2)The commitment of traders commercial category continues to add to their positions, adding 11,000+ contracts last week which places them within shouting distance of their all time record long position. Perhaps, more importantly, commercial traders are becoming increasingly bearish on crude while building net long positions in natural gas.

3) The crude oil spread versus natural gas is bumping up against solid resistance at crude oil priced at 20 times the natural gas price. This is reflective of the commercial traders price action.

4) The COT Signals triggered a buy signal for Monday’s trade which corresponded with a technical breakout to the high side.

There are two natural gas futures contract sizes. The full size carries a margin of $5,400 and recent average day range of $1,600. The mini contract is 25% of the full size contract. The margin requirement is $1350 and its daily range is around $400.

Please call with any questions.866-990-0777

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

Following Up on Corn, Weekly Exports and the Dollar’s Devaluation

 

Corn continues to march to new highs, now trading around $4.80 per bushel. Much of what we’re seeing is demand driven. I was looking at corn sales for the marketing year ending September 1st and it validated much of what we’ve been discussing.

 

From the USDA website. China has imported 236,000 metric tons this marketing year. Over the last three years, their U.S. corn imports total 0. Yes, that is a 0.  While this is only 1.5% of our total exports, it must come as a surprise demand factor due their absence of imports in the past. Also of note, Taiwan imported 651,000 metric tons. This is up from 488,000 last year and 0 in the previous two years. Yet another upside surprise. Combine this with Japan’s 66% increase over last year and you have three Asian countries’ demand increasing from 166,000 tons in 2008 to 5,216,000 tons in 2010. This accounts for 1/3 of all exports and obviously represents a HUGE piece of the pricing mechanism. Weekly net exports are as high as they’ve been in the last 10 years.

Fundamental Analytics Weekly Net Sales chart is the 2nd, “Interesting Formation .”Full access to currenc and historical grain reports is available at USDAGrainReports.com

I apologize for the poor formatting. While I may be technically competent, I’m not always technically capable. CORN – UNMILLED                                     MARKETING YEAR 09/01 – 08/31   OUTSTANDING EXPORT SALES AND EXPORTS BY COUNTRY, REGION AND MARKETING YEAR1000 METRIC TONS       AS OF SEPTEMBER 2, 2010——————————————————————————–                      :      CURRENT MARKETING YEAR         :NEXT MARKETING YEAR                       ———————————————————                      :OUTSTANDING SALES:ACCUMULATED EXPORTS: OUTSTANDING SALES                        ———————————————————   DESTINATION        :THIS WEEK: YR AGO:THIS WEEK: YR AGO  :SECOND YR: THIRD YR——————————————————————————–                      :EUROPEAN UNION – 27   :     1.0      0.3       0.0      0.0        0.0       0.0   SPAIN              :     1.0      0.1       0.0      0.0        0.0       0.0   U KING             :       *      0.2       0.0      0.0        0.0       0.0                      :JAPAN                 :  4329.5   2595.1     166.6     88.9        0.0       0.0                      :TAIWAN                :   651.4    487.9       0.0      4.3        0.0       0.0                      :CHINA                 :   236.0      0.0         *      0.0        0.0       0.0                      :OTHER ASIA AND OCEANIA:  1214.5   1696.4      57.3    117.9        0.0       0.0   HG KONG            :     1.3      1.5       0.0      0.0        0.0       0.0   INDNSIA            :     0.0      1.4       0.0      0.0        0.0       0.0   ISRAEL             :   226.0      0.0       0.0      0.0        0.0       0.0   KOR REP            :   832.1   1633.3      57.3     57.8        0.0       0.0   MALAYSA            :     3.3      3.0       0.0      0.2        0.0       0.0   OPAC IS            :     0.0      1.6       0.0      0.0        0.0       0.0   PHIL               :     0.5      0.0       0.0      0.0        0.0    &
nbsp;  0.0   SYRIA              :   151.0     50.0       0.0     60.0        0.0       0.0   VIETNAM            :     0.3      5.6       0.0      0.0        0.0       0.0                      :AFRICA                :  1144.5    557.7       0.0    174.6        0.0       0.0   ALGERIA            :     0.0      0.0       0.0     26.5        0.0       0.0   EGYPT              :  1090.0    487.8       0.0    130.1        0.0       0.0   MOROCCO            :    29.5     49.9       0.0     18.0        0.0       0.0   TUNISIA            :    25.0     20.0       0.0      0.0        0.0       0.0                      :WESTERN HEMISPHERE    :  3739.0   4112.2      61.9    151.2        4.6       0.0   BARBADO            :     3.2      6.1       0.0      0.0        0.0       0.0   C RICA             :   129.4     71.3       0.0      0.0        0.0       0.0   CANADA             :    90.2    251.3       6.7     22.1        0.0       0.0   COLOMB             :   295.5    582.3       0.0      0.0        0.0       0.0   CUBA               :    75.0    200.0       0.0      0.0        0.0       0.0   DOM REP            :   243.1    196.8       0.0      0.0        0.0       0.0   ECUADOR            :     0.0     45.0       0.0      0.0        0.0       0.0   F W IND            :    19.5     17.1       0.0      0.0        0.0       0.0   GUATMAL            :   248.8    394.9       0.0      0.0        0.0       0.0   HONDURA            :    82.1     96.7       3.5      0.0        0.0       0.0   JAMAICA            :    64.8     57.6       1.5      0.0        0.0       0.0   LW WW I            :     0.5      1.8       0.0      0.0        0.0       0.0   MEXICO             :  2283.0   1822.9      30.2     80.1        4.6       0.0   NICARAG            :    11.6      8.7       0.0      0.0        0.0       0.0   PANAMA             :   103.7     99.0       0.0      0.0        0.0       0.0   PERU               :    36.5    217.5       0.0     23.5        0.0       0.0   TRINID             :    24.0     15.0       0.0      0.0        0.0       0.0   VENEZ              :    28.2     28.2      20.0     25.5        0.0       0.0——————————————————————————–TOTAL KNOWN           : 11315.9   9449.6     285.8    5
37.0        4.6       0.0TOTAL UNKNOWN         :  3786.6   2681.9       0.0      0.0       50.8       0.0——————————————————————————–TOTAL KNOWN & UNKNOWN : 15102.5  12131.4     285.8    537.0       55.4       0.0EXPORTS FOR OWN ACCT  :      –        –       21.9     34.3         –         – OPTIONAL ORIGIN       :   141.8    127.1        –        –         0.0       0.0——————————————————————————–

 

These export figures also fall right inline with the Dollar’s declining value. The Yen hit a 15 year high against the Dollar last week and the Chinese Yuan continues to appreciate, in spite of their officially pegged boundaries to the greenback. We also saw the Dollar depreciating against several African currencies, including the Egyptian Pound.

 

Further examination of the table reveals little in the way of exports to the Euro zone, with Spain and United Kingdom being the only two countries to make the list. Obviously they have an added advantage in being able to grow their own crops but, with the severe weather problems they’ve had this summer and the impact on their crops, one would think we might see an uptick in exports to this area.

 

I read an interesting article this weekend detailing the competitive devaluation race between Euro zone, United Kingdom and the United States. The current political plans are similar among all three. All three must devalue their currency in order to make their exports more competitive and force increased domestic consumption upon their people. This is the only way they can grow their way out of their recessions while keeping domestic inflation in check. However, at the same time they are printing money to devalue, they are forcing the individual savings rate to increase (the U.S. has gone from 0 savings to 6% in the last year), this also reduces domestic demand, stifles small business and lowers taxable receipts. Keeping this in mind, it becomes a race to see who can implement the process the most efficiently and beat the other faltering countries to the end game of sustainable growth and manageable debt.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

 

Bucking the Dollar’s Decline

The main argument supporting inflation is based on the current prices in the commodity markets. The argument postulates that the massive injections of capital through low interest rates and the government’s active purchase of long term treasuries is debasing the U.S dollar and making our products cheaper on the international market. The logic is sound in assuming that price paid has a direct relation to the exchange rate. However, since 2007, the U.S. Dollar Index is down less than 5%. This doesn’t seem so bad on the surface until one considers that because the U.S. Dollar Index is trade weighted with more than 40% of its allocation going to the Euro currency futures, it doesn’t accurately reflect the Dollar’s value against the developing Asian nations and thus, the world.

 

United States’ businesses have made their profit margin through purchasing goods and services overseas at a favorable exchange rate and reselling them domestically for years. As a country, we have enjoyed our success for many years. During this process, we helped to develop an economic infrastructure overseas that we failed to remain competitive with domestically. The economies in these countries have continued to develop and strengthen and so have their currencies. We’ve seen the Dollar decline by more than 20% against the Indian Rupee and nearly 30% against the Japanese Yen since ’07. The Chinese Yuan/Renminbi is artificially capped by their government and has only been allowed to rise 7% against the Dollar over this same period.

 

The fact that the countries we’ve done business with for years are now stealing some of our economic thunder should come as no surprise. We’ve witnessed this story throughout history as cultures adapt new foreign technologies to their own use and use their production advantages of cheap labor, fewer legal restrictions and years’ worth of foreign direct investment to implement the same business plan in their own country, thus exploiting their own competitive edge in labor and capital, just like we did here, 100 years ago.

 

Productive land is the only production input with any upward price pressure. The inflation argument based on commodity prices is domestically tied to the agricultural land component of the economic equation. We have not seen inflation in labor as our own unemployment rate hovers under 10%. We have not seen inflation in the capital markets as the Federal Reserve Board recently committed to near zero interest rates for the foreseeable future. Finally, non- agricultural land has seen a crash in the housing market, which is being followed by the commercial market. Arable farmland and mineral deposits are the only sources of upward price pressure.  The growing middle class of India, China and other Asian nations is creating a consumption premium in the finite goods that must be grown or mined through their new found purchasing power.

 

Fortunately, we are able to benefit from the growing agricultural demand to help offset the years of domestic overspending. The United States still holds a strong lead in grain production. U.S. grain exports are on a tear this year and are expected to continue. China has been an importer of corn for the first time in 14 years and their soybean imports are up more than 5% from last year. We should be able to exploit this advantage as the developing middle class in India, China and the rest of Asia continue to move up the personal consumption ladder, which includes eating more of what they want and less of what they can afford. We will also see a surge in textiles and technology purchases as their disposable income climbs.

 

The net result of this is a changing shift in the floor prices for commodities as the world adapts to new levels of consumption and global production catches up. The old normal of $4 beans and $400 gold is long gone. The panic low of the economic meltdown in December of ’08 was $4.40 in soybeans and $700 in gold. Markets like corn and sugar never broke their upward trends. Currently, corn is supported by China’s continued imports while India remains the largest gold consumer.

 

The most compelling case, in my opinion, is in soybeans. Soybeans are fully supported by both China and India through solid demand in feed and cooking products. Technically, the soybean market has been trapped in a $2 sideways range for more than a year, trading between $8.75 and $10.50. Furthermore, as of January of this year, commercial traders, via the Commitment of Traders Report had actually accumulated, and held a net long position in this market until the recent test of the $10.50 highs. This implies that both soybean producers and end production consumers believe this area to be, “fair value.” Finally, we are on the cusp of the seasonally strongest time of year for the active soybean commodity futures contract. Therefore, any disruption in supply could generate a violent breakout higher, easily approaching $12.50 per bushel or, $10,000 per futures contract.

 

The United States will continue to benefit from our major advantage in farmable land and push it’s agricultural technology efficiencies to the utmost. Unfortunately, as a country, we would be lucky to cover 2% of the national debt through agricultural profits. A better personal finance option is to put the only source of domestic inflation to work by studying the markets themselves and learning how to take advantage of the supply and demand dynamics of a global agricultural imbalance.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.