Cutting Through the Rhetoric

There are times when the markets tell us more about what’s going on than the people on TV. I think this is one of those times. The recent rhetoric has been a political budget argument over nickels and dimes when we they need to be talking about hundreds and thousands. The political blame and spin game is being played at its highest level. The reality is that we are quickly approaching the end of the second round of quantitative easing. The government’s balance sheet reached a record level of $2.63 trillion as of April 7th. This is evidence that the fed has been putting their purchasing power to work. The $600 billion that was enacted to keep interest rates low, provide loans to new businesses and help the economy regain its footing after the financial meltdown of ’08 may be coming to an early end. The markets suggest that the Fed’s next meeting on April 26th could put a kink in the free flow of dollars coming to the market.

There are arguments on both sides of this fence from the insignificant periphery right down to the board of governors itself. The quantifiable portion of this argument is that the commercial traders clearly expect a slowdown in inflation and the economy in the near term. The consensus and conviction of the commercial traders’ positions can be seen in multiple markets; corn, oil, heating oil, copper, bonds, 10 year notes, S&P 500 and Dow Jones futures, etc. Their shift in positions can best be described as, “defensive.”

Copper is typically referred to as the, “economist” of the metals markets. Its use in building construction has always been a fair barometer of the economy’s growth and contraction. Commercial traders in copper from the commitment of traders report have shed nearly 40% of their positions since late February. The combination of China’s successive rate hikes and tightening lending practices paint a clear picture that their fully stocked warehouses are in no danger of depletion.

The crude oil market has seen consistent selling by commercial traders above $100 per barrel. Fear, due to the unrest in Northern Africa has been the primary driver of crude oil prices. This market has remained oblivious to the fact that the storage wells in Cushing, Oklahoma are bumping along near record levels. The price of gasoline has disconnected from the price of crude due to refining issues, not supply issues.

Interest rate futures have seen a flush of commercial buying. The 10 year Treasury Notes have seen commercial positions increase by more than 20% while the 30 year bonds have seen commercial traders increase their net position from 70, 000 contracts at the end of February to more than 120,000 contracts currently. Their buying of U.S. interest rate futures is part technical, and part predictive of a flight to safety driving down Treasury yields.

The flight to safety is predicted from commercial traders selling stock index futures. Commercial traders were buyers on the mid March stock market correction. However, their buying was light and their selling since has pushed their net momentum to negative levels. They may view the extended period of low volatility in the VIX index combined with testing the markets’ February highs as reasonable long liquidation levels or, low risk short selling opportunities.

This combination of moves is certainly bearish. I believe it is predicated by the theory that QE2 may be brought to an early end. If this is the case, the short term reaction would be a stronger U.S. Dollar. This would obviously be a short term negative for commodity markets in general like copper, oil, grains, cotton, etc. However, this would do nothing to alter the global change in demographics. There will be no fewer people to feed and this will not impact the growing global purchasing power that has fueled much of the commodity rally. Therefore, the macro trends will remain intact. This will simply force out many of the weaker hands that have been riding the coat tails of the rallies on the way up.

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 of loss in investing in futures.

Food or, Fuel?

Corn is facing unprecedented demand on all fronts. The USDA
reported that prospective corn planting for 2011 is expected to be 5% higher
than last year. That would make this the second largest crop planted since
1944. The 92.5 million acres is second only to 2007’s record of 93.5 million
acres. In spite of the growing acreage in corn and higher yields driven by
greater technology, corn stocks are still down 10% from this time last year. In
fact, the corn on hand versus this year’s expected demand, (stocks to usage
ratio), stands at 5%. This is the lowest number since 1937. There are currently
6.5 billion bushels of corn in storage versus global demand of 123.5 billion
bushels.

The government’s push towards ethanol was actually initiated
by Carter during the oil crisis of the 70’s. It was left dormant until the post
9/11 energy independence push. Corn was trading at $2.25 per bushel in 2001.
Cheap, clean burning corn made it a political win/win for energy independence
and the global warming, green energy crowd. This led to government mandates and
subsidies to increase ethanol production every year through 2015. This year, up
to 40% of the corn crop, at a price above $6.50 per bushel, will be allocated
to ethanol production. If we multiply the intended planting acreage times an
average yield of 155 bushels per acre, we can see that the cost of the corn
input of ethanol production will be more than $37 billion dollars.

The U.S. also exports more than 60% of the corn we produce. Our
exports have continued to climb even as the price of corn has nearly doubled in
the last year alone. Meat consumption has just begun to grow in Asian countries
as they’ve begun to prosper and develop their own middle class. This will not
only continue, it will accelerate. Global meat consumption is still only 20% of
the U.S. average. The demand for feed grains continues to outpace production by
1-4% per year. China is determined to have a self -sustaining hog industry by
2013. These factors help explain the continual decline in ending stocks in the
face of growing harvests.

The demands on the corn market from ethanol and food
production leave absolutely no room for weather related issues. This year’s
crop is crucial to restoring our reserves. Based on the current ethanol
policies, it would have to rally another $.50 cents per gallon just to catch up
with the current price of gasoline. Corn would have to reach $8.82 per bushel
for gas and ethanol to reach equilibrium at $3.15 per gallon. Ethanol/ gasoline
blenders also receive a federal credit of $1.30 per bushel. This pushes the break-even
corn price to $10.12 per bushel for ethanol producers.

The price of corn hit an all time high of $7.79 in June of
2008. Remember, this followed the largest crop ever harvested in 2007. We
already know that global gasoline demand will increase, as fuel must be
exported to Japan. We also know that Japan’s imports of all foods will be
higher than ever. China is doing everything they can to put the brakes on their
economy but it won’t derail the growing appetites of their people. Finally, the
continued decline of the U.S. Dollar will serve as double coupon day for global
shoppers as we remain the world’s supermarket.

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 of loss in investing in futures.