Arabica Vs. Robusta Coffee Spread

The uncertainty that has kept retail investors out of the equity markets, out of the interest rate markets and out of the commodity markets still remains as all eyes focus on this weekend’s Jackson Hole meeting of central bankers, minus Mario Draghi, President of the European Central Bank. Investors are unsure what to do, as the decisions made at the meeting will have a bigger impact on the markets than any earnings story in the stock market or supply and demand story in the commodity futures markets. Cash is still king. However, a spread trade is one type of discretionary trade that is relatively immune to the central bankers’ decisions.

Spread trades are relative value plays. The actual profit or loss is determined by the movement of the markets relative to each other as opposed to what each market does on its own. The coffee spread trade that will be outlined trades two types of coffee against each other. The advantage to this in news event driven markets is that the, “risk on” and “risk off” announcements will affect both markets similarly. Therefore, what is lost on the contract that is owned will be made up for by the contract that has been sold. Only the movement of the two markets against each other will affect the account’s cash balance.

There are two types of coffee traded in the futures markets, Arabica and Robusta. Arabica coffee is the premium coffee used by Starbucks to make their specialty coffees while Robusta is the cheaper of the two and used to make instant coffee and espressos. The economic weakness in the EuroZone has boosted demand for Robusta while reducing demand for Arabica as European tastes move down market along with their economies. Europe imports more than half of the world’s coffee production and imports by Spain have fallen by 6.6% over the last year. This makes sense considering Spain’s 25% unemployment rate.

The move towards cheaper coffee drinks has shifted the normal balance of supply and demand by closing the gap between Robusta and Arabica coffee beans. Coffee blenders have been using more Robusta in their blends to try and hold consumer prices down. This shift picked up steam after last summer’s Arabica prices soared due to the weak Columbian Arabica harvest. This shift has caused Arabica’s premium over Robusta to decline from $1.45 per pound at the end of last year to around $.70 currently. Much of the recent gains came from a weak Vietnamese Robusta harvest.

The timing of this spread has more to do with Brazil’s Arabica crop. Brazil is the number one producer of Arabica beans and their harvest is quickly drawing to a close. Their crop received substantial summer rains that forced the trees to bloom early and beans to develop ahead of schedule. However, the early formations of the bean pods led to unsustainable weights on the trees. Many pods fell early and the expectations are for this year’s Brazilian crop to be of good weight but poor quality. Poor quality Arabica beans will be blended with Robusta beans and used for inferior coffee products. This will leave fewer high quality beans available for the premium coffee drinks Western cultures have grown accustomed to.

It’s already been noted that slowing economies have forced consumers towards cheaper products. Therefore, if this weekend’s Jackson Hole meetings reveal further economic weakness then premium blend demand would be expected to decline. Conversely, an uptick in economic expectations should begin to fuel ownership in all commodities. A rising economic tide floats all ships. Given the relative value of Arabica beans on the open market, they could be considered an outright buy on their own. However, due to the economic uncertainties, it would be prudent to trade with a reduced risk profile rather than betting the farm on a single outright trade. Buying Arabica beans while selling Robusta beans will limit losses on an overall decline in the economic outlook while maximizing the return based on the fundamental scarcity of Arabica beans over Robusta. Finally, any upside economic surprises should add fuel to the fire in this spread, causing it to widen towards its historical average around $1.45 per pound.

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.

It All Comes Down to Price

There are two basic types of traders, discretionary and systematic. Discretionary traders attempt to figure out the lay of the land, the supply and demand as well as the macroeconomic and political outlooks on the markets they trade. They assimilate all of this information into an overall outlook on a particular market and synthesize a trading plan from those inputs. Most billionaire traders are discretionary. They are able to discern patterns that are not programmable and they are able to vary their bet size to match the current market conditions and their overall risk profile. Richard Russell, who I mentioned in last week’s article, is a discretionary trader. Some more famous names include George Soros, Paul Tudor Jones and Julian Robertson.

Successful discretionary trading has become increasingly difficult due to the global political factors that make us all wonder what tomorrow’s world will look like. Will the Euro burst? Will Syria use chemical weapons and catalyze a new Cold War between the U.S. and Russia? These low probability yet, high impact possibilities have made it harder and harder for discretionary traders to try and picture the world two, five or even ten years down the line. This is also the type of timeframe they need to position the billions of dollars that they manage. The net result is that many of the world’s largest hedge funds and money managers have been moving to cash. It is becoming increasingly clear that they would rather not invest than try to guess correctly in a world that changes the rules both domestically, and globally by the day.

The mass exodus can be seen in the markets through declining trading volume. Trading volume in all major indices has steadily declined since the market bottom in February of 2009. The brief uptick last September was barely more than half the volume we generated in ’09. Both the industry and the government have shaken investor confidence. Three quickly attributable causes are the demise of trading firms like Bear Sterns and MF Global, governmentally imposed restrictive short selling rules and the attack on high frequency trading. These events shake the faith in the system and force participants to the sidelines. Clients need to know their accounts are secure, that their positions pass muster and that bureaucrats won’t destroy the laws of liquidity.

Systematic traders base their decisions on black and white rules or algorithms that will spit out the same response relative to the input received time and time again. Many trading systems were built on rules that held fast throughout the 90’s and 2000’s until the markets collapsed and the government got involved with quantitative easing programs and Treasury repurchases. The government’s artificial manipulation of the markets relegated the historical rules of market relationships worthless. Therefore, many of the premises that these mechanical systems had been based on became not only useless but wrong. They became the equivalent of, “GIGO” garbage in, garbage out. The exit of mechanical trading systems from the market has further diminished overall market liquidity.

Manipulated prices by governments and ratings agencies have rendered the inputs of the decision models used by discretionary traders and the mechanical models of trend following systems virtually useless. Ironically, this brings my personal trading philosophy full circle. My discretionary trading came to an end shortly after I left the trading floor of the Chicago Mercantile Exchange. Discretionary pit trading allowed me to vary the size of my trades by being able to read the order flow and allowed me to capitalize on flush trading opportunities. However, a couple of years after returning to Sandusky to raise kids, I began to focus on mechanical trading systems. I understood that the game had changed and I needed new tools to successfully trade from a screen instead of the trading pit. The sole input to many of my early trading systems was simply the price of the market I was trading. The philosophy was, “There is no way I can assimilate all the variables in a market and cross reference the associated data streams. Therefore, I will assume that the fair value for the market I am trading is the last traded price. After all, it reflects all of the variables I’m trying to quantify.”

The major advantage to trading systems is that one brain doesn’t have process the day’s events of the world and attempt to predict how they will impact the market being traded. There are times when a trader will nail a government report number right on the head only to have the market react in a completely different manner than had been expected. It’s a hollow feeling to be right and lose money. The primary objective of participating in the markets is to turn a profit. The fewer things make sense, the more important it is to know our own limitations. Mechanical trading may not hold the same potential of the great discretionary traders but it does allow me to grind out an expected profit.

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.

More Reasons Why Cash is King

Two of the most respected names in equity investing are Richard Russell and John Bogle. Richard Russell has been publishing the Dow Theory Letters since 1958 and John Bogle is the founder of the Vanguard family of mutual funds. These equity gurus have more than 100 years of experience between them and share the commonality of fiduciary duty to their clients. This has meant encouraging investment in products other than those they sell at times when they’ve felt that owning the equity markets outright did not present their clients with the best opportunity for asset growth and protection. This is one of those times.

Richard Russell continues to adhere to his bear market thesis based on the lack of confirmation by the Dow Jones Industrial Index (DJI) when the Dow Jones Transportation Index (DJTI) made new highs in May of last year. This year, the roles have been reversed but his operating thesis remains the same. The bear market remains intact because the DJTI failed to confirm the January highs in the DJI. He expects that it could take several years to work through the, “…leveraging and inflation and lying and cheating and shenanigans that lasted from 1945 through 2007.” That’s quite a statement coming from an equity investment advisor.

John Bogle is a bit of a mixed bag. He’s an outspoken republican who voted for Bill Clinton and Barack Obama and has donated nearly half of his net worth to charities. He feels that this may be the worst investment environment that he’s seen in his 60 years in the markets. He strongly supports financial reform and reductions in leverage. He defines a fiduciary standard as, “Put the interests of the client first. No excuses. Period.” Sometimes this means shying away from even low cost equity investments like the ones he pioneered.

Anecdotally, a study was just published that stated that the top 1% is hoarding cash. This study was published by CNBC and has been spun equally to the far right and the left. The left argue that this justifies their case for higher taxes, which would allow the government to then put that cash to work in the economy. The right argues that the Democratic led government must provide some leadership and clarity on tax, healthcare and foreign policy issues before they feel comfortable putting their cash to work. The third option, I suggest is that they simply understand that the primary equity markets are overvalued and have therefore, reduced their outright equity exposure. Furthermore, treasury yields have been artificially devalued to the point that real yields are negative on all maturities less than 10 years. Therefore, cash is the only place to be at this point in time. Perhaps the top 1% actually knows something about investing and growing capital.

The metrics that lead to the valuation concerns include an S&P 500 that is within the top 10% of its earnings range. The point here is that as reported corporate profits have been fantastic. In fact, according to Crestmont Research, the S&P 500 3-year average earnings per share have increased by 80% since the market bottom in March of 2009. As we all know, sustaining a percentage increase becomes increasingly harder with each percentage point that is gained.

Further adding to the rich valuations is where we stand within this business cycle. The recession ended in July of 2009 but post recession real GDP appears to have peaked at 4% in the fourth quarter of last year. We have fallen precipitously since with Q2 real GDP coming in at 1.5%. Wells Fargo Securities published a report using data from the National Bureau of Economic Research that compiled their four primary coincident indicators: employment, real income growth, real wholesale sales and industrial production then indexed them from peak to trough of each business cycle since 1954. They found that there have been a total of six economic recoveries that have lasted more than 36 months. July marked the 36th month for this recovery. Thus, this recovery is becoming longer of tooth with each passing month.

Finally, when we look at the four primary coincident indicators just mentioned, we find that industrial production has been responsible the primary motivation of this recovery. This becomes intuitive if we backtrack the corporate profit scenario we mentioned earlier. Unfortunately, the precursor to industrial manufacturing is the purchasing of raw materials for production. A survey of the primary measures of industrial production and purchasing managers shows that all of the major manufacturing indices have turned negative with most now showing visible outright contraction. Those in contraction include the Richmond Federal Reserve Manufacturing survey as well as the Chicago Purchasing Managers Index and the Institute for Supply Management Report.

The equity markets sit near substantial overhead technical resistance as well as facing a flood of negative fundamental and anecdotal data. Those who’ve managed to ride out the gyrations of the meltdown in 2009 would do well to take some chips of the table at this point if not, outright hedge their equity portfolios. The top 1% has increased their savings rate from 24% of net income in 2007 to 56% currently. Regardless of your political inclinations towards these people, I would suggest we’d do well to emulate their investment models as best we can within the confines of our limited budgets. After all, the government couldn’t have made them that successful by itself.

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.

Gas Prices Jump More than Expected

The recent jump in gas prices were expected to be much more gradual. We saw commercial traders as strong buyers of crude oil below $80 as June came to a close. We firmly believed that this would be the bottom of the cycle as the national average fell to $3.30 per gallon. What no one expected were the simultaneous mechanical failures of some of the main pipelines and refineries. This has caused the price of petroleum products like heating oil, gasoline and diesel fuel to skyrocket by 25% in little more than one month.

The refineries here in the U.S. use about 9 million barrels of crude oil per day. The last two weeks has seen nearly 2 million barrels per day taken off supply as unplanned shutdowns due to various mechanical issues and fires have popped up across the country. Further adding to the refinery issues is a cutback in supply that will be coming from Canada due to a leak sprung in the Enbridge pipeline, which has spilled more than a thousand barrels of unrefined crude oil in central Wisconsin. Enbridge has fallen under increasing regulatory scrutiny, as this is just the latest of a trail of pipeline failures. The most notable was a 2010 incident, which dumped 20,000 barrels of oil into the Kalamazoo River.

Mechanically, major refiners near Chicago and San Francisco have both been shutdown. There are two refineries that have been shutdown simultaneously in the Chicago area and both of them are among the 10 largest refiners in the country with the Whiting, Indiana facility ranking 7th and the Wood River, Illinois facility ranking 10th. These outages combined to raise the price of gasoline in the Chicago area by more than $.44 in less than a week. The Chevron facility in Richmond, California is responsible for 10% of the gasoline production on the west coast. Reports are conflicted on the how long these refineries will be out of operation. Estimates range from weeks to months on each individual facility with consensus that the Chevron facility in Richmond will probably be out of service the longest.

Political and fundamental factions had already begun battling over the true value of crude oil from March through July. This is seen as the battle between speculators and commercial traders. Commercial traders had been heavy sellers of crude oil futures from March through May when the market was trading above $103 per barrel based on Iranian threats and general unrest in the Middle East, which led to speculative buying. These threats were competing with a market that was massively over supplied. Eventually, over supply won and the Commitment of Traders analysis generated sell signals at both $109 and $106 per barrel. June’s precipitous declines moved commercial traders to the buy side as they covered short positions and increased their positions by more than 30% during the month of June.

The final fuel to this petroleum rally is the expectation of further government stimulus to the economy. We’ve suggested over and over that the key to the upcoming election is the domestic economy and recent polls concur. The biggest thing President Obama could do to help himself would be to force a resolution in the Eurozone. The markets hate uncertainty and any conclusion to the drawn out death spiral of Ireland, Portugal, Spain and Italy would create a huge relief rally in the stock market. However, since his sphere of influence doesn’t extend far past our shores, he’ll do the next best thing by flooding the market with Dollars, which will lead to nominally lower interest rates and show that he is taking action.

Regrettably we will bear the unintended consequence of higher gas prices as our Dollar is devalued on the global market and our refineries find it more profitable to ship finished petroleum products overseas, rather than sell them on the domestic market.

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.