Energy Fork in the Road

One economic topic that isn’t getting the attention it deserves is the energy policy. The drought of 2012 along with the expiration of subsidies paid to ethanol blenders will make it nearly impossible to reach the Renewable Fuels Standards (RFS) as early as next year. The standards that were put in place to increase this country’s energy independence were based on protectionist interests and were only viable as long as ethanol produced by the U.S. was subsidized while Brazilian ethanol was simultaneously taxed.

The difference between U.S. ethanol and Brazilian ethanol is the source of their primary inputs. We use corn, which is slower to grow, harder to use and more expensive than the cane sugar Brazil uses as the feedstock for their ethanol production. It will be very interesting to hear how the Presidential candidates debate their renewable energy policies, especially as 40% of our primary crop is diverted from food to energy production. This year’s drought has created a political collision course between food costs and the Renewable Fuels Mandate as well as the Energy Independence and Security Act.

The corn market is about as American as you can get. The U.S. produces as much corn as the next two largest producers, China and Brazil, combined. Unfortunately, production will fall nearly 15% short of 2011’s 314 million tons. The current Renewable Fuels Mandate allotted 40% of last year’s corn to produce 13.95 billion gallons of renewable fuel and 2012 will require an additional 8% increase over 2011. This brings total renewable fuel sources to 15.2 billion gallons on total consumption of 134 billion gallons in 2012.

The drought has pushed corn prices to an all time high of $8.43 per bushel. While the market is now 14% lower at  $7.25, the rally has been more than enough to shatter the profit margins of ethanol blenders. The combination of expiring refining subsidies along with higher input costs is leading to the shut down of major ethanol blenders. This raises the capital market question of who’s going to be responsible for meeting the aforementioned production targets? Ethanol distillers are losing more than $.40 per gallon at the current prices.

The idea of diverting 4.7 billion bushels of an estimated 11 billion bushels in total U.S. production towards an inferior yet, more expensive product seems silly in the face of rising global food prices. This is exactly what would be required to happen to meet next year’s Mandate. Furthermore, reaching next year’s goals using the current 10% ethanol blend is nearly impossible given the current mix of gasoline and diesel motors. Diesel biofuels and biodiesels are given a 50% bonus in RFS for their lower greenhouse gas emissions as measured by the EPA. The friction this creates in meeting the Renewable Fuels Mandate is called the, “blend wall.” The blend wall is the physical limitation of production and blending facilities based on the most common 10% ethanol blend. The mandate calls for 13.8 billion gallons, 10% of expected 2013 US consumption. However, current facilities, assuming they were all open and operating at full capacity, can only produce 13.3 billion gallons of ethanol.

The candidates will have to address the subsidies that farmers and blenders are paid as well as their plan on handling imports. These are most likely, the easy issues to address. Developing a complete energy plan will also include a discussion on the much more economically friendly topic of our vast natural gas reserves which have the capacity to place us on a much more sustainable path.

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.

The Fed, the Ultimate Commercial Trader

The anatomy of a market trend is the process of accumulation, public participation, excess and finally, distribution. The recent Federal Reserve meeting assured zero bound interest rates well into the future. This has provided the fuel for the excess and final upward leg of the stock markets before distribution kicks in. Based on what I see in the CFTC’s Commitment of Traders reports, it appears that the small traders, the ordinary citizens of this country are going to be the ones left holding the bag when Rogoff and Reinhart’s, “Bang Moment” from, This Time it’s Different triggers the fire alarm and the market tumbles. In some ways, this is simply how free markets work. In other ways, this may be the single biggest fraud ever perpetrated on the average U.S. taxpayer.

The story starts after September 11th. The stock market, which was already approaching bear market territory, down 17% from the May highs of 2001, tumbled. The markets closed for five trading sessions and our country was panicked. Faced with a nation in shock, the government and the Federal Reserve Board began lowering interest rates to facilitate a rebuilding of U.S. confidence and economic prosperity in the face of one of the darkest events in American history. The elixir of cheap money worked. The S&P 500 rallied nearly 19% by the end of 2001.

The accumulation phase of a trend begins when an already beaten market has the knockout punch thrown at it. Buyers who understand value and are able to see through the storm that has driven a market to panic levels begin to step in and prop up the market allowing it to find a bottom. This clearly fits the 2001 market story – already on the decline (-17%), knockout punch (9/11), panic levels as market closed, buoyed by investment banks and the Plunge Protection Team spending cheap government Dollars, the market rebounded.

The public participation phase is typically seen as see saw consolidation above the recent lows while individual investors decide whether it’s safe to buy new shares or use the first pop of a rally to bail out of their losing shares. The S&P held fast at 10 – 20% above the lows until the following June when the market began to make new lows again and unemployment pushed towards 6%. The markets’ penetration of the September 11th lows brought about further economic stimulus in the form of lower interest rates. Interest rates bottomed in October of 2004 around 1% as unemployment peaked at just over 6% for that business cycle.

Excesses began to build as the mortgage industry picked up steam due to the implementation of looser lending standards trickling through the economy via President Bush’s plan to put home ownership within reach of every American citizen. Lending rates and requirements dropped and the U.S. consumption boom swelled to excess in the form of second houses, new trucks, flat screens and Harleys. The S&P 500 rallied 48% between August of ’04 and the market top in October of 2007.

The fallout from the economic crash of 2009 is where we begin to see collusion within the investment-banking sector at the expense of the retail investor. There is no question that the immediate action by the Federal Reserve was necessary to shore up the markets and the global economy. The Fed stepped in and lowered rates and insisted upon loans being drawn from the TARP facility as a show of force to the world that our markets were not broken.

This bottom is also the beginning of new accumulation. Banks were shoring up the stock markets using federal money. Charles Biderman of Trim Tabs was the primary voice suggesting this. He was severely ridiculed at the time yet, managed to provide enough inexplicable data to prove that something was an unannounced, heavy-handed buyer. The point is, this was the third trip to a market crash that was averted by the Federal Reserve. Investors are known for their pattern recognition skills and it became evident to the primary broker dealers that Bernanke’s third mandate had become (has become?) protecting the stock market.

Two thousand and ten tacked on another 12% as retail investors continued to be frightened and or, too broke to invest. Large broker dealers held fast having already booked better than 50% returns from the ’09 lows thanks to the, “Bernanke Put.” Eventually, retail investors came back to the market as Fed speech after Fed speech insisted that they would do anything necessary to instill market liquidity and confidence. This also meant driving down yields to artificially low levels, which has forced retail investors into riskier assets like the stock market.

This led to a flat 2011 as the world decided whether or not Europe would implode one country at a time. Meeting after meeting, press conference after press conference, virtually nothing had been decided and yet, this is when the retail investors, having missed out on 70+% from the ’09 lows decided it was time to get back in the market. Quantitative Easing 2 and 3 along with Operation Twist provided confirmation that the Federal Reserve Board would, indeed do anything it could to ensure faith in the markets. Nothing says faith like a rally and nothing creates a rally like lack of other investment options. We currently sit within 5% of the 2007 all time high.

This is clearly the excess phase as Europe has yet to settle their issues and no matter how you view our economy, it’s simply not healthy. Furthermore, the internals of this rally do not justify the levels we’re trading at. This leads us to the punch line. Commercial traders have been selling stock index futures with abandon as we’ve approached these highs. The only major buyers have been the small speculators. The stock positions that the government acquired with our tax dollars at the 2009 lows are now being sold back to the retail investors (taxpayers) on the open market at much higher prices. When the market tumbles because small specs can’t support higher prices alone, it will be the greatest transfer of public debt to private citizens ever as the small speculators will be left to absorb the losses in their own accounts.

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.

Iranian Sanctions do More Harm than Good

The Iranian petroleum industry has been crippled by the economic sanctions we have imposed on Iran along with the European Union and other countries in July. Iran is exporting less than 1 million barrels per day and that’s a 20-year low. This knocks them from third place on the global exports list down towards India and Brazil at 23rd. It also makes for good press and sound bites by the President on September 11th. Unfortunately, his actions on this embargo are actually separating us from global trade with the very partners we need to pull our economy out of the doldrums. Furthermore, it is galvanizing the Iranian citizens’ resolve against us.

The restrictions the U.S. has placed on the Iranian banking system has forced Iran to conduct business in the local currency of its export destination targets. This has created new insurance of shipments as well as leasing or, ownership of the oil tankers themselves.  Previously, most of this business was done in U.S. Dollars. Now, we see countries like India, China and Japan trading rice, medical supplies and steel for Iranian oil and conducting this business in the destination countries’ local currencies, the Rupee, Yuan and Yen.

The economies of India and China have slowed but they are still growing and continue to hold the greatest potential for future growth. Growth requires petroleum and the relationship they are forging with Iran to meet their needs is problematic to say the least. These countries are using the same tactics that Russia used in the Cuban Missile Crisis to facilitate good will among a trapped nation by providing economic and human relief from their perceived oppressors. This is also exactly what we did during the Berlin airlift immediately following World War Two. The strategy continues to be replicated because it works.

The countries that are continuing to do business with Iran may not be entirely altruistic in their trade of base human needs for oil. The banking restrictions the U.S. has put into effect along with the E.U. oil embargo has caused Iran’s currency, the Rial to plummet. Officially, the Iranian Rial is fixed at 12,259 Rials per U.S. Dollar. Unofficially, the real exchange rate has fallen to 26,000 Rials per U.S. Dollar. The devaluation of their currency provides them with a smaller return on the oil they trade with their partners but more importantly it creates a spiral of misery for Iranian citizens.

Iranian citizens find that their expenses have more than doubled. To put this in perspective, if $1 bought a loaf of bread in June, it now costs $2.12. Your daily expenses are now twice as much as they were two months ago and your personal employment outlook is bleak, at best. The Iranian citizen unable to provide for his family will buy right into the governmentally censored media and blame his child’s hunger on America and the European Union. That same citizen will be more than grateful for the bag of rice labeled in Hindi.

Iran’s supreme leader, Ayatollah Khameni has vowed to form, “an economy of resistance.” Therefore, President Ahmadinejad will continue to work with the oil industry to ensure that enough is sold to keep the economy moving while simultaneously ensuring that the average Iranian citizen remains miserable enough to despise us. Iran is the 18th largest global economy with plenty of reserves to plod their way through these sanctions. Therefore, the leaders can afford to keep their citizens miserable while still providing enough nourishment to make them strong enough to fight. We will continue to be held up as the scapegoat for their misery as long as these restrictions are in place. This strengthens the cultural divide between east and west and separates us from the, “understanding countries” like India, China and Japan.

Economically, the United States can’t afford an isolationist policy that restricts trade with some of the fastest growing countries. The cause may be the believed infraction of the Non-Proliferation of Nuclear Weapons Treaty but the effect will be the loss of international trade and good will. Iran has been growing as the sole mega-power within their geographical area, in large part thanks to our actions in Iraq and Afghanistan. Iran will not witness an Arab spring. Perhaps, we should question their desire to pull the trigger on a nuclear winter.

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.

Follow the Market Makers – Not the Chasers


This year’s corn market provides a textbook example of the
accumulation and distribution of positions throughout a market’s trend as well
as identifying the strengths and weaknesses of the market’s primary
participants. We’ll use empirical data to reveal why the Commodity Index Funds have
little impact on the markets major moves as well as which trading group does
move the market and finally, who comes up with the short straw when the market
turns.

The corn futures market began the year with talk of steady
to lower prices throughout the year. We commented ourselves in early April that
this was going to be a, “Buy beans, sell corn” kind of year. Our expectations
weren’t based on rocket science. The early planting intentions called for
record acreage and the beautiful spring weather accommodated the seeding
process. These factors kept the price of corn in check between $5.50 and $6.50
per bushel. This also matched the USDA’s crop insurance price threshold of
$5.68 per bushel for the 2012 marketing year.

The corn market has two strong seasonal periods.  The first is planting time. There is
always fear that the crop won’t get in the ground and therefore, limit the
year’s crop. Small speculators and end line users of corn tend to bid up early
prices. Speculators hope that this the drought year and they finally hit a home
run while end line users hope to lock in the year’s input prices in the production
of cereals and chips. The early seasonal attempts to rally were cut short by
commercial traders hedging their crop above $6.25 while hoping to lock in trend
line yields around 160 bushels per acre. This would’ve generated about $1,000
per acre. 

The mild spring finally flushed out the small speculators as
prices made new lows for the year by the end of May, around $5.50 per bushel.
The commercial hedgers then began to cover the hedge positions they had placed
above $6.35 per bushel. This represented a cash gain of more than 12% to the
supply side commercial traders. The decline brought prices down to the low end
of the year’s forecast. At this point aggregate global demand for 2012 put a
fundamental floor under prices. 

Corn buying from commercial producers and Commodity Index
Funds took place in waves. This also represents the low point for small
speculator positions as they had been forced out of the market on the April-May
decline.

The June 12th USDA Supply and Demand Report was
the first evidence that spring’s early plantings were wilting in the heat of
May and June. The market pushed to new highs by June 26th. The rally
provided a definite shift in mentality. Traders were now in the classic,
“accumulation phase” of the market. This is characterized by rising open
interest and new highs in price. This shows that the market is welcoming new
participants who are happy to enter – even at all time high prices.

Commodity Index Fund position changes are tied very closely
to the accumulation and distribution processes of the market. Commodity Index
Funds are forced to maintain a percentage allocation stated in their prospectus.
Therefore, as the market climbs, they are forced to buy more while they are
forced to sell as the market declines. The net result is that Commodity Index
Funds will raise the floor price of a commodity as they venture into a new
market and establish their position. However, once their position is
established, their position management only affects the speed with which the
market moves, not the final prices. Thus, Commodity Index Funds may only be
guilty of increasing the volatility of a market as they add or, shed positions
accordingly. Throughout this summer, the number of contracts they’ve held has
remained within 4% of their starting point. Their value, on the other hand has
fluctuated by more than 20% as the market has rallied.

Finally, the market has stabilized between $7.75 and $8.40
per bushel. The decline in volatility over the last six weeks has brought the
retail traders back to the game. Just like clockwork, we can see that the small
traders are purchasing their contracts from the commercial traders. Commercial
traders have shed about 27% of their total position over the last month while
small speculators have increased their positions by 25.5%. This is the classic
distribution pattern as those who’ve ridden the trend take profits by selling
their positions out to the small speculators. The small speculators will be
left holding the hot potato and will be burnt at the top of this market just
like they were at the bottom in April and May.

The likely outcome is that the corn market will fall through
the support it has built up around $7.75. This will likely trigger the exit for
most small speculators. The fall may be swift as Commodity Index Funds shed
contracts to maintain their portfolio balance. Finally, the commercial traders
will be waiting as ready buyers who will now cover the short positions they’ve
initiated over the last month between $7.75 and $8.40 per bushel.

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.