Paradigm Shift in the Cocoa Futures Market

Cocoa futures are one of the most volatile markets. This has been primarily attributed to three historical variables politics, antiquated farming methods and weather. Two of these three variables are being addressed directly while the third remains a wild card that may pull the trigger on a substantial rally in an agricultural market undergoing a complete paradigm shift.

The Ivory Coast is the world’s largest producer of cocoa. Prior to 2011 it was presided over by Laurent Gbagbo who ran the country in typical West African fashion for more than 10 years. The open elections of 2011 led to a brief civil war when Alassane Ouattara was elected President and Laurent Gbagbo refused to cede the Presidential office and used his cronies in the military to hold off the inevitable. The regime change was inevitable because Ouattara, who is a former International Monetary Fund (IMF) economist, has the full support of NATO as well as the military backing to support a more democratic and transparent government. The installation of Ouattara should eliminate much of the political volatility that has been a hallmark of the cocoa futures market for many years.

President Ouattara, who was educated here in the U.S. at Drexel University, is quickly modernizing the Ivory Coast’s cocoa markets. There’s been rapid development in soil reclamation, fertilization and education. Most cocoa is grown by individual farmers on small plots of land and is harvested by hand as it has been for hundreds of years. The application of modern agronomy techniques will cause the Ivory Coast’s cocoa production to increase rapidly over the coming years. The combination of infrastructure improvement and political stability supporting free trade and as well as modern farming practices will increase yield and depress prices once the changes are fully implemented.

The effects of Ouattara’s Presidency can already be seen in the decline of volatility in cocoa prices. Major chocolate producers no longer have to worry about civil war, the government closing ports or henchman attacking farmers on their way to collection stations to force the price higher. The price range in 2012 was $2,003 – $2,707, a measly 35%. The range for 2011 was more than 90%. In fact, the five-year average range is more than 50%. These wild rides are less likely to occur, as weather becomes the only variable left to move the markets.

This sets the stage for the current battle in the market. Cocoa futures have been on a steady slide since fall. The market appeared to be forming a technical bottom during this period. However, it was clear by the commercial selling that the bullish saucer base pattern, between $2,310 and $2,510, that had been supported by the small speculators had little chance of pushing the market higher. The slide through the 2013 price level is primarily attributable to the small speculators being forced out of their long positions at a loss.

The market has recently traded as low as $2,100. Commercial traders have been covering their short hedges and locking in futures supply line purchases since the market first fell through the $2,310 level. Commercial traders have been net buyers in nine out of the last ten weeks. Recently, weather issues have reduced estimates for the current mid crop harvest due to a lack of rain throughout the Ivory Coast as well as growing regions in Ghana, the second largest producer. These two countries account for nearly 60% of the world’s production.

The key price level is $2,000 per ton. The market traded below here once in 2011 and rallied $500 per ton in just a few weeks. Overall, the market hasn’t spent any time below $2,000 per ton since the commodity boom of 2007. We’ll side with the commercial traders and look for buying opportunities as the last of the weak speculators are forced out of the market. Perhaps, the best way not to miss out on the rally is to place a buy stop order above the market’s recent resistance level around $2,150. If this order gets filled in the May cocoa futures contract, place a protective sell stop at what becomes the low price of this move. We’ll look for a minimum price target of $2,310, the bottom of the old saucer formation.

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.

Using the COT to Buy Gold Futures

The 2013 rally in the metals markets appears to have run its course. The metal markets are now flushing the weak traders out of their positions and, at least for the gold futures and copper futures market, setting up a new bottom to create a summer rally. In the past, we’ve discussed the rotation of money flow through the metal markets. There are four primary U.S. metal markets and the rotation between them hinges on expectations of inflation versus industrial production.

The chain from most industrial to most speculative is as follows; copper, silver, platinum and gold. This is based on the percentage of the metal used, rather than by weight. Otherwise, silver would far surpass platinum. Investor sentiment for all four metal markets can be tracked through the Commitment of Traders (COT) report published each week by the Commodity Futures Trading Commission. This report tracks the amount of investment among the three primary market participants, commercial traders, index traders and small speculators.

Categorizing the markets’ participants and measuring their degree of participation within any market is a primary forecasting tool. We use this in the trading world to track the imbalance of positions between the smart money and the dumb money. Our research quantifiably defines the smart money as the commercial trader category in the COT reports. Index trader participation is neutral so that leaves the dumb money as the small speculator.

Don’t take this personally. Commercial traders have access to the best information, algorithms and intellects. This may include direct physical observation of the markets in question and it certainly includes the research and analysis of a team of highly trained specialists who focus solely on the market they make. We as small traders are at an immediate disadvantage simply due to our commodity trading taking a back seat to our day jobs, families and other obligations that prevent us from putting 40+ hours per week into any single market.

Our trading focus is on the size of the imbalance between commercial traders and small speculators. Commercial traders are, “negative feedback traders.” They have a sense of value for the market they’re trading and the farther away the market gets from their predetermined value area, the larger their position grows. They buy more as their market becomes increasingly undervalued and they sell more as their market becomes increasingly overvalued.

Market turning points occur when the commercial traders’ fundamental sense of value kicks in and the market begins moving back towards the expected value area. The forecasting value lies in tracking this imbalance and preparing for the market’s turn. This is part of what we were discussing five weeks ago in, “Not Quite Time for Gold to Shine.”  We wrote, “The absence of an expected rally in the gold market through the last few weeks leads me to believe that the internals simply don’t support these price levels, yet. Therefore, the market will continue to seek a price low enough to attract new buyers beyond the commercial traders’ value area. Typically, this would lead to a washout of some sort that may force the gold market to test its 2012 lows around $1,540 per ounce before finding a bottom.”

The metals markets as a whole have declined over the last three weeks. Silver has been hit the hardest, currently down more than 12%. Copper has held up the best, down 5.2% and gold and platinum are somewhere in the middle.

Commercial traders are net bullish in both gold and copper. Commercial traders have been net buyers in the copper market for four out of the last five weeks and net buyers in gold for each of the last three weeks. Both of these markets are providing us with exactly the type of setup we look for. Commercial traders are net bullish on the weekly charts while small speculators have cracked the market just enough to create an oversold situation on the daily data.

Our quantitative research shows that we can buy in once the gold market begins to turn higher as long as we place a protective stop loss order at whatever this low turns out to be. This defines the risk so we know how many contracts we can trade. We know we have a 65% chance of being profitable and an average profit of $3,865 vs. an average loss of $1,958. The exceptional aspect of this trade is that we’ll only hold the position for five days. This is about how long the market will take to bounce and define a new value area.

The numbers in the copper market are even more impressive. The same setup applies. Our risk will be to the low of this move and we won’t enter a long position until the market starts to head higher. Our analysis shows that we should win about 75% of the time and our wins are once again more than twice our average loss. Finally, we won’t hold the trade for more than five days.

Trading in line with the commercial traders and using the small speculators to compress our risk allows us to trade with commercial effectiveness on a small speculator budget and time frame.

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.

Buy Beans Below the Teens

The growing season for U.S. crops is right around the corner and several factors, fundamentally, technically and seasonally are lining up to suggest that the time to buy soybean futures and soybean meal futures may be right around the corner. Last year’s drought placed heavy demands on Brazilian and Argentine crops as well as the beans left over in the bins. The tight supplies have left us with a stock to usage ratio of less than 5%. In fact, the USDA recently stated that this year’s U.S. stock to usage ratio of 4.3% is the lowest since 1965. Typically any ratio below 10% is bullish for U.S. beans.  Meanwhile, the global stock to usage ratio is the lowest since 1996.

Demand for soybeans also continues to increase. Chinese hog farming represents a large portion of the soybean demand through their use of soybean meal as feed. The USDA expects that China’s hog production may reach more than 60% of the world’s total in 2013. In fact, Chinese soybean imports have increased six-fold since 2000 to meet the growing demands of their own domestic usage. U.S. exports are already 25% above last year’s levels and currently stand at 93% of the USDA’s export expectations of the U.S. crop in 2013 for the marketing year ending this August. China’s imports have led the way and are up 13% year over year.

Seasonally, soybeans tend to sell off and make an early spring low sometime in February. This is followed immediately by a rally into Memorial Day as planting related weather concerns force the market back and forth between, “too dry” or “too wet.” The late February low also coincides with the South American harvest, which is currently in full swing. The South American harvest sell off is similar to the September harvest sell off we get here in the U.S.

The final piece of seasonal analysis is the analysis of the seasons themselves. Last year’s drought has not been sufficiently squelched by winter snows. Soil moisture in the leading soybean producing states is running dangerously low. Nine of the most productive states are sitting at 20% of normal soil moisture. This is the mirror image of last spring when only 20% of the same area was below normal moisture levels. The world cannot afford a drought in the U.S. in 2013.

Moving to the more technical nature of the market the commercial traders have been net buyers of beans since November. Their net position has doubled and they’ve only been net sellers twice in the last 15 weeks. Commercial traders have been early buyers in each of the last three years. Each of the last three years has given us an early rally, as well. Deeper research reveals the importance of this. Commercial traders have come into the year on a positive note one third of the time over the last 30 years. Soybeans have had meaningful early rallies in seven out of the ten years that commercial traders have started the year on a bullish note.

The USDA has raised its 2013 forecast to a range of $13.55 – $15.05 per bushel. These estimates are based on the November soybean futures, which will be this year’s planted crop. November soybeans are currently trading at $12.70 per bushel. The November beans have formed a triple bottom on the daily chart near $12.55. This would imply the market wants to trade lower and see what happens under the $12.50 area. Technically a test or, penetration of $12 would provide an ideal bottom to start looking at the buy side for the November soybean futures contract. Breaking the $12.50 level would accomplish two things. First, it would flush early and weak buyers out of the market and allow the positions to reset themselves. Secondly, it would create an oversold condition that, combined with positive commercial trader momentum could be used as a springboard to get long on the bounce higher.

There are far too many bullish global factors to ignore the buy side of soybeans in 2013. The fundamental factors of growing global demand in the face of record low current inventories will magnify any weather related issues. The soybean market typically overshoots its targets and suggested price ranges. Therefore, buying soybeans $1.50 below the bottom of the USDA’s price targets may very well net a profit in excess of the USDA’s high side of their forecast at $15.05.

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.

Higher Cattle Prices in 2013

The outlook for cattle prices in 2013 appears to be even higher than 2012 due to declining herd sizes and an increasingly favorable export climate. The US cattle herd has been in decline over the last few years. The drought of 2012 has led to the culling of more animals including non-productive dairy cows and heavier steers that have managed to avoid the feedlots. The addition of these animals into the production mix did three things. First, it increased the average weight of cattle coming to market. Secondly, the increasingly tight supplies already pushed the April live cattle futures contract above the 2012 highs. Finally, it has led to the smallest U.S. starting herd since 1952.

The USDA’s January cattle inventory report shows a total U.S. cattle herd of 89.3 million head. This is the smallest calf crop since 1949 and is the 18th consecutively smaller calf crop. Producers and finishers appear to be coming to the consensus that it’s better to have fewer animals at heavier weights than more animals at lighter weights. The University of Missouri points out that steer weights are up over 34lbs from last year and December marked the 49th consecutive week of heavier steers on a year over year basis. There is an argument within the industry as to the real reason behind the growing weights between those who say weights are increasing due to better animals being culled versus the addition of the beta-agonist, ractopamine.

Politically, 2013 will see a good boost in demand due to Japan’s relaxation of the ban on U.S. beef following the mad cow episode of late 2003. This year, Japan will allow U.S. imports of cattle up to 30 months old. This relaxes the 20-month age limit rule that effectively crushed U.S. exports to Japan. Prior to mad cow, Japan was the number one destination for U.S. beef exports. In fact, Japan imported more than 500,000 tons of American beef as recently as 2000 in contrast to 2012’s total imports estimate of just over 200,000 tons. Many agribusiness insiders see the relaxation of the age limit as Japan’s recognition of globally tight supplies for the foreseeable future.

We’ve addressed the certainty of a declining cattle supply in 2013 as well as sourcing added demand in this marketing year due to freer trade, that leads us to the primary variable of input costs. This brings us to the feed vs. ethanol battle over the 2013 corn crop. Some of the blend tax incentives for ethanol producers were allowed to expire in 2012. Ethanol producers are still bound to the Renewable Fuels Standards mandate that shows 2013 as the first time that the mandate’s target is set beyond the blend wall. This year, 13.8 billion gallons of our fuel supply is supposed to come from ethanol. However due to our primary blend of 10% ethanol, we are unlikely to produce the 13.8 billion gallons to meet the mandate target.

The Renewable Fuels Standards face an application dilemma that must be sorted out by the bureaucrats to put the fundamental factors of the ethanol market back into equilibrium. Currently, unblended ethanol is trading around $2.37 per gallon while wholesale gas prices are about $2.65. The disequilibrium comes into focus when we realize that ethanol is about 25% less efficient than gasoline and should therefore, trade at a corresponding discount. Using the example above, ethanol should be trading at $1.99 per gallon. Ethanol blenders will have to push for either reenacting the expired ethanol blending subsidies or, governmental clarification of E85 liability and warranty issues that will allow the expansion of the E85 delivery infrastructure.

Finally, the cattle market will keep its eyes focused clearly on the skies. The drought of 2012 was genuinely historic with many ranchers still feeling the pinch through the high price of hay this winter. The run-up in grain prices was brutal to cattle ranchers, as crop insurance provides no relief for livestock ranchers. Therefore, this may be the most important weather year that I’ve been witness to as a steady and useful supply of rain will be necessary for both grazing and growing feed crops. The National Oceanic and Atmospheric Administration (NOAA) expects 2013 to be a normal year however, several universities’ grain forecasting models are leaving room for exceptional volatility with average December corn (2013 crop) prices expected to finish around $5.75 per bushel but, quickly tailing out to more than $6.50 per bushel without factoring in the rising tide of any additional volatility.

Cattle farmers appear to be taking proactive steps to managing their businesses in 2013. The Commitment of Traders Report clearly shows commercial buying both in the grain markets and the cattle futures market itself. Commercial traders have bought more than 11,000 contracts of corn below the $6.50 per bushel level in the December contract. This is evidence of cattle producers attempting to lock in their feed costs for the coming year at anything near normal feed prices. We’ve also seen commercial traders nearly double their long position in the cattle futures as they guarantee their ability to make future delivery. U.S. Cattle ranchers locking forward production costs at these levels shows that they’re projecting their profit margins based on growing global demand rather than declining input costs. Given the miniscule herd numbers, we could see prices really skyrocket in 2013 if the weather is decent and ranchers can hold back animals to re-grow the herd size on forage, rather than feed.

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.