Category Archives: Energy Markets

Corn to Rally using Crude Oil as Analog

The corn futures market was facing unprecedented demand heading into this year’s planting season. The tightest supplies since 1937 and the governmentally mandated ethanol program’s consumption of 40% of this year’s crop put extra pressure on Mother Nature to produce a record crop. We all know that this spring broke the 100-year-old record for rainfall. When we combined this with cold temperatures, flooding along the Mississippi and a southwestern drought, it became obvious that corn acreage would suffer as farmers would be forced to wait for the fields to dry and planted more beans and less corn.

Last week, the USDA issued its acreage report and the markets fell out of bed. Corn acreage planted was reported up 5% from last year at 92.3 million acres. This is the largest planted area since 1944 and second only to 2007. The market sold off nearly 12% in the next two trading sessions as traders, farmers and end line users scratched corn their heads in wonder. Message boards were lit up as people wondered how there could possibly be an increase in acreage when the main question was, “How many acres have been lost due to flood damage and the wettest spring on record?”

The USDA’s accounting methods and history of revision has been brought to the forefront of this discussion. Is the USDA turning into the Federal Reserve System and constructing its data to fit its needs? The report did create a flush in the market and ease food and ethanol prices instantaneously. The flush also washed out most trading and hedge funds on the long side of the market.

The reported acreage versus the expected acreage was one of the biggest surprises on record. One industry analyst, Rich Feltes actually found these numbers to closely match his own forecasts while Carl Zulauf from Ohio State questioned the validity of the USDA’s estimates and points to next week’s USDA Supply and Demand Report for more accurate data. Finally, some of the largest Ohio farmers don’t see any way that the acreage reports can’t be revised sharply lower.

The real issue here is, how do we trade it. The analog I’d like to pass on is crude oil’s decline to $90 per barrel on the news of Saudi Arabia’s production increase combined with waning demand in the face of a recessionary Europe. Crude oil sold off hard on a news event down to what was previously a resistance level for that market – $90 per barrel. Corn sold off on a news event down to a level that was once also considered resistance – $5.50 to $6.00 per bushel. The dynamic in crude oil has changed so that what was once resistance – $90 per barrel, is now support. I believe the same is true in the corn market. I expect the market to bounce around here as traders square their positions but ultimately, I believe the acreage numbers will decline and the acreage that has been planted will not provide the 155 bushel per acre yield expected due to delayed planting.

Ultimately, the tight corn stocks coming into this year combined with the ethanol market and growing global demand will place added stress on this year’s crop, which I believe will be smaller than the most recent USDA predictions. Therefore, this sell off in the corn market should be bought in anticipation of higher prices at harvest.

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.

Setting of the Rising Sun

Japan’s economic crisis has been slowly trudging down a dead end road since their economy collapsed in the early 90’s. Their insistence on maintaining public programs as status quo has been financed by selling government debt to domestic corporations and private citizens. This has cannibalized both private citizen and corporate savings. This tacit deal has allowed Japan to artificially keep interest rates low based on their captive pool of treasury purchasers. This process of spending more than the government is collecting on an annual basis, combined with sales of treasuries to finance the difference has left them ill prepared to handle this disaster at a time of global economic uncertainty.

While some economists are taking the stance that Japan’s rebuilding is just what they need to get their economy back on the right track, I think it’s quite possible that their economy may be too far gone to save. Furthermore, the scale of their disaster will place a huge burden on developed nations who will be called upon to assist them in the process. Many of these nations, including the United States, have no room for error in their own economic policies. The end result could be a localized natural disaster that triggers a global recession.

Professor Ken Rogoff of Harvard School of Public Policy Research wrote a book in 2009 describing the historical relationship between banking crises and sovereign default. His research states that the average historical tipping point is approximately 4.2 times debt to revenue. Once a country is spending 4.2 times more than it is collecting, default is on its way. John Hayman and Lawrence McDonald, cite individually, that Japan’s expenses outpace revenues by more than 20 times annually. Their debt to GDP ratio, their total assets and earnings minus total debts and liabilities, is around 200%. The third largest economy in the world spends 20 times more per year than it earns and owes twice as much as it’s worth. One note of caution, the United States ranks third in the debt to revenue ratio, behind Japan and Ireland and we owe as much as we’re worth. We will be double negative in 2011 if we don’t change substantially.

Debt will surely rise even further as Japan borrows to rebuild. Standard and Poor’s downgraded Japan’s credit rating to AA in January, prior to the disaster. Japan will have to move to the open market to finance their reconstruction. Their domestic lenders will be busy financing their own rebuilding processes. This will force Japan to pay open market rates for most of their new debt. Open market rates will be AT LEAST 100 basis points and most likely, closer to 200 basis points higher.  The interest payments would total more than 25% of the country’s revenue. Japanese credit default swaps will sky rocket.

The strain of rebuilding Japan will affect us whether we lend financial assistance or not (which we will). The demand of replacing 30% of Japan’s energy source will show up in the price of fossil fuels. Japan currently consumes 5.2% of the world’s oil supply. Replacement of lost energy will add another 1.3 million barrels per day plus the added oil necessary for the reconstruction. Their added demands equal Italy’s total consumption. Add this to the global uncertainty of North African fuel supplies and the added fuel that goes into fighting a third global conflict and we have questionable supplies coupled with increasing demand.

Rising oil prices couldn’t come at a worse time for our economy, which had been gaining some traction. GaveKal research published a chart in which rapidly rising oil prices are overlaid with economies growing more than 2% above their leading indicators, which we are. This has happened 5 times in the last 70 years. Four of the five led directly to recession. The fifth was in 2005 and was ameliorated by the credit and housing booms, which may have delayed the recession until 2007. Rising fuel costs act as a tax on the economy.  The latest housing numbers, the worst ever, blame much of it on high gas prices. Furthermore, while the unemployment rate is stabilizing, the length of time people are unemployed is at an all time high of 37 weeks. Finally, the stock market has returned to its upper 10%, in normalized valuations. Japan’s natural disaster could very well mean this is the zenith of our economic recovery.

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.

Diversification is not Immunization

Every market crash or bursting bubble is like the ice cream truck calling kids to the street. Portfolio managers and re-balancers know they get the opportunity to truly be heard only when something goes wrong.

Most people live their lives reacting to new stimulus. If something hurts, they don’t do it again. If something works, there’s no reason to change. Portfolio managers attempt to anticipate areas of pain and mitigate that pain wherever possible. However, there are times when efficient portfolio analysis, modern portfolio theory and just plain common-sense investing will still force one to endure periods of pain.

Portfolio composition is usually based on a collection of assets that tend to relate to each other in a predefined and expected way.

There are three basic relationships:

— Positive correlations: Two asset classes rise or fall together, predictably.

— Negative correlations: One class rises when the other falls and vice versa, predictably.

— Non-correlational: No predictable relationship.

The right balance of these relationships across multiple asset classes will smooth out returns and help to insure the predictable performance of one’s portfolio.

There’s an old saying from statistics 101: “Correlation does not equal causation.” We can measure how markets move relative to each other, but without understanding their relationships, we can’t say for certain what caused what. Sometimes, understanding “why” has a bigger impact on one’s portfolio than the actual mix of assets.

Last week we saw many markets fall. The stock market is lower, as are precious metals, bonds, grains, coffee, sugar, cocoa, crude oil and the energy markets. Many of the classic market relationships people use to balance their portfolios failed to behave in the anticipated manner and did not balance the risks associated with investing. Markets can and do, behave in unanticipated ways.

Commodity markets have been trending toward generally higher prices. The stock market has also had a nice rally and is up more than 9 percent since Labor Day. During this time, the Federal Reserve Board also announced a second round of quantitative easing to keep interest rates low and weaken the U.S. dollar. Consequently, bonds have rallied in price while the dollar has fallen.

The sudden about-face in many of the markets is twofold. First, the news regarding Ireland’s financial health has become increasingly pessimistic. Ireland was on the financial default radar, along with Greece, more than six months ago. Ireland has been very proactive in implementing domestic austerity measures to rein in spending. Furthermore, Ireland has also steadfastly maintained its financial issues are limited to a few banks that became overleveraged during their own housing bubble.

Unfortunately, the European Union has the same fears about Ireland and Greece we did in the U.S. with our own domestic banks and that is that every bank was more overextended than initially thought, requiring an even bigger lifeline to maintain solvency. Finally, Portugal and Spain are also on the verge of financial insolvency themselves.

The second fear to hit the markets was China’s announcement Wednesday its economy may be overheating again. Rumors are circulating China may follow several banks in Korea in raising its interest rates to slow down inflation and thus, economic growth. The data coming out of China certainly reinforces the idea it may constrict lending in the near future. China has a published cap on the amount of money its nationalized bank will lend in any calendar year and it is quickly approaching that ceiling.  The fears are also evident in China’s stock market, which has slid more than 5 percent in the last few sessions.

These two events combined to cause havoc in our domestic markets as they immediately unraveled the underpinnings of our market rallies. The Chinese news sucked the demand out of the commodity markets. China’s clampdown on inflation is pulling money out of the commodity markets and reducing overseas demand for raw materials. The news from Ireland and the European Union has the equity markets spooked. For many investors, the 50-percent correction in the equity markets from our own financial crisis is all too real and all too recent. Our domestic stock market’s rally and the quickly approaching year’s end makes it easy for many traders and investors to simply pull money out of the markets.

News events shock the markets and broadly sweeping economic forces create seismic shifts in market behavior. During these turbulent times, typical market relationships may fail to behave in the predicted manner.

As the Chinese economy becomes a first class consumer, we must accept our role as a supplier, rather than our historical position of end line consumer. As a supplier, we need to recognize the demand-needs of our trading partners. This is a broadly sweeping change that will affect the commodity markets for years to come.

News from Ireland and the European Union can shock the stock market, reawakening nightmares of 2008, but plans can be made to account for these events.

It does require proactive management of one’s portfolio. The old days of the passive hedge and allocation strategies may be gone.

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.

Oil Addiction

The United States’ energy dependence has followed the same path as a junkie. We have become addicted to cheap oil over the last forty years. In fact, our entire economy was built on cheap oil. Just like any good junky, we weathered the initial supply crisis in the 1970’s and, having seen the error of our ways, vowed to set ourselves straight. Fortunately, it was just a temporary shock and we didn’t really mean it. Besides, remember how bad it was? It was horrible for domestic employment and inflation was everywhere. We were invaded by foreign automobiles. We were forced to listen to crackpot after crackpot on the evening news telling us that we should be using alternative energy sources available right here in the U.S.  Thank goodness that didn’t last.

 

Fast- forward to 1990 and a tiny little country in the Golden Crescent was having its, “freedom” threatened. Amazingly, one little country, smaller than New Jersey and with fewer people than the city of Houston, was able to mobilize the mightiest fighting force in the world. A desperate addict needing a fix will do almost anything to ensure their supply keeps flowing. The subsequent rally in oil prices was hardly noticed due the prosperous economic times of the period. We got to watch the war on TV with Wolf Blitzer calling the commentary from the video feed on the nose of precisely guided weapons. The technology boom got underway, the war was a huge success and we reveled in national pride.

 

Here we are in 2010 and we’ve gotten used to paying a higher premium for petroleum products and we’ve successfully defended our suppliers. My issue is this; the United States must develop a consistent and focused energy plan if we are ever going to become self -sustaining. We have the resources. The U.S. has greater natural gas reserves than the Saudi’s have oil. This past week I’ve read two alarming pieces targeting the future of the United States’ energy consumption. After doing some research on my own, it has become clear that there is a major disconnect between where we are being told we are headed versus where we actually are headed.

 

The government stimulus packages and vehicle emission standards have pushed for electric cars as the primary source of green energy. It’s made for great press as our ailing auto manufacturers have produced catchy, warm and fuzzy commercials and brainwashed the general public into believing we are on the road to self-sufficiency, leading us away from foreign oil dependency and the wars it has brought with it.

 

However, if look behind the Wizard’s curtain, we reveal some startling facts.

The U.S. currently imports 67% of its oil.

The cessation of Gulf oil production will increase this to 75% by 2012. This will put oil at $125 per barrel and gas at $4-$5 by 2012.

Half of our top ten oil importers are countries that are unsafe to visit according to our State Department. Their official language reads, “Travel Warnings are issued when long-term, protracted conditions that make a country dangerous or unstable lead the State Department to recommend that Americans avoid or consider the risk of travel to that country.” This includes countries like, Iraq, Nigeria, Saudi Arabia, etc.

According to T. Boone Pickens, our current energy policy prices in oil at $300 per barrel by 2020. Oil is currently just over $80 per barrel.

 

I wrote about the spread between natural gas and crude oil a few weeks ago stating that it was near an all time high. The spread between any two markets is based on using a standard measure for both to determine absolute value. Energy markets are measured in British Thermal Units, BTU’s. This defines how much work or, power, is generated by the combustion of a given quantity of substance. The current relationship between crude oil and natural gas is that it takes $14.07 worth of crude oil to do the same work as $3.80 worth of natural gas. This means we pay about 3.7 times as much for crude oil to do the same amount of work as we would for natural gas. The five- year average for this ratio, including today’s inflated price is, 1.7.

 

Natural gas has always sold at a discount to crude oil and until the last 10 years, the relatively low price of crude oil has dictated business as usual. In the wake of 9/11 and the global recession, the government has spent hundreds of billions of dollars aimed at stimulating the economy, nurturing energy independence, cleaning up the environment and improving the infra structure of the country. Unfortunately, the money from that pie, our tax dollars, have been sliced so thinly that the result is virtually, nil. Our dollars’ have been spent on a Jack-of-all trades and master of none. This is most clearly evident in the outside investment and performance of alternative energy source companies specializing in wind, geothermal, solar and fuel cells, which have all lost at least 30% over the last year. Clearly, the investment community has little faith in the current administration’s ability to coordinate a sustainable alternative energy plan.

 

Finally, the push towards electric automobiles is simply a public relations gimmick. According to the U.S. Energy Information Administration, highway diesel usage trumps residential gasoline consumption by more than an 8 to 1 margin. Does it really make sense that the government enacted emission restrictions on passenger vehicles prior to commercial vehicles? Electric, residential automobiles with two seats and a 100 mile range are not going to effectively address the problem of energy independence.

 

The primary focus of our energy policy should be natural gas. It burns 30% cleaner than crude oil and nearly twice as clean as coal, which it’s also currently cheaper than. Finally, in energy equivalents, apples to apples, we have three times more energy reserves than Saudi Arabia. We should regain our dignity by developing the infrastructure, creating fueling stations and putting our people to work through the use of new technologies with an extended shelf life. This is a fundamentally sound path towards a cleaner, more productive and independent country.

 

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.

CFTC vs. Commodity Index Traders

High grain and energy costs have finally generated enough momentum for the politicians to get involved. This past week, a paper was presented to Congress by Michael Masters of Masters Capital Management. He attributes the current price levels to creating an artificially high floor price due to the asset class categorization of commodities. The long only money that has poured into the markets is creating, “demand shock from a new category of speculators: institutional investors like
corporate and government pension funds, university endowments, and sovereign
wealth funds. He also, matter of factly states, “Index speculators are the primary cause of the recent price
spikes in commodities.”

One statistic that is being roughly, though widely, quoted, is the assumption that demand for exchange traded commodities over the last five years has increased equally between China and Commodity Index Funds. The CFTC is prepared to overhaul its system of reportable trading categories and players to try and pinpoint who is trading what and how much. The purpose is to differentiate between true physical price discovery and speculative froth.

Congress is prepared to assist the CFTC in outing the institutional speculative money by closing the swaps loophole that has allowed the billion dollar funds to enact futures transactions as swaps through their securities brokers (Merril, Goldman, etc.) who then hedge the swap in the futures market. This is how every individual fund has managed to stay off of the CFTC’s Commitment of Traders reports. The commodities are held assets with their broker while the broker executes the hedge and reports the position as their own.

The CFTC and Congress working hand in hand could bring an end to this bubble far quicker than peace in the Middle East or a bountiful global harvest.

Please, feel free to comment or, question. This is a small picture painted in broad brush strokes.

Have a wonderful weekend, Andy.