Traderbill's Financial Markets Weblog

…when it’s an ETF…or an Index Fund. Think about it there are commodities: gold, oil, corn, wheat, cattle, etc. Through the CTFC they are made available as futures with two classes of investors: commercials, those with a vested interest in the commodity such as producers who hedge their inventories with futures contracts, and speculators who easily move from one pit to another and could care less about the physical commodity…they never take delivery. Does anyone remember the I Love Lucy episode where she decided to speculate in commodities and got a ton of corn dumped on her front lawn? Well, that doesn’t happen…can you name any instance in which that has really happened? If you have a profit or loss you take it and close out the position. This is not to say that commodities trading is simple and over 80% of newbies get wiped out…about the same as options. Furthermore, you have to understand everything about the commodity you buy, such as weather, cycles, inventories, and more.

 

Many of you will remember Paul Erdman’s venture into commodities when he was CEO of a Basel based Swiss bank that a bank TB used to work for UCB (United California Bank), whose moniker was later changed to Uniformed Chocolate Buyers. That is because they had the misfortune of buying the bank, after an audit by the Swiss banking authorities by they way, and finding that the bank had a huge position in cocoa futures (think about that the next time you read TB’s commodities summary and see how any commodity can be significant). Earlier they had taken huge positions in an obscure currency and in silver (providing the title for Erdman’s book, The Silver Bears…fiction of course). See, Erdman is a very smart man…too smart in many ways…the bank had researched cocoa and found that there is a disease that hits the plants every hundred years…so they bought cocoa futures intending to reap huge profits…of course Hershey’s and Nestle knew a bit about chocolate too and so the bank lost…big time.

 

Until the last runup in gold, crude and then other commodities in the basket (we will get back to that later), how many of you cared about commodities?…or care now? TB follows them but has no interest in playing in them, while investment ‘biker’ Jimmy Rogers, who was a big factor in George Soros success, loves them…in fact has been a perma-bull in them. As in stocks, you can be a perma bull or bear in commodities and eventually be right because when they move they move big as we have just seen. When that happens people forget you have been wrong for the past ten years and flock to you for advice. That is because when it happens investing is in a crisis…not simply a bull or bear market. Then in another five, or ten years or whatever you are right again. Any ‘perma’ label is hard to shake.

 

There is currently more speculation about the causes of speculation then there are speculators themselves, figuratively speaking. It is being blamed on everyone from oil companies, producers, speculators, hedge funds…and now to ETF’s and commodities index funds. There are compelling cases for each of these…or at least on the surface.

 

Rick Santelli, CNBC’s man in the futures pits…and a veteran of commodities in trading was just screaming, trying to get his point across to the rest of the crew…who doesn’t get it…that on the last day of trading on a contract (expiry), the only buyers of that contract, besides those covering shorts, are those who need physical delivery. They didn’t get it…in fact all of them were trying to convince him that he is wrong…that is the beauty of CNBC…everyone can be an expert…TB has already pointed out that he is not an expert so don’t toss him into this. As far as commodities are concerned, TB is merely an interested observer. But here is what he has learned about futures and it supports, Santelli’s case: if you watch the ‘lead’ contract…readers have seen reference to this in TB’s columns you know that as expiry approaches in say the June contract (with oil that happens in May), and the volume and open interest increases in July while June falls…this is very visible…note TB’s comments that the next contract has 1/2…then 1 times…then 2 times, etc. the open interest of the lead contract. Strictly a function of the speculators rolling out the curve so that they don’t have to take delivery. In crude, at the close of the final day, if nobody wanted delivery, the open interest would fall to zero on the last day…instead there are usually less than 2,000 contracts…contrast to about 300,000 for the next month. First delivery of crude is roughly 45 days after expiry…which more or less coincides with ‘liftings’, the time between it comes out of the ground and is ultimately received. A crude contract is for 1,000 barrels. As TB has been reporting, recently the crude market has moved into contango…where the further out the contract curve the higher the price…you expect this with gold since storage costs, etc. impact the ‘profit’, but crude usually trades in ‘backwardation’ where the further out the curve you go, the less it costs and that curve is usually steepest when prices are rising…as they are then expected to fall. But over the last couple of weeks the long contracts, the longest is Dec ‘16 but the longest active contract is Dec. 15, surged…in fact Dec’ 15 rose over $10 in two sessions. What caused this? If we go back to 3/19, the last trade for April Crude, open interest was 56 contracts at the close…56,000 barrels which is typical, on 4/22 last trade for May, open interest was 6,222 barrels or 6,222,000 barrels (remember the closing price has to be multiplied by 1,000 to get the contract value), and on May 19, it was 4,345 contracts or 4,345,000 barrels! Someone needed delivery…but who? Not speculators as we have seen they trade the front contracts where volume is 100,000 contracts a day and open interest in the lead contract is nearing 400,000 contracts…there is just not enough liquidity after six months. Despite all of this, the smart guys on CNBC kept trying to tell Santelli he didn’t know what he was talking about…that you simply trade after expiry…sorry folks, can’t do that…but it didn’t stop one wiseguy from continuing to shake his head at Santelli…who has forgotten more about commodities than this guy will ever know!

 

To get a better picture lets look at prices on the expiring contract and Dec. 15 on expiry:

 

3/19 (April Contract): April $107.90; Dec ‘15 $98.81 - backwardation Dec ‘15 open int 12,461

4/22 (May Contract): May $119.37; Dec ‘15 $198.18 - backwardation Dec ‘15 OI 15,185

5/19 (June Contrct): June $127.05; Dec ‘15 $129.93 – CONTANGO Dec ‘15 OI 19,931

 

There you have it…there is a shortage of supply in the front end and that simply is not the case. Why? We now know that the Iranians are leasing tankers at about $140,000 a week to store crude, their crude is inferior and can only be properly refined in U.S. (which doesn’t buy it), China, and India. Would they do this if they thought oil prices would decline? By the way the U.S. does buy Iranian crude the same way we bought Russian crude during the cold war…it goes to Rotterdam or another harbor goes to another tanker and voila! …it is no longer Russian or Iranian…just a crude commodity.

 

Still doesn’t answer the question of why? To get at least a partial answer go back to when the first gold ETF began trading in London…immediately the price of gold moved up…why? Because they had to physically buy gold and put it in a vault each day…further driving up the price. Then StreetTracks got approval for their ETF (GLD) in the US, later followed by iShares (IAU). Together these contracts, which made gold easy to buy for individuals (keep in mind since you are buying the underlying commodity there are only ordinary gains or losses), and again gold surged. So long as it continues to move up more buyers will come in…but when it declines…it drops like a rock as sellers of the ETF’s now fuel the fire on the downside…that is what was so critical about $853 an ounce, the 38.2% retracement of the entire rally from the peak on 3/17 ($1,033.60). If you recall, it dipped below it on May 1-2 briefly but closed above $80 and then rose sharply again. But that is gold…what about crude?

 

With the commodity index ETF’s and index funds (which do have capital gains since they do not own the underlying commodities), they buy the front end and the big funds (like PIMCO) are huge and also short the long end of the curve. By doing this they are effectively hoarding and making supplies scarcer…of the futures, not the underlying commodity. A few years back PIMCO was criticized for buying bonds then buying puts on them or calls, or futures, but by not selling the physical bonds they were able to corner…some said manipulate the market as the cheapest to deliver price kept rising. This is what the indexers are being accused of doing…and due to all they interest in commodities, billions are piling into these funds further driving up the price of the underlying commodities…in other words it has nothing, or little to do with consumption demand. If so, once it is deemed that they have been milked to the fullest, or some exogenous event impacts them, prices will plummet…as gold did from the March peak to May.

For the entire article, see John Mauldin’s website: http://www.frontlinethoughts.com/printarticle.asp?id=mwo052308, then you decide as both cases are presented.

 

Interest is about to shift to food again…specifically beef as physical supplies are dwindling and young cattle…and hogs…have been slaughtered early since the cost of feeding them exceeded the value. Now watch for a huge increase in beef prices which will further impact restaurants and of course consumers.

 

TB was in COSTCO on Saturday and noted that no longer are all the shopping carts full to the brim…in fact maybe 10% were…most were half full or less…a lot of shoppers but less buying…and mostly foodstuffs and supplies. Meanwhile at the gas pumps the lines were the longest he has seen…and usually if it is crowded when he goes in, he gets gas after shopping…this time the line was even longer after! He didn’t buy gas there…instead opted to pay more and not wait in line…think about it.

 

TB hopes you found today’s piece interesting…albeit long…but it is a complex subject and further proof, at least to TB, that stocks are in trouble…at least for another downleg, meaning we just had a countertrend rally…not a new bull market and we are now entering the summer doldrums! CAUTION! 

 

Trader Bill thinks it is clear to anyone reading these missives that they are merely commentaries…as he sees it…and do not necessarily reflect the views of anyone other than his own. Information is gathered from sources he has found reliable, but no guarantees of accuracy are implied. These are merely observations of events in the marketplace offering in an attempt to offer a non-mainstream viewpoint. Hope you find it useful.
Copyright TBD Capital LLC May 27, 2008