MartinKronicle: Commodity Report
November 23, 2015
Markets largely ignored the terrorist attack in Paris on Friday, November 13 last week. Equity prices moved higher and many commodities continued to move lower. Copper, gold, iron ore, nickel and the Baltic Freight index all posted new multiyear lows. In the case of the freight index, it traded to the lowest level since 1985.
The release of Fed minutes from the last meeting told us that the Fed is on course to raise the short-term Fed Funds at the December meeting. The dollar moved higher on a week-on-week basis and this contributed to weakness in commodity markets.
Precious Metals- Both gold and silver continue to display weakness. Gold traded to the lowest level since February 2010 as the December COMEX futures traded to lows of $1062. The yellow metal finished up on the week at $1076.70 and silver moved to $14.15 per ounce, just 25 cents above recent lows and key support. Meanwhile, platinum group metals a mixed bag. Platinum fell $5.40 on the week to $855.70, the lowest level since December 2008. Palladium was up around $20 on the week.
Divergences continue in precious metals. The silver-gold ratio is around 76:1, which is a bearish signal for the sector. The platinum-gold spread is now approaching another test of all-time lows established on October 2; it closed at a $220 spread, platinum under gold.
The action in precious metals markets continues to point to new lows however; a delayed reaction to the events in Europe could bring some fear based buying back into these markets, particularly if there are any new attacks. I would look at any price recovery as another selling opportunity for the time being as the trend and path of least resistance remains lower.
Energy- Crude oil was little changes on the week closing at $41.90 on the active month NYMEX January futures contract. Processing spreads weakened in heating oil but strengthened in gasoline. Term structure in crude oil widened with contango on the December 2015 versus December 2016 spread in WTI making a new high above the $8 level. Widening contango is yet another bearish signal for the energy commodity. Brent futures have rolled to January and the Brent premium over NYMEX crude moved marginally higher to $2.76 premium for Brent over WTI level. The move higher is likely due to fears surrounding Middle Eastern crude flows in the wake of the terrorist attack. However, the spread did move below $1.50 during the week. The trend in the spread seems to indicate that Brent will eventually return to a discount to WTI crude oil.
Natural gas made new contract lows on December futures closing at the $2.1410 level as the market prepares for winter. Inventories rose to new all-time highs at 4 trillion cubic feet. It is likely that increasing inventories have caused price weakness as we head into the winter season but inventories are at a level that is close to full capacity. Natural gas open interest continued to fall, which could be a sign that some shorts have closed positions. The contango remains high and widened by 0.3 cents over the past week with February futures trading at a 19.4 cent premium to December futures reflecting that demand will rise this winter.
Base Metals- Nonferrous metals on the LME moved lower, with the exception of lead and tin, this past week. On COMEX, the price of active month December copper futures made new multiyear lows as concerns about China and the prospects for an interest rate increase in the U.S. in December dominated trading. Copper is now just above $2 per pound, the low of the week was $2.0305 per pound. Nickel fell to twelve-year lows as demand for stainless steel in China continues to be weak.
Grains- Grains were quite this past week. Soybeans and corn moved marginally higher and CBOT wheat is testing support. Wheat closed just below the $4.90 level on the active month December futures contract.
Soft Commodities- Last week was a continuation of bullish action in the soft commodity sector. While the FCOJ futures market pulled back to the $1.50 per pound level, other soft commodities gained. Sugar moved higher on the week and closed at 15.30 cents per pound, only 23 points away from recent highs and key resistance. The March-May 2016 sugar spread, closed at a 39-point backwardation up two ticks from the prior week. This signifies the potential for a supply issue this March. Cocoa futures made new multiyear highs trading up to $3420 before closing the week at $3366 per ton. The forward curve in cocoa is moving into backwardation on supply concerns. Coffee showed some signs of life and rallied from $1.1530 to over $1.24 per pound in aftermarket trading on Friday November 20.
Animal Proteins- Meat markets were stronger as December futures are rolling to February. Cattle futures moved slightly higher on the week as did lean hog futures. The long-term average of the live cattle versus lean hog spread has been around 1.4 pound of pork value in each pound of beef value. This spread, on December futures, closed at 2.24:1 last Friday, down on the week. The spreads in February is at the 2.26:1 level.
Recent terrorist event and the eventual response are likely to increase volatility across all asset classes. There are plenty of profitable opportunities in the weeks and months ahead in the commodity markets for those who understand these markets. The strong dollar and deviation between U.S. interest rates and others around the world will surely create volatility in all assets classes, particularly in commodities, which tend to be the most volatile of all. The majority of these opportunities will come from spread relationships. I remain bullish on the U.S. dollar and this means that I believe that commodity prices remain in a long-term bear market.
There will be no report next week. Have a happy Thanksgiving holiday.Continue Reading...
By Jason Pearce
Energies are an important sector of the commodity markets as they have one of the most widely-felt impacts on the global economy. The price of crude oil is used as a bellwether of inflation. This is why you may see the price of oil quoted in many market news reports. Heck, even the non-traders among us notice how much gasoline prices can fluctuate throughout the week. Driving by the local gas stations every day can prompt plenty of comments at the water cooler later on at the office.
Interest rates, currency exchange rates, shipping costs, the economy, war, and politics can influence the price of crude oil. Just as importantly, the tail can wag the dog as crude oil prices can influence interest rates, currency exchange rates, shipping costs, the economy, war, and politics! This makes the energy markets important for hedging. It also means that energies offer great opportunities for speculation.
In addition to crude oil, one can also trade the crude oil products: the RBOB gasoline and the ultra-low sulfur diesel fuel (ULSD). Furthermore, you can trade the inter-market relationships between all three markets. Right now, there may be a trading opportunity shaping up between gas and ULSD.
Energy Product Price Correlation
Even though the usages are different, gasoline and ULSD are highly-correlated in respect to how their prices move. If you removed the labels from the price charts of gasoline and ULSD and superimposed one of them over the other, you’d be hard-pressed to pick out the differences. This makes them ideal for spread trading.
Just so you aren’t surprised, you may want to know that the ultra-low sulfur diesel fuel (ULSD) was previously a heating oil contract. However, the only different is the sulfur content. In compliance with changes in the EPA rules for distillate fuels, the contract specs were changed from 2,000 PPM (sulfur content) to a mere 15 PPM. This happened back in the spring of 2013.
As far as price behavior goes, it appears that nothing has changed. Many ‘old-timers’ still refer to ULSD as the heating oil market. That’s certainly good news for those trading on seasonal patterns and historic inter-market relationships.
It’s Time to Get Crackin’
This week is the start of a strong seasonal pattern for the spread between RBOB gasoline and ULSD (ultra-low sulfur diesel). Until early January, gas should be able to outperform the ULSD market.
According to Moore Research Center, Inc., you want to buy the March 2016 RBOB gasoline contract and simultaneously sell the March 2016 ULSD contract on November 17th. The spread is exited on January 9th.
Using these entry and exit dates has yielded a profitable trade for fifteen consecutive years. In addition, the average profit was approximately +7.8 cents or +$3,274 per spread. With a perfecting batting average and a sizable average profit, what more could you ask for?
Counter-intuitive…Or Is It?
Fundamentally, one would think that the price of heating oil –I mean, ULSD- would heat up as winter approaches because of the dropping temperatures. In addition, one might expect gasoline to stall out because driving should be on an overall decline (going to Grandma’s house on Thanksgiving is the big exception, of course). So shouldn’t we be buying the ULSD contract and shorting the gasoline?!
The fact of the matter is that everyone knows the seasonal expectations for demand. It ain’t rocket science. However, the job of the futures markets is to anticipate and price in the expectations for the future.
The refiners start cracking the crude and stockpiling heating oil long before the cold weather actually arrives. They continue to operate at capacity, which means they are not making as much gasoline. Therefore, the heating oil inventories are usually plentiful by the time winter actually gets here. Barring unusual weather extremes like a Polar vortex, the heating oil prices can then be on a downward slope once Christmas shopping season arrives since there is plenty of supply to meet the demand.
If one were to look at the last thirty years of price history, it would appear that there’s no real trend in the ratio between RBOB gasoline and ULSD. Therefore, the prudent strategy would be to sell when the ratio is near the high end of the historical range and buy when the ratio is near the low end of the historical range.
On the low end, the gasoline/ULSD ratio becomes a candidate for purchase after it drops to 0.85:1 or lower. This has only happened about a dozen times (basis the nearest-futures) in the last three decades. Each occurrence was a temporary event. Therefore, you should look for a setup to get long when the spread is in the tank.
Current Technical pattern
The March 2016 gasoline/ULSD spread has been in an uptrend since just before Labor Day. As a matter of fact, one could even argue that the spread bottomed nearly a year ago. After a sizable correction during the whole month of August, the uptrend continued. The spread is still in a bull market.
At the end of October, the March 2016 gasoline/ULSD spread cleared resistance at the July price peak of -17.36 cents (premium ULSD). This was a bullish breakout. Now that it has been cleared, the July peak has become a price support level. A pullback to somewhere around the July top should be viewed as a buying opportunity.
The ratio looks bullish as well. First of all, there’s the double bottom that was established between the December 2014 and August 2015 lows just above 0.83:1. This set the foundation for a bull market.
Secondly, although it has already risen from the August low, the current ratio of just under 0.89:1 is still historically cheap.
Be aware, however, that this observation is made on the nearest-futures price data. Because the seasonal patterns are partly baked into the price, you don’t always see the prices in the expiring contracts and the distant month deliveries converge. Notice that the April 2016 ratio is already priced at 1.03:1 because of the expectation that demand for gasoline is higher after the heating season ends in the March/April timeframe.
Jumpin’ Jack Flash
We know that right now is the time of year to get long the March 2016 gasoline/ULSD spread. This is a seasonal trade with a high hit rate. We also know that the technical structure of both the spread and the ratio is bullish. This reinforces the outlook for a higher price.
Given the fact that the spread is currently in a pullback from the recent new contract high, spread traders could have an opportunity to quickly add to a long position. The seasonal play calls for getting long on Tuesday. The setup for an ‘add-on’ position would be to buy another spread on a close above the November 9th contract high of -13.17 cents (premium ULSD). You could risk the ‘add-on’ position to a close below the November correction low that precedes the entry. This allows you to really step on the gas if you have a winning trade on your hands.
Just like the commodity itself, trading a gasoline or ULSD futures contract can be both risky and volatile. Handle with care. You should know your risk tolerance and determine your position size before you jump in…or else your account could be gone in a flash.Continue Reading...
MartinKronicle: Commodity Report
Report for the Opening of markets on November 16, 2015
Last week, many key commodity prices continued to move lower. Precious metals, base metals, energy and many agricultural commodities moved to the downside. The only bullish action in the raw material markets was in sugar, cocoa and frozen concentrated orange juice futures. The dollar, which has been rallying since the middle of October, finished the week close to unchanged.
At the end of last week, the terrorist attack in Paris will leave traders with a new spin on markets as they return to their trading desks this week. The fear factor will certainly rise to a new level given the brutal nature of the attack that killed scores of innocent people and injured hundreds. Fear tends to breed volatility in markets and we are likely to see an increase in both in the weeks ahead as the civilized world digests and responds to the horrific events.
Precious Metals- Both gold and silver continue to display weakness. Gold made a new contract low by 70 cents as the December COMEX futures traded to lows of $1073. Continuous contract lows are at $1072.70 the July 24 lows. While gold marginally and closed the week at $1083.40, silver moved to $14.23 per ounce, just 30 cents above recent lows and key support. Meanwhile, platinum group metals moved aggressively lower last week. Platinum fell over $80 on the week to $861.40, the lowest level since December 2008. Palladium was also down over $80 on the week. It is fast approaching key support that is $20 below its current price.
Divergences continue in precious metals. The silver-gold ratio moved higher to over 76:1 which is a bearish signal for the sector. The platinum-gold spread is now approaching another test of all-time lows established on October 2.
The action in precious metals markets continues to point to new lows however; the events in Europe last Friday could bring some fear based buying back into these markets. I would look at any price recovery as another selling opportunity for the time being.
Energy- Crude oil moved lower on the week and broke short-term support at the $42.58 level and closing at $40.74 on the active month NYMEX December futures contract. Processing spreads weakened in crude oil adding to bearish sentiment. Term structure in crude oil widened with contango moving higher in both WTI and Brent crude. Widening contango is yet another bearish signal for the energy commodity. Brent futures have rolled to January and the Brent premium over NYMEX crude moved lower to $2.47 premium for Brent over WTI level. The move lower is the result of growing inventories. The IEA said last week that global inventories of crude oil are now around the 3 billion barrel mark.
Natural gas recovered marginally this week with December futures closing at the $2.383 level as the market prepares for winter. Inventories rose above the November 2012 all-time highs to 3.978 tcf. It is likely that increasing inventories have caused price weakness as we head into the winter season but inventories are at a level that is close to full capacity. Natural gas open interest fell a bit, which could be a sign that some shorts have closed positions. The contango remains high and widened by 0.8 cents over the past week with February futures trading at a 19.1 cent premium to December futures reflecting that demand will rise this winter.
Base Metals- Nonferrous metals on the LME moved lower, with the exception of tin, this past week. On COMEX, the price of active month December copper futures made new lows concerns about China and the prospects for an interest rate increase in the U.S. in December. Copper now seems to be on a path towards $2 per pound.
Grains- The USDA issued its monthly WASDE report this week. The report confirmed a third straight year of bumper crops in grains. All major grain prices moved lower in the wake of the report.
Soft Commodities- The only bullish action in commodities was in the soft commodity sector last week. The biggest volatility last week once again came in the FCOJ futures market, which moved to highs of over $1.60 per pound on Friday before pulling back. Citrus greening in Florida is causing supply concerns and is fueling the explosive action in FCOJ futures. Sugar moved higher on the week and is only again above the 15 cent per pound level. The March-May 2016 sugar spread, which I highlighted in last week’s report, closed slightly higher at around a 37-point backwardation. This signifies the potential for a supply issue this March. Cocoa futures appreciated and they are now at the highest level since July. The forward curve in cocoa is flat nearby and in backwardation in deferred delivery months.
Animal Proteins- Meat markets continue to show signs of weakness. Cattle futures moved lower on the week and lean hog futures made another new low at 52.80 cents per pound before recovering. The long-term average of the live cattle versus lean hog spread has been around 1.4 pound of pork value in each pound of beef value. This spread, on December futures, closed at 2.385:1 last Friday, down marginally on the week.
In October, this spread moved higher before collapsing down to 1.8:1 as the contracts neared expiration.
Events in France at the end of last week will likely increase volatility across all asset classes. There are plenty of profitable opportunities in the weeks and months ahead in the commodity markets for those who understand these markets. The strong dollar and deviation between U.S. interest rates and others around the world will surely create volatility in all assets classes, particularly in commodities, which tend to be the most volatile of all.Continue Reading...
by Jason Pearce
Trading At the Margins
Commodity markets can sometimes shoot to the moon or crash into the abyss. Price trends can also persist for years at a time. Yet, history shows that commodities are mean-reverting over the long run.
It’s somewhat intuitive that this would be the case. Supply and demand adjusts to accommodate the price. When price is at multi-year highs, producers ramp up production to take advantage of the profit margin. Buyers start backing off or, in some cases, find cheaper substitutes. Eventually the market gets saturated as a supply glut starts to build and prices plunge.
Conversely, low prices will squeeze and sometimes even eliminate the profit margin. This can cause some producers to start stockpiling supply instead of selling it. Or they may reduce production of that particular commodity and focus on something else. You see this happen when farmers switch which crops they plant because of the change in price. Then there are the producers that don’t have deep enough pockets to endure a prolonged period of operating in the red so they eventually get forced out of business. On the demand side, buyers may start to increase their buying to take advantage of the bargain prices and build their stockpiles when it’s feasible. This lessens supply over time and the commodity’s price eventually goes back up.
Even Better For the Spreader
Spreads between correlated markets tend to show an even stronger tendency of mean revision. This is why I’ve always focused more on the spreads than just the outright markets. When a spread between two highly-correlated markets hits price levels that it has rarely seen over the last couple of decades, we know it is on borrowed time. The probabilities favor a major reversal.
The persistence of regression to the mean is the whole reason why some of the best trading opportunities can materialize when commodity spreads are trading at the margins. At the very least, you should not have to worry too much about getting in and then getting stuck with ‘dead money’ where your position just drifts nowhere for months on end. The prevailing fundamentals have to maintain their momentum in order to justify the extreme prices, or else the move will run out of steam and the inevitable reversal starts.
To that end, there are some inter-market spreads currently trading at or near levels that are historically extreme. Some of them have already shown signs of a reversal and some are still trending as statistical outliers, but they are all worth monitoring. If you are a spread trader, you will want to keep close tabs on these potential trading candidates. Investigate how your trading methodology could be applied to take advantage of these situations extract profits from these opportunities.
Here’s the major theme in the metals sector: Either gold is just too darn expensive or else the rest of the metals (precious and industrial) are a screaming bargain down here. This is an anomaly that will eventually be corrected.
The good news is that, as a spread trader, you don’t have to guess which of these metal markets are priced correctly and which are not. You are simply betting on the return to normal in the relationship. If gold crashes while the other metals sit there, the spreads converge. If the other metals explode higher and catch up to gold, the spreads converge. There are actually five different scenarios of how the spreads can converge. Kinda like the old saying “Heads I win, tails you lose”. That’s a pretty good position to be in. Take a look at the charts and see for yourself.
The gold/silver spread tagged 80:1 at the end of August and began to retreat. As you can see on the monthly timeframe, the last couple of time the ratio reached 80:1 it quickly rolled over and began a major decline. If history were to repeat, the strategy would be to short gold and buy silver.
The ratio between 50,000 lbs of copper and 100 oz. of gold dropped just below 1:1. Over the last couple of decades, this has proven to be a temporary event and, therefore, a great buying opportunity. Be careful, though. You can see that the ratio has the potential to move substantially lower before recovering. The lows of the financial crisis prove this.
The platinum/gold spread inverted and hit a record low this year. The ratio hit the second-lowest level on record. We wrote a more in-depth post on this one earlier. It has been a favorite trade on the long side anytime you can buy the platinum under the gold.
The relationships between crude oil and its products have been in transition. The products reached historically unsustainable premiums over crude oil this summer and came crashing down. Rebounds could provide short sale opportunities. In addition, gasoline traded at a significant discount to ultra-low sulfur diesel fuel and it is now on the mend. Seasonal support kicks in soon, so buying a pullback in the gasoline/ULSD spread might be an appealing opportunity.
FYI: Until the spring of 2013, the ULSD was actually the heating oil contract. The only thing that changed is that the futures contract specs are now based on 15 PPM (sulfur content) rather than 2,000 PPM. This was done to comply with changes in the EPA rules that require lower sulfur content in distillate fuels. So don’t freak out about this being a new market. The ULSD is strongly correlated to heating oil so the historic price data should still serve as a good guideline for price boundaries.
Anytime the ULSD/crude oil ratio has hit 1.45:1 or higher, it has eventually petered out and then dropped back under 1.2:1. It appears to have peaked out months ago. However, there may still be plenty of downside ahead. Selling rallies in this spread could be the way to go.
The RBOB gasoline/ULSD (formerly heating oil) spread tends to be a good candidate on the long side once the ratio between these two markets drops to 0.85:1 or lower. The March 2016 ratio was already this low a couple of months ago. The spread is already in an uptrend and seasonal patterns will start to reinforce the rally this month. Take any pullback as an early gift from Santa!
After the historic 2012 drought spurred a significant liquidation in the US cattle herd, the beef market turned into a raging bull as prices rocketed higher for a couple of years. Since then, price has been on the defensive.
The big run-up pushed livestock spreads and livestock/feed spreads to record highs as well. Although the spreads are now working their way lower, history suggests there’s still a long, long way to go on the downside. Spread traders should be watching for short sale opportunities.
Both the ratio and the spread between feeders and live cattle topped at record highs last year and have been on a south-bound train since then. It’s still quite a ways off until the median level is hit. This could be a spread worth shorting on the rallies.
Judging by the current live cattle/lean hog ratio, beef is way too expense. Or is the pork too cheap? Could be both. Historically, the live cattle/lean hog spread has been a short sale candidate whenever the ratio was above 2:1. It’s above there now. Look for a setup to get short.
Livestock & Feed
More than half of the production cost in the livestock business is feed. Corn is the most popular feed for the animals. Therefore, it only makes sense to trade the spread between livestock and feed costs.
The stampede to record highs in feeder cattle, combined with bumper corn crops, caused the spread between feeders and corn to reach record highs by the end of 2014. This created a huge profit margin and encouraged more beef production. Since then, the feeder/corn spread has been working its way lower. As you can see on the long-term chart, the current bear market is still at historically high levels. This could keep the downward trajectory intact. Selling rallies may continue to be what the smart traders are doing.
The feeder/corn ratio made a record-shattering high of nearly 7.5:1 last year. It has been working its way lower since, but the long-term charts show that a drop below 3:1 from here is still quite a reasonable expectation.
In comparison to the cows, it’s the pigs that are really getting slaughtered. It’s not quite there yet, but the current trend could push the value of a lean hog contract below the value of a corn contract. If that happens, it could quickly turn into a great buying opportunity. Keep this one on the back burner for now, but move it to the front burner when you can buy 40,000 lbs of hogs for less than the cost of 5,000 bushels of corn. The hog/corn spread may not sound very sexy, but it’s been a reliable money-maker for us in the past.
Somebody better call Dr. Phil because the relationship between the byproducts of a crushed soybean (meal and oil) is historically out of whack and the relationship between Kansas City and Chicago wheat is completely upside down. History suggests that there will be reconciliation, even without therapy.
The soy meal/bean oil spread appears to have formed an epic double top between the 1973 historic high and last year’s new record high. Previous excursions to the upper price boundaries have been followed by meal completely surrendering its entire premium over the meal. The spread still has several thousands of dollars of downside ahead of it if history is to repeat.
The Kansas City wheat/Chicago wheat spread pops up on our radar screen anytime the KC wheat trades at a discount to the CBOT wheat. The recent plunge to -40 cents (premium CBOT wheat) really has our attention since it’s at a low we’ve only seen three other times in the last forty-five years. This rubber band is really stretched. Being long for the snapback could be something worth getting positioned for.
The price difference between good coffee (Arabica) and the ‘cheap stuff’ (Robusta) continues to shrink. At a certain point, coffee roasters may take advantage of the narrowing price difference by adjusting their blends to use more of the Arabica coffee. Or maybe the consumers will figure out that Robusta is over-priced on a comparative basis and consume more of the Arabica drinks. Regardless of how it plays out, something will happen to reverse the narrowing price gap when it gets tight enough. This coffee spread is not too far away from where prior reversals have materialized. If the ratio between the value of one Arabica coffee contract and one Robusta coffee contract drops below 2.4:1 it will be time to start stalking the java spread.
In the Hunt
I was sitting in the trading room of a well-respected trader several years ago, and he had a sign on the wall that caught my attention. It read: A good hunter never chases. He waits. Boy, does that sure have everything to do with trading!
The spreads that we discussed are the big game right now. They offer some great potential profit opportunities. Continue to stalk them, but wait until you have an actual trade setup before pulling the trigger and entering a position. No cross-hairs, no shot. No setup, no trade. Be patient and wait for the clean shot, lest you waste your bullets and, more importantly, your capital.Continue Reading...