Friday, March 03, 2006

An Interesting Look at the Commodities Markets

Lately, many of the commodity markets have become
extraordinarily volatile, which causes some seasoned
commodity traders, like Richard Morrow of Bullfrog Capital
Management, to stand aside...or to look for opportunities
to sell short.

But other seasoned traders, like Kevin Kerr, the mind
behind the Resource Trader Alert, embrace the volatility by
selectively buying options on commodity futures. Despite
the fact that Richard and Kevin employ extremely different
tactics, both have amassed impressive track records. So we
chatted with both of these seasoned professionals [at the
beginning of Feb.] to get their take on the commodity
markets...and what we should expect next.

Commodities are rallying...and because they are rallying,
investors are buying them...and because investors are
buying them, commodities are rallying. You get the idea.

Commodities are red-hot...and everyone knows it. Even so,
almost no one knows exactly what to do about it.
Should we be buying $65 crude oil or selling it?
Should we be buying $570 gold, or selling it?
Should we by buying 19-cent sugar or selling it?
Or, if we are stock investors, should we be
buying ExxonMobil and Archer Daniels Midland and Phelps
Dodge, or selling them?
The answers are not self-evident, especially because many
large institutional investors have decided to throw money at
the commodity markets.

"Billions of dollars of long-only index-fund money is
pouring into these markets," explains Richard Morrow,
founder of Bullfrog Capital Management. "And that's
throwing the traditional fundamental influences all out of
whack. These markets are just too small to handle an influx
of money this large."

"How small is small?" I ask.

"If you added up the entire value of the 2005/06 corn,
wheat, soybean, cotton and rice crops they would total
roughly 60 billion dollars. In other words, the entire
U.S. Agricultural row crop sector is 1/200 the size of the
So this new liquidity that's pouring into 'our
markets' cannot be efficiently absorbed."

"Sounds like you've got two sets of 'fundamentals'
influencing the commodity markets,' I suggest. "You've got
real-world demand for the commodities themselves; and
you've got index-fund demand."

"Right," Richard agrees, "and the interaction between these
two different sets of fundamentals have created extreme
price inefficiencies."

"Give me some examples," I ask.

"We're going to have the biggest US and world soybean crop
with the largest carryout ever. And beans are $6.00.
They just shouldn't be up here. With record U.S. and world
soy carryout [Editor's note: "carryout" refers to the end-
of-season stockpile] and big U.S. soy acreage coming, I'm
looking for an opportunity on the short side of the soy
market. Cotton is another interesting one. The funds are
record-long into one of the largest US carryouts ever! The
U.S. crop is materially larger than a month ago and the
U.S. domestic consumption is falling like a stone from
already low levels. Furthermore, cotton exports are running
below pace to meet the USDA estimate. So it is very
possible that the U.S. will end up with a cotton carryout
over 8.0 mil bales. This would be the largest carryout in
and is more indicative of sub 45-cent July cotton
rather than 58-cent cotton."

"We're no longer in a world market for commodities, or even
a U.S. market; we're in an index-fund market. The markets
that I trade are being swamped by long only index money.
Cotton, corn, wheat and cattle all have record open interest
due to the tidal wave of index fund flows. These markets are
simply too small to handle these huge inflows on a weekly basis."

"If it is any comfort to you," I reply, "index-fund money
seems to be sloshing around in all the commodity markets."

"Oh yeah, I know," says Richard. "I think you've got about
$20 of index-fund premium in the crude oil market right
now. Crude should be trading about 5.8x natural gas on a
BTU basis
. But the current ratio is 7.3 to 1, or 26% over
valued. And I think that natural gas is way overvalued too.
Natural gas inventories are going to all-time highs.
How anyone
can be bullish $9 natural gas is beyond me."

"What about gold?"

"Same story," Richard relates. "The inflows into gold and
silver are simply huge. We have no idea how high these
markets are going. Our feeling is that gold is the 'new
Google.' Investors want to own it at any price...I can tell
you this; if the money-flow into these markets stops,
there's going to be some great opportunities on the short

"Yeah, that's true," I agree, "but you might need to wait a
while for that to happen. The fundamental short-sellers are
almost always too early."

"Maybe so," says Richard, "but I'm still finding opportunities
to trade...It's just that the game has changed."

After hanging up the phone with Richard Morrow, I dialed
Kevin Kerr.

"Are the index-funds changing the game?" I began.

"No question about it," Kevin says. "There is clearly a new
force in these markets. A new herd of buyers and
speculators...and they're more powerful than the
fundamentals. So I'm gonna play with them...I certainly
don't want to fight the herd."

"Is that why you bought sugar calls a while back?"

Kevin chuckles. "No, I entered sugar because
I thought it was too cheap in a world where ethanol
production was increasing demand for sugar. Once the move
started, of course, ethanol stories started landing on the front
page of the Wall Street Journal and the funds started piling in.
That's what I mean by playing with the herd."

"It probably didn't hurt that Bush mentioned ethanol in the
State of the Union Address."

"Yeah, that helped trigger a 100-point jump in
sugar," Kevin agreed. "I've never seen a move like that in
my entire career."

"Are you getting a little nervous [with high-priced] sugar?"

"Yeah, I've already advised my subscribers to close half
their position...and we'll probably exit the second half
very soon."

"So what trades have you opened recently?

"Well we've got a couple new positions in corn...The
rationale being quite similar to the one that prompted my
sugar trade. Ethanol production is the topic-du-jour, which
directly benefits the corn crop. Obviously, ethanol
production will not create any big pop in demand between
now and the expiration of our July options, but the STORIES
about ethanol will probably pull fund money into the corn

"So you're riding with the herd again?

"Trying to, but I wouldn't buy corn just for that reason. I
thought corn was too cheap, even without the ethanol story.
But this story just provides the catalyst for a move."

"But what about the underlying size of the corn crop,
doesn't that concern you?" I asked.

"Sure, it's hard to get wildly bullish about a crop that
could have record U.S. stocks at the end of the season.

That's why many traders out there feel corn is overpriced,
and that there's too much of it. They may be right. But
the point is that I don't think so. There's still a lot of
uncertainties with the grains for potential drought etc..
I could write a whole book on it, (actually I am) but
suffice it to say there are a lot of unknowns for the corn
right now...But don't get me wrong; I am not the type of
trader who gets married to a position. If corn starts to
head too far south, we'll take it off and try to buy it
cheaper...or just wait it out."

By Eric J. Fry for The Rude Awakening

The Rude Awakening is a free, daily e-mail service.
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Two things. First, crude oil is trading at a premium to its normal ratio with natural gas, and natural gas itself may be overvalued, which would mean that crude oil prices should "naturally" be probably HALF of what they are now.
That does not seem like a situation that can be long-lived, although of course "short-lived" might be a few years.

Second, "the entire U.S. Agricultural row crop sector is 1/200 the size of the S&P500."
One could buy ALL of the corn, wheat, soybean, cotton, and rice crops that America produces in a given year for 0.5% of the market cap of the S&P 500.

That's a pretty powerful illustration of the effects of industrialization, and indicates just how far behind the curve that most Arab and African nations and societies are. A successful agricultural economy will mean that everyone survives and prospers at a basic level, but it won't make anyone into a wealthy nation, much less a Lord of the Earth. Sans oil or hardwoods, how do they compete ?

And, what's worse (for them), is that while their societies haven't yet embraced industrialization, America and a few other advanced nations are moving beyond industrialization and, dollars to doughnuts, the "Information Age" is going to make those societies who participate 100 times more powerful and wealthy than did the "Industrial Age", which itself expanded wealth and power 500-fold over the "Age of Agriculture".

Further, it's not as though we gave up Ag in favor of assembly - on the contrary, we're expecting to have record harvests or stockpiles of corn, cotton, soybeans...


Blogger Susan's Husband said...

Yes, I was just speculating the other day that we are about to enter the era where the manufacturing sector experiences the same shrinkage as a percent of the population as agriculture did over the last couple of centuries. For now it is being outsourced, but the day is not far off when technology will under price sweatshops.

March 03, 2006 6:18 AM  
Blogger M Ali said...

I don't think the problem is embracing industrialisation per se.

Pretty much every Third World country has industrialised to some degree or the other.

The real issues are more basic i.e the lack of a skilled and educated workforce, rampant corruption, big state sectors, badly functioning legal systems, impossible bureaucracy and the lack of awareness that making things as hassle-free for the small entrepeneur is far more vital than promoting favoured sectors like IT.

Oroborous: You ought to read Walter Wriston's The Twilight Of Sovereignity if you haven't already. It's the best tome on the coming Information Age that I've read.

March 03, 2006 7:12 AM  
Blogger Bret said...

I did (and probably will continue sometime in the future to do) the commodities futures trading thang. I stopped trading in 2002 for a variety of reasons, one of which is that the huge influx of index funds hurt my trading models and I've not had time to update them (due to the robotics company I started).

Once I get some time, however, it should be even easier to make money, because the big index funds tend to be somewhat predictable and it should be possible to anticipate, on average, what they'll do. You can be much, much nimbler trading a few contracts while they're trading thousands of contracts.

March 03, 2006 9:04 AM  
Blogger Harry Eagar said...

Since I don't believe markets react to facts, I am skeptical about market analyses.

But here are some facts:

1. U.S. corn consumption was about 10B bu/year for over 10 years while consumption was under 9B bu/year in each year. Yet corn prices varied up and down during all that period.

So what was moving the market? Not supply and not demand.

2. Hawaii has passed a law mandating ethanol in gasoline next month. The idea was to provide another market for molasses. As of two weeks ago, the largest molasses producer in the islands had had zero offers for its feedstock.

People who are counting on ethanol to make money are going to be disappointed.

In 1986, Iowa forgave its 5-cent/gal gas tax in order to force ethanol on motorists. I tried last month to find out from the Iowa Department of Revenue how much road fund tax they had given up over the last 20 years.

'That's a really good question,' I was told. But they don't know the answer.

Billyuns and billyuns of nickels (although the subsidy is now down to 2.1 cents/gal). Nickels that would largely have been contributed by out-of-staters, since a large fraction of the gasoline sold in Iowa is to folks passing through on Interstate 80.

Here's a theory: the GOP move to eliminate U.S. farm subsidies so that Third World farmers can compete on world markets is a nefarious plot to trick the Third World into putting its effort into a deadend development program.

After all, from the S&P comparison, it appears that if you controlled the world's entire farm sector, you'd have less gross income that the state product of California.

Those dastardly capitalists!

March 04, 2006 12:05 AM  
Blogger Oroborous said...

Susan's Husband:

Ah, nanotech.

A successful and widely-applied nano technology sector, especially in materials, figures prominently in my expectations for a productivity explosion in the advanced world, leading to a U.S. per capita GNP of $ 150,000, in constant dollars, by 2050.

M Ali:

Valuing a widely skilled and educated workforce, and endeavoring to create one, is more or less what I meant by "embracing industrialization", not just the presence of a few factories.

China and Pakistan both have nukes and missiles, but only China has embraced technological advance - Pakistan just has a small group of skilled elites.

I saw you recommend Walter Wriston's The Twilight Of Sovereignity over at Orrin's place, and I put it on my reading list then - although it's a "hope to read" list, not a "will read" list, unfortunately.


Yeah, but one can take a beating waiting for the market to value one's position "correctly"...

The short-sellers during the bubble were fundamentally right, but many lost a lot of money waiting for everyone else to come to their senses.


So is the ethanol just going to be shipped in from the mainland ?

Perhaps the molasses producers should get into the distilling business ?

March 04, 2006 12:57 AM  
Blogger Duck said...

The extent to which an economic segment is valued seems to be based on the newness, and therefore the inefficiency whith which it is manufactured and distributed. As new products mature they are inevitably commoditized, and the growth window moves up the chain of innovation.

Also, it's not accurate to judge the value of agriculture solely on the size of the base commodities, as much of the value chain from seed in the ground to food in my stomach has been added on to the tail end, in the form of food processing, and services in the form of food preparation in restaurants. The efficiencies gained in the production of staples has enabled these other value added services to extend the chain. So do these other services count as agriculture or not?

March 04, 2006 9:10 AM  
Blogger Duck said...

I looked into future and option trading, but gave it up for three reasons:

1. My sanity
2. My financial well being
3. My career. I found it impossible to do any kind of short term trading without being consumed by the need to track my trades during the workday. Not a good career practice.

March 04, 2006 9:14 AM  
Blogger Harry Eagar said...

Yes, the first tanker load of ethanol was landed this week.

Here we are seeing scale effects. There have been several attempts to run distilleries in Hawaii for drinks, which you might think would be a slam dunk, since your feedstock would be virtually free.

Doesn't work that way. One reason is that Bacardi is invincible in the market.

Another is that, with the serial decline of sugar, the total amount of molasses is too small to run a big, efficient distillery.

The local cane plantation would be happy to have a new customer for its molasses but they crunched the numbers, and it makes more sense to ship the molasses to big California distilleries and reimport the ethanol. That isn't what the legislators want to hear, they want new manufacturing in the islands.

Very Soviet, ze zentral planners hev decreed it whether it makes any sense or not.

By the way, I got to cover a massive molasses spill once, when the storage tank sprung a leak. I love my job.

March 04, 2006 10:39 AM  
Blogger Duck said...

Good thing about a molasses spill is that the sea otters can lick themselves clean.

One of my favorite cable shows is "Modern Marvels" on the History channel. They did a segment on shipping technology. Modern shipping is so efficient that it adds, on average, ony 1% to the cost of products shipped.

March 04, 2006 10:50 AM  
Blogger Oroborous said...


No, they don't count.

They're services, adding flavor or convenience, but one could simply cook and eat the commodities as is, at home.
(And really, we as a nation ought to do more of that; it would be slightly healthier, and marginally strengthen the financial picture for most people).

It would be like adding the economic activity of car washes to the manufacturing sector.

The trick, re options trading, is to work with LEAPs - at least, IMO.

Short term traders in anything need to be really, REALLY good. With LEAPs, you just have to be mostly right.


Amazing that a round-trip by ship is cheaper than home brew.

I remember you saying that the Hawai'ian molasses spill was ankle deep, comparing it to the fatal Boston spill.

March 04, 2006 5:45 PM  
Blogger Hey Skipper said...


That's a pretty powerful illustration of the effects of industrialization, and indicates just how far behind the curve that most Arab and African nations and societies are.

Just when I thought I knew what your conclusion was going to be, you surprised me with what must be the most fundamental point of all: the degree to which certain parts of the world have effectively put themselves completely adrift.

I just came back from a trip last week that involved a certain company prominent in the supply chain business.

The Arab nations and Africa are so far behind, they don't possess the skills to mimic even the simplest parts of supply chain management.

And that gap is replicated across the breadth of our entire economy.

The further behind they get, the faster they will get further behind.

Is that gulf becoming even larger than that which faced Native Americans after the Europeans arrived?

March 08, 2006 9:58 AM  
Blogger Oroborous said...

I'm certainly happy not to be predictable; otherwise, why read my written thoughts, except out of courtesy ?

What did you think was coming ?

Is that gulf becoming even larger than that which faced Native Americans after the Europeans arrived?

I would argue yes, because the Amerinds could and did acquire European weapons, which they used to great effect.

The forces that we currently face, or might face in the near future, can only destroy our tools of violence. With the exception of small arms, they can't turn them against us.

The Amerinds were eventually doomed for the same reasons that hostile Arabs are, as you note: We have far superior supply chains, more ability to collect, organize, and move critical supplies.

We're so far ahead that we're patronizing the Iraqis, by spanking them instead of having to crush them, as we would a near-equal.

We're building the weapons of science fiction, they're turning artillery shells into mines.

It doesn't take a genius to see how that's going to turn out.

March 08, 2006 10:17 AM  
Blogger Hey Skipper said...


I wasn't expecting the tie-in with Arab & African economies.

I think you are right that the gap is far larger. The technological substrate underlying steel and gunpowder was not something an educated European could not have reasonably grasped from end to end.

What's more, the concepts required to operate the material consequences of gunpowder and steel were also fairly simple.

Which brings me back to the hive mind. It wasn't such a necessary thing then, but is indispensable now. The internet has been a hive-mind amplifier cranked to 11.

Provided, of course, your society has the libertarian bent to take advantage of it.

March 09, 2006 9:47 AM  
Blogger Harry Eagar said...

Back in the 1970s, I used to think that the Arabs were going to push the Israelis into the sea.

I reasoned thus: First I learned that in the 1967 War, more Egyptian tanks were destroyed by their crews not bothering to put lubricating oil in the engines than by the IDF.

If figured that someday, in the not too distant future, the 50 million Jew-hating Arabs would produce at least a few thousands of young men with as much mechanical sense as the average American high school student circa 1937.

In the next war, it seemed, there would be tank drivers who knew you had to add oil, and the Israels, outnumbered 20:1, would be destroyed.

Just shows how wrong I can be.

Ideas really do have consequences, but not foreseeable ones. When Suleyman the Magnificent mobilized to attack Rhodes, he had a fairly easy time of it, because the Turkish army was, for its time, large, powerful, efficient, under unitary command and much better organized, tactically and logistically, than the clumsy, feuding Europeans.

Had one been covering bets at the time, rational projections would have had the Turks rolling up the Europeans.

Just at that time, though, Europeans learned to think, and all bets were off.

Funny how that works out.

March 09, 2006 11:23 AM  
Blogger Oroborous said...

It does appear that culture really, Really, REALLY matters, which wasn't something that I knew as a young man - thought rather the opposite, in fact.

Whyever do the Africans and Arabs, among others, not copy what is demonstrably A BETTER WAY to order society, or at the very least, why don't they cherry-pick some of the most productive elements ?

It's a continual puzzle to me, and the answer seems to be that they just don't want to.

They're willing to buy automobiles and arms, but not willing to learn how to design or build such, and certainly not willing to change their societies in ways which would foster such development.

That's why I expect current African, Arab, and Persian cultures to have as much impact on 22d century societies as the Aztecs did on 20th century humankind.

March 09, 2006 4:28 PM  
Blogger Harry Eagar said...

A theoretical explanation for this, prior to Huntington, who I find not too satisfactory, was developed by Marshall Sahlins in 'How Natives Think.'

It's quite a rare book, but you guys who live in the big city might be able to find it in a good library.

March 09, 2006 7:00 PM  

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