Even Newer Futures Contracts!

Hard Assets Investor just published an article of mine running down the new futures contracts that I had discussed previously (Cobalt, Molybdenum, and Distillers' Dried Grain), as well as the proposed Canadian Oil Futures contract. You can read the full article here.

Nice try US government, we're still not buying natural gas

Two weeks ago the Wall Street Journal ran an article with the headline: "Natural-Gas Data Overstated". Apparently, the Energy Department has for some while been screwing up its statistical projection for natural gas and significantly overestimating the country's gas supplies.

Basic economics tells us that when demand stays constant and supply diminishes, prices go up. And according to this report, supplies, in fact, have diminished, albeit somewhat artificially. And how did the market react? It didn't:

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View the full FUTURE:NG00 chart at Wikinvest

Other than that spike the day of the announcement (April 5) natural gas investors apparently couldn't care less about the US Government's overstated inventory figures.

This highlights the fact that in the US we have access to about as much natural gas as we could ever want. Granted, a lot of it is underground, but unless gas stocks were actually low (like, in danger of running out) knowing that our stocks are slightly less than previously thought doesn't actually affect the price. At some point, the functional supply of gas changes from a number of mmBTUs to the categorical figure "plenty". If we got to a point where we were consuming enough natural gas to see stocks diminishing the gas drillers could ramp up production so quickly that no blip would be seen.

So, nice try government, but the market knows better.

Building a Better Gold/Silver Spread

Yes, I realize the blog has been morphing into my simply posting links to articles I am writing for other blogs, but I assure you there's still original content to be had here.

Regardless, here's a new article I wrote for Hard Assets Investor, wherin I devise a multivariate statistical model for the Gold/Silver spread.

The basic idea is that, since gold and the US Dollar are highly correlated, and gold and silver are highly correlated, while silver and the dollar are NOT highly correlated, you can use silver coupled with the USD exchange rate in a multivariate model to observe statistical deviations from historical norms.

The takeaway? Even though past performance does not guarantee of future returns, according to this model at least, gold is trading well above its historical expectation for the current values of silver and the dollar. If you buy into the model, the play would be to short gold, buy silver, and buy a foreign currency with US Dollars.

Diversify by investing in grains

On Monday, Hard Assets Investor published another article of mine, the premise of this one is that it turns out Grains (Corn, Oats, Rice, Soybeans, Wheat) have fundamentally NO correlation with the broader stock market. This makes them an excellent candidate for investors seeking true diversification.

When I say "true" diversification, what I mean is that most investors' idea of diversification is owning lots of different types of stock, and maybe a few bonds. The problem is that stocks (and even bonds, depending on which ones you own) tend to have high co-correlations. That is, if the share price of Coca-Cola suddenly bottoms out, you can bet that a lot of other companies will as well. If interest rates go up at some point ever in the future (I know, ridiculous right?), all other factors being equal, the entire stock market will go down. Lot of good your owning stocks in different industries does you then.

The traditional view has long been that you should own some combination of stocks, bonds, and cash or money-market funds, weighted depending upon your risk tolerance and age. The problem is that with those three categories its nearly impossible to diversify within your risk tolerance. That is, stocks are riskier than bonds are riskier than cash.

That said, commodities provide just as much risk (and upside) as stocks while, as my research demonstrates, offering little to no correlation with the broader market, depending upon which commodities you invest in (i.e. not oil or gold).

You all know my issues with Commodities ETFs, but if you're purely looking for diversification, an ETF that holds a big basket of different grains might be the way to go. Personally though, if you have an account with a futures brokerage I always prefer owning the contracts directly.

The Problem with Commodities ETFs

Last week, Hard Assets Investor published another one of my articles. In it, I compared the correlations between several energy ETFs and the prices of commodities they are tracking. The takeaway message is that, for the most part, ETFs do a bad job tracking commodities prices. There are a few reasons for this.

The first, and primary reason why the correlation is less than perfect, is that the front-month futures contract for every commodity is constantly changing. Since most ETFs hold only the front-month contract, this means that sometime before expiration, the fund must sell its holding of one (soon to expire) contract and then purchase another (soon to be front-month) contract. There is almost always a significant discrepency between the two prices, particularly if it's a commodity that doesn't deliver every month. Take a look at the futures chains on the CME group website for crude oil, gold, and corn. As of writing, the difference between the front month and second month contract is about 40¢, $1, and 10¢, respectively. That may not seem like much, but that price difference represents a pure loss in the value of the fund with every roll that takes place. Just to prevent declines, the fund would, on average, have to be increasing in value between 1 and 5% a month. That means that, depending on the commodity and the fund, a monthly percentage increase, if not sufficiently high, may actually mean you're losing money.

The second problem with ETFs is that they create a secondary market on top of what is already a volatile market in its own right. And, while the underlying instruments are the same for both, (futures contracts) the factors driving the supply and demand may be drastically different. For example, while natural gas might be moving up on strong demand resulting from a particular weather forecast, if the primary participants are energy hedgers, no such demand would exist for UNG, the world's biggest natural gas etf. As such, UNG might theoretically follow the price of gas with something of a lag, rather than actually track the price in real time.

Don't take my word for it, take a look at this graph comparing oil price movements with the price of USO, the world's biggest crude oil ETF, over the last four years:

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View the full Crude vs USO chart at Wikinvest

Now, you might be saying "those charts seem to follow each other reasonably well" but that's the problem. Reasonably well isn't good enough. An investor buying a share or shares in a commodity ETF that puportedly tracks the price of a commodity wants her investment to actually do just that, not merely track the price "reasonably well".

It's true that there are some ETFs, especially those dealing with precious metals, that eliminate the problem of the roll yield altogether simply by buying and hoarding the commodity in question and storing it in a vault somewhere; no futures contracts required. While certainly effective in mitigating the problem, this only works for a very specific subset of commodities that do not have a cliff for their usefulness. Other than those few cases, in general, the moral is that if you really, truly want exposure to commodities, don't waste your time with an ETF. As they stand, very few of them can be relied upon to achieve their goals. Though that may change in the future, for now, your best bet is get into the futures market directly.

New Futures Contracts!

Last week, a couple of the major commodities exchanges announced the addition of some new futures contracts to help producers and consumers of raw goods hedge their expenses, and simultaneously give commodities traders three more reasons to develop stress-related ulcers.

First, across the pond, the world's foremost metals market, the London Metal Exchange (LME) yesterday opened trading of cobalt and molybdenum futures. In shocking concordance with my previous post about the emerging need for a lithium futures contract, the cobalt contract is designed specifically with battery manufacturers in mind, cobalt being a major input to rechargeable batteries in things like laptops and cellphones. Molybdenum, which I had never heard of before this Wall Street Journal article, is apparently used in the production of stainless steel.

Meanwhile, here in the States, the ever-growing Chicago Mercantile Exchange announced that it will be adding a contract for distiller's dried grain (DDG), a by-product of corn ethanol production. This is interesting because, with the addition of the contract, which will begin trading in April, ethanol producers can now effectively hedge every step of their production. For example, before the harvest you might buy a corn contract so as to protect yourself from unexpected price swings at your local grain elevator. Then, once you've got your corn and begin distilling ethanol, you can sell both a DDG and ethanol contract to lock in prices for your two resultant byproducts. Further, you can buy or sell oil, gas, or natural gas contracts to take advantage of spread deviations between the fuels. This is also interesting because the DDG contract may become a major hedge-staple for corporations that produce ethanol for non-fuel purposes... you know, like Jack Daniel's. The government, and now the private markets, are conspiring to make ethanol a real and viable energy source with plenty of economic safegaurds.

A bizarre reaction to these announcements is concern that opening these contracts to the public will increase volatility in the prices of the commodities and could potentially drive them too far one way or the other. Yes, that is true, prices will become more volatile... but only for the traders. The hedgers (people producing and consuming ethanol) actually need volatility to protect themselves from things like price-fixing and sudden, unexpected swings. Without and open public market, there's no way to plan for and predict what DDG would and will cost. Also, hedgers are not entering and exiting positions over and over to make a quick buck, they are locking prices in, exiting positions, and taking the difference as market protection.

Increase in Housing Starts Contributes to Lumber Run-Up, or is Nonexistent

As per my post last night, and today's news on housing starts, I certainly ought to eat a little crow; according to the Census Bureau, January housing starts were up from December, as well as January 2009. Specifically, according to the Bureau's report:

Privately-owned housing starts in January were at a seasonally adjusted annual rate of 591,000. This is 2.8 percent (±11.5%) above the revised December estimate of 575,000 and is 21.1 percent (±12.3%) above the January 2009 rate of 488,000.

So yes, it appears I was wrong with my initial assessment and the housing market indeed showed signs of picking up in January, potentially contributing to the Lumber run-up of the last month. However, the actual meaning of the housing start increase is slightly more complicated than the above quoted numbers and, I would make the case, much less meaningful than reports are making it out to be. Let me explain.

First, regarding the meaning of the number itself, the 2.8% increase in housing starts is an increase in the seasonally adjusted housing start rate. Because the US Housing market is highly seasonal (i.e. more building projects begin in the spring and summer months) examining trends on a purely month to month basis is not meaningful when analyzing long-term trends. Housing starts will almost always go up in March, and they will almost always go down in October. As such, the US Census Bureau developed a statistical method called X12 (and its predecessor X11) used to remove the expected seasonal effects of this type of data. The best article I could find describing the algorithm is, oddly enough, on an old Federal Reserve Bank of Dallas webpage, but suffice to say the algorithm is designed to remove expected seasonal effects for a given data series, thereby showing the actual overarching trend. Thus, the published number is a point estimate for what the current annual housing start rate is; in this case, 591,000 housing units started per year. As with any statistical analysis, there is a margin of error to that point estimate, and the margin is given right in the reporting sentence. "This is 2.8 percent (±11.5%) above the revised December estimates..." Wait a minute, 2.8% ±11.5%? That should give us a range of –8.7% to +14.3% and, if I'm not mistaken, –8.7 ≤ 0 ≤ 14.3. As any statistician can tell you, a confidence range that includes zero is not statistically significant at all. And the Census Bureau uses a 90% confidence interval in their calculations, so it's not as though they're being overly conservative with their estimates and confidence ranges. In other words, this number is fundamentally meaningless. In fact, if you actually bothered to read the report (as apparently no one in the media did) you'd see that the "±11.5%" figure is asterisked with a footnote that reads as follows:

"90% confidence interval includes zero. The Census Bureau does not have sufficient statistical evidence to conclude that the actual change is different from zero."

So, in other words, there is no evidence that there was a change in the seasonally adjusted rate WHATSOEVER. This number is meaningless.

Moving on, despite the lack of evidence for a month over month change, the increase in rate from January last to now does appear to be truly significant, with a confidence interval of 21.1 percent ±12.3% (between 8.8% and 33.4%) for the change from January 2009's seasonally adjusted rate. (Note that that range does not cross zero.)

The report also lists the raw housing start numbers (those that haven't been seasonally adjusted). Here are the highlights (all numbers pulled from the aforementioned report):

• 2008 Year in full: 905,500
• 2009 Year in full: 554,500
• January 2009: 31,900
• November 2009: 42,300
• December 2009: 37,100
• January 2010: 37,800

The takeaway from all of this is that the housing market has improved significantly since 2009. In fact, using either the December or January estimate for the seasonally adjusted housing start rate yields a significant improvement over the 2009 total figure. However, there is not sufficient evidence to suggest that any further progress has been made over the last two or three months, the numbers (both seasonally adjusted and raw) do not demonstrate sufficient statistical significance to draw that conclusion. Starker still, is that the market today remains at about 65% of where it was in 2008.

How did the Lumber market today respond to all this? Somehow, despite the hype, prices moved mostly sideways; either this information was already priced in, or it doesn't really exist.

Full Disclosure: As of writing, author is short May 2010 Lumber (LBK10)