Tuesday, April 27, 2010

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.

Tuesday, April 20, 2010

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:
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.

Tuesday, April 13, 2010

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.
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.

Thursday, April 1, 2010

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.

Monday, March 1, 2010

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:
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.

Tuesday, February 23, 2010

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.

Wednesday, February 17, 2010

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)

Tuesday, February 16, 2010

Lumber Supply Shock, Nothing Else, Drive Prices Up

Today's Wall Street Journal ran a great article on the recent surge in Lumber prices. (Though, sadly, the online version's headline was changed from the print's pun-tastic "Builders Nailed by Lumber Prices" to the infinitely more boring "High Lumber Prices Threaten Housing Market".) The article does a fantastic job explaining the why's behind the recent insane price movements in the lumber market, which I have discussed at length in a previous post. In that post I laid out my then somewhat limited understanding of the reasons for lumber's price increase, which the WSJ article largely confirms and significantly expands upon. Basically, here's what happened:
  • Due to a dramatic falloff in demand, largely the result of a depressed housing market, lumber mills and loggers have significantly decreased production. According to the WSJ article, lumber output fell 45% (!!!) between 2005 and 2009.
  • As the housing market remained stagnant, lumber wholesalers saw no need to maintain large inventories throughout 2009, further disincentivizing output from loggers and mills.
  • Because of the lack of demand and low prices, several lumber mills have indefinitely shuttered. This, of course, in itself drove prices higher. The article specifically mentions Canfor Corporation, a Vancouver-based producer responsible for half a percent of total North American lumber output, who indefinitely ceased operation on January 5th 2010 as one of the major mills to shut down amid the sluggish market.
  • Annually, home builders restock their lumber supplies in January and February in anticipation of the upcoming spring building season. As supply was already incredibly tight and production was being scaled back across the board, wholesale buying triggered a supply shock up the chain, sending prices higher.
  • Additionally, some firms continued buying on anticipation of consumers taking advantage of the federal home-buying tax credit before it expires.
  • As the industry was not in any place to suddenly ramp up production, the market created something of a feedback loop, driving prices higher from January through to today.
  • Exacerbating the problem is that shuttered/suspended mills do not have the capital (or guarantee of near-term capital) to quickly start up operations again.
What is perhaps most interesting about this is that everyone seems to be in agreement that the surge is entirely supply driven. To the question of demand, the article says the following:
"The supply crunch is striking because, just a few years ago, the North American lumber industry was able to supply enough wood to start more than two million homes a year. That was nearly four times the pace of home starts in December."
In other words, home-building demand hasn't simply petered out, it's fallen off 75%, and still, the price goes up purely as supply stays tight. But perhaps the most interesting quote, in my mind anyway, comes towards the end of the article, in a discussion of near-term production prospects:
"The ongoing recession will keep production light, said Matt Layman... who called this the only sustained supply-driven rally he has seen in 30 years of trading lumber."
Thirty years is a long time, and Mr. Layman's quote only serves to highlight just how strange this market rally seems on the surface. My readers already know that I'm bearish on Lumber, but honestly, everything about this rally seems crazy to me. At least now we understand the circumstances that pushed prices high in the first place, but for this kind of rally to be sustained... I'm just not sure what it would take short of a spectacular resurgence in the housing industry.
Tomorrow, the US Census Bureau will announce the figures for January housing starts. A slight bump will be good news for the lumber bulls, a downtick could mean the beginning of the rally's end. I'll put a post up as soon as we see what happens, and what it's immediate effect may be.

Why I Love Commodities

Sorry about the dearth of posts lately, but I've been out of town. Speaking of...
I just got back from a trip to beautiful Whitefish Montana. If you're a skier and/or outdoor enthusiast, I can't recommend the city highly enough. On the train ride out there, I ended up having dinner with a couple of Montanans who own and work a farm on the eastern edge of the state. We got to talking and I asked them what they raise, to which the response came from the husband:
"Durum wheat, peas, and chickpeas." On hearing the word wheat, my interest was piqued, so I asked:
"I'm curious, do you ever use futures contracts to hedge your crops?"
To which he jumped into a very long, very interesting discussion about the commodities markets. The short answer to my question was no, because there is no durum wheat futures contract, he doesn't really have the option to hedge in the commodities markets, however, he can often lock prices in advance with individually agreed upon "forward" agreements with grain purchasers, though he admitted that this is not as useful as a true futures contract because there is less liquidity in the market.
"If you can't deliver your full crop," he said "you'd better have the cash". Following this conversation, the man's wife asked me:
"How do you know so much about wheat?" I explained that I was a commodities investor and sometime analyst, to which she said, "Wow, because you sound exactly like our son."
"What does your son do?"
"He's a wheat farmer."
The commodities markets have always fascinated me because, in some sense, it is one of the last, pure markets in the country. When you put a bid in for a commodity like wheat, you're not betting on earnings reports or interest rates, CEO scandals, cash flow statement readjustments, corporate lawsuits, etc. etc. You are simply betting on the price of a bushel of wheat. It is one of the few places in the world of business where the Montana Farmer and Wall Street Analyst are not just peers, but equal experts, and it is a market that is open to EVERYONE. If that doesn't stir your inner capitalist, I don't know what would.

Monday, February 8, 2010

Why I am Bearish on Lumber

By bearish, of course, I mean pessimistic. In other words, I expect the price to go down.
Here's a chart of Lumber futures prices over the last month:
Of particular interest is the big upward movement starting on January 28th. Between then and this last Friday, lumber TWICE went up the session limit of $10 / thousand board feet (mBF). At the beginning of the month, I was bearish on Lumber because I suspected housing starts have not actually increased whatsoever (and at the time I took a short position, only to be stopped out in accordance with my personal trading philosophy), however, now I am even more bearish because I don't think this pricing run up either makes sense or is in any way sustainable.
Quick background about the market, the random length lumber futures contract (what most people mean when they say "lumber") is used extensively by lumber industry participants, that is timber harvesters and construction companies, to hedge against erratic price movements in the cash market (the price you get at your local mill on any given day). The biggest factor affecting lumber prices is the US housing market. When the housing market is booming, lumber skyrockets. When home construction is depressed, so too the lumber market. There is very little else driving lumber prices, as most of the lumber we use is grown domestically, we export almost none of it, and what lumber we do import comes almost exclusively from Canada.
Now that that's out of the way... a recent article from Reuters basically comes to the following conclusions as to why the price has shot up:
  1. There are fewer mills currently in operation (many had closed down when the housing market dried up), creating a minor supply shock in the cash market and sending prices up.
  2. There is an expected increase in demand as the result of the approaching "Spring building season".
  3. A "realtor survey" showed pending home sales were up 1% in December.
My reason for being bearish on Lumber right now is that I believe there is a logical fallacy at play in the market. Follow me here on this treatise:
  • If the housing market picks up (i.e. demand increases)
    • Lumber inventories (i.e. supply) should be pressured and may diminish.
    • If inventories stay the same or diminish
      • The price should go up.
This is basic supply and demand, but I've made each bullet cascading to point out the conditional nature of how the market, in theory, responds. The other way for the price to go up would be as follows:
  • If lumber inventories diminish (i.e. supply decreases)
    • If the housing market moves sideways or picks up (i.e. demand stays the same or increases)
      • The price should go up.
Note the difference between the two cases. In the first, demand is the driving conditional; in the second, supply. Also note, and this is what's important, that demand, and demand alone, has an effect on the other predictive variable in the equation. That is to say, when demand changes, there is NECESSARILY an effect upon the supply. (Yes, I know, it's possible that demand has been perfectly predicted and supplies tailored to meet the expected demand, but this is incredibly unlikely in a market based upon a fungible commodity such as Lumber.) When supply decreases, on the other hand, there is by no means any necessary or expected response in demand. Demand could stay the same, demand could increase, demand could decrease. There's simply no way to know, or even extrapolate, based on supply alone.
What we have in the lumber market is the second scenario. Supplies seem to be diminishing because of the drawdown in milling operations. However, that in and of itself, in theory anyway, should not cause the price to go up. For that to happen, we'd need to see that demand has at least not diminished, or at best, has increased. If this were the other way around, if we knew that demand really was increasing, we could infer that supply was likely to decline, and the facts about the mill drawdowns would confirm this, and we could say that yes, indeed, lumber prices ought to go up. However, we cannot say that demand for lumber is increasing, we can only say that supply looks like it might be decreasing, and there is at best a possibility that demand is on the rise, depending on how much faith you put in a self-reported survey from an industry with a financial incentive to make itself look healthy. As for the "spring building season" mentioned in the Reuters article, it's important to note that this is buying by retail lumber dealers in anticipation of the season. This is not a construction company buying lumber to build a house. Unless that lumber is actually used, it will just sit on the shelf, delaying future orders and adding to the supply.
Of course, we can talk about what a market should or shouldn't do in theory, about what's the right or wrong expected price movement based on any set of information, but the truth is that a market cannot be right or wrong. A market simply is. Lumber is trading at over $270 / mBf because someone was willing to buy a contract at that price, and someone was willing to sell. However, while the market itself cannot be wrong, the participants in the market can be. Extrapolating that supply is decreasing based on mill slow-down is an assumption, and it can be incorrect. Believing the housing market is picking up is an assumption, and it too can be incorrect. If two people, a buyer and a seller, have the same incorrect assumptions, the price they agree on will force the market in a particular direction, and this will happen regardless of the assumptions' validity.
Now, this buyer and this seller, they might be right. It might be the case that lumber supply is falling, and that demand is picking back up, but personally, I don't think so. I don't think the housing market is picking up, and I don't think supplies are in any way close to depleted enough to cause a significant shortage. Housing starts declined in December, you can read the reports on the Random Lengths website (a sort of trade-mag for the lumber industry); do we have any reason beyond the above "realtor survey" to believe they have increased since? Again, maybe. Maybe I'm wrong about this, it's very possible, but I simply don't see housing starts increasing enough to justify this price run up.
Again, I could be wrong. I could be dead wrong and the US housing market might be ready to explode and the decline in mill output might cause a serious supply shock, but even so, in closing, let me drop a little perspective. The last time lumber was consistently trading above $260 / mBF was May - August 2007. Between then and now, it broke the $260 barrier only one other time: August 2008.

Saturday, February 6, 2010

WSJ commodities headlines continue to tell us when it's cold outside

As I discussed in a prior post, whatever the natural gas market is the other nine months of the year, during the winter it's an inverse thermometer for the Eastern seaboard. Take a look at these natural gas headlines for the last month from the Wall Street Journal:
Couple things to notice here, the first is that the 1/23 headline was modified from its original incarnation "Cold Forecasts Warm Up Natural Gas Prices" sometime between when I wrote my prior post and now. In fact, you can still see that headline as the page's title. So it's good to see that someone over there is insisting on slightly more variety of diction, even if the changes are occurring four or five days late.
The second, and more important thing to notice, are the functionally opposite headlines occurring 24 hours apart on 2/1 and 2/2. Anyone at all (say, for example, a professional commodities analyst) could point to at least TWO prior headlines that month and say that the news of EITHER 2/1 or 2/2 supports her model of rising OR declining gas prices. The volatility of these markets, especially when the weather is your primary driver, makes every session a significant one.
*In the print version of the 2/1 article, there was also a B-Roll shot of some dudes playing football in Washington DC with the caption:
"ICING THE KICKER? Unusually warm weather was a boon for football players in Washington in November; not so for those betting on gas."
Awesome. That picture really helps me get a better understanding of the natural gas situation. You couldn't have put a chart there or something? (NB: Yes I appreciate the irony of making fun of a superfluous picture, and then not showing said picture myself while discussing it, but wsj.com seems not be hosting it. Apologies.)

Friday, February 5, 2010

Commodities, the Nation of Greece Conspire for a Terrible Week in Europe

If you own stocks, this week probably wasn't your favorite. Still, it could have been worse; you could be European. The EU got smacked around this week in a scene not unlike the penultimate brawl in Road House, you know, when that dude with the stick beats up all of the bouncers at the Double Deuce. Take a look at the Euro over the last three months:
Then go ahead and change the view so that you're looking at the price over one month. I'm not a geopolitician, but from what I understand, Greece, Portugal, and to a lesser extent Spain, are all having terrible times restructuring their debt, so much so, in fact, that investors are fleeing EU investment vehicles for the "security" of American government bonds and the US Dollar. The dollar, in essence, this week fed on the ballooning deficit of three EU nations and the fears they brought to investors. The side effect here is falling commodities prices, as gold, copper, and oil all declined significantly over the last few days, thanks primarily to steady increases in the value of the dollar. Gold, for example, is down about $60 from where it opened on Thursday.
I find this notable for three reasons:
  1. The EU is experiencing the WORST of both possible worlds, as a collection of economically diverse, fully autonomous nations beholden to one central economy and currency, when one country suffers, EVERYONE suffers. This would be the equivalent of a debt crisis at an Illinois community bank making the dollar worthless in Japan. To what extent is Greece's fiscal stability the business of other EU nations? How beholden is Greece to EU nations helping it out of a jam?
  2. Commodities prices are decreasing as a function of a strengthening dollar against the Euro, specifically. The dollar has been falling against the Yen all month while moving more or less sideways against the Loonie. With all of the global trade that goes on, I would not have expected a simple shift from European to American investments, on its own, to have that sizable an effect on commodities prices; typically you'd need the dollar to get stronger against EVERYTHING for this kind of pricing plummet.
  3. Investors are fleeing Europe for the stability of the dollar. That's the US Dollar. The currency of the nation with 10% unemployment and interest rates of functionally 0. The nation with a $1.4 Trillion deficit. The nation currently fighting two wars. If the US economy is somehow the world's safe-haven right now, that does not bode well for the world.

Tuesday, February 2, 2010

Recently Published Article on Hard Assets Investor

Yesterday, the good folks at Hard Assets Investor were kind enough to run a somewhat lengthy article I had written for them about which classes of commodity provide the best hedge against dollar inflation. You can check it out on their fantastic blog.
For the article I compared various commodities closing prices to the USD/CHF exchange rate for that day, and analyzed the correlation (or lack thereof). The article makes extensive use of scatter plots and highlights the R_Squared value expressing a relationship (if any) between the two factors; I was considering publishing the full regression outputs, but they aren't any more telling than the graphics combined with the R_Squared values that appear. Also, I should point out, as I did in the article, that the data sets have some degree of auto-correlation, so these should not be taken as predictive analyses. Rather, they serve as a means to compare the correlations BETWEEN different commodities. Anyway, for the, you know, actual content, go read the article on HAI.
Quick and dirty summary:
Good Hedges: Precious metals, Grains
Bad Hedges: Meat, Lumber
There, satisfied?
Full disclosure, as of writing, author is short March 2010 Lumber (LBH10)

Thursday, January 28, 2010

Wall Street Journal Reporter Sets New Standard for Awful Journalism

Despite its attempts to predict the future, I'm generally a fan of the Wall Street Journal; I know of no other publication that so succinctly and clearly gives you the day's most important business news. People who read the WSJ thinking they're getting an edge on where the markets are headed couldn't be more self-deceiving, but if you're just looking for the basics of what happened in the markets, you'd be hard pressed, in my mind, to find a much better source. Also, for those scant of us who follow commodities, the WSJ is one of the few places I know among major media outlets that actually gives page space to the markets (albeit succinctly and usually on the back of section C).
Okay, now, with that caveat out of the way, I have to say that yesterday's article: "Traders Bet on an Oil Breakout," which purports to be the day's "Commodities Report" is unquestionably one of the most shallow, poorly researched, amateurish articles I have ever read. Anywhere. In my life.
Let's start with the headline:
"Traders Bet on an Oil Breakout"
Is that so? Which traders? What kind of break out are we talking about here? Up? Down? How big are these bets? Surely the article will expand...
Moving on, from the second and third paragraphs we get this:
"Since October, prices [of oil] have largely ranged from $70 to $80 a barrel, the narrowest four-month band since mid-2007. An oil "fear gauge"—the CBOE Crude Oil Volatility Index—early last week fell to the lowest level in more than two years.
But in the past few sessions, trading in the crude-oil options market has shown signs of reviving... While oil prices remain within that trading band, the volatility index has bounced off the bottom, according to some traders."
Note that this does not say that the crude oil market has picked up, rather the crude oil options market has shown signs of reviving, and we're given this graph of the volatility index to, I have to assume, support that statement. See if you can pinpoint the obvious bouncing off the bottom mentioned in the above paragraph:
See that big, significant bounce way down at the end there? Neither do I. It looks much more like random movements typical of every single market everywhere on the planet since the invention of markets. Which traders claimed the volatility index has jumped off the bottom? Oh right, some traders.
Back to the article, jumping ahead to the seventh paragraph, the author switches gears to talk about what's driving oil prices, and we get this doozy, possibly my favorite series of sentences that I've ever seen in a serious publication about financial markets:
"New swings, either up or down, likely will be triggered by expected changes in supply or demand. Some expect oil prices to tumble, taking a cue from last week's selloff in stocks, which fell on fears of another downturn in the global economy. Others say prices will soar because of stronger economic growth and fuel consumption."
Go ahead and read that again. Maybe think about having a calligrapher write it out and then frame it and put it on your wall. It would almost make a nice zen koan were it not so idiotic. Consider that this reporter, whose job is, apparently, to write news stories about financial markets, actually took the time to write that first sentence and pass it off as legitimate reporting. Did anyone read this article and suddenly have the epiphany that changes in supply or demand of a commodity might affect the price (either up or down, remember)? Next, we get two fantastic sentences telling us that some people think the price of oil will go up, while other people think the price will go down. Does this reporter have some insider on the NYMEX who's sending her tape recorded conversations from the back rooms, or has she made this inference all by herself? In other news from the world of logical tautologies:
  • If P, therefore P.
  • Q or (not Q).
The rest of the article goes on to talk about the proposed oil position limits by the CFTC (which I've previously discussed at length) and how they've caused some speculators to exit the market. This second half, so to speak, in its own right is actually a reasonable bit of reporting, but it certainly doesn't belong under this headline of "Traders [Betting] on an Oil Breakout". It's sort of like reading two different articles, one written by a reporter, and one written by that reporter's (admittedly precocious) 9 year old child.
What could have been improved? Other than "everything", this article is essentially three different articles, none of which is actually meaningful in its current incarnation. If this were an article discussing the signs pointing to a return to volatility in the oil market (as the headline purports) then a lot more work should have been done to determine if that "bounce" in the CBOE Volatility Index reported by some traders as the bottom is the result of explicit returns to the market by speculators and/or hedgers, or if it's just random noise. There is a mention in the article that Southwest Airlines, Newfield Exploration Co, and Chesapeake Energy all "recently" increased their hedging positions. If the CBOE volatility index increase is the result of hedgers taking greater positions, that implies less volatility than if these were speculators reentering the market. Do some reporting and figure out which it was.
If, on the other hand, the article were to focus on this crazy "supply and demand" theory that's been posited by the author, it should actually show some trends and figures for supply and demand. Is there a correlation between oil reserve estimations and volatility? How have global import/export numbers looked for 2009? What do the fundamentals suggest?
And lastly, if instead the article were to focus on the proposed CFTC regulations, maybe it could talk about how those regulations will affect volatility. The article ends with a quote from the global head of energy trading a Société Générale (a European corporate bank I've never heard of) talking about why hedging is important for companies that produce and consume oil. This is altogether worthless information. Of course hedging is important for companies that produce and consume oil. A better, more meaningful question to end the article would have been: "If enacted, how do you imagine the CFTC imposed position limits on speculators will affect volatility and/or liquidity? What does your bank plan to do if these limits are enacted?" At least then we would have seen an opinion that may provide insight into the the current state of the market.
Seriously Wall Street Journal, proofreading means more than checking for spelling or grammatical mistakes.

Wednesday, January 27, 2010

In the sugar markets, turns out Homer Simpson was shockingly prescient

"In America, first you get the sugar, then you get the power, then you get the women."
-Homer Simpson
Sugar Futures hit a 29 year high Monday, which I probably don't need to tell you, is totally insane. (No, it's not insane that sugar prices are up, it's just the phrase: "29-Year High".) Sugar prices were basically sideways for all of 2008, bouncing around 15¢ / pound, followed by a slow but rather unremarkable build through the middle of 2009 (along with every other market on the planet) then a couple bumps to up around 24¢ / pound in August, where it began moving back down, only to all of a sudden skyrocket over the last couple weeks to more than 30¢ / pound intraday on Monday. As of this writing, prices have come back down a bit to 29.3¢ / pound.
The sudden price move is the direct result of Indonesia expecting a "530,976 metric-ton production shortfall", as well as an atypical monsoon season in India (the world's second largest sugar producer and single largest consumer on the planet) that turned them from a net exporter of the crop, which they are historically, to a net importer, which they almost never are. (Source: WSJ.com) We've also seen declines in sugar production from the world's top exporter Brazil, and greater sugar demand than ever before from emerging markets such as Pakistan and China.
In other words, let me put on my reporter hat, ahem: Further exacerbating the sugar situation are declines in sugar supply everywhere in the world, coupled with increases in sugar demand everywhere in the world.
I've quickly pulled some figures from the USDA's most recent global sugar report (released November 2009) and reprinted them below. Remember that this does not take into account more recent news, like Monday's announcement regarding Indonesia (all data in thousands of Metric Tons):
RegionYearTotal ProductionTotal ImportsTotal ExportsTotal Use
North America2007/200813,3744,01993816,324
South America2007/200839,1171,48820,95918,568
Not the most obviously elucidating snapshot I realize, but the major thing to notice is the decrease in sugar output from Asia, coupled with its aggregate import/export flip.
I don't know enough about the cycles or other price drivers in the sugar market, but just going on this data I would seriously think twice before selling any sugar contracts at all; a 29 year high may be just the beginning.
Looks like Homer was right:

Tuesday, January 26, 2010

Gold Through the Ages

I've never been on the "CONSTANTLY INVEST IN GOLD ALL OF THE TIME!" bandwagon that seems to exist for some inexplicable reason, nor have I decided whether or not I like the idea of a gold standard, in theory or practice. I like the idea of the Dollar being pegged to something, but I've always been worried that there's nothing stopping everyone from collectively realizing that gold isn't actually useful for anything. I was chatting with a buddy of mine over beers last week, and when I mentioned my trepidation about the intrinsic, actual worth of gold, he said something I found interesting. This friend of mine, I should say in advance, is a big gold standard advocate, so you may have to take this with a grain of salt, but here's, basically, the point that he made (I'm paraphrasing here, I don't typically carry around a tape recorder when I'm having beers with a friend):
  • In Ancient Rome, an ounce of gold would buy you the nicest hand woven cloth garment, likely died a beautiful and uncommon color.
  • In Viking times, an ounce of gold would buy you a coat of soft, warm, and sturdy furs well made and stitched together with intricate designs and fastened with beautiful artisanal leather work.
  • In the Wild West, an ounce of gold would buy you a Wyatt Earp type three piece suit with a frilly shirt imported from France and a perfectly steamed fur-felt cowboy hat.
  • Today, an ounce of gold will buy you a beautiful, custom tailored Armani suit with a silk neck tie.
The more things change...

Sunday, January 24, 2010

Why the Swiss Franc is my Favorite US Dollar Barometer

Whenever I analyze the value of the dollar, either on its own or as a benchmark to compare with one or more commodities, I almost always use the US Dollar/Swiss Franc exchange rate (USD/CHF), which is the number of Swiss Francs you can get for one dollar. This may strike some people as strange, insofar as there exists another instrument, the US Dollar Index, which is designed specifically to provide a snapshot of the dollar's global worth. The USDX, as it's called, compares the dollar to a weighted basket of other world currencies, specifically the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona, and Swiss Franc. The idea is that by having a basket such as this, the effects of bi-national issues on currency prices should be minimized by the other currencies in the basket. It's a good enough barometer for most cases, but there's a few reasons why I prefer the Swiss Franc:
  1. The weighting of the currencies, though based on real economic data, is somewhat arbitrary. Currently for example, 57.6% of the weighting falls to the Euro, as it was determined that that percentage is how much the dollar is affected by that currency. If geopolitical relationships were to change at all, that 57.6% (or any other weighting) becomes less meaningful.
  2. Since most of what I'm writing about concerns comparisons of the dollar's strength with commodity values, I need a barometer that can gauge the dollar's worth in global commerce. Surprisingly, the USDX is not the index used to gauge how strong the dollar is in global trade; that honor falls to the Trade-Weighted US Dollar Index, which is a basket of about 27 or so foreign currencies, weighted by trade volume with the United States, and adjusted annually as trade volumes change year to year. You might think that this index would make a better currency barometer, but the fact that it's changing every single year actually makes it difficult to use when gauging long-term trends. Within a single year it's great, but otherwise you run into consistency problems.
  3. This is a bit more of an aesthetic reason, but the USDX is not a real currency. Like all indices, it had to be assigned an arbitrary starting value on a given date which, in this case, happens to be 100 as of March, 1973. So, when I read that the USDX is trading at 78, that means that the dollar is 22% weaker today against an oddly weighted basket of currencies than it was in March 1973. Sweet, good to know. No, when considering the value of the dollar, I want a tangible gauge. I want to know how many units of another nation's currency my hard-earned greenback will actually buy me. I can't walk into a bank tomorrow and say: "I'd like to exchange $100 for 57.8% Euros, 13.6% Yen, 11.9% Pounds Sterling, etc. etc." Well, I guess I could, but I'd look like an idiot.
All of that explains why I prefer not to use the USDX, but why the Swiss Franc? The nation of Switzerland has basically two major economic sectors (three if you count cheese with holes in it): high-end watches, and banking. The country is essentially a giant bank. Its historic neutrality protects it from major geopolitical upheaval and it's terrain makes it largely impenetrable in the event of a new world conflict. Its vast stores of gold give the economy a fundamental and irrefutable value, while its conservative approach to asset management make it's currency extremely stable. Because of Switzerland's limited industrial focus, the United States will almost never be in any sort of trade dispute with the country, unlike, say, with the EU, Japan, China, England, or even Canada, where trade relationships are intricate and new regulations, national or international, can have more dramatic effects on currency values. Because of Switzerland's unique status on the world stage, its exchange rate with the dollar truly lets you know how much the dollar is worth to the rest of the world.
I've been to Switzerland twice, it's a beautiful country, one I hope to return to some day. On my most recent trip there (in 2005) I held onto a SFr 5.00 coin, which today sits on my night stand and which I'll occasionally throw into my pocket if I need a bit of good luck. It is my favorite piece of legal tender I've ever possessed; hefty but not too bulky with beautiful engraving on each side. At the time I acquired it, the coin was worth about $3.85, as of this writing, it's worth about $4.80. Given what's happened to the US Economy between 2005 and 2010, that seems just about right.

Friday, January 22, 2010

Natural Gas Investors vs Meteorologists: The Eternal Struggle

Here are three headlines from the Wall Street Journal, each of them from the month of January:
I particularly like the 1/6 and 1/22 headlines, clearly demonstrating that WSJ commodities reporters are proficient with a middle school thesaurus. Anyway, take a look at Natural Gas prices over the last month:
That is some crazy volatility, and it has almost everything to do with weather forecasts. Though natural gas could be used to do just about everything oil does, currently, the cleaner burning fuel is used primarily for heating homes and other buildings. As such, during the winter months, when people are burning a lot more natural gas just to stay warm, the price can be driven by minor changes in the local weatherman's ten day forecast. In the summer, by contrast, Natural Gas is much more likely to follow energy patterns in general, and be driven by the same things that oil prices are driven by (reserves, projected refining capacity, projected demand, currency effects etc. etc.). I can just imagine natural gas speculators listening to the weatherman's tone before he actually announces the forecast, trying to get some glint of an overarching mood: upbeat means sell, foreboding means buy. Those who bought natural gas expecting the price to go up, no doubt, must become furious when the weatherman announces, jubilantly, that "this weekend's not going to be nearly as cold as we thought," with some sort of big, game show host smile. By contrast, when the forecast is worse than expected, natural gas bulls likely experience a kind of odd schadenfreude, delighting at the weatherman's gloomy and altogether dejected countenance as he warns his viewers to stay inside where it's warm. Truly, by literal definition, the weatherman is the natural gas investor's nemesis. By the same token, I've got to imagine natural gas sellers are quick to send the weatherman flowers when the forecast's got him down.
Obviously in the winter you'd expect prices to go up and in the summer to go down; in fact, there are whole businesses built around simply buying gas in March, pumping it into a salt cavity in the ground, and then selling it in November at much higher price. Why I find this so interesting, however is that the nature of the natural gas market changes every year from your typical energy market in the mild months, to a crazy spot market when the weather's cold.
Allow me to demonstrate. Here's a graph showing natural gas prices (in red) compared with oil prices (in blue) for the months of May, June, and July, 2009:
Now, here's the same chart from 11/1/09 to today:
Look at that divergence. It's as though people are buying natural gas to, you know, use it. Winter month natural gas prices are a perfect example of when a commodity market actually does its job: establishing prices for commodities.
A word of advice to any tri-state weathermen out there: stay away from the NYMEX building, unless you're looking for a fight.

Thursday, January 21, 2010

Commodities 101: How does one invest in commodities?

This post is part of Asset Prime's "Commodities 101" series.
The most direct way to invest in commodities would be to actually buy or sell the tangible goods themselves. You know, like growing your own Soybeans and then selling them to a grain elevator, or renting space in a meat locker and filling it with Frozen Pork Bellies, or melting down old pop cans and casting the aluminum into ingots and then hoarding those ingots until Aluminum prices rise. If you're not quite up to that level of commitment, fortunately there are myriad financial instruments at your disposal to get you going. One of the easiest ways to invest in commodities, particularly for folks already familiar with equity trading, is to buy and sell the stock of corporations whose earnings rely heavily on commodities prices. Think gold prices are going up? Buy stock in Barrick Gold (ABX) or Harmony Gold Mining (HMY). Think Lumber prices are going down? Buy stock in home construction companies such as Toll Brothers (TOL), or maybe sell lumber producers like Plum Creek Timber (PCL) and Weyerhaeuser (WY) short. Got a hunch about Corn? Buy or sell Archer Daniel's Midland (ADM) and/or General Mills (GIS). The major drawback of this approach is that all corporations have factors other than commodities prices dictating their stock performance, so that the change in a commodity's price may not cause the desired effect in the stock price.
Another option would be buying or selling shares of mutual funds, index funds, or ETFs that seek to somehow track the prices of individual commodities or some basket thereof. These instruments, that typically trade like stocks on the major exchanges, are all relatively new to the investment world and each has its own unique means of "achieving" its price goals. Some buy the underlying physical commodities and keep them in storage, others hold futures contracts at a certain specified leverage, still others have more exotic ways of attempting to track the underlying commodities. While these instruments may be a good option for some investors, in general, there is a gap between the price movements of these funds and those of the underlying commodities, usually the result of the expenses of maintaining and managing the funds, or liquidity problems with the instruments.
All that said, other than buying and sitting on physical goods, the most direct and, for our money, best way to invest in commodities is via commodities futures contracts ("futures" for short). These instruments provide investors the most unmitigated access to the commodities markets possible. Because they're so important to the commodities markets, we'll go over futures contracts in greater detail in a later Commodities 101 post. For now, suffice it to say that "commodities" and "futures" are just short of being purely synonymous, and if you're serious about investing in commodities, you need to understand futures and how they work

Wednesday, January 20, 2010

Time for a Lithium Futures Contract

Until practical physics and/or electrical engineers devise a better battery, lithium-ion is the power-source of choice for the ever-growing electrification of our automobiles. The batteries are going to become more efficient, more compact, with larger capacity and a longer life, and within ten years they're going to be integrated into the engines of every car that rolls off the assembly line. And all the auto industry needs to accomplish this is firm resolve, technical knowhow, and 700 million tons of lithium.
The Wall Street Journal today reports that Toyota Motor Corporation secured access to a long-term lithium source in Argentina, outbidding potential Chinese buyers.
As lithium increasingly becomes an input into our transportation and energy industries, demand for the metal is going to skyrocket, as will the number of mining operations seeking to acquire and sell it, making the price about as volatile as the element.* If the auto/battery/lithium mining industrial complex is going to maintain any semblance of sanity there will need to be a hedge for producers and consumers of lithium. This is the same thing that happened with palladium, a metal used almost exclusively in the production of catalytic converters, when wild price swings pre-futures contract made establishing budgets and allocating funds close to impossible for automotive manufacturers. A listed futures contract will afford automakers a relative stability when it comes to protecting themselves. I'd put the over/under at about four years before a contract is listed on either the LME or the COMEX (or both). Any takers out there?
*As an unfortunate side effect, look for these sorts of chemical/financial volatility puns to be used in 100% of news stories related to lithium price movements.

Tuesday, January 19, 2010

Commodities 101: What are Commodities?

This post is part of Asset Prime's "Commodities 101" series.
Commodities are the basic goods upon which businesses, economies, indeed entire civilizations rely for their continued existence. In the investing world, the term refers to a specific set of about forty or so products used as the primary inputs in the world's major industries.
As a rule, they are fungible and generic; a batch of a given commodity harvested in Wisconsin ought to be just as useful as a batch of that same commodity harvested in Brazil. With very few exceptions (the most notable being gold), all commodities end up getting used for something, whether it's building houses, powering nuclear reactors, or feeding cows.
Typically, commodities are categorized by their use or origin, and are often divided into five broad categories:
  • Metals - These include the precious metals, such as gold, silver, and platinum; as well as non-precious, industrial metals like copper and aluminum.
  • Grains - Just like it sounds, grains include wheat, oats, barley, rice, corn and soybeans.
  • Meats - Livestock, such as pigs and cows, as well as animal products like milk and butter.
  • Energy - The inputs needed to power engines, generators, and the like. This includes crude oil and its various refinements, as well as natural gas, ethanol, and uranium.
  • Softs - A hodgepodge of "other" commodities, includes cocoa, coffee, sugar, cotton, orange juice, and lumber. The term used to refer to tropical, agricultural commodities, but for whatever reason Pacific Northwestern wood products were thrown into the category.
Depending on where you get your news, you may see people divide metals into precious and non, refer to grains and oilseeds separately, make finer distinctions in energy, or break wood products out of the softs, but for the most part, those are the types of commodities that exist in the financial world, and they are the basis of the entire global economy.

Why Imposing Oil Position Limits is a Tremendous Mistake

As a follow up to my post on Friday about how the CFTC's proposed oil and gas position limits are ultimately wrongheaded, I wanted to talk a bit more about why position limits won't solve the problem, and why these regulations are ultimately bad for the markets they are supposedly trying to protect.
As I said in Friday's post, the problem is not position size, but leverage. And the reason leverage is a problem is that small market moves are amplified by virtue of the buying and selling that NECESSARILY must follow when positions are entered into via margin.
To understand this, first, consider that unlike a stock every futures contract is entered into by two individual parties. There is no corporate entity issuing these contracts to raise capital as is the case in the stock market. Further, the commodities do not necessarily have to even exist for the contract to be initiated. Today, I could "sell" you 5,000 bushels of oats to be delivered in September. Never mind that I live nowhere near an oat farm, let alone the Chicago warehouse to which those oats would be delivered. No, as an investor, I would be selling you those oats with the intention of buying the same amount of oats from someone else later to offset my position, hopefully at a lower price than the one I gave you. My bet is that the price oats will go down between now and September. Your bet is that the price of oats will go up. Thus, for every futures contract that exists, there is a bullish participant, and a bearish participant. The bullish participant (the buyer) expects the value of the underlying commodity to go up, or at the very least, to NOT go down. The bearish participant expects the price to go down, or at least to NOT go up. In every trade, someone is wrong and someone is right.
Now, back to the point at hand, by virtue of the fact that someone wins and someone loses on ANY price movement, the dramatic effects of leverage can work like a positive feedback loop. Commodities exchanges and financial institutions facilitating futures trading require that a certain amount of money be maintained in an account to maintain one's position. This is called the "maintenance margin" and adverse price movements can wipe you out, initiating a "margin call" where the exchange or brokerage requires you put up more money or else exit the position.
Let's take a concrete example with a fake commodity. Assume there are two speculators: Albert and Brian. Each of whom has $10,000 he'd like to invest in Widget futures, currently trading at $20 a box with one Widget contract equal to 500 boxes, making the total value of one Widget contract $10,000 (convenient, eh?). The exchange requires a minimum margin of $1000 per contract. Albert, the more risk averse of the two, buys exactly one contract. Brian, seeking to amplify his gains, buys ten contracts. Albert is not leveraged whatsoever, whereas Brian is as leveraged as possible. The next day, the price of Widgets falls from $20/box to $19/box. Albert is now down $500, whereas Brian is down $5000 (–$500 x 10 contracts = –$5000). Since Brian has fallen below the margin requirement of $1000 per contract, his broker tells him he must either add another $5000 to his account, or else exit his position. Having no more funds to allocate, Brian tries to sell his Widget contracts (all ten of them) to exit his position. However, because the price has gone down, many other investors are also trying to sell their Widget contracts, having received margin calls from their brokers. The flood of sell orders drives the price of widgets even lower. Eventually, some buyers enter the market at the deep discount of $18 / box, and this is the price at which Brian is forced to sell. Now, at $18 / box, Albert has lost a net of $1000, while Brian has lost every last penny. Incidentally, Albert (always patient) can wait for the price to go up, as he knows these sorts of market hiccups are to be expected. Brian, meanwhile, moves all of the rest of his money into T-Bills.
Now, what about oil? The above scenario is precisely what happened with oil futures in 2008. Take a look at this graph of oil prices from August 2007 through February 2009:
Oil was moving more or less sideways until February 2008. At which point, a perfect storm of geopolitical factors began driving oil prices up. As oil continued up, the bearish speculators (those who had sold oil) had to cover their positions as they were losing money. Some, certainly, received margin calls. Because they were leveraged they did not have the luxury to wait for prices to go back down to exit their positions. A flood of buy orders only served to drive prices higher until they reached the ludicrous peak of $140 / barrel, at which point, investors realized that was insane and began to sell crude like crazy. Those who had continued to buy oil all the way up to $140 now found themselves awash in sell orders and, because they too were incredibly leveraged, these folks were forced to cover their positions as oil went down, all the way through the public awareness of the credit crisis (how apropos) and into March of 2009, when sensibility and prudence (purely the product of fear) finally began to return to the market.
Would position limits have caused things to go any differently? Absolutely not. If anything, limiting the number of positions people or institutions can hold would have had an even worse effect by stifling the liquidity of the market. The problem is not position size, the problem is leverage. Now, admittedly, when large financial institutions take massive speculative positions in the market they somewhat amplify the problem. (Consider some hedge fund with 1000 Oil contracts all maximally leveraged suddenly getting a margin call; you now have 1000 more sell orders than you did five seconds ago.) But limiting leverage would in effect also limit position size. If your firm has $1,000,000 to deploy on oil contracts, and the margin requirements were $10,000 instead of $5000 per contract, the firm could buy only 100 contracts, rather than 200 under the lower margin. This would also give the firm much more breathing room, so to speak, when prices move against them. Margin calls would be fewer and further between for EVERYONE.
One last caveat, the margin problem is not so much with individual investors buying an oil contract here or there on margin, but with big firms buying hundreds of oil contracts on the smallest allowable margin.
Were I king of the CFTC, I'd impose a sliding margin requirement based on number of contracts. Something like, say, a 10% increase on minimum margin for each speculative position entered into past the 10th. Of course, lawmakers would rather their restrictions meet the populist demands than actually make sense from an economic point of view.
My advice? Stay the hell away from any index fund or ETF that tracks oil or gas. If these regulations go through, energy commodity funds are due for a liquidity shock, and some market maker will happily arbitrage your money right out of the fund.

Sunday, January 17, 2010

A follow up regarding my aforementioned "leash"

A friend of mine today wrote me an e-mail regarding my recent post on the importance of keeping your trades on a leash. He asked a pretty good question, which sort of made me feel stupid for not mentioning it in the post:
"So, how DO you keep your trades on a leash?"
Excellent question. Here's what I do, and by no means should you take it as gospel. It's a weird little system that I've worked out over several years of trial and error. (By the way, if anyone out there has any suggestions for improving this method, I'd love to hear them.) Here goes:
  • Before entering any position I determine how much money I'm going to allocate. Because of the relatively low margin, compared to a futures contract's true value, I always try to overshoot the margin requirement by a substantial amount. My target is to allocate at least enough money so that I'm operating at an effective leverage of 75% or less. The volatility of the market, in my opinion, makes being as leveraged as possible horrendously risky.
  • Immediately upon entering a new position, I determine my maximum loss. For me, my personal rule, is 20%. That is to say, I refuse to lose more than 20% on any given trade. I do some math and determine at what price I'll have lost 20% of my allocated funds, and set that as a stop with my broker (a buy stop if I'm short, a sell stop if I'm long). As a personal rule, I will NEVER move this stop away from my position (that is to say a 20% loss is truly my personal maximum).
  • I also determine what my exit point is; the price I want to exit this contract assuming it moves in my favor. I then set this as a limit order with my broker. (NB: I should say here that one of the best pieces of investment advice I ever received has caused me to be far more modest with my exit points than many traders would likely expect.*)
  • Throughout the day, I alter my stop order if the price has moved in my favor.
  • Unless I have new research to strongly suggest otherwise, I do not alter my limit price whatsoever.
Here's an example with a fictional commodity. Suppose I want to go long on March Widgets, which have a contract size of 5000 boxes at a price of $1.00 / box. My broker requires an initial margin of $1000 to enter into this contract. I decide that I will be allocating $2000 to the trade, for an effective leverage of 60% (I'm only buying one contract). To lose 20% of my $2000 investment, the total value of the contract would have to decrease by $400, which means a decrease in price of 8¢ ( [$1.00 * 5000] - [$.92 * 5000] = $400 ) Thus, I would set a sell stop at $.92 / box. From my research, I expect widgets to go up as high as $1.10 / box. I then set a sell limit at $1.10. Throughout the day I am constantly checking the current price of Widgets. If the price ever goes up, I move my sell stop up accordingly (whatever amount would result in a 20% loss from wherever the price currently is). This continues until I either get stopped out, or until Widgets hit my limit price, whichever comes first.
Some of you may have noticed that what I'm describing regarding moving the stop order is technically a "trailing stop" and many brokerages allow you to do this automatically (the stop order moves to some percent above or below whatever the price is currently). Personally, though my brokerage allows it, I do not use this sort of automation. The reason is that, as I've discussed before, the market may make a weird hiccup out of nowhere and then go back to normal trading. Such a hiccup might, if your trailing stop was automated, move your stop up or down, then immediately stop you out at a loss before going back to whatever the price was before. However, since I don't move my limit, if that hiccup happens to trigger my limit order, I'll happily take the money, thank you very much.
*That advice was: "Don't worry about trying to be exactly right. If you're basically right most of the time, that's much better than being exactly right occasionally."

Friday, January 15, 2010

Wrongheaded, shortsighted commodities law to also be meaningless

The CFTC (Commodities Futures Trading Commission) yesterday unveiled a proposal that would, if enacted, put limits on the numbers of oil and gas futures contracts speculators could control. This rule is currently in a "90-Day Comment Period". (The WSJ reports on it here.)
Here's a choice quote from Washington Senator Maria Cantwell's camp, pulled from a Reuters article on the proposal:
"While yesterday's proposal is a step in the right direction, we are concerned that the proposed limits may be too high to rein in damaging speculation in oil and gas markets," John Diamond, a spokesman for Senator Maria Cantwell, said.
Cantwell, a Democrat, has been a vocal proponent of increased energy market oversight and introduced legislation that would have forced CFTC to set position limits.
"The CFTC must set the limits at a level that does not allow excessively high speculative positions that ultimately harm energy consumers," her spokesman said.
The question as to what, specifically, is damaging about oil speculation remains to be answered by Ms. Cantwell. So let me help you out. The answer is nothing. Nothing is damaging about speculation in it's own right. What is damaging, however, is leverage. As I discussed in a recent post, the amount of leverage extended to commodities investors (in the form of margin) is absolutely insane. If you think about who the market is supposed to serve (producers and consumers of commodities) that kind of margin makes sense; if you're an oat farmer, you probably can't afford to buy or sell 5000 bushels of oats as a hedge against your own crop that has yet to be harvested, but an exchange can be pretty certain that that oat farmer will either have liquidated his position or else deliver on his contract once trading ceases. The man is an oat farmer for God's sake. He shouldn't have much trouble finding some oats. If you think about it as credit, and if the currency of your credit is oats, then I'll be damned if you can find a better candidate to whom to extend that credit than an oat farmer.
You might think, then, that the easy solution is to remove speculators from the commodities markets entirely. Sounds fine at first, but that really ends up screwing over the actual producers and consumers of the goods. These folks NEED speculators in the market to provide liquidity and ensure no one can unfairly corner the market. Think of it as market transparency taken to its utmost extreme.
No, the real problem is that there is no reason at all why speculators should be extended equivalent amounts of credit with which to move contracts around. You think some hedge fund manager in New York plans to drive a semi up to the NYMEX warehouse to pick up his 1000 barrels of West Texas Intermediate? No of course not, he'd probably get his suit dirty, and that suit cost more money than his margin on the oil contract.
If a firm (a hedge fund, index fund, etf, etc.) has say, $1 milllion to deploy on oil contracts, they can effectively buy or sell about 200 contracts, the equivalent of between $15 and $16 million worth of oil (assuming oil is at $75 - $80 / barrel). It's this kind of margin insanity that encourages wild and irresponsible speculation. Limits on the number of contracts you control are meaningless unless you make people accountable for the costs of those contracts.
What's that? Oh right. The actual limit. This law would set the maximum amount of contracts a trader could control at ~98,000, which works out to be about $7.5 billion worth of oil. So, look for that to affect, I don't know, Scrooge McDuck.

Thursday, January 14, 2010

The Importance of Keeping Your Trades on a Leash

Most people who start trading futures after having spent some time in the stock market expect the former to be like the latter. These people are usually in for a rude awakening. Intense volatility coupled with rock bottom margin requirements conflate to create a market environment not unlike a hurricane. In stocks, unless your're playing those crazy Russian IPOs with zero volume, a 5% swing might typically be a big day. In futures, a 5% price swing might mean the entirety of your life savings.
Let's take Lumber, for example. North American Softwood Lumber Futures (Random Length) are traded on the Chicago Mercantile Exchange and are priced in dollars per thousand board feet, one contract is equal to one hundred and ten thousand board feet. (Fun fact, 110 thousand board feet is exactly the amount of lumber that will fit in a boxcar. It's true, some guy told me that one time.) As of this writing, the front month (January) Lumber contract istrading at ~$220 per thousand board feet. That means that the net value of one contract of North American Softwood Lumber is $24,200. And yet, if you'd like to buy or sell one of these contracts, all you need to put up is ~$1800 (give or take, depends on your broker). So, today, with less than $2000, Joe Schmo can control nearly $25,000 worth of Lumber. That's an effective margin of 92%. Now, assume Joe is long 1 lumber contract, and the price moves down 5% to ~$209/mmBF. That 5% change is equivalent to a loss of $1210. Assuming Joe only put up $1800 to buy that contract, that leaves him down a whopping 67% on his initial investment, after only a 5% change in price. And remember, that's assuming he bought only one contract. Ouch.
To make things even more difficult, most of the commodity markets are open around the clock, so prices may be climbing or falling while you're eating breakfast, at the movies, or fast asleep. Take a look at this technical chart (retrieved via optionsXpress.com) of the March Crude Oil contract over the last three days, centered on yesterday's trading session:
What the hell is that? I mean, seriously, is that a prank? Oil opened the day at about $80.50 and closed the day essentially flat at about $80.35 per barrel. There was no news about oil, no major economic indicators were published, and yet, for some reason, between the hours of 9am and 1pm Eastern time, oil fell to about $78.80 per barrel and then rose back up to $80.75. If you were long March Oil, and only put up the minimum to enter into the contract, that kind of swing could potentially result in a margin call (depending on where you entered your position) immediately before jumping up to a multi-day high. If you were short, and were looking to exit at a price below $80.00, but, say, happened to live on the West Coast, you might be just arriving at work, only to realize upon powering up your computer that you missed the nadir you were looking for.
The moral is that when you're investing with futures contracts, you can't sit back and wait to see what the market does once you take a position. You need to remain active, agile, and vigilant. You need predetermined exit points, both to stop a loss AND to realize a gain, and you can't let emotion get the best of you.
Despite what your econ professor said, this market is not rational.