Tuesday, February 23, 2010
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
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
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.
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
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:
- 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.
- There is an expected increase in demand as the result of the approaching "Spring building season".
- 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.
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
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:
- 1/6/2010 - Cold Weather Heats up Natural Gas, OJ Markets
- 1/15/2010 - Natural Gas, off 2.5%, Falls on Mild Forecast
- 1/23/2010 - Chilly Forecasts Lift Natural Gas
- 1/27/2010 - Natural Gas Falls on Milder Forecasts
- 2/1/2010 - Elements Hold Down Natural Gas*
- 2/2/2010 - Cold Weather Boosts Natural Gas
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
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:
- 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?
- 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.
- 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
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
Full disclosure, as of writing, author is short March 2010 Lumber (LBH10)