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.

US Government to Grains Speculators: "You're all idiots"

Grains are notoriously one of the trickiest markets to play. First, the goods themselves are quite fungible. ("Corn too expensive? We'll feed the cows Oats for awhile.") Second, they're vastly interconnected to the prices of NUMEROUS other commodities. ("If Lean Hog prices plummet, we'll stop raising so many pigs, which means we'll need to stop buying feed. ") Third, most US grains are also produced in massive quantities somewhere else in the world, which makes the prices highly susceptible to currency effects. ("Well, it's a record Soybean crop in the midwest with the lowest export demand in history, but the Brazilian Real is the strongest it's ever been. Look for Soybeans to go up.") And fourth, (and this mainly applies to Corn but look for other grains to join the fun in the coming years), the government gives big subsidies to grain producers whose crops go to the creation of Biofuels such as Ethanol.

Obviously, with all of these factors you'd expect divergent opinions on what grain prices will do. The one thing you don't expect, however, is for everyone in the world to be wrong about basic grain facts. That is to say, it's one thing to incorrectly predict where and how prices will move, it's another entirely to incorrectly gauge the basic quantities of grain that exist. And yet that is precisely what happened. Allow me to quote from the "What's News" section of today's Wall Street Journal:

"The government stunned commodity markets by estimating record corn and soybean crops for 2009, sending prices tumbling."

The article goes on to report that the crop numbers were higher than ANY surveyed Dow Jones analyst predicted (geeze, I hope those guys still get their bonuses) . The markets responded by dropping their bottoms out. Take a look at this graph:

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View the full FUTURE:C00 chart at Wikinvest

I've zoomed in to about a three-week view to exaggerate the effect. Here you see front-month corn prices moving more or less sideways, and then shooting down the daily trading limit yesterday. As of this writing, prices are down a further 3% in today's market session.

Is there any reason for the prices to stop their descent? Honestly, I doubt it. Everyone and their mother was yelling about how 2010 was going to be a bull year for commodities, with China growing at a supposedly exponential rate and every other nation firing up its boilers to full post credit crisis. But already in 2010 the situation in China seems to be changing directions. Edward Harrison at CreditWritedowns.com recently had a great article about how the Chinese economy may be more of a bubble than anyone had anticipated, and with the Chinese government's insistence on keeping the value of the Yuan fixed, they're setting themselves up to have a currency as worthless as the one its pegged to (that would be the Dollar).

But the bottom line is that if your supply vastly outweighs your demand, no matter what that demand is, the price is going nowhere but down.

On the plus side, there'll be no shortage of corn tortillas.