This month’s article will give a brief overview of where commodities are and then drill down into a couple of interesting specific cases. The most interesting commodities at this juncture include crude oil, cattle, wheat, and natural gas and the commentary will be pretty heavy on graphs.
Overview
The rally in commodities over the past week was cut short today by a pretty massive amount of profit taking that occurred pretty much across the board. Zooming out on the market, it is likely that investors will view this sell off as a buy the dips situation. Yes, commodities look overbought in the short term – crude, copper, and grains are all up ~10% in the last week, but so long as monetary authorities remain bent on supporting a recovery, this buying could very well ‘have legs.’ The perception of risk (Europe, Korea, etc.) is still present but over the past week seems to be slowly draining out of the market, and many investors are beginning to view a lack of commodity exposure as the real risk.
Adding to this immediate positioning story, the fundamental story in many commodities is present to back up a bullish stance. Certainly inventories for commodities such as crude, copper, and wheat are not low on a historical basis – however it is quite easy to make the argument that these inventories are:
- Drawing down – inventory levels are lower now than they were 6-12 months ago.
- Expected to accelerate down – that is the pace at which they decrease will get more marked.
- Continuing to experience downside shocks – the latest example coming in the wheat market as a bumper Australian crop is partially destroyed by floods. Story
Crude Curve Hooks
The title refers to the shape of the forward curve in the crude oil market – something that can be seen by graphing all of the future contracts on one price chart. Over the past couple of weeks, there has been a very marked move in the shape of the forward curve in crude oil, with the front month[1] rallying (through Tuesday) while the back months got hammered. Enhanced roll commodity indices got chewed up on this recent move - good on both absolute terms and relative to the standard DJUBS commodity index. The back months were really getting hit hard (Dec 13 is down $1.50) yesterday while the prompt contract was flat, so my guess is that a lot of shops were flattening a short prompt/long long-dated spread. I’m not sure how justified comparisons between the current backwardation (actually a hook) and historical are. However, this is definitely an interesting development and one that bears watching.
Figure 1: Crude strip from one month ago. Note the contango – contracts further in the future cost more than the most prompt contract
Figure 2: Crude strip yesterday. Note the contango now only exists in the first few contract month, and the rest of the strip is in backwardation.
Backwardation was a dominant feature in the crude market from the beginning of 1999 to mid 2005 (Figure 1), and most of that time it was partly based on the belief that OPEC could produce much more oil if they so chose. It took 42 months (mid 2000 to late 2003) for the backdated crude contracts to price above the then OPEC basket ceiling of /barrel. I remember this was a big deal at the time, and there were many people who said that oil could never sustainably go over /barrel. The analog to the present time is that there may be part of the market which thinks that OPEC can and will hold prices within their - envelope. To the extent that the market gets fixated on the current stated OPEC envelope, we could set up a similar backwardation dynamic with tightness in cash markets leading to a sustainably profitable roll in futures contracts. Note in previous instances (Figure 3), not only were backwardations persistent (long lasting) but they accompanied huge increases in the price of oil. By itself, this is certainly not convincing evidence that crude prices will spike but it bears watching as additional evidence for an advancing oil price.
Figure 3: A comparison of the prompt contract of crude (CL1) and the contract 24 months away from delivery (CL24). Backwardation was an entrenched feature in the crude market for much of the first part of the decade. Investors who bought the prompt and then rolled continuously made more than holders of spot – which is the opposite of the conundrum commodity index funds have faced over the past few years.
Expensive Beef
Both feeder and live cattle are trading directly below their respective all time nominal price highs. Cattle are therefore joining the set of commodities (copper, silver, gold, sugar, and cotton) that are trading near or at multi-decade/all-time nominal price highs.
Interestingly, conventional wisdom right now is that herd liquidations (on the back of high feed prices) will keep cattle price down. However, at 114.8 mm head of cattle, the herd is now sitting at the lowest level since 1956. Since 2008, the herd size has been reduced by 6 mm head. I am becoming increasingly inclined to believe cattle prices could price break out – in spite of the risk of further herd liquidation due to high grain prices. Persistently higher grain prices ultimately mean higher set point for meat prices at some point since it is one of the primary input costs for raising cattle.
Figure 4: Feeder Cattle (1991-Present)
Figure 5: Live Cattle (1991-present)
Floods, Droughts, and Locusts – Otherwise Known as the Wheat Market
Flooding in Queensland and Victoria, Australia has ruined hopes there of a bumper crop in wheat. The biggest news for the market is that estimates of 5 mm MT of wheat will be downgraded from high quality milling wheat to feed wheat. Last week the Chicago wheat versus Minneapolis wheat spread compressed (the difference narrowed) opposite to what one would expect given the Australian weather. The situation in Australia sounds pretty biblical. In addition to the flooding there is the largest locust swarm in 75 years. My thoughts are with the Australian farmers – sounds pretty horrible – but the effect on wheat prices will probably be significantly bullish. Although Russian winter wheat progress is good so far, another bullish development is the fact that the largest hard winter wheat region of the US is now under significant drought pressure with no rains forecasted for the next week.
Given that the catalyst for the rally was the Australian flood forecasts, it seems possible that over the past week, the market has mispriced by focusing the rally in Chicago over Minneapolis wheat (similar to the reaction in August when Russia suspended grain shipments for 2010). Today, however, that dynamic reversed as Minneapolis March wheat broke to new 2 year highs and Chicago wheat sold off. Since 5 million metric tons of milling grade wheat may be used for feed, we can assume it may also act to some extent to displace feed corn (five million metric tons is ~ 10% of annual US corn exports and ~15% of annual US wheat exports), giving corn prices a bit of competition.
Is the Cold Enough To Save Natural Gas?
Weather forecasts have (again) trended colder over the past weekend, with the 6-10 day forecast continuing to imply colder than average temperatures for most of the important natural gas use areas. In spite of these cold 1-2 week forecasts, the medium term prospects (2-3 months) are not very good. The cold weather has changed none of the several factors (listed below in order of importance) in the past 2 weeks:
- Supply/demand ex weather was bullish last year, this year it is bearish – the net difference between the two years is on the order of 2 BCF/day.
- The level of contango has been reduced dramatically between last winter and now. (see figures 1 and 2 below) Last year, there was significant incentive to finance storage and sell later in the year (which created a degree of tightness in cash markets) – note that at the beginning of December ’09 the one year forward price was > .50/mmbtu greater than prompt price and the 12 month strip price was >0.50/mmbtu greater than prompt price. Currently, the analogous spreads are __spamspan_img_placeholder__.90 and __spamspan_img_placeholder__.11 respectively. With less attractive terms to finance storage (contango minus finance charges minus storage fees must be greater than zero), there is more incentive to dump gas in the spot markets. Therefore, I expect cash prices to be weaker this year, and not lead the charge as they did last year.
Figure 6: Natural gas 12 month average strip price – prompt contract price
Figure 7: Natural gas generic 13th month contract – prompt contract price.
- Significantly, winter temp forecasts for the East Coast are much less reliable (~ 7 days) due to their dependence on the Northern Atlantic Oscillation (https://www.cpc.ncep.noaa.gov/products/predictions/90day/fxus05.html), so bullish buying based on a two week forecast is speculative.
- Drilling continues apace. Last year at this time, rig levels were 200 lower than they are now.
- Producers seem to be drawing a line in the sand at .50 this winter, a level that was not defended in 2009-2010 winter.
In conclusion, although the longer term (>3 months) is probably supported by the flattening of the forward curve as it is an indication that consumers have reduced hedging programs and producers cannot hedge as profitably, the short term remains quite bearish in spite of cold weather.
Resources
[1] The front month contract in commodities is also called the “prompt” contract because it is the traded contract which is closest in terms of time to delivery.
