Monday, November 30, 2015

Gold or Nickel?

Post Number 9: Gold or Nickel?

I attended a meeting of an investment club a few days ago. The attendees were not professional traders, and the presenters were pretty much of the "I predicted the crash of '08 and I'm predicting it again" sort. In a room of true believers like this, there was one question on most minds: When do I buy gold and silver? Actually there were two questions; the other was: when will I make back my losses on gold and silver?

I added my two cents to the discussion saying that there were better hard assets to invest in than gold. I didn't have my charts with me, so it was mostly a qualitative statement that some things are cheap and other are dear. I promised to put up some charts on this site. So here are two.

First, lets talk about a metal that really is a good value, nickel. Here's a chart of forward ten year returns versus constant dollar price. BTW this chart is explained in detail in Post 2.

Like most of my charts it is done on a ratio (log) scale to better show the percentage changes. The red line is where we are now. So the model is forecasting that nickel will more than double in ten years. That's in constant dollar terms. If you believe there will be some inflation (most of those at the meeting certainly did) then it will do even better. BTW, the model has an R squared of 67%. That's great for a long term forecast.

Experienced commodities traders will counter with: The fundamentals are terrible. China is slowing, and there is no other buyer to take its place. Production is only slowly being cut back, and there are going to be surpluses for awhile. All of this is true, but remember that this is a ten year forecast. In the past, ten years has been long enough to work the surplus out. In terms of trading, I plan on waiting for some kind of trend reversal signal, probably based on moving averages.

Now here's the same plot for silver:

The fit is not as good at the low end of the price. That is because the series goes back to the time of the Hunts and the associated craziness. Since the mid 80s the fit is much better. It's forecasting a (50%) decline in the real price. It will take an awful lot of inflation to make up for that.

Tuesday, November 24, 2015

Post Number 8

There is a major change in the way developed market consumers are eating. The era of low and no fat diets are over. It turns out that diet has surprisingly little to do with cholesterol levels; most of it is genetic. It also turns out that eating appetite satiating protein foods takes off more weight than a carb-heavy diet. This change is most evident at breakfast, where eggs and meat are replacing grains. I believe there are great investment opportunities in this space. In this post I'll talk about the commodity background for milk. In the next post I'll go into specific investments and move to eggs.

US consumption of milk has changed rapidly over the years. Consumption of fluid milk is down; consumption of cheese, ice cream and yogurt are up. Here's a graph of total US consumption of milk on a milk-fat basis:

The next graph zeros in on the milk products that have been growing quickly. This chart includes exports, which have been growing until recently.

However, consumption of beverage milk has been declining:
Some of this decline has to do with long run factors such as smaller families, plant based alternatives and the increase of the lactose sensitive population. However, a lot has to do with price, as you can see in the graph.

So how to play this. Yogurt is the obvious play, but most of the players are private. Danone is an exception. However, Danone is strongly circumscribed by the French government. A while back it received a takeover offer, but the gov did not allow it. So I would stay away.

The same holds true for specialty cheeses (in the US that means non-American and non-cheddar). I simply can't find an investment vehicle.

I am going to recommend that one play for a rebound in fluid milk. Why go to the declining part of the market? Because I think the decline is over, and a rebound is near.
- Lactose free milk has been introduced and is strongly gaining share. This requires very little processing above what is already done at dairies.
- Milk has taken off among health-conscious athletes. This is particularly true for flavored milk. This group often leads the general consumer.
- The price of raw milk (the input to the dairy) has fallen both in the US and the world market. This is good for both consumption and processing margins. It has to do with the slowdown in China. Here's a graph of New Zealand milk export prices along with the stock price of Dean Foods, the largest US dairy.
Next Post: Dean Foods

Friday, November 13, 2015

Southern Peru Copper

Post Number 7 - Southern Peru Copper

I said in the last post that I was going to start a series on the milk and egg markets, both of which have some interesting prospects. But I've gotten several emails asking me to spend some time on more specific trades. So I've added a new page about the trades I actually have on. You can get to it from the right hand side on this page. Here's one that I have on now...

One commodity strategy that has proved profitable over the years is to buy the low cost producer during the down part of the cycle. This is a highly contrarian trade for two reasons. First, all producers will be doing badly when prices of their product are low. Second, P/E ratios are normally very high since earnings are so low. The key is being able to wait out the cycle and eventual high returns.

But not all producers are able to wait it out. Some will go broke. Others will survive but have to have severe recapitalizations. That's the reason I like the low cost producers. Normally they will continue to make some profit even in the lean years. So their chances of survival are high.

So let's talk about copper. Prices are down from their highs, but still not extremely cheap. Here's the graph I introduced in Post Number 2, but for copper only:

Remember the x-axis is the deflated price going back to 1980, and the y-axis is the ten-year forward return. (If you are unsure about the graph, I explain it in detail in Post 2.) The red line is where the price is now. So the model is forecasting a return of 0.75, or a (25)% loss. Using a multi-factor model, the ten year return is (15)%. Still bad.

Now the stocks of commodity producers often bottom before the commodity itself. This is because the producers have the ability to cut costs and run lean. So they can make do even in poor markets. Along this line I want to be involved in the lowest cost major copper miner. Here is a list of costs I got from various annual reports:

Company           Ticker    Operating Cost/Lb.
Southern Peru    SCCO     1.06
Freeport             FCX        1.52
Rio Tinto           RIO         NA
Billiton              BHP        1.13
Codelco                             1.35
Antofagasta      ANTO     1.40
Quantum           FM          1.40
Anglo Amer      AAL        NA

These numbers are mine from various sources. SCCO is the lowest cost major. It is also close to a pure copper play.

So this is a dilemma. I'm still bearish copper, but I like the company. Sounds like a spread trade to me!  Here's a graph of the spread at aproximately one to one value ratio of stock to copper.

(Apologies for the poor graphic; I was in a hurry and just lifted it from my trading platform. I usually prefer to do stats and graphics in R even tho it takes a little work.) The point is that this looks like it has gone parabolic since 2014. Actually, the scale is pretty tight, and I think it has a ways to go yet.

One more thing: if you are willing to pay some more in trading costs, you can look at the SCCO junk bonds instead. These are yielding 7.4%. Of course their delta to copper prices is a little less, so you wind up shorter copper.

New Page

I've gotten several emails asking me to spend some time on more specific trades. So I've added a new page about the trades I actually have on. You can get to it by clicking on "Current Positions" on the upper right hand side on this page.

Monday, November 9, 2015

Who's the Current Sucker?

POST 6 - Who's the Current Sucker?

Garrison Keillor, the NPR host and comedian has a tagline about a town where "all the children are above average." It's somewhat funny (at least it was the first time), and highlights what this post is about. The fact is that generating positive alpha is a zero sum game. For every supergenius hedge fund manager who outperforms, there is a corresponding schlub who loses. So one way of analyzing the markets is figuring out who the suckers are and how much money they have to lose.

In the past there was a steady and reliable supply of suckers. In the equity markets they were retail investors and actively managed mutual funds. There have been numerous studies, both from academics and industry, that show these two groups underperform. So there was a lot of alpha on the table to harvest. The rise of index funds and ETFs have sharply reduced this. Note that hedge funds have underperformed a balanced portfolio for about fifteen years.

In the commodity space, the situation is a little more complicated. Sure, the retail commission house customer is a reliable loser. But another loser is the passively managed funds. Why? Because these index funds regularly come to the market to roll very large positions. The short term traders see them coming (I was going to say "the floor", but that dates me.) and front run their rolls. Over time this adds up to a lot of money.

Another important set of losers, more important to my style of trading,  are the financial investors. These are long-only portfolio investors who buy the commodity asset class as part of their portfolio. Now we can argue whether commodities ex gold are in theory a reasonable part of of a balanced portfolio. But what happens in practice is that these buyers come in when commodities go up, and they leave when commodities go down. In other words they are late stage trend followers.

I started my trading career in the 70s, during the big commodities run up. I remember the financial investors (We called them crossovers.) coming in in the late 70s and early 80s. I remember the analyses they wrote about the portfolio diversification commodities would give. I am ashamed to admit that I even wrote one for a commodities hedge fund. Well, what happened? Volcker tightened, and the bubble burst. Commodities went down in real terms for twenty years (see Post 1). The crossovers crossed back again, back into stocks and bonds and out of commodities. In net they lost a lot. It gave that generation of investors a bad taste about commodities.

It took another generation to repeat the mistake, but repeat they did. In the 70s, the mantras were non correlation and inflation. In the 00s, the mantra was BRIC. Same result. We are now in the stage of their exiting commodities. I believe we still have a ways to go on this. The point is that once they leave, they won't be back soon. So a large pool of commodity suckers has left the table.

What does this mean for trading? It means that we should be looking for singles and doubles, not home runs. It also means we should favor mean reverting trades rather than momentum. The late stage momentum guys will not be there to bail you out.

P.S. I realize the last few posts have been pretty general and not about tradable ideas. I'll get to that in then next post.

Next Post - Milk and Eggs for Breakfast

Thursday, November 5, 2015

Oil and the Saudi budget

POST NUMBER 5 - Oil and the Saudi budget

The name of this blog is The Commodity Strategist, so I plan to concentrate on longer term issues instead of reacting to news coming off the tape. However, there were a few pieces of news on the oil front that that do have longer term implications. So here's my take:

There's a widespread view in the oil markets that Saudi Arabia is playing a game of chicken with various higher cost oil producers, especially the US shale industry. The theory is that the Saudis will overproduce to keep the price low enough that shale goes broke and then raise the price again. And if the low price hurts Russia and Iran, so much the better.

This really underestimates the Saudis. They have been in the oil business for a long time and have seen many cycles. I'm sure they realize that they cannot keep the price of oil above its long run supply cost for very long. If they do, it winds up crashing, just like a year ago. If OTOH they cut production unilaterally to support the price, world production will continue to increase. In the limit, their production goes to zero. Not good!

So I'll bet that they see sub $75 prices as a steady state. This should be enough to curtail a lot of high cost production - as it has already. They do have a major problem though. In the last few years, Saudi government spending has exploded. That's what happens when the government is taking in a gazillion dollars per year with $100 oil.

Saudi Government Breakeven Oil Price

2010       $69   / bbl.
2014       $106 / bbl.

The increase in government spending was pretty much broadly distributed: education, social services, government payrolls, defense, air conditioned soccer stadia, gold plated Mercedes, etc.

The information we have gotten recently is that they are getting serious about reducing spending. The 2015 budget was originally set at $229 billion. With that level the IMF is forecasting a $107 billion deficit. So far the Saudis have said they plan to cut investment by 10% (that includes the stadia and gold plated Mercedes) and to borrow another $27 billion.

All parties know that this won't be enough to stabilize the financial situation. The good news for them is that there are some almost painless cuts that can be made. Most obvious is the subsidy for gasoline. The UAE has recently eliminated this. It's easy to do with oil prices already low enough that it won't result in a huge extra cost to consumers. Some commentators have said that cutting back on payrolls and social services will make the population restless, but I see no actual evidence of that.

The budget path the Saudis take has long run implications for oil. If they continue on the path of right sizing their government spending, it means we are in for a long period of oil price stability at around these levels. In this scenario my feeling is that the price will slowly climb to maybe $65 in 2015 dollars, but it won't be quick enough to make a trade. This is bullish for most world economies since they will not have the price instability to upset planning.

OTOH, if they do not do this, there will be trouble down the road. They can finance things as is by drawing down reserves and foreign assets. They can also ramp up their borrowing; I'm sure the long-only geniuses who bought the subprime paper will gladly buy their's also. The result: wildly fluctuating oil prices, an eventual default and probably a turn for the worse in the middle east (yes, that is possible).

NEXT POST - Who's the Sucker Now?