Monday, January 4, 2016

Post Number 13 - Industrials Metals in the New Year.

Happy new year to everyone! 2015 was a great year for value traders in commodities. Most of the overvalued assets fell closer to their long term value. Here's hoping that 2016 sees more of the same.

The next few posts are going to go through the value situation for most of the commodities I cover. The format will be pretty much the same for all of them. I'll give a forecast by drawing a regression line on the ten-year long-term graphs (the Pure Value forecast). Then I'll give my personal forecast with some adjustments (Burt’s Forecast). Finally I'll talk about how I intend to trade them, or just stay out.

This post is on the metals. Here's the table of forecasts of real (inflation and US$-adjusted) prices:

Pure Value Forecast
Burt’s Forecast
+60 %
+80 %
+20 %
+20 %
- 4 %
+5 %
-30 %
-21 %
-42 %
-26 %
-30 %
-20 %

Why are my forecasts different from the ten-year graph forecast? I also have a proprietary model that adds to the Pure Value model a term that accounts for the “financial” flows. In other words it considers the non-producer and non-consumer money that comes in and out of commodities over time. These flows have been especially important for metals, but less so for harder-to-store commodities. The last few years have seen strong outflows of this money, depressing prices. So my forecasts are nudged upwards, on the assumptions that this source of selling will eventually end.

One more thing about biasing the forecasts. A thoughtful reader emailed me that I may be using the wrong index for the US dollar (Remember, all prices are adjusted for the international US dollar value). I am using the Federal Reserve’s trade weighted index. He noted that the currencies of many commodity producing emerging market nations have fallen precipitously. Many of these countries are either not in the Federal Reserve's index or only have a small weight. However, their weight in commodity production may be quite high. For example, Russia and Indonesia are the world’s largest nickel producers, and their currencies have fallen by almost half. This will reduce nickel’s cost of production, and thus price.

This is a good point. However, prices are made at the margin. For example, there is plenty of nickel production in Canada and Australia. What will probably happen is that these places will see a reduction in their high cost output. So as the price goes up towards equilibrium, the miners in Russia and Indonesia will see a return to profitability. Nonetheless, this is something to keep in mind, especially when we get into the agricultural forecasts.

Well Holy Toledo, we actually have a metal with a substantial undervaluation, Nickel. This is the first time in years! I'll trade this from the long side.  Aluminum is also undervalued, but the amount is not enough for a good risk/reward.

The other metals are still mostly overvalued. The problem is that the overvaluation has been reduced, and the fast money is heavily short. So these are somewhat dangerous. My strategy is to wait for short covering rallies before going short. Copper is my favorite because of its liquidity, and I now have a small short position. Even copper has been squeezed in the past, but I would be more nervous about the smaller markets.

Also, I plan to keep shorting the actual commodities, not the stocks of commodity producers. Some of the junior miners have been reduced to little more than options. And of course, you pick up carry being short a metal, you pay carry short equities.

Another thing to keep in mind is that we may well see a credit event of a large metal producer or trader. Not mentioning any names, but readers probably know the usual suspects. Were this to occur, the first reaction (probably starting before the actual event) would be liquidation of inventories. This would lead to spikes down. Longer term, these are probably healthy. Production is simply higher than expected future consumption in most metal markets. So taking capacity out is needed. This could be by a shutdown of the bankrupt company or, more likely, its merging and rationalization.

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