It's all About EM Demand, China and India

With all the sturm und drang of the US political season, it is excusable that investors are looking less to emerging markets (EM). However for commodities traders and investors, that is not possible. The fact is that almost all the growth in commodity supply and demand comes from EM. And right now EM is in serious trouble.

This article will focus on commodity demand. Over the medium term, there's not much that can happen to supply. Putting in a new world class mine or plantation province takes many years. These were cut back sharply starting in 2013, and will not revive for quite a while. So over the shorter term commodity prices will be set by demand.

Here's a table of the World Steel Association's forecast for steel demand in 10⁶  tonnes:

	2016	2017	Change
Developed Markets	406	410	4
Emerging Markets	436	457	21

So EM is the growth driver for steel. The numbers are similar for virtually all industrial commodities. DM economies expand in the commodity-light service sectors. EM economies expand by building things.

The two biggest EM economies are China and India. Both of these are having problems, for different reasons:

China is experiencing massive financial outflows. It's impossible to get exact numbers, but Barclays thinks it was $207 billion in the third quarter. Data from the Federal Reserve TICC report shows that China and Belgium (China holds treasuries in Belgium for some reason) liquidated $184 billion in treasuries during Oct alone. So the outflow may be speeding up.

Analysts have varying reasons for the massive movement out of China. Rising US interest rates, the falling Yuan and a clampdown on corruption in China are mentioned. But my view is that this is wealthy people in China seeing the end of the Chinese growth model. China is going through the same process that Japan went through in the 80s. The export-led growth is maxed out, but China still has a huge savings rate. So the capital is seeking a better and safer home. Trump is speeding this up, since he will certainly reduce China's exports to the US. But it would happen anyway.

The Chinese leadership realizes this and is steering the economy toward services. Long term this is the right path, but the process will be bumpy. Basically, a lot of heavy industry will have to be shut down. Services are much less capital-intensive than manufacturing, so the returns on capital will be lower. Also, services are far less commodity-intensive, so that demand will be muted.

So China will not have a need for incoming capital. It has also massively expanded its higher educational system, so it probably won't have much of a need for foreign technology either. History tells us that if a nation doesn't need foreign assets for growth, it doesn't let foreign companies make much money. So my advice is to avoid Chinese stocks as an asset class. This is also negative for US companies that have major operations in China (GM, WYNN, YUM).

India is a somewhat different story. It is at an earlier stage of the growth cycle. Exports and construction have a large place to play in future growth. Because of the rule of law and English language, it also has a major stake in service exports, a particularly good sector. The problem here is self-generated. Like many EM countries, much business is done in cash. This is done to avoid taxes as well as distrust of the financial system. India wants to change this. So the government has called in all large denomination bills. But business culture doesn't change overnight. So a lot of business has ground to a halt. In time this will dissipate, and India will resume its growth.

The Hike

The Fed raised rates by a quarter point yesterday. This was as expected, but the tone of the statement and the press conference was rather hawkish. So everything sold off, including most commodities. Here's my take...

The big number to me was the forecast for growth, at about 2%. If this is true, then the Trump optimism is worth zero. That's the same crappy growth we got during Obama's eight years. It's also a big step down from previous Fed forecasts. Many people may not know that the Fed has been forecasting a return to 3+% growth for about six years. They have been wrong of course. This year they finally threw in the towel, probably at the exact wrong time. I believe 3% is likely.

Any rise in interest rates is bad for commodities, especially monetary-tied ones like gold. But if the rise is due to a stronger economy, that's actually a good thing. The big risk is what happens to emerging markets, where most of the demand growth comes from. A protectionist US would be a great negative. We have to see how Trump policy evolves. However, the people he has picked for his economic advisors are all pretty savvy, and undoubtedly understand what is at stake. So I bet they will tread lightly. In all, I'm still pretty bullish, especially on equities. The major risk here is that many commodities are not longer cheap, so you don't have that long term value working in your favor. But a lot of the companies I hold can do quite well with current prices.

I bought back the South 32 shares I sold last week.

Uranium

Uranium is close to breaking out. Here's a graph of U.TO, a Canadian fund that only holds uranium as assets:

So it filled a gap. Might have to chop around for awhile before it moves higher. I'm keeping my whole position.

Here's a graph of CCJ, the leading western uranium company:

I took some off this morning. Again, at important chart levels.

Was I wrong on platinum?

A friend took issue with yesterday's post about platinum being overvalued. Here's his argument:

There has been a major shift in light vehicle emissions catalysts over the last few years from platinum to palladium. Partly this was economic; Pa is cheaper than Pl. Also the emissions fiasco at Volkswagen and the changes in emission testing that it engendered is causing Europe to shift autos from diesel to gasoline. Diesel uses more Pl and vice versa.
But this has overshot. Pl is only about 25% more expensive than Pa now. Many of the new generation of catalysts have a Pa/Pl ratio of 7 : 1. But world supplies of Pa/Pl are only 1.2 : 1. So the arb is now the other way; it favors Pl.

I don't know what to make of this, although my friend is really smart investor. Does anyone reading this blog have any ideas? Comment below.

Position Changes Today

I got out of my platinum position. It actually looks quite good on the chart, and I wouldn't be surprised if it continues to move up. But that's not how I trade. I look for long run fundamental under or overvaluation. Here's a long run chart of platinum in constant 2016 dollars:

So platinum is still pretty expensive on this basis. Not for me.

I also added to POT and uranium (CCJ); these are cheap. The basis for the POT investment is the same as my DE one. Here's the SA article of Oct 12.
http://seekingalpha.com/article/4011644-like-john-deere

Back blogging

I haven't posted for quite awhile here. Instead I switched my posts to Seeking Alpha. That has allowed me to reach far more viewers than I can here. In fact, I have over 10,000 viewers there!
However, SA is set up for long heavily thought out posts, not quick short ones. So I'm going to put the short ones here, and reference SA when necessary.

So let's start. A few months ago I went long South 32, the Australian miner. It is my largest position, and it's been a real winner. Today I took off 16%. It has run up today on a Citi buy recommendation, and I love to fade short term moves like that. Still quite bullish longer term tho. I especially like the manganese market. The original SA article is at:
http://seekingalpha.com/article/3999964-south32-best-stock-mining-sector

I'm also putting on starter positions in Potash (POT) and platinum and uranium metals. The uranium rationale is at
http://seekingalpha.com/article/4027206-uranium-commodity

More later.

CNXC Today

The reason CNXC is up so much today was the earnings report and call. Not only were the numbers good, but management's commentary on the coal situation was quite optimistic. In fact, it pretty much followed the analysis I laid out in the previous post. They also will continue the distribution at the rate of .51 per share for the time being. There will be no distributions to the subordinated holders (these are mostly CNX Energy), although they hope to resume that.

So everything is on track. The next big item is political. Once the DNC convention is over, we will have to see which way Hillary goes. If she keeps veering left and depends on attacking Donald, it will be bad for coal. If she moves to a more centrist policy and a positive campaign, it means she is going to fight for Pennsylvania. That's good for coal, and might be a good sign for how the Clean Power Plan will be implemented if it survives court challenges.

Nickle Victory Lap

I took off my nickel metal position today, but kept my Norilsk equity. Apparently quite a few others had the same idea since it finished down over 3%.

This was my biggest position in a while, and some of my friends thought I was too early. This is a good example of strategic commodity investing. So let's go through it again.

The spark for the trade came from the 10-year graphs. Nickel was the most undervalued metal in the world I follow. On a closer look, I saw the cost curves put out by the sell side and some consultants. Most of them had about 75% of production losing money. That can't last forever, right. Ok the value is there, but what about the catalysts? Where will they come from? That is what the naysayers meant.

The key here is that if the value is there, and the cost of carry is small, you can wait it out. I truly did not know what was going to make nickel go up, but I knew something eventually would. As it turned out, it was something that neither I nor most others thought would happen. A populist was elected in the Philippines and cleaning up mining pollution is one of his populist ideas. If you had asked me (or probably and other investor) if this could happen, I would have probably said no. The Philippine government was in bed with the mining industry. But it did happen, and the upside was about 35%.

Nickel is still undervalued, but less so. There's a lot of nickel ore on the earth. The Chinese may have to pay a little more for it, but they will get it. Don't expect the Chinese NPI industry to shut down or even contract much. That's not the way China works. They don't shut stuff down; they funnel money into it one way or another. I noticed that they just made a deal with the miner in New Caledonia.

So I don't think the risk/reward of holding nickel and paying carry here is worth it. But Norilsk works the other way. It has a 4% dividend. That I can wait with.

The Coal Turnaround

I've taken positions long thermal coal companies. I've gone long CNXC and increased my positions in the defaulted debt of US coal companies. I'm also considering South32. I am not buying the commodity itself.

Times are very very bad for the US coal industry. I think readers of this blog will know why:
- The new technology of fracking has led to much lower natural gas costs. Natural gas competes directly with coal as an input to electricity generation.
- The Obama administration has encouraged this switch in the hope of reducing CO2 emissions, although the percent of world emissions saved is miniscule.
- The industry itself increased its leverage in the years prior to the decline, and has not had the resources to retrench.
- The collapse of LNG prices in Asia, has hurt the coal export market. Here's a graph from the Wall Street Journal of the Asian price.

The result of this is that all coal prices have fallen sharply. Here's a nearest futures continuation graph from barchart.com of Eastern US coal:

And here is a similar chart of coal CIF Rotterdam area. This is a good proxy for the world export market:

I believe the little upmoves in the right hand side of these charts are not fakeouts, but are the end of the long declines. Here's my argument:

The US coal industry extended its leverage in the years leading up to the bust. For example in 2008, at the height of the financial crisis, Peabody Energy had a liabilities to assets ratio of .67. As of the last financial statement before Chapter 11, it was .92. Some of this was operating losses, but a large part was a 42% increase in debt. The company simply did not have the financial flexibility to hunker down when times got very tough.

The situation was exacerbated by the failure of the industry to cut back production when the writing was on the wall. The combination of declining consumption and stable production has led to a very big increase in coal inventories. Here's a chart from the US EIA of coal consumption and stocks. Note that this ends in March 2016. I explain below why I think this has since turned around. Data is in 000 tons.

OK. That's the bad news background. Here's why I think things are turning around.

Recent data on coal railroad loadings has gotten better. This chart is from the American Association of Railroads:

You can see how coal loadings finally turned down in late 2015 and early 2016. Recently it has moved up, although not to earlier levels. This is consistent with a story of production cutbacks to a level which start to reduce inventories. However, railcar loadings and production are not likely to get back to earlier levels for a long time, if ever.

Natural gas prices have moved up. This directly impacts coal since a large number of powerplants have dual fuel capability and will chose whichever is cheaper. Here's a chart of August 2016 gas futures:

Weather has a surprising effect on coal demand (surprising to me anyway, since I thought coal was mostly used for baseline generation). In fact, analysts I have read put part of the blame for low coal consumption on the mild winter. So far Spring has been hot in much of the sunbelt. It hasn't been cool anywhere.

The result of this has been strengthening in coal prices. We saw this in the earlier charts, but it is important to know that the futures market is forecasting even higher prices for some coals, particularly eastern US.

      ICE CSX Coal
Aug 2016    40.20
Aug 2017    47.25

Since production costs may actually decline a little over the next year, this will be a big boost to cash flow.

So it looks to me like a typical commodity "cobweb" turnaround is happening right now. There is one big risk however. The Obama administration has proposed a new set of rules, the Clean Power Plan. This would sharply limit how much coal can be burned. They did this by regulatory action since they know that it could not be done legislatively. Much like the recent administrative action on immigration, this is being challenged in the courts. It is currently before a Federal Appeals Court. If this is upheld, it will be a huge long-term negative for the industry and a short term blow similar to Brexit was to the Pound. The ruling could come soon.

If you are willing to accept this risk, there are many assets you could buy. Probably the easiest is the ETF KOL. This is an ETF of coal miners, suppliers and transporters. However, it is not US focused. Several of its largest holdings are Chinese, and its largest holding, Teck Resources (TCK), does a lot more than coal.

If your tax situation is appropriate, the MLP CNXC should be considered. It was spun out from Consol Energy. David Einhorn, who owns much of Consol, wants it to concentrate on its gas E&P operations. Einhorn still owns much of CNXC, but I would expect him to sell on strength. Right now it's dividend rate is about 20%. However, only about 40% of that is covered by income, so I expect some reduction.

Finally, if you are willing to take on high risk and you want upside optionality, consider the bonds of the defaulted coal companies. For example, Peabody Energy bonds are going for about twelve cents on the dollar. If the coal market does righten itself, and if the Chapter 11 proceedings are not closed too quickly, these could be worth much more than that.

Back from a long hiatus...

The updated long-run strategy graphs are online.

Page 1

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These are a key part of my process. They are a great screening tool.

Effect of Brexit on Commodities

Lots of effects...

1. There is a rush to safe assets by a lot of wealthy people, and most commodities are not safe assets. Precious metals and a few others may be, but otherwise this is bearish. To my mind this is the major short-term effect, and it will happen immediately.

2. The USD will rise, also bearish. This is actually part of 1.

3. Most economists are taking down DM growth by a few notches. Bearish, but not too much.

4. These very big market moves tend to feed on themselves. Who knows which hedge fund or shadow bank is overexposed and will default? How big will this be? By its very nature, it's hard to know. But the market will keep this in mind, and you can be sure that there will be sharp reactions to every rumor.

5. The biggest wild card is the effects on EM, particularly China. The first order effects (export slowdown) aren't too bad. But the effects of 1 and 4 may well cause problems. We will see.

The other side is how the world's central banks react to this. The obvious course is for rates to be lower for longer, maybe much lower for much longer. To my mind the key is whether we approach negative rates in the US. I do not believe the US population will stand for negative rates, and because of this monetary policy will lose effectiveness. Could be fun.

Longer term, a big question is what happens to the EU. To my mind it is obvious that they have to open up the regulatory system to political control and to reduce German control. Otherwise more countries will follow the UK's example. But people in power want to stay in power, so who knows?

The upside scenario is that the EU gets reformed, and Britain gets a good exit. The latter is not too unrealistic. Not talked about much is that Britain has a large trade deficit with Europe. And the items they import (German cars and French wine) are politically powerful. So there will be a lot of pressure to keep the UK in the trade loop.

Why is everyone so bearish on the stock market?

First off, let me toot my own horn. The options trade I recommended last week worked out beautifully. SPY opened on Monday at 205.50. So if you wrote the expiring 205 straddle, you made about two points. If you just bought the market, you made about a point and a half.

Second, I want to point to an article by Richard Bernstein Still no one Wants to Play. It expresses my sentiments exactly. I know a lot of professional traders, and I real a lot more. These folks are  overwhelmingly frightened and mostly bearish. Why? I can think of three reasons.

First (as Bernstein says), many people look at history and think that the economic/market cycle is well advanced. What they miss here is that this cycle has played out very slowly, There are good reasons for this, and they have to do with the very slow return of confidence. The upshot is that we are nowhere near the end of the cycle. If I had a dime for every well known prognosticator who forecasted a recession (or claimed that we were in one now)....

Second, almost all the pros now trading suffered a near-death experience in 2008, and that has remained firmly in their reptilian brain. Like I said in a much earlier post: 2008 was the Gen X version of what inflation was to the boomers. It will keep them frightened till they retire or die or both. Just like the fear of inflation led many in my generation to miss the greatest bull market in bonds ever, they will miss out on risk assets.

Finally, and directly relevant to commodities, is China and the far east. No I don't mean that they are over producing and destroying our jobs. They are, but they are also oversaving. This savings has to go somewhere, and a lot of it is leaving China (with good reason). So there is a very large inflow into mostly low risk assets that is keeping the equilibrium rate of interest low. The forecasts of the Fed's "dotters" that we will get back to a 4% fed funds rate in this decade is crazy. More like 2.5% top. This may be bad for Wall Street (another reason they are so glum), but it's great for valuations.

OK, enough of the rant. Suffice it to say that at some point the rally in risk assets may well have legs. I'm guessing that time may be now. This is a risk / reward type of play. I'm long upside calls.

Tactical Option Trade

This is not my kind of trade, and it is definitely not strategic. However, there may be a decent risk/reward in the expiring SPY options. SPY as many of you know is the largest option market in the US, and has all sorts of feedback with actual stock prices. The options that expire this Friday have an abnormal open interest at the 205 strike.

Strike  OI
195      178K
200      149
205      393
210      201

Many of you have already noticed that, in the absence of new fundamentals, prices tend to go to the strike with heavy OI. There is good reason for this. As time to expiration goes to zero, the near-the-money options have very high gammas. For example, on expiration day if it's above the strike the delta is near one and near zero if it's below. So holders of these options tend to hedge as it moves around the strike. There is also an incentive for large option traders to pin it to the strike: they can trade on the Saturday following the last trading day on the Board, while retail cannot.

So the trade is to sell the 205 straddle. Obviously this is picking up pennies in front of the steamroller. But if you keep the size low and determine to do it every execution day, it does have a nice trade profile. I'm not doing it; it doesn't square with the name of this blog. But maybe you should?

What to do with Soybeans Here

The USDA gave us bean bulls a nice present on Tuesday with a big change in bean consumption /  ending stocks. The market responded as expected and then some. So what to do now?

My guess is that we will need some additional bullish info to keep the market moving up. Given the time of the year, that would probably have to be weather related. So far weather in the midwest has been quite good. The NOAA has a three month climatological forecast of near normal to slightly above precip and near normal temps . So my guess is that beans and corn both will at best tread water and more likely give back some of their gains until we get some real issues. But I don't see a huge downside. The ending stocks are  going to be tight enough that any actual crop problem will require demand rationing. So I took almost all off and am reestablishing on declines.

World Bank Commodity Data

I've graphed the commodity price data from the World Bank. Previously, I was using the IMF data. Many of the price series are similar. However, the WB does have some different ones, and they started in 1960 vs. the IMF's 1980. To account for this very long series, I used the annual data rather than monthly. The last point is the current price.

The graph are all deflated time series using the US PCE deflator and the $US value. I graphed them as time series rather than the 10-year returns of the IMF graphs. I'll get to that later.

There are 73 price series.

Here's the link for the first 25:

Here's the link for the next 25:

Here's the last bunch:

Norislk vs. Metal Prices

Norilsk is a relatively large stock position for me. Here's a graph of it versus the prices of the metals it mines. The metals average is 50% nickel, 25% copper and 25% palladium. This isn't exact, and platinum should figure into the mix, but it's close. It shows how the stock is a proxy for metals prices. That is fine with me.

Hey, What About this Rally?

I haven't been blogging much recently. I've been on a bike trip, and I didn't have much to say anyway. Since the last few posts, the commodity markets have continued rallying. Here's what I find interesting: I talk to / read about a lot of commodities traders and analysts, and virtually all of them hate this rally. Yesterday I read the latest JPM strategy take. It was pretty much the same: the rally is caused by:

1. Short covering from a severely depressed psychology, and
2. The debt-fueled electroshock the Chinese government is giving to its economy.

These are both true, but in my view they ignore the most important point: Many commodities had gotten to very cheap long-run levels. They were at levels which given time would lead to significant cuts in production or at least left no room for any production or consumption risks. Nickel (my largest position) is the former. Soybeans (my second largest) is the latter.

This is really key for value-biased strategists like me. At some points you don't have to anticipate a catalyst. If you can buy it cheaply enough, you can just stay with it, knowing that the catalyst will eventually come. This time it's the Chinese electroshock. Who knows what the next one will be?

What am I doing here? I did cut back on beans a bit, mostly by rotating some into corn and also selling some OTM calls. Keeping the nickel.

One of the pieces I posted here and on Seeking Alpha was my view that the bottom in commodities was basically in, and that I would be trading from the long side for the next few years. I got a fair bit of blowback on it from various traders (BTW, how do you guys get my phone number? I prefer you comment below.) The basic thrust of the criticism is that previous down cycles have taken many years to play out, and we are only partly into this one. I beg to differ. First off, the top in this cycle was in 2008 (using the IMF index as usual). So we are eight years into the down cycle. Second, there are shorter cycles within cycles that operate on the span we consider here, two to seven years.

I'm going to write a long piece on this for next week. In the meantime, look at this chart of inflation-adjusted copper prices going back to 1913 with 2016=100.0. See if you can spot the cycles I'm talking about.

Copper in 2016 Cents / lb.

Do Over on the Fertilizers

There's a saying among data analysts that most of the work is in getting the data in the right form. After that the analysis is usually easy. That was my problem, but I now have it solved. So here are the 10-year forward graphs for the fertilizers:

Urea seems fairly valued.

Potassium and phosphate do not graph well. The problem is that prices for these rose very sharply in 2008/9 and have only retraced part of the move up. Since the 10-year graph stops in 2006, the current price is off the charts. I suppose that means that there is more downside to come. I'm not getting involved. Here are the charts FWIW:

Retraction

I took down the post on the undervaluation of the three major fertilizers. I found a programming error. I'll get to it this weekend and republish the results.

Peabody Energy Files for Bankruptacy

So BTU filed for Chapter 11. What to do now? Well, the equity is just about zero, so my position is now effectively only long the subordinated bonds. These are still trading in the 5.5 - 6.5 range (nice). I'm going to cut the position back now. When I had the cap structure position on (long bonds, short stock) it was a hedged bet. Now it's just a lottery ticket on the sub bonds being worth something. That depends on how much time the Court and the senior creditors give them. Coal prices probably will recover later this year, but it may all be over by then.

This is a great trade for someone willing to go through all the documents to see what avenues are open to all the remaining participants. This takes time and an ability to fight boredom. That's not me.

Is The Commodities Rally for Real?

I wrote an article for Seeking Alpha on why I think the bottom of the commodity cycle has been made. Before I go into the substance of it,  remember that just being bullish doesn't make for a trade. You have to have a risk/reward setup that meets your objectives. I believe that commodities will not run back to 2014 levels quickly. Instead I expect an upward sloping trading range that will give numerous points to take intermediate profits. Along that line, I wrote Nov 2016 Soybean 12 calls against my long 10 call position. If the market dips, I'll add back.

Commodities are Cheap
Here is a graph that I used in the first post of this blog. It graphs a commodity index over time in both nominal terms and adjusted by the US consumer price index and the value of the US dollar. If you were reading the blog at that time you may remember that I use the IMF commodity index as a base and splice it back to 1947 with the US PPI for crude materials.

The commodity index on a deflated basis is actually getting close to the lows of the late '90s. Now it is well known that over time commodity prices tend to fall relative to other prices. (I know the "sustainability" guys don't want to believe this, but just look at the graph!) Nonetheless, the situation in the late 90s was truly extreme. We had a major crisis in emerging markets, the major commodity demand growth area. We also had a huge flow of funds from what was then called the old economy into the dotcom stuff. I thought that commodities were undervalued then, and we are very close to that now.

Oil Prices
Energy is the most important commodity group on the board. Not only is it the largest by dollar value, but it serves as an input to everything else. If you want to get physics class philosophical, you can say that energy is even more basic than food. And energy prices are dominated by oil. Readers of this blog know that I think that oil prices will slowly rise over the next few years (And I am painfully aware that I am still somewhat behind on a long Dec 2018 crude trade). This will boost the cost of production for everything else. BTW it is not true that declining natural gas prices will compensate for this. Worldwide, oil is much bigger than gas. In fact the increased use of gas is mostly displacing coal, so overall energy prices are not falling.

The Lags are Long but not that Long
The reason that the commodity "cobweb" price/volume pattern repeats itself is that there are long lags in both the production and consumption of commodities. Over the short run elasticity is very low; over the long run it's much higher. It takes only a year to turn around production of row crops and poultry. It takes two years for pork. Maybe three to five for cattle. Maybe five to ten for for mined metals. We are now about four and a half years into the downcycle. Most of the decline has been in the past two years. My feeling is that we should start seeing the both supply and demand responses very soon. These are clearly happening in energy, and somewhat happening in metals.

The Last few Years have been Lucky
This blog has poo-pooed the climate change and sustainability scaremongers many times. Simply put, humans will find a way to cope and thrive. We are not going to run out of anything important to improving the quality of life on earth. Nonetheless, the agricultural situation of the last three years has been exceptional. Here's a graph of total world grain yield. Note how exceptional the last three years have been.

The long term trend is up, true. But the markets have gotten used to bumper crops. Consumers are complacent, and the fast money is short. I believe the ags in particular are ripe for a major rip.

Refer to a post of about a month ago in which I gave a table of years in which the ENSO index declined. This is one of those years.

Emerging Market Economies will not Stay Down Forever
Last year I wrote a sour post on the disaster in EM. In retrospect I was probably too cynical. It's true that most EMs wasted a great chance to diversify and reform their economies. But that's a cyclical problem. Longer term, most of them are still growing, and will likely resume higher growth when the financial flows revert. Hopefully some of them have learned their lesson, and will use future inflows for infrastructure rather than current consumption or corruption. Infrastructure is heavily commodity intensive.

Error

A reader called me to say I made a mistake in Friday's post. I had said that the volatilities on BTU were elevated because there weren't enough shares to short. So I wrote calls on BTU against my long bond position.

This was wrong. Only the puts have elevated volatility. The call volatility, at about 230%, is actually right in line with the 25-day historical vol. If you can find shares to short, there's a nice conversion arbitrage.

Even with this, I still like the overall position. If the bonds are worth almost nothing, the stock should be worth absolutely nothing.

Peabody Energy Follow-Up

The lottery ticket on BTU has worked pretty quickly. Prices are all over the place on this near-
Chapter 11 bond, but I think the offer has gone up to about 7 1/2. I wrote some calls on BTU equity against the position. The logic in this trade is very strong; if the bonds are worth almost nothing, the stock should be worth absolutely nothing. However, there are only a limited number of shares available to short. When this happens, people resort to buying options, and vols go up. The vol of the calls is about 230%; the puts about 300%!

Additionally, rumor has it that there is a big fund with an existing long bond/short equity trade. He is already sucking wind, and may be forced to blow out. We will see.

A Lottery Ticket on Coal - not by Shirley Jackson

I used to buy a lot of what traders call lottery tickets: trades with a low probability of success but extremely high potential payoffs. The best commodity trade I ever made was buying long dated $100 crude calls in 2008. It was about a 25 bagger. Thats what can happen with a lottery ticket.

I haven't found many of these recently, but I did one a few days ago. I bought the Peabody Coal (BTU) 6% coupon bond due in 2018 for 5 cents on the dollar. I went through a retail broker, since I trade so few bonds. If you have access to the wholesale market, I think you can get it even cheaper.

BTU looks like a clear bankruptcy situation. Moreover there is a lot of debt ahead of my bond on the seniority ladder. My argument is that the situation is so bad that the lenders may work with the company to extend and pretend. Even buying some time might make this trade work.

I don't really follow coal to closely, but it's hard to see much help from the commodity front. Natgas is still a better alternative for almost all electricity generation, and it keeps getting cheaper all the time. A hot summer might change that, if el Nino doesn't peter out. Longer term, I see slowly rising overall energy prices, but it's too long term to bail out BTU. So in all likelihood, I will lose 100% on the trade. That's what usually happens with lottery tickets.

Nickel

I have been hinting about going long nickel in several posts. I've now actually done it.

Undervaluation The ten-year graphs on this site forecast that nickel will double in real terms in ten years. That's a pretty good starting point. Nickel is the most undervalued metal I follow. BTW, there is a good reason for this. Back a few years ago, when China was frantically buying every metal in sight, Indonesia enacted an embargo on nickel ore exports. Their objective was to force local processing of the ore. Because many believed that Indonesia could not build the necessary processing facilities quickly enough, this created a panic in the market. Nickel went to absurdly high prices. This led to more production, and the typical commodity "cobweb" ensued. I think we are now at the opposite end of the cycle.

Nickel now sells for about $4 per lb. The graph below gives the cost curve. Most production is now losing money. BTW, the negative costs for Norislk (NILSY) is not an error. Norilsk produces so much coproduct metals that it more than covers their production costs. More on that later.

The fact that these miners are losing money does not mean they will shut down production immediately. Current prices may well cover their cash production costs. Also, some production is going to be subsidised. For example, France said last month that it would subsidise the nickel industry in New Caledonia, which had previously been expected to reduce production. Another issue is that the value of the Indonesian Rupiah has fallen by about half. This reduces the cost curve.

Nonetheless, the main thrust of this blog is to think strategically. All the above risks are short to intermediate term. In due time production will be shut down, and prices will rise. The remaining producers wind up doing very well. This is a three year trade.

So how to play this. Normally for longer term trades, I like to invest in the equity or debt of the lowest cost tradable producer. That would be Norilsk. For more on Norilsk's fundamentals, see the excellent Seeking Alpha article

http://seekingalpha.com/article/3940446-norilsk-nickel-worlds-largest-nickel-palladium-producer-significantly-undervalued

My numbers are slightly different from his, but only marginally. Also note that Norilsk also produces other metals, particularly copper and palladium. These revenues combined are actually larger than from nickel. I am a little bullish on palladium and a little bearish on copper.

In this case, however, I also bought LME nickel. The total return from this I estimate at 10% - 15% per year unlevered (I am unlevered). It's also easily tradable. More important, it does not have the Russian country risk. Now I personally feel that the Russian situation is not as bad as the market thinks, and its market is undervalued. But I could easily be wrong here. So keep that in mind if you follow me into Norilsk.

Is it Time to buy New Crop Calls in the Ags? Part 2

In the last post I gave the argument for the possible upside in corn and soybeans. Let's talk about tactics.

Which to concentrate on? Nov beans are 2.36 times Dec corn. That's within the average range. However other things currently make corn more attractive to farmers. Input prices, particularly fertilizer, are way down, and corn uses a lot more of these. The USDA is forecasting a two million acreage increase in corn and for soybean acres to be down marginally (some analysts disagree with that). So I tend to favor beans. However, corn is usually more susceptible to poor weather, so you can really take your pick.

The option volatilities really do make the trade feasible. Nov bean ATM vols are running at about 15% versus the 17% range for most of the past year. OTM vols are of course higher (10 calls are 17.5%) but still quite cheap. Very far OTM calls are even higher. I wouldn't do a spread trade tho. If and when a crop problem occurs, all vols and trading costs will go up. This will make it costly to take profits.

If you want to do corn, Dec ATM calls are about 21%. That's within the range of the past six months.

I am buying a half position of ZSX100C at the current market and another half at 10. Beans are under pressure because of the favorable conditions in South America. This is providing a good entry point.

Is it Time to buy New Crop Calls in the Ags?

Last week an old friend called me with the idea of positioning long for the US growing season. Here are my thoughts. This is a pure risk/reward type of trade (i.e. with less than a 50% probability of success, but with a big payout if it works.).

Corn, wheat and the bean complex are all down a lot. This is fundamentally based; the world has had good to great crops for two years. Stocks levels are high. The speculative money has left commodities, and is actually somewhat short. It's hard to see US acreage down much, so we may get another bin buster this fall.

However....
We may not. We are currently in a extremely high ENSO period. The US NOAA is forecasting that these el Nino conditions will dissipate this summer and may well bring on a la Nina event in the fall. Here is a list of years since 1950 in which the ENSO has fallen by at least 1.0 from FEBMAR to AUGSEP, along with corn yields relative to trend:

	ENSO Change	Corn Yield
1954	-1.346	-10.6%
1958	-1.152	-0.9%
1964	-1.012	-10.8%
1970	-1.473	-12.3%
1973	-2.558	4.6%
1978	-1.35	7.2%
1983	-2.543	-22.9%
1988	-1.949	-24.7%
1995	-1.296	-9.3%
1998	-3.315	1.8%
2010	-3.339	-0.7%

So the average of the 11 years is  (7)%. The average for soybeans since 1960 is (4)%. Probably more important for this trade, the crop was bad over half the time.

So this smells like a pretty decent option position to me. Let's look at the specifics of the options market.

MORE TO COME

How are the Blog Positions Doing

I started this blog in October of 2015. About a month later, I started making actual recommendations. In all cases, I actually put my own money in these recommendations. Here's a little more detail about how I invest.

- I only look at notional position size. Leverage does not appeal to me. This means that I normally trade smaller commodity positions than most people. I do the same on the short side.
- All my equity trades are alpha-based. Basically I look at the trade vs. the ETF SPY. I do have another account in which I have some broad-based mutual funds, but that is not the point of this blog. BTW, I have held one mutual fund for over 30 years!

So let's evaluate the trades I have on here:

Long Southern Peru Copper, short copper metal. Put on Nov 13, 2015. This has done decently:
SCCO   -3.5%
SPY      -7.6%
Copper -1.2%  >> net gain of 5%

Long Dean Foods. Put on Dec 12, 2015. This has been my big winner:
DF         +19.9%
SPY       -5.1%  >> net gain of 25% wahoo!

Long Alcoa Preferred. Put on Oct 26, 2015:
AApreferred -5.2% (incl pref div)
SPY              -6.3%  >> net gain of 1%

Long Dec 2018 Crude (WTI)
I have traded this position quite a bit, but the original was put on on Dec 7, 2015 at $53. So it has a loss of -12.5%.

I also have on a cocoa options position. This is rather complicated, and I'm not going into all the details. It's basically short gamma, neutral delta.

I hope to have most of these on for much longer. I also plan to buy Nickel either using the metal or Norilsk. More in the next post.

Round Trip for Emerging Markets

With all the sturm and drang about emerging markets these days, you would think they might be at all time lows. You would be close to being right. The largest emerging market ETF (EEM) started trading in 2003. Not coincidentally, that was the beginning of a major bull for EM. It's all been reversed:

So we had a classic bubble. A major asset class almost tripled on a relative basis and then did a round trip.

Are we at value? It's always hard to catch a falling knife, and my sense is there is no risk/reward in this trade. Remember, we haven't had much in the way of actual defaults in EM yet (or in DM for that matter). So far it's just been the slowing of growth and possible financial trouble. Wait till some of these guys actually default (I mean you Venezuela et. al.).

Just for fun I wrote a stock options valuation calculator using the Shiny package in the R language. I really just wanted to see how Shiny worked, but the result turned out to be quite useful. Check it out here.
Note: Shiny isn't the most compact code, so the page will take a few seconds to load, but once it loads it runs great. Email me or comment below if you have any thoughts or ideas for improvements.

Cocoa

The cocoa market has a soft spot in my heart. It was the first commodity I ever concentrated on, and I have continued to follow it all these years. My first real job in commodities was as cocoa analyst for MARS Inc., the privately help candy company. BTW, MARS was a truly excellent company and probably still is. The big reason for this was (is?) guidance from a really smart family that takes a multi-generational outlook. I doubt if they will ever IPO, but if they do, I'm in.

Anyway, there are a few structural issues in cocoa that make it somewhat unique:

- Cocoa is a tree and it takes 6 -8 years from the time prices provide incentive for an increase in plantings until you start getting substantial production from the new trees. Say one to two years for the plantings to occur and another five or so for the trees to mature. Once the tree has matured cash costs for harvesting are very low. So cocoa can and does have multi-year cycles, like oil.

- Cocoa fundamentals are exquisitely researched by the major participants in the industry. The large candy companies have staffs continuously examining the trees in the major growing regions. They see even minor effects of weather or disease quickly. Some of the large trade houses also do this research, but on a smaller scale.

- Cocoa speculators are generally technical. This makes sense; it's more difficult and costly to get fundamental info than in say, corn or soybeans. So technicals are all they have. This mostly means they follow trends.

Let's start with the long run position of cocoa using the ten-years graphs. Click here for an explanation.

Interestingly, cocoa has the highest r-squared on this graph of all the commodities in my universe, over 90%! I've backtested it, and you can actually do pretty well in cocoa using this alone. The ten year outlook is still bearish. Let's go a little deeper.

I'm not going to spend any time on current year's supply/demand because as I said, the major players know far more about that than I ever could. So I'll concentrate on the longer term and then discuss tactics. This "time arbitrage" is where Commodity Strategists have their edge.

The bullish case in cocoa can be summed up like this: Demand in emerging markets will increase as their populations adopt a middle-class western diet. Meanwhile cocoa production in the traditional area of west Africa will stagnate as old farmers retire, and their sons move to the cities.

I don't find this argument persuasive. First, as I said in my post of 10/21/15, I don't believe that most EM residents will ever move to a western diet. This is even more true for cocoa since chocolate is a cold weather food. Even in the US or EU consumption strongly dips in the summer. Second, the current productivity of cocoa trees is extremely low. Most African cocoa is grown by "smallholders" who cannot or will not adapt current farming techniques. Yields per acre on commercial plantations are much higher. Also, the African farms mostly use older cocoa varieties that yield much less than newer ones (although they do have better taste). As an example of what can be done with yields on a modern plantation, see United Cocoa.

My view is that cocoa is still historically overpriced, and that there is no "this time is different" case to be made. So I want to be short. Now let's look at tactics.

As noted in the beginning, cocoa speculators are largely trend followers. I once backtested a simple strategy using the CFTC's Commitments of Traders report. The strategy simply waited until the managed money went long (short) by a certain amount. The system did the opposite. It was a net positive strategy, although the drawdowns were too large to actually trade. Here's a graph of the COT over time from barchart.com:

My backtest found that the key statistic is the position of Large Speculators (CTAs). That is the green line in the middle panel. You can see that these specs got maximum long slightly after the peak in prices in early December. You can also see that they are now largely washed out, down to about the lowest long level they have been on the chart. On this basis, now would not be a good time to initiate a short position in cocoa. In fact, now is probably a good time to cover shorts.

So is this a good time to actually go long? I wouldn't. As a Commodity Strategist, I am only playing this from the short side. Nonetheless, the combination of the spec washout and the appearance of heavy manufacture buying at this price back in early 2015, is tantalizing. If you want to do it, you could probably buy here with a 2,700 stop.

The 10-Year Forward Graphs have been updated. You can view them at the Ten Year Forward Graphs link on the right side of this page.

There aren't too many surprises. Most commodities have fallen into a general value level, and are not clear buys or shorts. A few of the industrial commodities (some metals, iron ore, uranium) still have further to fall. And there are a limited number that do seem to warrant long positions. I'll talk about a few of the last category in this post.

Crude Oil has finally become officially cheap. It has happened quite quickly, in about a month. Using the current spot prices for Brent and WTI, I expect them to double in the next ten years. But of course you cannot buy the current spot and hold it. Well actually you can, but storage and other costs will more than eat up your gains. If you want to do this trade, it's best to buy the forward futures position. Guess what? The last currently traded future, Dec 2022, is going for $48.79. So if I am right, and the price goes up to $60, you make 23%, or about 2% per year. Not good enough. So no trade there.

Shrimp is expected to go up by about 80%. You can invest in this via non-US aquacultural companies. However I would caution against it. This is one of those commodities where there really has been an "this time is different" event. Over most of the history of my price series, shrimp was a wild-caught product. I remember as a boy what an expensive delicacy a shrimp cocktail was! Now most shrimp is farm-raised, and costs are much lower. Different world. Of course you might get an outbreak of some shrimp disease that comes from the unnaturally close confinement of shrimp in the farms, but I wouldn't want to bet on it.

Wheat and Barley are somewhat undervalued, but they have the same contango structure that oil has. So same non-trade.

Aluminum and Nickel are expected to gain by 60% and 80% respectively. I think nickel is a buy. The best bet is to buy cash metal and pay the storage. If you don't want to open a commodity account there is a somewhat thinly traded ETN, symbol JJN, that will do it.

Both hardwood and softwood are cheap. These can be bought via timber companies or REITs. I would worry that electronic communication has given us a "this time is different" situation in softwood. Paper production has already fallen by a lot, and may have a lot more to go. Also, given the world's demographics, I don't see homebuilding going back to pre-recession levels. Hardwood may be a buy, since many old growth forests in S. America and tropical Asia are being cleared. I cannot think of a clean way to play this. If any of you can, let me know.

Cotton is both cheap and has a flat futures curve going out three years. The problem here is that if the supply/demand balance tightens, the years after 2018 may go into the same kind of contango that Wheat or crude has. That would eat up profits. Nonetheless, this is an interesting situation, and I will look into it further.

Equities and the Emerging Market Curse

OK, I'm not an equity analyst, but as a non-professional (unprofessional?) investment blogger, I am entitled to my opinion. So here it is:

The most important factor in equity prices is the future growth of corporate earnings. Graph the long term S&P against corporate earnings and you get parallel lines (on a log scale). So, where is future earnings growth going to come from? Not from the developed world. The demographics of these areas, combined with their debt levels, make for a long period of slow growth in the US and very slow or zero growth in EC and Japan.

That leaves the emerging markets, BRICs and such. For most of the century, it looked like the ball had been passed to them. But it hasn't been organic total factor productivity growth for many years. Rather their growth was the result of capital inflows and movement of non-market peasants into the market economy. I remember talking with a portfolio manager of a major asset management company about four years ago. His working maxim, "you've got to put your money where the growth is. That's China." BTW, I also seem to remember a series of pieces from Goldman a few years ago that divided the world into stable and growth markets. The "growth" was EM.

What did the BRICs do with the inflows? Well a lot of it was stolen. Brazil is the poster child of this only because Brazil has a somewhat honest judiciary. Many of the countries that don't make the corruption news were as bad or worse. Much of the rest went to uneconomic or vanity projects (the skyscraper curse). And a lot went into an overcapacity of heavy industry. That's why we are where we are in the commodity space and the traditional manufacturing space.

But that's over now. The inflows have almost dried up; I'll bet that net of corruption they are about zero. Meanwhile:
- The demographics of EM are moving towards EC levels.
- There's no more developed market export market growth for the stuff they are able to produce (commodities and manufacturing).

So where's their growth going to come from? Ideally they should transition from a commodity/manufacturing model to a consumer goods/services model. The problem is that this is hard to do. With manufacturing, you only have to import the technology from in the West and add a few million impoverished peasants. Services are more culture-dependent. You have to develop the human capital within the context of your society. This is not a quick job. It will happen, but only slowly, and it may not need much help from the S&P 500.

What I'm trying to say is that multinational corporate profits are likely to grow only slowly over the long term, maybe low single digits. With the P/E of the market at about average, this means overvaluation. And this is why any news from China has such a disproportionate effect on the market. It's the only source of growth left!

I've been almost out of the stock market for about a year now. Still hold a few special situations, but not overall beta. Recently I have started nibbling on high yield and senior loans via discounted closed end funds. I suspect that will continue for most of 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
Nickel	+60 %	+80 %
Aluminum	+20 %	+20 %
Zinc	- 4 %	+5 %
Copper	-30 %	-21 %
Lead	-42 %	-26 %
Tin	-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.