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.