Risk Over Reward

Thinking About Investing

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Commodity Markets
by Alpha and Vega, an Investor and a Trader November 9th, 2010 In this issue: 1) The Basics 2) The Players 3) Speculation and Manipulation 4) How to be Eddie Murphy from "Trading Places" For a PDF version of this newsletter, please look here: Dear Friends, Colleagues, and Investors, In this edition of "Risk over Reward" I'll provide a primer on how commodity markets function and delve into the effects of speculation and manipulation. 1) The Basics Commodities are fungible, physical products like gold, crude oil, sugar, and soybeans. Commodities can be traded in a few different forms. One common contract is the deliverable future. A deliverable future trades on an exchange with a specific expiration date. Let's say I buy 1 crude oil future for $80 with an expiration date of January 23rd 2011. On that date I will be obligated to take physical delivery of crude oil at a specific location at a price of $80. The contract specifies the quality of the product I will receive and the logistics of accepting the product. A deliverable future may change hands thousands of times on an exchange before expiration; most of the traders having no intention of dealing with the physical commodity. Non-deliverable futures (also known as "cash settled futures") are similar, except that no product is ever delivered. Instead, the contract expires at a specific date and the holder receives the difference between the contract price and the price of the product. For example, if I paid $80 for the crude oil contract, and oil is now trading at $85, I will receive $5 from the seller of the contract.

Another common type of commodity contract is the "forward." Forwards differ from futures in that they do not trade on an exchange. Instead, they are between two parties. This allows the contract to be more customizable but exposes both buyer and seller to counterparty risk. For any given commodity, there are a series of futures with various expiration dates. For example, crude oil futures exist for every month from now through at least 2018. The contracts with nearer expiration tend to trade much more frequently. All of these futures taken together are called "the curve", because they tend to form a relatively smooth shape. Some commodities typically form an upward sloping curve known as contango. For example, a gold future with a later expiration date will almost always cost more than a nearer date. This is because the future with later expiration includes the price of storing and insuring the gold, as well as the cost of capital. If it costs me $1 a year to store an ounce of gold and another $1 to insure it, I would rather own the right to buy gold in a year for $1000 than buy it today for $999.50. Below is a graph of the gold curve.

Some commodities frequently form a downward sloping curve known as backwardation. This generally occurs in commodities that are costly or difficult to store for lengthy periods. It can be caused by a short-term lack of supply, but may persist if producers hedge more than consumers. I'll discuss this at greater length in the next section. Below is a graph of the crude oil curve in 2007.

2) The Players Natural Sellers - The natural seller of a commodity is the producer. For example, a coffee grower must sell his coffee. He could eschew the commodity market and wait to sell his coffee until it is harvested, but that would be risky. In this scenario, he will invest in equipment and fertilize without knowing what price he will eventually receive for his product. Instead, he can enter into a contract to deliver his corn in 3 years at a specified price. He will know today exactly what price he will receive in 3 years, so he can make smarter business decisions about how much to invest in production. He can also reduce his earnings volatility from seasonal weather fluctuations. The downside is that the farmer will not benefit from an unexpected increase in the price of coffee. Natural Buyers - The natural buyer of a commodity is the consumer. For example, Starbucks is a massive consumer of raw coffee. Over time they can pass some price increases on to their customers, but their profit margins are still hurt by sudden increases in the price of coffee beans. To reduce their risk, they buy coffee in the forward market. In some commodities, the natural sellers are more active than the natural buyers. This causes the commodity curve to slope downward in a condition known as normal backwardation. The future price of the commodity keeps falling until market makers or speculators believe they have a high enough expectation of profit to buy the futures. Market Makers - The market maker effectively serves as a middleman between the natural buyers and sellers. The coffee farmer may wish to enter a contract to sell his harvest in May, while Starbucks may wish to enter a contract to buy coffee in July. The market maker will take the other side of each trade

and bear the risk that the price of coffee moves significantly between May and July. Another service the market maker provides is in preventing temporary supply and demand imbalances. For example, let's say the farmer wishes to sell his coffee today and Starbucks will be buying tomorrow. The market maker will buy from the farmer today and sell to Starbucks tomorrow. In exchange for the risk and the time it takes to facilitate these exchanges, the market maker can expect to earn a profit by slightly underpaying the farmer and overcharging Starbucks. Speculators - Traders at hedge funds, large banks, and commodity companies speculate on future price moves. These speculators generally have no interest in the physical commodity itself, they are simply betting on what the natural buyers and sellers will do. For example, a speculator may sell coffee futures as a bet that the weather will be conducive to a healthy coffee crop. If the weather is good, farmers will produce more coffee and have more to sell, so the price will drop. The speculator will be able to buy back his futures later at a lower price and earn a profit. 3) Speculation and Manipulation Speculation in commodities takes many forms. The price of commodities is ultimately driven by supply and demand, so any factor that influences supply or demand is a potential source for speculation. In the previous section, I mentioned that speculators bet on how weather will impact the supply of an agricultural crop. Another common weather bet is to speculate on the extent to which hurricane activity in the gulf of mexico will decrease crude oil production. Speculators also make longer term bets on both demand and supply. For example, a speculator may believe that global GDP growth will surpass expectations leading to higher than expected demand for commodities. Another speculator may wager that aggressive investment in production will increase supply and depress prices. These speculators serve a valuable function of researching commodity fundamentals and sending price signals to the market. For example, crude oil supply and demand may be balanced at a price of $80 today. However, speculators may believe that in 5 years, demand will far surpass supply causing a severe shortage. The shortage may send prices flying up to $300 and reduce global GDP. The speculators bid up crude prices to $120. The price increases is noticed by oil executives, who respond by investing in new production. In 5 years, this increase in production could result in a crude price of $150 and mitigate the damage to global growth. Commodities are generally believed to be an inflation hedge. Theoretically, they should rise at the same rate as inflation and produce a 0% real return. However, since many investors become attracted to commodities when they

fear inflation, commodities tend to surge as inflation rises. A speculator may buy commodities on the expectation that inflation fears will soon cause other market participants to buy commodities. In the last year, gold surged 30% as investors desired a hedge against the effects of the US Federal Reserve tripling the money supply. Other speculators try to profit directly from the trades of others. For example, a speculator may notice a pattern that at the end of every month, a corn farmer sells futures, resulting in a temporary decrease in the price of corn. The speculator will sell futures an hour before he expects the corn farmer to sell. An hour later, the corn farmer will still sell futures, be he will receive a lower price. The speculator will buy back his futures for a profit. The speculator's profit comes directly at the cost of the farmer. In general, studies suggest that speculation reduce the volatility of commodities by reducing temporary supply and demand imbalances. However, a growing number of speculators are "momentum traders" who increase volatility. Commodity speculation is generally short-term and performed by specialists. However, in 2007 and 2008, a large amount of new money began chasing commodities. Fund Managers and Mom and Pop retail traders looked at charts of commodities over the previous 5 years and decided they wanted to participate in the commodity rally. They bought commodity ETFs, which in turn bought commodity futures. This price insensitive buying pushed all commodity prices higher and caused a bubble. Crude oil was pushed up from a fair value of around $75 to $145. Like all bubbles, the commodity bubble soon burst and sent crude oil below $40. Commodity markets are much less regulated than stock markets. There is no clear definition of "insider trading" and very few traders have ever been prosecuted for manipulation. "Manipulation" of some kind is a daily occurrence in the commodity markets. A minor example is of a trader pushing the market price of a commodity a few pennies to trigger stop market orders. A much more serious form of manipulation is cornering a market. In 1979, the Hunt brothers bought up 1/3 of all the world's silver, mostly on credit. By controlling such a large percentage of supply, they were able to control the market price of silver and drive it artificially higher. In 1980, the COMEX created a new rule that limited the purchase of commodities on credit, and effectively forced the Hunt brothers to sell a portion of their silver. This triggered a 50% price collapse over four days. A common form of manipulation is forcing out the "weak hand." A trader puts on a position against a known counterparty. The trader estimates that if he pushes the position far enough against his counterparty, the counterparty will give up and close the position, pushing the bet further in favor of the trader. For

example, let's say you bet that corn prices in 2013 will rise and I bet they will fall. If you control several billion dollars and I only control a hundred million, you can keep bidding up corn prices far longer than I can sell them. Eventually my loss will be so great that I will be forced to buy back my futures and drive prices up even higher. Whether you are right or wrong about corn prices in 2013 is irrelevant - you will earn a profit by forcing me out of my position. 4. How to be Eddie Murphy from Trading Places In the movie "Trading Places", Randolph and Mortimer Duke try to corner the market for orange juice concentrate. They bribe a government official to get an early look at a critical crop report. Billie Valentine (played by Eddie Murphy) and Louis Winthorpe (Dan Akroyd) foil their plans by stealing the crop report and passing on a fake report to the Duke brothers. Even in the lightly regulated commodity markets, stealing a government crop report and using it to manipulate prices is illegal. So, unfortunately we won't be getting rich following Eddie's lead any time soon. The closest we can come is trying to identify situations where a speculator is overexposed. The Duke brothers committed their fortunes to a leveraged position; when the futures began moving against them, they were forced to sell and this dramatically increased the volatility, and potential profit for a savvy trader. When Brian Hunter of Amaranth made an oversized bet on Natural Gas futures, another trader was ready to sweep in for the kill. John Arnold of Centaurus let Hunter push the market far from equilibrium and then swept in to take the opposite position. Arnold profited from Hunter's bust. Your speculating trader, Vega
Risk over Reward: A conversation about intelligent investing we discuss the nature of risk and uncertainty, macroeconomics, security valuation, and how to think about markets and invest profitably - http://www.riskoverreward.com/ Read our online posts at: http://www.riskoverreward.com/ Subscribe to the newsletter at: http://blogspot.us1.list-manage.com/subscribe? u=8568d749127b61697bffe2b17&id=40b55d58d8