Commodities Roundup: A Bull in a Pack of Bears
October 30, 2008
It’s more than three months old now, this bear market we’re in. While some may consider May to be the beginning of the stock market’s bearish retreat, Commodities were still humming bullishly along until their about-face in mid-July. With the same bearish macroeconomic forces weighing on both, stocks and commodities have moved uncharacteristically together – right down the kitchen sink.
If you have been selling calls over the last two months as we have been recommending, chances are that your portfolio is reaping the benefits about now. The question is, when does low become low enough? Is it time to start looking for bottom picking opportunities? Is it time to start selling far out of the money puts as many markets now appear “cheap?”
And we at Liberty Trading believe the answer is, no, it isn’t. At least not in most commodities.
While equities and commodities are falling together, they are doing so for different reasons. Equities have fallen from a variety of factors, not the least of which is investor fear. Commodities have declined from expectations of lower global demand as a result of slowing world economies. While futures do tend to forward price markets (they are now anticipating a recession), it is our opinion that prices will continue to have a hard time strengthening as long as global demand remains weak. Decreased demand generally results in building inventories. These will take some time to use up, even after we begin to recover from recession.
This is not to say that markets can’t rally. They certainly can, especially from their curent oversold levels. It is our opinion, however, that falling demand and building inventories across several sectors will keep major long term trend reversals in check, at least in most commodities. This should continue to set the stage for additional call sales on rallies in select markets (see our past articles on selling calls in Euro, Silver, Unleaded and Natural Gas at www.OptionSellers.com )
For the bottom picker in all of us, however, there are a handful of markets that just might have the right fundamentals to overcome macroeconomic pressures and at least hold their own as far as prices go. In a bull market, the commodities with the least bullish fundamentals will rally slower, often deemed “weak sisters” by traders investing in the complex as a whole. Bears looking to short a rally will often seek out a weak sister market as their first candidate as these markets tend to fall first and fastest when the trend reverses.
Consequently, for traders looking to sell puts to take advantage of distant strikes in a bear market, one would seek out a commodity with the most bullish (or least bearish) fundamentals. Perhaps we could call such a market a “strong sister.”
Regardless of what you name it, the Coffee market may be fitting the bill for such a commodity. Coffee prices have trended steadily downward along with the rest of the commodity complex over the last 12 weeks. However, prices have receded less and in more orderly fashion than that of the complex as a whole. Consider that the Reuters CRB complex (an index of commodities as an asset class) fell a whopping 45% from the highs in mid-Juy through this week’s lows. Coffee prices, however, have receded only 31%.
There are several reasons for this. Coffee is a fairly liquid contract at the ICE but it does not enjoy the gargantuan open interest of its commodity brethren such as gold or crude oil. This means there is less institutional money in coffee and thus, the market is not as subject to hedge fund liquidation as are some of it’s higher profile counterparts.
However, the main reason for coffee’s relative resilience is it’s base supply/demand fundamentals.
The market has spent the last several months digesting 2008’s sizable crops from both Brazil and Vietnam. Yet as the 2009 Brazilian crop has already “flowered” (the blooming process when beans are created), the market will soon begin to focus on the upcoming yields. This is critical to the price of coffee at the Intercontinental Commodity Exchange (ICE) because Brazil is the world’s largest producer and exporter of coffee and grows more than three times as much coffee as Vietnam. Brazilian production takes on even more weight for US market traders when one considers that Vietnam primarily produces the Robusta variety of Coffee (traded in London) whereas the majority of Brazil’s production is that of the Arabica variety traded in New York on the ICE.
Brazil experiences an every other year “on/off” cycle in coffee production where higher production years are usually followed by lower production years. This is a natural cycle of coffee trees. 2008 was an “on” year for coffee production. The USDA estimates that Brazil produced over 51 million (60 kg) bags of coffee this year. This is expected to result in a 6 to 7 million bag world production surplus in 2008 and has been the fundamental justification for coffee bears throughout the year.
The year 2009, however, will be an “off” year for Brazilian coffee growers. While it is too early in the growing cycle to estimate next year’s crop size, 2007’s “off year” production yielded just under 40 million bags while 2005’s crop netted 37 million bags with roughly 75% consisting of the Arabica variety. If similar numbers hold true for 2009, we could see a greater than 20% decline in year over year Brazilian coffee production. With global demand growth expected to increase by 2% in 2009, many private forecasts are now projecting a world coffee supply deficit next year by as much as 10 million bags.
There is another key fundamental at work as well. Working capital for coffee exporters and coops has been restricted as a result of the credit crunch. This could lead to cash flow and production problems in the coming months for producers in Central and South America including growers of “premium” beans such as Columbia and Costa Rica. Such challenges could further hamper 2009 global yields.
Our projection is not for a sweeping rally in coffee prices. Rather, given the current fundamentals, we feel prices will decline more slowly should commodities continue to trend lower. However, should prices in the overall complex correct to the upside, coffee should outperform.
Given the current volatility in prices, this should set the market up well for a strangle (selling puts and calls in the same market). Calls can be sold at strikes of 1.70 or higher on the call side and .90 or lower on the put side. We favor the Spring contract months.
A strangle of this width gives the trade a sizable profit zone and establishes strikes beyond the trading range of coffee prices for the last 36 months.
Today’s announcement by the US Federal Reserve to lower interest rates should give commodities an impetus to the upside over the short term. However, we feel price strength across the complex will be short lived and could provide an entry point for the trade described above. We will be working closely with clients in positioning.
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Figure 1: March 09 Coffee [ICE]
Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.
James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
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