Despite numerous calls from the media that the commodities boom was set to fizzle, it seems that investment flow toward commodities continues at a breakneck pace. Those that steep themselves in classical, backward-looking technical analysis can certainly arrive at the view that gold, silver, crude oil, corn and wheat are overbought and set to top. However, in a broader, forward-looking view, it certainly seems like a number of forces continue to suggest that commodity prices are capable of rising further and longer than most would expect. In addition to classical inflationary pressures pushing up commodity prices, it has become clear that rising prices don't instantly result in rising supplies. Furthermore, it is also clear that the markets have drastically understated physical demand and in most cases haven't even recognized rapidly rising investment demand in commodities. In short, we have inflationary prospects, ongoing global growth, rising investment demand in commodities and in many cases the rising implied investment demand has in fact, resulted in a tightening of the fundamental condition in many commodity markets.
Last week, even an obscure commodity like Rhodium reached its highest level since 1991, and the Silver ETF fund saw its net asset level rise above $911 million. In fact, a single silver ETF fund saw its holdings of silver reach an astonishing 70 million ounces within a couple weeks of its implementation. While some might suggest that the investment flow toward silver is ridiculous and unsustainable, we would caution that money could continue to flow toward silver as long as the investors are "paid" for their views, the economy continues to expand and high oil prices leave the threat of inflation in the air. In fact, the size of trade in the silver ETF is virtually insignificant in the scope of the equity market, as the big share trades in the silver ETF have been only 2 million shares, while the most active on the NYSE can typically trade 50 million shares in a session. While we are not suggesting that a particular commodity based ETF will be the main focal point of all interest, seeing a major supply threat in a commodity that is also being lifted by soaring oil prices could certainly result in a prolific movement of capital!
Perhaps the most important thing one can take from the last three weeks of commodity action is the potential that the amount of money capable of flowing toward commodities is simply much bigger than what the markets are willing to concede. The silver and copper markets are prime examples of the profound impact that can be seen if attitudes shift. In silver many players discounted the chance for a bull market because of confidence in a silver surplus, but the new ETF and the favorable global environment for silver has completely altered the landscape in a very short period of time. On the other hand, the investment theme isn't the only force driving up commodity prices, as the biblical rise in copper prices (from 65 cents in 2002 to over $4.00 in 2006) has not been the result of massive fund and spec interest; it has largely been driven by raw physical demand and neglected production!
We think that the investing role in commodities is set to expand and surpass even currently inflated expectations, especially in those commodities that are potential alternatives to petroleum. In fact, given the unabashed success of the silver IShares, we suspect that Wall Street types are scrambling to replicate the silver ETF in other markets, and it is only logical that they train their focus on commodities that are being plugged into the energy chain and on those that have a "story". Old fashioned grain analysts and producers might say that investment demand for grain won't actually consume the product and that prices will be set to disintegrate when the funds turn away from commodities, but one had better realize in the near term that the mere mention of a "corn", "wheat" or "sugar" ETF could result in a rally that simply dwarfs rallies spawned by physical supply threats. Given the prospect of a summer US gasoline debacle, the fact that the world economic continues to grow and more importantly that Iran seems to be set in its defiance of the UN, we have to think that alternative energy commodities like corn, sugar and perhaps even wheat and soybean oil are poised to get their turn in the fund buying cycle!
WHEAT STRATEGIES
The wheat market fundamentals continue to improve, with a smaller than expected crop in the US, threatening weather for the tail end of the growing season for the winter wheat crop and higher than expected demand from India. In the May USDA Supply/Demand report, world ending stocks for the 2006/2007 crop year were pegged at their lowest level since 1981, and the world stocks/usage at 20.8% was the lowest on record (since at least 1960). World wheat ending stocks were pegged at 128 million tonnes for 2006/2007, down from 143.7 million tonnes for 2005/2006 and 150.19 million tonnes for 2004/2005. The USDA Crop Production report was also supportive, with winter wheat pegged at 1.323 billion bushels for 2006/2007 as compared with 1.499 billion bushels last year. All wheat production came in at 1.873 billion bushels from trade expectations of near 1.949 billion bushels and 2.105 billion for the 2005/2006 season. The USDA pegged ending stocks for the 2006/2007 season at 447 million bushels from expectations at 466 million bushels. This would constitute the lowest ending stocks total and the lowest stocks/usage ratio since 1996/97.
These numbers are impressive and suggest higher prices are ahead, but traders remain nervous that a rally now will hurt US exports, as other countries are more price competitive on the world market than the US is at this time. However, the USDA has already lowered its export forecast to just 900 million bushels for 2006/2007 from 1 billion this season, 1.063 billion last year and 1.158 billion two years ago. If the dollar keeps moving lower and world stocks continue to tighten, the estimate may need to be boosted.
The USDA pegged Kansas production for 2006/2007 at 319.6 million bushels, and traders are likely to debate this estimate back and forth in the weeks ahead. Kansas crop conditions have deteriorated some since May 1st, and with hot and dry weather for the week ending May 20th and more called for going into the week ending May 27th, traders could begin to lower the Kansas and Nebraska crop estimates. For the week ending May 14th, Kansas crop conditions showed just 25% of the crop in good to excellent condition as compared with 23% the previous week, 26% the week before that and 30% the week before that. Topsoil moisture was rated 12% very short (versus 9% the previous week) and 21% short (versus 18% the previous week). Subsoil moisture was rated 23% very short versus 19% previous week. As a result, a string of 90-degree days without moisture could stress crops, and traders might be forced to knock of another 40-50 million bushels from the winter wheat crop.
India's Farm Ministry pegged 2006 wheat production at 71.54 million tonnes, compared to 73 million in their previous estimate and 76 million forecasted earlier this year. A recently announced import tender of 3 million tonnes was intended to replenish government stocks, and local traders and end users will not see that wheat unless those stocks are released. As a result, the Indian government might still allow private imports to help fight the sharp rise in prices. Private forecasters believe there will be at least 5.5 million tonnes of imports into India this year, while the USDA forecast is currently stands at 4.5 million tonnes. This is in sharp contrast to India's net exports of wheat for the last 6 years. With Iraq and India buying wheat on the world market, other end user buyers could get more active at extending coverage.
The Commitment of Traders report with options (as of May 9th) showed the Chicago wheat market in a classic bullish setup with non-commercial traders (trend following funds) net long 12,027 contracts and non-reportable traders net short 26,317. This leaves the market vulnerable to new buying from funds and short covering from small specs if resistance levels are violated.
Suggested Trading Strategies: 1) Buy December Chicago wheat at 426 with an objective of 461. Risk the trade to 414. 2) Buy the December Chicago wheat 430/500 bull call spread at 20 cents and then sell December 400 put for 17. Hold for summer rally and risk 9 cents from entry. 3) Buy the December KC wheat/sell the July 07 KC wheat at +20 Dec with an objective of +57 Dec. Risk 7 cents from entry.
CORN STRATEGIES
The bullish news from the USDA combined with cool and wet weather in the eastern Corn Belt was enough to see December corn bounce more than 26 cents off of the pre-report May lows. Funds were noted buyers of nearly 40,000 contracts in the 3-day period following the report. While traditional grain traders might believe that the market is about to see the bubble burst due to record open interest and possibly the highest net long position from funds in history, we should point out that the corn story is appealing, as corn has shifted from a feedgrain to a feed, energy, industrial and sweetener commodity market. A world and US production deficit for the coming season, extremely high profitability for ethanol and HFCS producers and the likelihood that China will shift from the world's second largest exporter to a major importer are the key bullish forces for the corn market. Good weather could be a factor to burst the bubble, but the the weather necessary to kill the 2006 bull trend is unlikely to be present until late June, and the market looks poised to attract a significant, maybe even historic, weather premium between now and then.
The sharp reduction in ending stocks was seen as the most bullish factor of the USDA reports, as normal weather is expected to result in ending stocks for the 2006/2007 season at just 1.141 billion bushels or 9.8% of the anticipated usage. This will be only the third year in the past 31 in which the stocks/usage ratio was below 10%. This forecast leaves little room for error, and the focus is likely to stay on the new crop development, as a below normal (trendline) yield world spark extreme tightness for the coming season.
Demand factors are impressive, as the USDA expects a 34% jump in domestic corn usage for ethanol and a 6.2% jump in exports for the coming year. World ending stocks for the 2006/2007 season were pegged at 92.26 million tonnes as compared with 129.31 million tonnes for 2005/2006 and 131.32 million tonnes in 2004/2005. This would constitute the lowest world ending stocks level since 1975 and the lowest stocks/usage on record (since at least 1960). US ending stocks for the 2005/2006 season were pegged at 2.226 billion bushels as compared with 2.301 billion estimated in the April report.
The longer term demand factors look supportive, and funds are also finding plenty of interest in corn as a good hedge against inflation and higher energy prices. China is pushing to expand its dairy industry in the years just ahead by providing incentives for producers to import dairy cows and expand operations. China per capita dairy consumption is only 20% of the world average, and the sector is expected to grow at a 9.1% pace through 2010, a move that will force a jump in feed consumption. If growing weather is poor in China, their import campaign could begin later this year. China's exports in April totaled just 40,000 tonnes, which brought the January to April cumulative exports to 2.24 million tonnes. China's corn prices jumped recently amid talk that stocks have been depleted in Shandong, which is one of the major growing areas but is also the top cornstarch producing region in China. Drought in northern China seems to be an annual concern at this time of the year, but this year there are reports that 41 million acres have been effected, which is 36.3% higher than average.
US export sales for corn came in at 1.129 million metric tonnes for the week ending May 4th, and cumulative sales have reached 85.5% of the USDA forecast for the season as compared to 77.5% on average over the last five years. The data suggests that the USDA is likely to continue to raise export and lower ending stock estimates for the 2005/2006 season, and beginning stocks for the coming year might decline.
Even if we assume that producers plant 1 million more acres than what was indicated in the March intentions report, a yield of 134.1 bushels per acre (10% below trend) would project US ending stocks at just 219 million bushels for 2006/2007 as compared with 2.226 billion for 2005/2006, 2.114 billion in 2004/2005 and 958 million bushels the year before that. While we are not predicting a yield reduction, this study illustrates the potential extreme tightness that could occur if the weather does not cooperate. If yield comes in at trend (149 bu/acre), the extra million acres would boost ending stocks to 1.289 billion bushels, which would still result in the second lowest stocks/usage ratio in the past 10 years. Even if yield exceeds the trend by 10% to a new all-time record high of 163.9 bu/acre, ending stocks would only increase by 133 million bushels over this season.
The Commitment of Traders report with options for the week ending May 9th showed the market in a classic bullish setup with non-commercial traders (trend following funds) net long 188,305 contracts and non-reportable traders net short 110,055. The selling trend of fund traders (reducing their net long by nearly 20,000 contracts in one week) is a short term negative force. Funds are estimated to have bought at least 40,000 contracts since that report, but it is our opinion that as a percentage of open interest, the net long of the fund trader is far from a bubble-bursting scenario. In fact, the fund net long was 12.4% of the open interest, but to reach the record high percentage of 21.9% in April of 1995, funds would need to be net long nearly 331,000 contracts.
Suggested Trading Strategies: 1) Buy the Dec corn 280/360 bull call spread at 18 and then sell 1 Dec corn 260 put for 15. Hold and risk 7 cents from entry. 2) Buy December corn at 281 with an objective of 315. Risk to 272. 3) Buy July 07/sell December 07 corn at -8 July with an objective of +8 July. Risk to a close under -12 July.
SOYBEAN COMPLEX
Without a major weather scare for the US, the soybean and soybean meal markets look to struggle to add much to the current price level, but futures could show periods of strength during times when the market follows corn and/or wheat prices higher.
The USDA news for the first look at the 2006/2007 season looks decisively bearish. The USDA pegged US ending stocks at 650 million bushels as compared with the 2005/2006 estimate of 565 million bushels. World ending stocks for the 2005/2006 season were pegged at 55.94 million tones, up from 53.75 million tonnes reported last month and 47.73 million tonnes for 2004/2005. This constitutes a new record high for US and world ending stocks. In order to keep their ending stock forecast down to 650 million bushels for the 2006/2007 (still a record high), the USDA predicted a jump of 190 million bushels in US exports to 1.09 billion. This appears to be an aggressive usage number given the record crops in South America and the record world ending stocks. Even if we assume that producers plant 500,000 fewer acres than what was estimated in the March intentions report, a yield of 44.8 bushels per acre (43.3 was the 2005/2006 record) would project ending stocks near 937 million bushels as compared with 565 million in 2005/2006, 256 million in 2004/2005 and 112 million bushels for 2003/2004.
For the NOPA monthly crush report for April came in at 130.8 million bushels, which was below trade expectations of 137.4 million bushels and down from 142.9 million bushels in March. The reduced crush and the slower than expected demand pace added to the short term bearish demand tone. A slowdown in poultry production and continued expectations for record supplies (and increasing exports) out of Brazil and Argentina have helped to keep a lid on demand.
The outlook for continued sharp increases in soybean oil used for the production of biodiesel and the increased headline news on the green fuels has helped to support aggressive new buying from fund traders in soybean oil over the past several weeks. However, the new contract high and lower close on the day of the USDA report would suggest that a healthy correction may be in order before the market finds solid commercial support. The USDA pegged oil ending stocks at 2.379 billion pounds for the 2006/2007 season as compared with 2.749 billion pounds for 2005/2006. The USDA projected that soybean oil used for bio-diesel production should total 2.3 billion pounds for 2006/2007 as compared with 1.1 billion pounds estimated for 2005/2006.
Suggested Trading Ideas: 1) Wait for a setback in December oil to the 26.10- 25.62 zone before considering longer-term buy strategies. 2) It will take a close under 617 1/2 for November soybeans to turn the chart pattern bearish. 3) Consider using short meal as a hedge against long positions in corn or wheat. December meal key resistance comes in at 184.80 and 188.30 with 178.80 as key support. Another close under support would leave 168.10 as longer term objective.
UNLEADED GAS
As we expected, the unleaded market came unglued in the wake of another minor weekly inventory build at the EIA. However, over the last 5 weeks EIA gasoline stocks have shown a net decline of 3.6 million barrels, and since the beginning of April, gasoline stocks have declined by 5.4 million barrels. We recall that the EIA originally indicated that the failure to rebuild gasoline stocks in the month of April could put the US on a path to a significant supply situation later this summer. Certainly structural changes to the US oil infrastructure such as gasoline rule waivers and a halt to strategic oil reserve-building are bearish developments. It is also clear that recent demand expectations have softened, and one certainly sees the recent stock market slide as a sign that demand for oil is being somewhat reduced. However, we suspect that demand will soon rebound and that the slowing of demand seen recently merely allowed for a temporary rebuilding of stocks. It also appears that Iran is single-mindedly focused on continuing its nuclear enrichment program, and with the EU being rebuffed in their efforts to bring them into compliance, Iran should continue to be a topic that lends support to oil prices. For those who do not embrace the bull view toward gasoline, we would suggest that they keep a close eye on the upcoming EIA weekly implied gasoline demand numbers, as we expect to see a reading of 9.5 million barrels before the end of May and we also expect to see the highest weekly figure in modern times sometime in early June. In fact, if the July unleaded contract manages to spend some time below 195, we suspect that retail gasoline prices will fall right into the summer driving season kickoff. In other words, the bull market in unleaded has not run its course, and the correction last week should deflate bull call premiums enough to make an August option play attractive just ahead of the volatile trading window.
Suggested Trading Strategy: Buy an August unleaded 213 call and sell an August 221 call on a spread for 180 points and use an objective of 600 points. Risk the position to a net premium of 70 points.
