Middle East Crisis: Positioning for the Unthinkable in Commodity Prices

by: Daily Trading

While the press of popular opinion is now drawing our attention to the rapidly rising price of foodstuff commodities like the big three (corn/wheat/sugar), few have bothered to take into consideration the behavior of the primary driver of foodstuff commodities. In case you are wondering, that is ethanol. In recent weeks the price of ethanol has gone parabolic. Little wonder why corn and sugar are moving higher; 40% of corn produced in the U.S. and 70% of sugar produced in Brazil goes into producing ethanol.

Ethanol Futures

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Or is it the other way around -- i.e., are corn and sugar driving ethanol higher? Yes, sometimes it is difficult to distinguish what is the chicken and what is the egg. In any event, given that ethanol and gasoline are used somewhat interchangeably, I don't think the price of ethanol would be advancing unless gasoline was, which it is. I know it is a rather sad state of affairs when the price of what we eat is governed by the price of crude -- but that is just the way it is.

Now here is where things start getting really interesting. This has been something that I have been swinging around in my head; it scares me that this may well prove to be the endgame. Trouble erupted in Tunisia and Egypt essentially over the price of food (bread); granted, there were massive underlying problems, but all the same, food prices sparked the fire.

Now it appears trouble is spilling over into other Middle Eastern nations. Now what if food prices continue on their current trajectory? What if we see the price of wheat, corn and sugar advance another 20% in six months? What will happen then in Middle Eastern nations that are already experiencing social/political unrest?

My point is this: If an oil-rich Middle Eastern nation falls into chaos, the price of oil is likely to spike materially, and so too will ethanol, and on the back of that the price of corn and sugar ... and every other foodstuff commodity, which in turn leads to more unrest/rioting/revolution. Yes, it all becomes a little bit too much to comprehend.

It is cold comfort to learn that the trend in commodity prices is strong. Our proprietary commodity index of 35 commodities equally weighted is making new highs day in day out.

Proprietary Index of 35 Commodities Equally Weighted

Revolution in the Middle East might not be such a fantasy after all. While that may be all well and good, what is the best way of capitalizing on the probability of "revolution"? I can think of nothing better than deep OTM calls on Exxon Mobil (NYSE:XOM). Volatility is so cheap at the moment that you can pick up January 13, 2011 calls for about $1. So for $1,000 you can buy 10 options -- which would equate to a $100k exposure in Exxon. If the stock price got to 110 within two years, that would be a 30% move from current levels. I think this would be a very cheap "insurance" policy to have if the unthinkable happens in the Middle East.

It is not a case of being right or wrong in trading; rather, it is how much you stand to lose if you are wrong and make if you are right. There is nothing more or less to it than that.

Disclosure: I am long XOM, DBC.

Additional disclosure: Long Deep OTM LEAPs Calls on XOM