Shrinking Correlation In Commodities Calling For Bottoms Up Approach

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Includes: DBC
by: Darspal S Mann

Summary

Traditional relationships between the prices of different commodities seem to be getting weaker.

More bottoms up approach to research might offer better opportunities.

Need for risk-control and ground level understanding far more important than just the demand-supply dynamics.

There is a comfortable relationship between the price of certain commodities, based on demand, supply, replacement properties, common growth drivers, etc., that are well accepted by markets and seconded by the price correlation data, but lately, the relationship is getting increasingly weak in an increasing number of commodity pairs, something that may allow more opportunities for active managers.

Even though divergence among various commodity groups, e.g. energy and metals, was visible for a while, but not so much in the pairs within a commodity group, allowing some easy trend trading opportunities, e.g. mean reversion or momentum strategies, and a broader retail participation. Even if one ignores the cross-commodity correlation, there is a growing list of commodities where the relationship seems to be breaking down or getting extremely weak, which may allow a true bottom-up research discipline to shine.

Some may argue that this is just a case of a lag effect, but few would disagree with uncertainty over how long this lag may last. In the meantime, the markets with more institutional participation and driven by fundamentals may allow investors closely monitoring the dynamics of each commodity to monetize the trends.

Oil and natural gas

There is a well-established relationship between oil and gas, supported by the energy producing properties and the substitute value of each, which traditionally led to relatively high correlation in the price of both these commodities, but as the correlation chart below suggest, the trend seems to be changing.

Click to enlarge

Image by author, based on data from the U.S. EIA (energy information administration)

The reasons for the gap are varied and well-covered at various platforms, be it long-term changes related to the pace of technological advancement or short-term factors like weather trends, storage infrastructure, regulatory challenges, but the trend remains established, with crude oil down 21% over last year and natural gas down 3% during the same time frame. The divergence is much bigger over the last month.

Wheat and corn

Even though there are hardly any listed stocks in the U.S. that could reflect the full impact, the grain prices have rallied strongly over the past year, especially sugar that is up more than 55%. But the divergence is equally visible in some of the agriculture commodities as well.

Because wheat and corn can be substituted in the feed grain markets, especially for pork and poultry production, there is a relationship in the prices of the two commodities and usually, the wheat markets tend to follow the corn markets, while maintaining a spread.

Over the last year, wheat prices are down more than 15% and corn prices are up more than 10%, some of the divergence can be blamed on short-term weather-related issues, but another divergence underway nonetheless. In the meantime, the spreads between Kansas City wheat and corn futures are trending near historically low levels.

Soybean-to-corn price ratio is another indicator used to decide on acreage switch between corn and soybeans, which leads to a significant correlation between the two commodities, but soybean is up 14.5% over the past year and corn is up 10%.

Cocoa and coffee

Since farmers can replace coffee and cocoa crops, at least theoretically based on the climatic conditions required, and the coffee yield is approximately 1.5-2 times higher than the Cocoa, there is a relationship between the prices of two commodities, but here again, the relationship seems to fail to hold up as well, considering cocoa is down 3.9% over the past one year, while coffee is up 8.2% during that period.

Click to enlarge

Image source: Trading economics

Iron ore and Steel

The relationship between iron ore and steel is probably the easiest one to understand and measure, with iron ore being the key ingredient in the production of steel, but here again, divergence or the length of lag between the two prices has been failing to follow the usual trends over the past few months. Over the past few months, the steel prices continued to ramp in spite of iron ore failing to join the party, even though usually it's the iron ore markets that tend to have volatile movements.

Note: All prices used are yesterday's closing and sourced from Trading Economics; 'Brexit' related volatility might change things.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.