Elgrey's  Instablog

In May I am interested in following commodities:

Soy Oil - I talk about it for last couple of months and still no luck. As I write this post the positioning of funds is on extremely bearish levels - I checked past years all the way back to 1995 and funds have never been so bearish. I do not believe that such situation is going to last for long. I can see pressure from palm oil but it is not that enormous to justify such bearishness. Neither we have a super dominance of supply over demand in soybeans market. So stiff upper lip and see what comes next. What makes me worried is USDA saying that they forecast price to be within 48-50 cents for the rest of the season. But judging the amount of shorts accumulated by funds, there should be a bounce to 52-53 levels once they begin covering shorts.

Cotton - I continue shorting it. USDA forecasts 70+ cents price range for this marketing year, COT is still bearish and prices have gone down from 92 to 84 as of right now. Before my target price range was around 70-75 cents. Now, after late plantings caused by bad weather I will consider leaving the trade within a range of 75-80 cents.

Natural Gas - I continue shorting it despite all the rallies. OK, confession time - I was early to jump in by 2-3 weeks. But at that time all the indicators were saying that market reached the top. It is incredibly difficult to predict tops and bottoms for NatGas - this is one of the most volatile commodities among all of them. Anyway COT is still bearish, injections season has begun, volatility is monstrous - we saw price levels of 4.50 about 2 weeks ago, a week ago NG was below 4.20, a day ago it touched 4.50 again and lost 15 cents as of now. EIA weekly report is due in 8 hours and it can turn the tables. Next item to consider is usage of coal by power plants - the usage of coal has increased as price for NG accelerated meaning that demand for NG is getting softer. I read monthly NG report by EIA and noticed something interesting - in Jan-Feb of 2013 production of NG was 2 percent less than in Jan-Feb'12 but there is 45% (430 vs. 756) less NG rigs today comparing to last year Jan-Feb. This reminds us that not all rigs are equal and that a large portion of NG comes from oil rigs the number of which is 1325 vs. 1241 (average for Jan-Feb of 2013 vs. same period of 2012).

Silver - I wrote a lot in my previous posts so basically there is nothing else to add.

Question marks:

Heating Oil - HO is back on my radar. Prices have fallen a great deal but I expect them to reach USD2.60 levels before opening longs.

Corn - Speculators have accumulated record short positions, hedgers are at record long levels. I have seen this case before so I do not plan to buy corn today but I am watching the market for near-term developments. OK, what bothers me now - high volatility which translates into high price of protective puts. Next thing is excessive pessimism about poor planting speed - it does not mean much yet. It may translate into troubles later but it is too early to judge now. Weather (drought) is next - there are heavy rains now but will they last long enough to end the drought? I guess that by the end of May we will know more. Let's wait.

Coffee - The end of May is always a good shorting opportunity but will this year be the case? Prices have been in a steady negative trend for many months. I cannot ascertain myself whether there is any more potential left for bears.

Live Cattle - I am still watching it and keep asking myself whether market capitulated or rally will be soon?

I am not Jewish but I always regard them as one of the smartest people. When I look at my recent trading decisions I think of rabbi Shlomo Riskin saying "When you're one step ahead of the crowd you're a genius. When you're two steps ahead, you're a crackpot." I was too early to leave a few recent trades and to start other ones. Doing that properly could earn me a lot. But bad times always pass, learn from your mistakes, stiff upper lip, and move on.

Let's see what April brought me:

Soy Oil - BO was underwater in April. Not by a large extent a couple of cents only but still - the month began at 50.2 cents and ended at 49.2 cents per pound in July contract. I had thoughts to leave the trade during 2nd half of April if I would see price appreciation which did not happen. Therefore I was early for a bull party but since I already came wearing a fancy hat I better stay in.

WTI - initially I was not going to liquidate this position but during early April prices drop made me worried and I sold oil and saved profit. I guess no matter price recovery that we have today we yet to see further bottoming.

Cotton - shorting CT was a good idea until 26th of April when prices jumped for whatever reason. Some say because of crop planting fears. From the past years I know that slow planting is not a sign of poor crop so I am optimistic about coming pull back. However I am not targeting 70 cents level in June. I will leave the trade when prices be within 75-80 cents. OK, anyway prices went down from 90 cents to 87.50 cents in July contract.

Live Cattle - I chose not to roll over my April contract into June and booked losses. I keep LC on my radar but I am neutral for now.

Natural Gas - timing was not my friend in April. NG continued its bull run through April. Prices reached maximum levels on April, 18th adding another 10% since the end of March. Thank God I hedged the position. Good news for bears is that coal by plants usage started to grow again. Looking at 1 minutes price bars I start to notice more long red bars meaning that bigger chunks of NG come for sale. It looks like some funds started a quiet liquidation.

Silver - I issued a buy call just a few days before the stellar crash. Timing, timing, timing… But I also said - buy protection. So I am less worried now. Also - do not give up, it is too late to sell. Weak hands are leaving, strong hands are replacing them. Stay calm, price will return to 30+ levels.

Rest of the items on my April schedule did not appeal me and I ignored them.

The month was very difficult, one of the most difficult months within past year horizon. I was early to jump in almost every trade. What keeps me alive is that everything is hedged in my portfolio. But this is a small relief as no one has an intention to lose when opens a trade.

What a week! Just a few days after I wrote a blog about buying silver it crashed! The blood is on the streets, on trading desks, on margin accounts and everywhere else it can be. OK, lyrics aside - what has happened and what is likely to happen next?

Doing a simple analysis of front contract daily price changes revealed that there were 12 similar or worse crashes during last 50 years. And here is crashes hit parade and the events that happened to take place on those lucky dates:

22-01-80 -22.73% Hunts times

26-03-80 -21.78% Hunts times

23-09-11 -17.75% Recession fears

14-03-80 -17.65% Hunts times

28-02-83 -17.60% n.a

17-03-80 -17.14% Hunts times

20-04-06 -13.75% Margins changed

13-06-06 -13.01% n.a

13-03-80 -12.97% Hunts times

02-10-08 -12.92% October 2008

20-10-87 -12.02% Black Monday

17-09-81 -11.30% n.a

5 times out of 12 drops took place when Hunt brothers attempted to corner the market,

3 times drops happened when all markets dropped,

1 time it happened when margins were hiked but I could not identify events that caused that, and

3 times I could not identify anything at all.

Speaking in terms of VAR (value at risk) the above events represent 0.1% of total population (12 out of 12500 trading days). VAR analysis takes into account 95% or 99% confidence level not 99.9%. In other words what happened on 15th cannot be explained using one of the most used approaches in today's risk management and it cannot be predicted. It just happened - markets are not perfect.

And since we are dealing with something very unusual let us see how prices reacted in the past. I am going to drop "Hunts times" events from further analysis as those are not relevant - we are not in a situation when someone artificially inflated prices of a single commodity, the whole metals sector and many other markets took pain on 15th:

23-09-11 Having finished the day at $30 level it took markets 2 months to hit $35 again

28-02-83 It took 2.5 months to recover from $10.3 to above $13 levels

20-04-06 In 3 weeks prices jumped from $12.5 to $14.8

13-06-06 Again, in 3 weeks prices appreciated from $9.6 to $11.3

02-10-08 This time it took 4 month to get from $11.1 to $13.1 levels

20-10-87 Prices attempted to bounce but stuck in the range and in several months a long-term silver bear market began.

17-09-81 Another bear market that lasted for 1 year

5 times out of 7 prices recovered quite fast but there is no unanimity.

Let's try another voodoo spell - maybe it helps? This one is called Commitments of Traders report. Let's see positioning of users of silver and speculators during periods of price crashes:

23-09-11 Users - Ultra Bullish, Speculators - Ultra Bearish

28-02-83 n.a.

20-04-06 Users - Neutral, Speculators - Neutral

13-06-06 Users - Bullish, Speculators - Bearish

02-10-08 Users - Ultra Bullish, Speculators - Ultra Bearish

20-10-87 Users - Ultra Bullish, Speculators - Ultra Bearish

17-09-81 n.a.

2 times out of 7 data was not available. Other 5 times users of silver never had bearish stance. In fact 4 times they were feeling the bottom and they were buying bottoms. No wonder they are called "smart money". And today users of silver are extremely bullish again. They have been bullish since early Feb, they realized market bottoming. But of course they did not and could not predict what happened on 15th. As I say above this drop had a chance of 0.1%.

Speaking of bottoming - how do users of a commodity realize it? Well, here comes next portion of black magic - let's see how much it costs in the real world. Take an example of Hecla Mining Company, largest US silver miner. Download their audited form 10K for 2012 and do some homework. What we are looking for is a benchmark indicator for cost of silver - in real world no one would be selling it below its costs, right? Not in the long run at least. So, we are looking for:

(A) - gross sales

(B) - profit from operations adjusted by costs of one-off events (they are not relevant to usual production costs).

(C) - cost of operations

(D) - indication of silver dollar value using product sales during 2012 multiplied by average prices during the year

(E) - share of silver dollar value in A

A = 321M

B = 38M + 25M (one-off event cost) = 63M

C = 321M - 63M = 258M

D = 6,4M SI oz * $31 = $198.4M

E = 198.4 / 321 = 62%

Hecla cost of silver production = C * E = $160M

Cost of 1 SI oz = $160M / 6.4M oz = $25

Hecla will not be selling silver below the cost for too long. They would rather close down the business. And by the way - they reduced silver output by 1/3 between 2011 and 2012. Guess why... Commodity markets react fast, another example - last April natural gas prices were below the cost at $1.90, today it is $4.10. And by the way - they state they do not hedge the price. Probably, they know that from this point prices have no other way to go but up.

OK, let's get to conclusions. The only time when prices did not recover well was the case of Black Monday. Why did it happen? Well, hard to say now but it do not think we are in that situation. In 1987 US Government tightened monetary policy and it was reasonable to sell assets and sit in cash. But today situation is very much different. Some say inflation is up to 10% p.a. In all other cases it took weeks or months to score a 2-digit recovery. What am I going to do? I will wait a few more days and if Black Monday won't be here I will buy again. And of course I will hedge my long bet buying puts. Just in case.