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Huge return for JJC put option holders as copper price faces a serious correction in 2011.

Rapidly rising commodity and food prices have caused a series of riots across countries in the Middle East recently.  The political leaders in Tunisia, Egypt, and Jordan have all agreed to step down.  These latest developments are exactly the kind of nightmare the Chinese communist government has been trying to avoid, and will likely reinforce its determination to cool down its steaming economy.  Last year, it raised the major banks’ required reserve six times (in addition to interest rate hikes) resulting in a ratio of 20%, a record high for the country. However, copper investors seem to think that China’s economy will continue its lightning pace and remain out of the government’s control. Copper price has been breaking record every month, trading at three times of its recent low of $1.50 just two years ago. This may prove to be a risky investment position as there is evidence suggesting that roughly 2.5 million tonnes of current demand is a direct result of Chinese government’s one-time massive economic stimulus.  Copper consumption in China jumped by 45% from 5.5 million tonnes in 2008 (a record high back then) to 8 million tonnes in 2009, the year of global financial crisis. The increase is more than five times the global supply shortage (444K tonnes) in 2011, estimated by a recent Reuters poll of analysts. Any effect from the government’s tightening policy should be sufficient to wipe out the entire shortage and create a surplus situation. Analysts at Deutsche Bank have projected that there is a danger that Chinese copper consumption disappoints in 2011, with growth close to zero. Investors should also recognize that it is likely in the interest of the Chinese government to maintain cheaper copper price to develop the country at a lower cost. However, a price level above breakeven point is necessary to ensure adequate supply for the long term. Scotia Capital estimated that on average copper miners recover all their costs including interest and depreciation at $1.36 per pound.  This implies that even if the price falls back to $2, miners will still earn healthy and sustainable profit. To capitalize on this possible pullback in copper price, one could buy June 2011 put option on JJC (copper ETN) with exercise price of $50. If the copper price falls back to $3.50, this investment will break even. At $2, the option’s value will appreciate by roughly 14 times. With this kind of favourable combination of odds and payout, it is worth to allocate a tiny bit of your portfolio into this investment. A relatively more conservative approach would be to split the investment in half and purchase another 6-month put option in June.