Commodity markets are caught in a perfect storm and it might take an act of God or Uncle Sam to put them at rest.
Here’s the landscape that commodities are facing today: An energy policy that mandates 36 billion gallons of biofuels by 2022, an agricultural policy that restricts acres and prevents supply from meeting the mandated demand, inflation-oriented fiscal policy designed to help banks re-collateralize real-estate loans, and otherwise solid world economic conditions driving investors to commodities as promising vehicles for growth.
All of these ingredients have fueled a massive run toward commodities. Last year investment funds rose from $110 billion to estimates of $150 billion to $200 billion. Commodities are in a bull market, and grains, as much as any, are feeling the upward price pressure.
MARKET SUSTAINABILITY
Investment money is historically involved with non-essential markets or third-party investment vehicles. Thus, the influx directly into commodities is not only new for the investor but also the cash industry that the exchange represents. Some of the impact that this influx of money has had on the industry is important to understand to avoid potential investment losses. It is also important to understand how closely governments around the world monitor essential markets such as food.
The U.S. energy policy mandates biofuel production to increase from seven billion gallons to 36 billion gallons by 2022 (see “Exuberance has peaked”). Of this, grain-based ethanol will make up 15 billion gallons.
Current build-out pace will accomplish this by 2010, but there are not enough corn acres planted in the United States to supply the corn needed for these plants. Thus, the U.S. energy policy is mandating the demand, but the U.S. farm policy is restricting the use of acreage via the Conservation Reserve Program. With total acres restricted, farmers are just shifting the acres they have to the crop they think will pay the most. The U.S. Department of Agriculture’s (USDA) March 31 acreage report confirmed corn acres will decline 7 million acres as farmers increase soybean and
wheat acreage.
As a result of flat acreage, corn-ending stocks will fall from 1.9 billion bushels in 2005 to a projection of only 650 million bushels in 2008. This barely meets pipeline supplies and assumes a trendline yield. Any adverse weather would immediately result in a shortage. About the only way to avoid a tight stocks situation would be an act of God — or, more to the point, a gift from God in the form of great weather and record yields.
Although the Secretary of Agriculture has authority to release acres into production, if potential stocks dictate the need, the U.S. government currently seems content betting on weather and scientific plant genetics rather than releasing more acres into production. This can change — and any change in policy would have a huge impact on prices.
If there’s no acreage release and bad weather reduces yields, then corn could rally beyond $8 per bushel and soybeans could climb above $20. It sounds almost fantastical, but Minneapolis wheat hit $25 in February, and soybeans traditionally have traded higher than wheat. From current levels, those prices would equate to a $45,000 gain on an initial margin deposit of approximately $4,000 for either a corn or soybean contract.
OUTSIDE INTERVENTION
Of course, this type of price explosion could cause some serious potential issues that investors would have to monitor. Food processors are already under intense pressure to raise retail prices or operate in the red. This income squeeze has become so heightened that the first protest since World War II against high food costs took place in Washington on March 12.
The march, organized by the American Bakers Association, lobbied officials to change agricultural policy to get markets under control. The organization actually has cooked up a good argument based on the law that requires the U.S. Secretary of Agriculture to maintain a “reliable and affordable supply of food.”
If lobby efforts are successful, or if poor weather develops and reduces stocks even more, the USDA likely will be forced to make some decisions that would destroy the bull market with the stroke of a pen. “Getting involved,” shows what has happened during past periods of government intervention.
Possibilities include:
Allowing foreign ethanol to enter the United States without tariff
Releasing some acres from the set-aside program
Temporarily mandating all or a portion of U.S. ethanol plants to close for a period of time to free up supplies; U.S. plants would continue to receive their scheduled subsidy to maintain financial stability
Ban exports of U.S. grain (this one is highly unlikely but has been implemented overseas)
Obviously, if any of these options were enforced, it would have a dramatically negative impact on prices and liquidity would be questionable.
LIQUIDITY CRUNCH
The volatility and influx of investor funds have already impacted the liquidity of the market. Cash traders have pulled away from the market for two reasons. First, end users do not want to be stuck owning too much inventory at current prices because many sectors, such as the ethanol industry, are not able to turn a profit on the end product they sell (see “Profit profile”). Currently, nearly every ethanol plant is in the red at today’s cost of corn, even when considering the value of Dried Distillers Grains with Solubles (DDGS, a high-nutrient feed that’s a co-product of the ethanol production process).
Secondly, many grain elevators are not buying forward contracts from farmers because they would need to sell futures for a hedge, which could require more margin money than their lines of credit will allow. For these reasons, current volatility has removed some of the liquidity in the futures market. This could cause an issue for an investor if there is a reason or need to exit the market quickly.
Fiscal policy that encourages a weak dollar will likely continue until the banking crisis is solved. This is adding fuel to the raging bull commodity markets. With the underlying tight stocks situation and the current fiscal policy, money seems to be pouring into commodities. Even pension funds are allocating to commodities. Because of this, as well as mandated demand, restriction on acres and relaxed fiscal policy, the bull market looks pretty solid for grains throughout the year.
WHAT TO DO NOW
Buying breaks in commodities will likely remain the fad of most traders. But with this surety of success comes the contrarian thinking that one of the two mentioned arrows will pierce the heart of this bull. A better way to approach this market, with an eye toward the bearish risk, is to employ some option positions designed to provide some precautionary fiscal health.
Option programs can be employed against futures positions to help manage the exposure of an adverse move. For example, we can convert an open-risk trade into a controlled-risk position by purchasing a put. This will establish an emergency exit if we need one. The cost of a May 500 put is only 15¢ and would limit losses through April 25 to $3,400. This position would keep the upside open as the position would continue to profit as futures rallied.
If a trader is willing to cap the upside at $7.50 per bu., then selling a 750 December call would result in a credit in the account to cover the cost of the put. “The cost of insurance” (left) shows how the long futures, long put and short call reduce the potential exposure to $2,500. The resulting reward-to-risk ratio (3.8 to 1) is still pretty good.
Investment money has ventured into essential commodities. Societies cannot live without food, and economies cannot afford excessive prices. Investors in the past normally traded equities or the stocks of food, seed or tractor manufacturers. But now with the massive injection of investment funds in commodities, there has been a dramatic effect on commodity prices.
The risks of commodities are different than those of equities because there is a much greater risk of government intervention. The reward, however, can be huge — especially this year as a near-perfect storm for a bull market exists. But for the same reasons that we have a bullish scenario, the political pressure of high-priced essential commodities increases. Thus, the higher the market goes, the greater risk to the investor. The only other risk we can identify at this time would be record yields. Both risks can be managed by using some discipline and a few options.
Bill Biedermann is the senior vice president of Allendale Inc. in McHenry, Illinois. Reach him via the Web site www.allendale-inc.com.
