The most powerful signal of when to buy a commodity is when the commercial entities are near record long or have near record high positions in the futures market signaling that a major bottom is at hand. This information on commercial activity, as well as on speculative fund activity, is provided every Friday afternoon by the Commodity Futures Trading Commission (CFTC) in the regulator’s Commitment of Traders Report (COT).
Think of the commercial entities as the insiders in a publicly traded company. When the CEO, vice presidents and directors are buying large quantities of stock in the open market, they are signaling that the people who know more about the company than anyone else believe that the stock is a good value. While it is not exactly an apples to apples comparison, it is analogous to commercial entities in commodities.
Commercial entities in a commodity market represent the producers and the end users of the chosen commodity. Take coffee as an example. The producers in this case would be the Brazilian and Colombian farmers and the end users would be the coffee roasters like Starbucks or Procter & Gamble, the maker of Folgers and Nestle. The commercial entities know more about the economics of the coffee market than anyone else in the world. They are best equipped to make judgments as to when coffee is cheap and when it is expensive.
Fred and Ginger
Commercial entities make decisions based upon their own business economics while speculative funds make decisions based upon potential for investment profit. The waltz that these entities dance with each other is equal and opposite in that when coffee prices have been falling and prices are cheap, speculators are short while the commercials are long. Speculators typically care about following the price trend. Commercials simply are looking for good economic value.
For example, if coffee is trading well below the cost of production, farmers are more likely to store as much coffee as they possibly can instead of locking in losses. They will only sell what they must to pay bills. This has the effect of being long the futures market. Conversely, if coffee prices are trading so low that the profit margins for a coffee roaster like Starbucks are attractive, Starbucks will stockpile coffee in an attempt to lock in favorable long-term profit margins. This also has the effect of being long coffee futures. So, when farmers do not want to sell and the commercials want to buy as much as possible, you have a looming scarcity building in the market at prevailing prices.
The opposite is true when coffee prices are too high. When Starbucks is unable to make a profit when paying high prices for coffee, they will operate hand-to-mouth to try to buy time for when prices become attractive again. Typically, when coffee is bought at prices that are too high, a Starbucks will sell short so that it may recoup lost profit margins when prices do fall back down. This effectively creates a large short position.
When farmers see prices that are attractive and profitable to their operations, they will sell as much as possible to lock in these profits and store as little as possible. This effectively builds short positions on behalf of the farmer. So, with farmers being willing aggressive sellers of coffee and the commercials buying as little as possible and operating hand-to-mouth, a looming oversupply in the market builds.
In short, if you buy when the commercials are near a net record long/high position and you sell when commercials are near a record short position, you are more apt to be on the right side of the value commodity investor’s profit food chain.