Neal Kottke has been involved in futures markets, particularly in the grain sector, since the 1960s. He has worked on the physical and futures side, traded, ran a clearing member firm (Kottke Associates), ran the Board of Trade Clearing Corporation (BOTCC) and operated as a commodity trading advisor (CTA). He even owns a working farm in downstate Ill., so he has a view of the grain sector from every perspective. We sat down with Neal to talk and the industry and the grain markets.
Futures Magazine: You have been involved in trading agricultural markets — both cash and futures — for more than 35 years. Tell us how you got involved in the business.
Neal Kottke: I got out of the Army in the 1960s and joined Continental Grain Company as a grain merchandiser and worked in the grain export markets. I worked in Minneapolis, New York, Chicago and Paris, so I had a broad learning experience in the export markets. I had worked in Chicago and became familiar with the futures markets and the interface with delivery, so that was my transition between the cash grain market and the futures market. I resigned from Continental, bought my own membership and formed a small clearing firm called Agri Trading in 1976. It was a clearing firm. but I was trading. We cleared our own trading and I was the principal trader.
FM: You have had a long eclectic career in the business that encompasses cash and physical trading, futures brokerage and exchange management. What are you spending most of your time on now?
NK: Basically it hasn’t changed, we are still a trading firm. Our principle business is option market making in grains, meats and energies. They are proprietary traders of Kottke. They trade on the floor and they make markets in options. Kottke is now a customer of ADM.
FM: You recently changed Kottke’s status from clearing member to introducing broker, why?
NK: Capital considerations. We could be a member firm and I didn’t need to be a clearing member. We have enough memberships (shares in CME Group) to be a member firm.
FM: There has always been a creative tension between the commercial and speculative side of trading, particularly in grain markets, how has that evolved over the years? How has the emergence of the long-only commodity funds affected that balance? How?
NK: When the grain markets went through their explosion in the 1970s, they were led by an export demand. At that time, the commercials were the predominant influence and drivers in the grain markets. Today’s grain markets are different because you have the added impact of, particularly in corn, ethanol as a demand factor and [most recently] that has been where the expansion of demand has come from. Along with that, you have had an increase in the capital that can be employed in a speculative nature in the form of managed futures. So those two features are great influences, and therefore the commercial side is diminished to some extent.
FM: Aren‘t the long-only commodity funds a larger factor that traditional CTAs?
NK: I am not sure I agree with that. They both have impacted the markets. I think that the long-only feature has been over emphasized and overstated. I say that because it is not dynamic. It comes, it is absorbed by the markets and then it is there. And then it is rolled. Now it has an impact on spreads, but that is not really the flat price driver that managed capital and that goes both ways in the market. [Long only funds] once they are in, its impact is lost, it has been absorbed.
FM: There are many people, particularly in Congress, that believe these funds have had a dramatic influence, particularly in crude oil. What is your opinion on that?
NK: I would disagree. Congress has alleged that the funds caused the energy spike. The world uses 80 million barrels of oil a day, prices 80 million barrels a day. When you compare that to the amount of speculative capital that is available for crude oil trading, it is ridiculously small. You are talking about a massive markets and the cash was trading there. They didn’t make that up. Now there are a lot of influences. China is increasing demand and adjustments had to be made by other users and producers. That is what makes these markets, it isn’t money running on the screen that makes the markets. These people are over impressed with what they think they see, they are seeing the tip of the iceberg. It is ludicrous to think that capital in the futures markets was driving the cash crude oil market. They are looking for a villain and the villain is the world, but that is not a popular thing to say.
FM: What about wheat?
NK: The long-only holders of soft red wheat in Chicago have impacted the delivery mechanism or the spread, but even there I would submit that the issue with wheat spreads and delivery is not the long-only funds, the issue is with the soft red wheat contract itself and what is deliverable. It is a small contract and being made more difficult by the delivery specifications.
FM: Can you trade commodities without taking into account the effect of long-only funds?
NK: If you trade commodities, you have to take into account every factor that you can. So long-only is a factor, but it is an overrated factor. One of the things that a very wise trader told me was a comment made during a market rally [when] somebody said, ‘Well I don’t like the quality of the buying,’ and this person said, ‘Sir, I would suggest to you that you don’t look at who you think is buying or selling the market, you simply look at where the market is itself.’ And I agree with that.
FM: The Commodity Futures Trading Commission (CFTC) is mandated by Dodd-Frank to create a spec limit regime that encompasses both futures and over-the-counter (OTC) markets. Are you expecting significant changes as it pertains to grain markets? What do you think will be the impact of aggregate position limits?
NK: I presume that there will be a hedge exemption and from that presumption it will become quite difficult to discern that which is a hedge and that which is not when you talk about over-the-counter markets or cash markets. Specifically when one talks about grains. It could be done in Bermuda. The market will adjust. [Regulations] can be as tough as they want, but there will be those in Geneva, Switzerland who will trade cash grain if they wish. This is not unprecedented. Back in the 1970s there was a cash grain market. We called it the Italian corn market, and the trading unit was 1 million bushels of corn, and it traded. Sometimes it was delivered and sometimes it wasn’t but it was a real market. Now who is to say that is not a hedge or that it is a hedge. I can assure you that anyone who was a commercial just took it into their position and treated it as their overall position. My point is that you can create a cash market and it can be real. The results of that market are part of the world market which is reflected in positions and valued on the CBOT. It is an international market particularly in grains.
[Regulators] can only influence those that are captive—that is U.S. citizens, U.S. companies and or those that elect to — otherwise they will be ignored.
FM: Do you think the CFTC realizes that?
NK: I don’t know what they realize. An amazing thing that I have observed over time is that those that wish to legislate behavior are victim to the wish becoming father to the thought: if I wish to do this, then I think I can. There is no monopoly on these markets and I believe the open interest in [European] wheat is now exceeding ours.
The notion of legislative limits is always food for thought. We have limits on price and today is a perfect example (we spoke to Neal on Oct. 8 when the grain complex was locked limit up after the United States Department of Agriculture world supply/demand report). December corn is limit up 30¢ higher. We have ordained that. Therefore it is $5.28 ¼. The fact is even on our own exchange, synthetic futures options are trading 36¢ higher. Now you tell me what the limit is. So the market is working in spite of 20 feet away an options market trading 36¢ higher.
FM: You formerly headed BOTCC. What is you opinion of the mandate to clear most OTC swaps? Is there a risk as well as an opportunity in moving these products onto a clearinghouse?
NK: One of the things we have seen in the world of finance is that company to company traded credit default swaps (CDS) have proven to be quite dangerous to say the least. There is a question of if we can clear them on an exchange, could we see the exposure. I have not read anything about anybody calling for a position limit in swaps. I understand the drive; the drive is to make that market transparent rather than opaque. Specifically in the area of CDS, the main question always asked is how do you margin CDS? If we are discussing corn and the market is $5 and you are short from $4.90 I know you are out 10¢ a bushel, so you will need that margin plus the initial margin. I have a mechanism to daily margin your account. The CDS is quite another animal. The problem is we know those things are discontinuous. One party buys the insurance and another sells it, so it is like a piece of insurance and then it rests. There aren’t a large number of buyers and sellers making a market. And in the end it either defaults or is doesn’t, it is binary. The rational margin on that CDS is somewhere between zero and full value. I understand why it should be done but I would be curious how do you really margin these things.
The issue with the writer of the swap, the seller, is that it is even more important to understand his balance sheet as to his availability to withstand a complete requirement to pay. The best [solution to] that is too make him put up 100%, but that would probably drive away business. I have never been able to understand the model for margining. It has to be done differently than the traditional clearinghouse mechanism. The traditional clearinghouse mechanism relies on a functioning market to price the underlying and what really makes it work is you make people come up with the money every day.
FM: They are off exchange because they don’t want to put up the money.
NK: That’s right. We laugh when we say that, but they don’t want to put up the money. They also are not sure how it should be fairly priced. If you put these things on exchanges, you will have clearing members that will be on both sides of the market. If you got enough trade in it, then you will be pricing it. But those that are short it, you better be sure that they have the wherewithal to meet the ultimate cost.
FM: One of the criticisms mentioned by futures commission merchants (FCMs) of the CME’s plan to clear OTC products, particularly CDS, is that funds to back them would be commingled in the clearinghouse with funds backing the rest of their portfolio. Would you prefer a separate structure?
NK: That is some comfort but I would rather say, were I still making that decision, I [would want to] understand their model for margining, pricing and maintaining financial integrity. If I understood that and agreed to it, then I would rather go with the business model that works. I understand that you could separate them, but, as a practical matter, if you blew up one clearinghouse, I don’t think that is going to bode well for the remaining [clearinghouses].
FM: How has the grain markets changed over the years?
NK: Significant moves in the past were export driven; commercials were the significant drivers. They have been diminished by an expansion of domestic consumption. A second example of that would be the large amounts of managed capital which goes in and out of the grain markets. That has different features, [there is] the long-only feature, but there is the capital that avails itself of the market on the upside and the downside. And while the grain markets have [always] been international markets, electronic trading [has allowed] the whole world the same access to these markets at all times. They are much more robust. You have access to them regularly from Beijing, or wherever, just as if you were sitting in Chicago. That makes them deeper markets and I think they are better markets.
FM: We have spoken to some managers who say that despite the huge increase in volume in agricultural markets because of electronic trading, it is actually more difficult to execute size because of certain trading algorithms. Have you found that to be the case?
NK: I haven’t had that experience. I can tell you in executing options size, you can do a much better job with futures on the screen. The options markets themselves are much deeper and tighter because those that are trading options have access to the underlying through the screen. That tightening of the availability takes so much friction out of the markets and makes it a much better and more responsive market.
FM: Talk about the two managed futures programs you offer: Swinford and Willis.
NK: Swinford is a very traditional, fundamental trader. His background is in the swine industry and farming, and he concentrates in trading hogs and cattle. He also trades the grain markets. It is a fundamentally driven program from Mike Swinford. The [Tom] Willis program is quite a different approach to markets. Willis uses a technical approach to trade a diversified group of markets [this is a separate program from what Willis does as part of Mesirow Financial]. Kottke is the CTA and they are traders under us. They execute through our people on the floor and on the screen.
FM: Are you actively looking for additional managers to offer programs through?
NK: Yes. We bring structure [and] do administration, [but] finding these managers is not easy.
FM: Are high frequency trading programs having an impact on grain markets? How?
NK: When people talk about high frequency, they are usually talking about stocks. There are all kinds of arbs you can do with stocks; you can do basket stocks against one stock or one stock against the indexes. In grains, high frequency is not a big issue because there is not a lot you can arb against corn. Where there is an arbitrage you can do is in beans [with the crush]. There is a high frequency trade there, but it is a stabling influence. In the grain world it is minor.
FM: After a pretty boring first half of 2010, grain markets have been on the move. What do you attribute this to and where do you see the complex heading in 2011?
NK: The grain markets showed some signs of life beginning in late spring/early summer and the first issue that impacted the grain markets was the dryness in Eastern Europe. Those suspicions were confirmed and there was substantial crop loss in not only wheat but also barley in that geographic area. That was the first wave and wheat led the markets at that moment. While this was going on, we believed in North America that we were producing a record corn crop. The early conditions were quite good and those conditions changed a bit. There had been some suspicions that some of the excessive moisture early in the season was going to cause us some problems. The market discounted that, it is very rare that you have too much moisture in any circumstances. Then the weather turned less than ideal in Ill, Ind. and Iowa, and the corn crop suddenly became suspect. That is where we are now. But today’s USDA report, with substantial reduction in their estimate of corn yield, confirmed what the market has been suggesting for some time.
The higher tech corn seeds were particularly devastated in these areas where there were less than ideal conditions and that is troubling when one looks forward. I am not sure we understand why this much reduction in yield came about. We are still dealing with a corn crop of uncertain size.
For 2011, the reports out of Ukraine and Eastern Europe is that their planting conditions were not good—because they are fall planted winter crops, so their production is suspect going into next year. Obviously the signal to the markets is that the rest of the world should plant as much of everything as it can and we will see an expansion in acreage. World stocks are tight. The market says that right now and we will need a substantial increase in production in 2011 to alleviate the situation. I would say that it could be a [difficult] market for greater than one year in duration.
It will be a big year where the market will be quite on edge. It caught users by surprise because the conventional wisdom was that we [would have] a record yield. And it didn’t turn out that way.
The tripled stack corn hybrid and the results from that are very disturbing. With that type of hybrid, you have to have a percentage of your corn called refuge corn, the non triple stacked variety. Well what was found in the areas where there were problems with early moisture and not enough moisture and some problems with temperatures is that the refuge corn produced just as much or more than the high tech corn. That is exactly what occurred on my farms in central Ill.
FM: What are the major factors that will impact the grain markets?
NK: One of the issues will be world economic stability. Presuming reasonable economic growth, then increased demand from China, and it is difficult to shut that down. They have all the dollars they need and then some. If you rally corn to $5, it will not change the demand curve in China at all. It will change it elsewhere, but it is not likely to change it there.
FM: What are your major concerns for the industry?
NK: I am very optimistic about the opportunities that are out there for the futures and options industry. I am talking about the traditional products from financials through grains, metals and energy. The reason I see opportunity is because underlying currencies, not only the dollar, are under such a state of duress. That alone affords opportunities in all the markets. The opportunity is there and the world will continue to have a need for price discovery and risk transfer. I see that need increasing as we move forward. What are the caveats? Sometimes it gets too good. The forces that have been most contributory to the instability in our currencies, the political forces, could also come to bear to try and constrain what they may deem inappropriate in any pricing mechanism, whether it is financial, agricultural or energies. We already discussed the concerns that were issued when crude oil made its peak. As usual, scapegoats were sought and speculators always join that list. To that extent, too much success in our industry could be our undoing.
FM: The futures industry model worked well through the recent market turmoil, has the story been told?
NK: We, who are in the industry, overlook an important question, we just take it for granted that everybody understands that these markets work and that is not necessarily understood. That is not really understood by a great many people and it is important that we understand that. Markets don’t bring a story that people understand. The corn market that rallied is good news for the farmer but not good news for the meat producer. The market by its nature is the carrier of news that satisfies and dissatisfies at the same time. We have to appreciate that those that are disappointed by the news the markets brings are going to be very unhappy about it. That is a reality that we should not dismiss.
