Steve DeCook has traded grain and livestock markets from a fundamental perspective for five decades. His commodity trading advisor (CTA), Fundamental Futures Inc., had a successful 19-year run, averaging better than 15% per year with more than $100 million in assets under management, before closing shop in 2002. DeCook continued to trade for friends and family, but when he saw a huge new fundamental factor come into the agricultural markets in 2004, it got his competitive juices flowing and he launched his new CTA, Four Seasons Commodities Corp. His Hawkeye — he is based in Des Moines, Iowa — spread program would put on bear spreads in front of the long-only commodity index rolls. The huge size of these indexes, particularly the Goldman Sachs Commodity Index, made this a consistent winning trade and DeCook was one of the first to exploit it.
We talk to DeCook about running a CTA in two different eras, the evolution of the money flow trade and the fundamentals in the grain markets.
Futures Magazine: Steve, you have operated as a commodity trading advisor (CTA) in the 1980s when it was a relatively new asset class and in the 2000s after alternative investments were more established. Talk about the different eras.
Steve DeCook: Back then I traded heavier. We would trade one contract per $25,000, now we are trading one contract per $100,000. So I am trading smaller. Another thing, I am trading pretty much all spreads, which is less risky. [Though] the way spreads are moving around nowadays, that is not always true, but generally spreads are less volatile. We have volatility in the market now for reasons that [are unclear]. It is hard to find an explanation for a fundamentalist as to why things happen the way they do sometimes. So in general we are trading smaller and trading spreads to reduce our exposure to the market. Our returns are [smaller], also. We are aiming at 10%, whereas in the 1980s and 90s we were [targeting much more]; one year we made 80%.
FM: There is less risk tolerance by both retail and institutional investors. How did you adjust to this?
SD: One thing that is different now is back then you had the commercial crowd, you had the floor crowd and you had the general public. Well, the general public is gone and they have been replaced by the funds, an even greater influence than the general public ever was. Back then traders wanted to see where the general public was because we wanted to fade whatever they [were] doing. Now the funds are replacing them, but you don’t have the same attitude. The floor crowd is a smaller influence now.
FM: Aren’t you competing now against the floor crowd?
SD: They are watching the funds too, to see if they need to follow them.
FM: Do you think that there is too much emphasis on certain risk measures like Sharpe ratio and Value-at-risk? Has the pendulum swung too far toward risk aversion?
SD: There is a lot more risk aversion but I don’t pay attention to those risk measures. I know what the Sharpe ratio is but if you asked me to explain it right now, I couldn’t. I don’t use things like that. If something is going wrong, I want to know why it is going wrong. If something is not adding up I need to get out. Sometimes I may like my position but need to get out or lighten up whether I want to or not. No matter what you are talking about, risk is a top priority.
The [allocators] don’t want you making 50% because if you are good enough to make 50% you can have a bad year and lose that much also, which scares them to death.
FM: You traded in an era where Commodity Corp. would drop you if you averaged less than 15% over three years; now people are targeting less. Is it a hard transition?
SD: It is not hard to get used to because it is a self -imposed risk control. Whether some fund is risk- averse or not, I still have my own rules as far as limiting exposure to losses in the market.
FM: When you launched your new CTA in 2004, it was mainly to take advantage of money flows created by the growth in investments into long-only commodity indexes. Are the opportunities still there to take advantage of these money flows?
SD: Not so much anymore. Once somebody figures it out then it doesn’t work anymore. It worked pretty good for a couple of years then everyone figured it out. Because of a new paradigm, today I am not doing much of that. For example, five years ago the lead month always would go to full carry to the next month as you approached first notice day. Now look at May corn trading 30¢ over July. We have such a demand structure for ag commodities, led primarily by China, that those rules don’t work anymore. We have a different demand structure in the market, which wants and demands the lead option; we have relatively low inventories of grain available; and that big monster China is lurking in the background ready to buy anything, whether it is foodstuffs or raw materials. So, the idea of the lead option always being cheapest because of fund roll just doesn’t work anymore.
FM: When you started this there weren’t as many folks trying to get in front of the roll. Has it become a more difficult trade? Are spreads moving toward full carry much earlier or not at all?
SD: In some cases not at all. At one time, the full carry used to happen just before first notice day. That moved back into the middle of the month or during the Goldman roll, which was the fifth to ninth business day of the [preceding] month. And now if it is detectable at all, it’s maybe before that. It might be the first of the month a full month before first delivery day. Everyone is continuously trying to get ahead of the crowd and by the time you get to the point that you expect a big roll, it already has been done and there is nothing left there anymore.
FM: Does this create greater risk?
SD: It takes away the possibility of a bear spread working at all. Thinking that way can be expensive. I don’t anticipate that roll [much anymore].
FM: Do you need another fundamental reason to put on a bear spread instead of just taking advantage of the roll?
SD: Yeah, you’d better have a fundamental reason other than the fund roll; otherwise it is just not going to happen. It looked like there was more [volume] fading the funds than there were funds that were actually rolling.
FM: Do you trade more on seasonal factors?
SD: I always keep an eye on seasonality; I may or may not follow [seasonality] because it is another thing that so many people are doing that it doesn’t work anymore. I don’t have as much confidence as I used to have in it. It is more fundamental analysis like I did for many years except I have tailored it into some kind of a spread strategy rather than a directional trade. If I am bullish corn I can buy corn but [I ask] is there another way to take advantage of that and minimize the risk with some kind of spread? Maybe it is an options straddle or a bull call spread, or I can bull spread corn or I can buy corn/sell wheat. There are tons of alternatives.
FM: Many of the indexers are creating alternative products that change the roll components to avoid the effect of contango. Have you noticed a difference in the roll? Has it affected the way you approach the trade?
SD: I don’t know exactly what the [indexers] are doing but it is [another factor in why] the bear strategy for fund roll is seldom there anymore. The reason I got back in the business in ‘04 is not there any longer. We have to go back to traditional supply and demand, seasonal spreads; looking at all the factors I looked at back in the 70s, 80s and 90s to devise a spread strategy. For example, right now I am long corn and short wheat, and that has nothing to do with any fund roll.
FM: Many folks have seen the inflows into these indexes as manipulating the price of commodities, particularly crude oil. What is your opinion on the long-term impact these products have had on price?
SD: Whenever the price of something isn’t where somebody wants it to be, whether it is a politician or somebody in the industry, the first target is always the speculators, the traders. You have to blame somebody. Back in the 1970s, cattle prices were low and the cattle industry wasn’t happy about it and they wanted to blame the speculators. They wanted to have a ban on anybody going short the market. They don’t know anything about how the market works. It is the same way the politicians are talking about oil today. Funds can have a short-term effect for a day or two, maybe even a week, but it always comes down to supply and demand. There have been all kinds of investigations over the years. There is always somebody demanding an investigation as to how the speculators are affecting the market. I don’t know how many studies there have been, but they all come up with the same conclusion that speculators didn’t have anything to do with it.
One thing that [people] don’t understand is that the market is an anticipatory market. Today’s supply and demand numbers don’t mean very much if [traders are anticipating] supply and demand numbers 90-180 days down the road. They don’t get that.
FM: The end result is they got position limits into Dodd-Frank. What do you think the impact of those limits will be?
SD: It doesn’t affect me because I am not close to the limits. It is fine to have limits, but I am not sure what the right limit should be. It is not going to change the way the markets move, and I don’t think it is going to change price.
FM: You have been involved in the industry for several decades. Tell us what you think the impact of the MF Global situation is having. What are your customers telling you?
SD: We had several of our accounts at MF Global; they eventually transferred to other houses and got some of their money back. We ended up losing one account. Some people used their commodity account as a pseudo bank account to keep excess cash. They felt confident and comfortable about having excess cash, which is good because you didn’t have a margin call to worry about. Now people are reluctant to do that. Leaving a lot of extra cash in your account probably is not a great idea. We went through this with FC Stone a couple of years ago. There was no charge of pilfering money, customer funds were never threatened, but it did create a fear factor because of the publicity [although] no customers were at risk. [The MF Global situation] has caused people to keep less cash in their account.
I am on the board of a bank here. When we went through the crisis [our bank] was required to pay their FDIC (Federal Deposit Insurance Corporation) fees three years in advance. In ’09 they had to pay their dues for ’10, ’11 and ’12. [It] didn’t make me feel any better [to think that] they are in that much trouble that they are borrowing ahead that much to have money to cover bad situations. They raised the fees and they had to pay three years in advance.
FM: You have been through a few of these crises but never has segregation been breached. How bad can this be for the industry?
SD: People do eventually forget about it, except if you were directly hurt, which a lot of people were. It seems like flat-out criminal activity to me.
FM: The other big new factor in agricultural markets is the battle over food vs. fuel. Over the last decade the percentage of the U.S. corn crop dedicated to ethanol production has gone from less than 10% to approximately 40%. What impact is this having on markets?
SD: If you reduce your demand by 40%, obviously the price of corn is going to be lower. If corn is going to be that much lower, then you would draw the conclusion that food prices would be lower too. On the other side of the coin, if you stopped producing ethanol now, gas prices would jump 75¢ to $1 a gallon, so energy prices would be higher. You have to conclude that food prices have been driven higher by ethanol, but energy prices have been held lower. I am not sure how you balance those two out. When you take a bushel of corn [to make ethanol], one third of it is ethanol, one third of it is distillers grain (DDGs) and one third of it turns into carbon dioxide. So when you use 5 million bushels of corn for ethanol, one third of that is not lost, it turns into a high-protein feed for livestock.
FM: Is that growth in ethanol demand sustainable?
SD: That gets into politics. We have been exporting ethanol to Europe and Brazil, but we are kind of at a blending wall ceiling as far as domestic production. It is going to increase over the years, but not near the percentage increase we have seen over the last [decade].
FM: Will the increased supply of natural gas change this dynamic?
SD: Unless it gets into T Boone Pickens’ [plan of] putting compressed natural gas in cars in a big way, it probably won’t matter that much. A few years ago I invested in a natural gas exploration company. The good news is they find natural gas every time they stick their finger in the ground; the bad news is I am not making any money because natural gas is so cheap they can hardly give it away. I don’ think that is going to make a difference [for] ethanol. It is going to take too long to get that into the system where the auto industry is using it on any mass scale.
FM: Are we at a point with price, where people will switch to natural gas on their own without a government subsidy?
SD: You would think so. We are an entrepreneurial country, and where there is an opportunity to make a profit somebody usually jumps at [it]. There is concern that it will take some time to get this on board, and if it takes two or three years to get it on board, is that price differential still going to be there to make it worthwhile?
FM: When we spoke in the second half of 2006 you said that corn was about to set a low that would last our lifetime. So far you have been spot on. Any change in that prediction?
SD: I would raise the price now. I don’t see corn getting under $4 for a long, long time. There is so much demand in the world. The cost of production right now is around $5, so if you get under that you will start to reduce acres. I just can’t see corn under $4. And over the next 12 months, I don’t see it under $4.50-$5, I don’t think we will spend a lot of time under $5, but we may if we have a big crop this year. I think $4 is a low that I don’t think will be taken out for a long time, if ever.
FM: You no longer are concentrating on money flows. What are the main factors affecting the corn, wheat and soybean markets now?
SD: If you had to put it in one word, it would be ‘China.’ They have an insatiable demand. They have moved to a capitalistic system and people are learning that they can work where they want to work, they can go to school if they want to, they can save their money, they can have a TV, they can have a refrigerator, they can have a cell phone. Things that 20 years ago where only for the rich. The city people are having these things and enjoying them. They are finding out that the capitalistic system is an okay thing. And with that, the diet improves too. They have a huge hog population. Last year they had 40 million tons of corn they pulled out of reserve to hold down domestic prices and set aside the demand. They had a bumper crop, but they still needed to pull down their reserves. They still have not filled that reserve; they are looking at the U.S. to fill [it]. They are hoping that the U.S. has a big crop this year and the price will be cheap enough this fall to refill their reserve with 40 million tons of corn. They are just a demand factor out there that we never have had before. Any time you analyze any market the first question is, “Where does China fit in to all this?’
FM: Any other new factors besides China?
SD: That is by far the biggest. This time of year the key factor that trumps just about everything, is weather. [Couple that with] China [and you have] the two [main] factors for price analysis right now. We know that if any grain gets cheap, China is always there to buy it. They are pretty disciplined--buy grain when it is on a break for whatever reason. The one thing that would put them in a panic is if we would have a weather problem this year and the market took off, and they did not have the coverage that they need for that 40 million bushels of corn. But they have money.
FM: Give us your medium- and long-term outlook on corn, wheat and soybeans.
SD: Weather is a big issue and our longer-term weather people are estimating a corn yield this year of 160-165 [bushels per acre], which would be a very good crop but not a bin buster. On beans, I would guess in the 43.5-44 [bushels per acre] area, which would be above trendline yield. With those numbers, I would say the market is fairly well-priced today. It probably would put corn down a little, but I don’t think it would stay there. I told you that I don’t think corn will go under $4; I don’t think beans over the next year will be able to go under $13. If South America can rebound and have a good crop next year, there would be more downside risk at that time. But between now and end of year, I don’t see a lot of downside no matter how good the crop is, and if you have a weather problem, it is hard to say what number you could get to on the topside. On balance, it is a good time to be a farmer. Prices are going to be relatively good for the foreseeable future. Wheat is a follower of corn. We do have ample stocks; we do have a good crop coming on. It probably can get cheaper than corn during harvest coming up, but for the rest of this year corn and wheat are going to stay attached to each other.