CommodityEquity

How to play the coming LNG boom

2011-12-21T20:28:00.000-08:00

Many readers are familiar with recent changes in the natural gas situation. To recap: new drilling techniques (fracturing and horizontal drilling) have unlocked an enormous new source of gas. The traditional markets for natural gas have not been able to absorb the supply, and much of the additional gas has gone to lower-valued uses such as electrical generation. Moreover these same drilling techniques are now being used for oil, and are producing copious natural gas as a byproduct. The surplus is probably baked in for several years.

While this is happening in the US, the situation in the rest of the world is much tighter. Gas from older exporters such as Russia and newer ones like the Mideast and Australia are priced against oil. The final cost to the consumer may be double or triple the US price. There are many shale deposits in Europe and Asia as well, but extraction is many years off.

I can think of a few ways of investing in this...

First, it is clear to me that there will be a large and growing demand for the higher-tech drilling needed to carry this out. For the next few years, this will be in the US, but eventually it will go worldwide. The problem for investors is that much of the technology is owned by gas producers, who are suffering from the very gas glut they created. Names in the equipment and service space include Baker Hughes (BHI), Halliburton (HAL) and Helmerich & Payne (HP). Some of these stocks have been hit pretty hard since August.

Second, it is likely that the US - world price discrepancy will be arbitraged. Some think this will occur as nontraditional markets for gas are developed in the US (think vehicle fuels). I do not agree with this. The cost of the infrastructure modification is just too great. Instead, it is more likely that the US becomes an exporter of gas. Several companies are starting to look at this. One, Cheniere energy (LNG) actually has signed contracts with two overseas buyers. I have invested in the associated MLP (CQP). This has a 10% return backed by an associated pipeline. If the LNG export plan is successful, it would be a huge upside.

Another winner from the US - world arbitrage is likely to be LNG tanker owners. There is currently an overcapacity of oil tankeers, but LNG is a different animal. I like TeeKay (TK) and the associated MLP TeeKay Partners (TGP).

Finally, for those with a longer term horizon, companies with a position in European shale acreage are interesting. Western Europe will probably be wrangling over environmental issues for years, but the eastern Eur countries will go quicker. Poland is starting right now. Companies there include Marathon (MRO), Nexen (NXY) and the small cap San Leon (London SLE). Shell is in Ukraine. Another way to play this would be to short Gazprom (OGZPY), the main Russian exporter.Of course, the political situation in Russia will likely overwhelm other fundamentals.

Long Cocoa

2011-08-23T12:20:00.000-07:00

Here's why...

1. Weather in the West African cocoa zone has gotten quite dry. It was very wet for several months, but no more. In fact, satellite photos show suprisingly low levels of vegatation. This has happened awfully fast, so the satellites may be wrong or not getting the whole picture. Nonetheless, it is a big change.

2. Last week's Committemnts of traders had managed money net short cocoa. This is very unusual. The outside money normally wants to be long, and this is especially true for markets which they don't fully understand, like cocoa. I have gone through the records, and a short MM position has always let to a rally.

Libya and the mid-Continent Refiners

2011-08-23T12:12:00.000-07:00

To show how things are so completely interrelated, the success of the revolution in Libya is responsible for the relative decline in the mid-US refiners. The "reasoning" is this : Libya will come back on stream; world (Brent) prices will come down and be equalized with WTI; and the refiners will lose their edge.

All this is plausible but awfully premature. Brent - WTI will not get back to normal levels until pipelines are built that can move the oil surplus in mid-North America to the coasts. BTW, the surplus is getting bigger with continuing drilling in "oily" shale structures. For now, the prospective pipelines are having a hard time getting financing (one was put on hold yesterday). So I'm using this as a chance to add to positions.

Sold out of Barry Callebut

2011-08-11T07:28:00.000-07:00

The dollar price of this stock has skyrocketed because of the increase in the Swiss Franc. I still love this company. Also the great weather in the African cocoa region means that their factories will be humming all year. Nonetheless, I don't like global macro plays. I don't believe I have any edge in this sort of thing. So I got out yesterday. It was a great trade.

What's that old saying about lucky vs. smart?

The Mid-continent Refiners

2011-07-29T12:46:00.000-07:00

I believe there is a significant opportunity in the US refiners. My list includes :

MPC The refining spinoff of Marathon Petroleum. This is my favorite.
CVI CVR Partners refining business. This also has a fertilizer component, which this blog has talked about extensively
SUN Sun Oil, which has recently spun off its coke business and is now more of a pure play.

The basic theory here is one of increasing US crude production between the Rockies and the Appalachians. Most of this is currently traditional oil. Over time an increasing percentage will be shale oil, as the technology of fracturing ever more viscous hydrocarbon improves. The result of this has been an oil "lake" in the nations's interior, somewhat similar to the natural gas "bubble" in North America. A result has been much lower prices in this region. Most of this blogs' readers have noticed this as the Brent - WTI spread. In fact, it is really the mid-US - rest of world spread. This has led to much lower input costs for refineries in this area.

Additionally, this is an out-of-favor industry. The prevailing theory is that US oil demand will fall over the coming years because of higher prices, lower growth and inroads from alternate fuels. This will make many refining assets surplus.

I don't buy this. As long as the low-priced crude is available, it makes sense to refine it. True, some of the refined products will have to be shipped to the east coast, reducing net backs. Still, the sum will be quite positive to the refiners. Also, it makes sense on a worldwide basis for US cat cracking to be used for export products to high gasoline growth parts of Asia.

-- more to come --

Update and More on CALM

2011-06-30T08:14:00.000-07:00

UAN This has been a huge winner, up 13% since I first put it on the blog. Today the USDA came out and said that corn acreage is higher than the market had thought. UAN products are sold mainly to grow corn. I took a little off. The stock may have a downturn now as the market reflexively reacts to lower corn prices. (Fertilizer companies are often used by equity traders to play the ag market). If so, I'll buy more.

BARN This is a little tricky. In Swiss Franc terms the stock has been steady. But the Franc has been gaining sharply. In US$ terms, the stock is up slightly since I put it on the blog and up 19% since Jan 1. The company's EU sales are being hurt by the strong Swissy. Still, I believe this is a good outsourcing and EM story, and I am holding on.

CALM This has gained 6% since I put it on the blog. The ample supplies of feeds in this morning's USDA report should be good for this name.
Some more info on CALM. The stock pays out 1/3 of earnings in dividend, rather than a fixed amount. Management thinks this makes more sense in a cyclical business like eggs. I agree, but I'm sure this is widely disliked by the average retail and long-only investor. This is the sort of thing I like to see: a non-typical but smart commodity-oriented decision.
The other thing about CALM is that it is very heavily shorted (38% of the float!). I'm not sure what this is about; there may be something I don't know about. One idea I have heard - that other egg producers are using it to hedge! Also, it seems the shorts have been in this since forever. If you have an account at a broker like Interactive Brokers, who allows you to lend out your stock, you can pick up about 8% annually on the borrow!

WORKING ON -- Marathon Petroleum (spinoff).

Cal-Maine - Undervalued vs. Egg Prices?

2011-06-22T08:57:00.000-07:00

I have liked the fundamentals of most protein producers for over a year. The only thing stopping me from going long was the rise in feed input costs. However, that may less of a concern now. The US grain/bean crops went into the ground in pretty good shape, and there are a series of weather fronts moving through the Pacific that should keep it there for awhile.

One I have followed is Cal-Maine. CALM is the largest, and only publicly traded, egg producer. I haven't done all the DD yet, but here is the basic commodity story. CALM generally follows egg prices. Eggs have gone us a fair bit in the last few months, buy CALM hasn't. The company is cheap on normal valuation measures, and pays a nice dividend. More to come....

Barry-Callebut (Swiss)

2011-06-09T09:28:00.000-07:00

This is the second post since I restarted the blog last week. I'm going to try to post at least once a week.

I have been long Barry-Callebut (BARN) for several years. Currently it's a 3% position. Earlier this year it was 5%, but I took some off. I still love the company and am looking for a place to add back.

BARN is the premier industrial chocolate maker in the world. By "industrial" I mean that BARN has almost no confectionery business; it sells its chocolate to candy manufactures and to the upscale food service industry. Because of its size, BARN can produce chocolate at lower cost than the candy makers themselves. The outsourcing phenomena that business has seen in so many industries is true here as well. In recent years, BARN has done business with companies that used to totally control their own processes, including Hershey and Nestle.

So BARN is the low cost producer - a situation I like to see in commodity businesses. Market growth will be a continuation of increased outsourcing and final demand growth in EM. BARN will be a leader in both of these.

BARN usually hedges all its cocoa and sugar buys and sells. In other words, the BARN customer takes the futures price risk of the soft commodities. OK, so where is the commodity story? It's in the long run. Because of its storage costs, cocoa is a commodity that is very hard for "financial buyers" to take control of. That trick was played a year or so ago, and it ended badly for the hedge fund in question. This means that cocoa is likely to continue to be available at reasonable cost for the indefinite future. Prices have gone up somewhat, but that's a positive for increasing production. I believe there is a risk premium in BARN (and in many commodity-consuming stocks) because of the worry of the commodity bubble.

This is a risk I am willing to take. If you don't agree, you can create a partial hedge by buying cocoa futures. I do play cocoa from the long side, especially when the commitments of traders shows managed money net short. These guys generally don't know anything about cocoa, and are easy pickins for a short squeeze. In fact, it looks like one of these events is occurring as I write this!

If you want to invest in BARN, you should be aware that it is priced in Swiss Francs. Also, the company just had its debt upgraded to investment grade and may be planning a bond issuance.

CVR Partners

2011-06-03T17:41:00.000-07:00

This blog has been inactive for quite some time. I'm going to restart it, but with more frequent and shorter posts.

I am long CVR Partners (UAN). It's a 3% position for me. UAN is an MLP that produces nitrogen fertilizer. The key fact is that its plant is allied with an oil refinery. It uses the bottom of the distillation column (called petroleum coke) as its input. This is practically free, since pet coke has minimal value. All its competitors use natural gas as an input. Thus, UAN has a cost advantage and should be able to make money in most markets. Another part of the story is that this is effectively a call on natgas prices. I'm not a big bull on natgas, but many people are. There's no question that natgas is dirt cheap vs. oil on a BTU equivalent basis.

UAN's management says they expect to pay out about 10% ($1.90) this year. With the sharp rise in nitrogen prices, they should be able to do this. So there's value here. The catalyst will likely be the actual payout announcement.

I am a big believer in the long term agricultural story, so an efficient fertilizer company is a nice play. MLPs are normally bought by conservative, income-focused investors. For that reason it will probably take some time until retail and long-only are comfortable enough with the name to bring it to full value. However if there are no unexpected problems, I expect a doubling in three years.

As far as risks go, I'm willing to take the macro risk of the overall agricultural market and nitrogen prices. There is execution risk of course. UAN is a one-plant company, so any fire, flood, labor problems or such would have serious effects.

2007-12-24T13:26:00.002-08:00

The Long Term Bull Market in Molybdenum

Molybdenum (Mo) is one of the many industrial commodities that languished in the 1985 – 2002 period. It was characterized by low prices, low or negative investment and a lack of interest by consumers except as a routine item. Additionally, much of Mo is copper byproduct, and the low copper prices caused miners to maximize moly production as much as possible.

This all came to an end in the ‘00s as steel demand growth in the developing world blew out. Moly went through much the same process as other industrial metals, with prices rising about eight times. The structural situation, however, may be even stronger than some others.

Supply / Demand

Estimates of moly supply/demand are confusing, with discrepancies between sources. However, all agree that inventories of moly have been reduced to very low levels. Previously, many of the stocks were carried by dealers; consumers and producers kept inventories just in time. The eight times price increase has made it too risky and costly for dealers to continue in this role. There may be speculative stocks held by private speculators/hedge funds etc., but in the following I assume that there will be no stock drawdown from hereon.

Usage of moly has grown 3.2% per annum over the past ten years. However it has grown 6.6% per annum over the past five. Partly this is due to strong emerging markets and infrastructure buildouts over this time period. There is reason to believe that there is a structural element to this as well.

Moly steels are stronger and lighter. On vehicles they are a gas saver. Many observers see a higher use of alloy steels here.
Because of strength and corrosion resistance, moly steels are also heavily used in oil/gas drilling, especially in deeper wells.
Moly stainless substitutes somewhat for nickel stainless and currently has a significant price advantage.
Moly is used as a catalyst in fuel refining. It is the major catalyst used in making ultra low sulfur diesel – potentially a big growth story in Europe and the USA.

For this analysis, I will also assume that potential demand will grow by 4.5% per year. Actual demand will be constrained by production.

Future moly supply hangs on new mine openings and Chinese exports. As in all mineral markets, there are a huge number of explorations going on, most of which have little chance of going forward. The mines I include here are those I think have a high probability of coming to fruition.

The Chinese situation is somewhat confused. China has effectively banned all toll roasting of moly, indicating a tight situation. There are reports that production of concentrates at state-owned mines are up, but private mines are down. I will assume that the growth in the Chinese economy will slowly reduce exports.

See the table at the top. All figures in million lbs. Mo equiv:

The take-away from this is that there can be no significant moly stockbuilds until the end of the decade. After that, if all things go well (a big if), it can resume a more normal market.

Prices

There is no way to accurately forecast moly prices. This is a situation of zero surplus stocks, but very high current prices. However in view of the above, it seems reasonable that prices will remain quite high until 2010. The 1960 – 2006 deflated average price is $14 / lb. In light of the strong fundamentals, this should probably provide a long-run floor.

Investment Possibilities

Moly metal forwards are very difficult to get. One could buy cash and hold it, but in view of the price level, that is a poor idea. If it could be traded, one would guess that there would be a hefty backwardation in moly metal.

Possible equity plays:

The best mine in the world is likely to be the reopened FCX Climax mine in Nevada. Reputable sources claim it will have an operating cost of $3.50 per lb. Unfortunately, FCX is clearly not a pure moly play, but if you were decide to go long copper or gold stocks, this would be a consideration.

General Moly (GMO). They are developing a new mine in Mount Hope Nevada and own another high grade moly claim nearby. This is one that looks like it will get done. It will take about $1 billion. Investors include the steel companies Arcelor-Mittal and POSCO (Korea). This is important because they will become dedicated consumers as well. The funds Coghill, Sprott and Citadel are also in. Production is scheduled for 2H 2010. This is a claimed low cost project – total operating cost including an onsite roaster is $7.65 / lb., and a moly price of $15 gives a claimed IRR of 25%. Grade is high for an open pit at 0.1%. One downside: some think the 2010 startup is optimistic, maybe very optimistic. http://www.generalmoly.com/gmo1dir/investors.htm

Molymines (MOL.TO). This project is backed by some of the same principals behind Fortescue Metals Group, a very successful Western Australia mining venture. This is probably a slightly higher cost project. However it is located closer to the expanding markets in Asia. Grade is 0.06%. One advantage is access to ultra cheap Aussie natgas for power. Also, there may be other economic minerals on the claim, especially iron ore. If so, there could be significant upside.

http://www1.molymines.com/default.aspx?id=1&category=1&Ddte=1&DGrd=1

Adanek (AUA.TO). A smaller producer. This should be the 1^st new moly project online.

http://www.adanacmoly.com/index.php

Thomson Creek (TC). This company operates the Thomson Creek mine in Idaho and another in BC. It has a PE of 16, P/B of 4.3. They also have a Mo roaster in PA, which also does toll work. This would seem to have lower risk since it is already in operation. However, production at both mines has been below expectations.

http://www.thompsoncreekmetals.com/s/Home.asp

The Trade

General Moly (GMO) seems the pick of the litter here. Molymines (MOL.TO) also looks good, especially in view of the track record of the principals.

For those who want to be market neutral, hedging new ventures is difficult. The betas of GMO and MOL.TO are statistically unreliable. In reality this is going to be quite nonlinear. In a major economic meltdown, these stocks could go to near zero, while a 10% correction might mean nothing for the long term. To partially hedge, I am buying XME puts, strike at 10% under the market.

Update on the copper trade

2007-11-15T12:25:00.001-08:00

I have a trade on long PCU/short comex copper (dec 07 at this point). As I mention in the sidebar, I've hedged most of my equities with various instruments, short S&P500 futures being the easiest. I hope to keep this position on for a very long time. Let's see how it has done since the start of the credit crunch:

.................PCU.....Comex.....Dec SPZ7
July 15......112.5........3.66..........1558
Nov 15......107...........3.08..........1456
% change...-5%........-16%...........-7%
Note: PCU is dividend adjusted

So the trade has done quite well. Even unhedged, it would have made 11%, pretty good on a relative value trade. And if you hedged it that goes up to 18%!

So what to do here? I'm in a bit of a quandary: on one hand I believe that the trade will pay many times that over the next few years. Copper the metal is still way overpriced, and we are just starting to see the beginnings of new supply brought on by the price rise. Also, PCU is still a very profitable company, and is lower cost than most of its competition. OTOH, instinct tells me to take profits on a big gain like this. So I'm taking the chicken s*** way out - I'm taking a little off. Hope to put it back on if the whole stock market tanks big time.

LINQ

2007-10-08T13:28:00.000-07:00

Last week I mentioned that I had bought LINQ Resources, an Aussie commodity investment fund. This fund invests in mostly late stage exploration and development, rather than operating mines. Many of its investments are more of a private equity type rather than stock market plays. It has a somewhat higher risk portfolio than the big cap mining companies. I think it is worth the risk:

1. It's selling for 10% - 15% below NAV. This is the good think about buying closed end funds.

2. A hedge fund that specializes in buying discounted funds like this and eliminating the discount through activism has bought a large position. This fund has an excellent record, and I expect it will be successful.

3. I'm not sure the management of the company is too savvy financially, but they do seem to know their mining. I'm hoping that the infusion of financial expertise from the hedge fund owner will lead to a better company.

3. The company still has a substantial cash position. I've noticed that private equity companies tend to go up after they manage to invest their funds.

Sorry....

2007-10-01T07:25:00.000-07:00

I wasn't able to post last week. Family issues. However there are a couple of things worth noting. First, I'm taking off a little more of the levered loan trade. This was an extremely large position that is now only a large one. Also, the discount on the closed end funds that I bought has narrowed significantly. I still expect this to do better, but it's not the gift it was a month or so ago.

Also, I have a new commodity equity trade, an Australian investment company called LINQ Resources (Yahoo symbol: LRF.AX). Hopefully, I'll be able to post a full analysis of it later in the week.

Take off the oil trade

2007-09-18T11:35:00.000-07:00

The oil trade (long oil equities, short crude futures) was the first trade I posted when this blog started in Nov. 2006. link It's time to book the (very substantial) profits. Here's why:

1. The crude market has moved from a big carry to a big backwardation. Remember, a major rational of the trade was to collect the carry in crude. The current term structure is telling you that current oil prices are not driven by spec demand, but by real oil consumption.

2. If oil goes into blowout phase, the equities will not follow as hard. Equities are a long term investment, and will more or less follow the long term forward crude price. I doubt that Dec 2011 futures will blow out.

3. The downstream parts of the oil industry are starting to soften. There is a lot of refinery capacity being built around the world, and much of the output will come to the US. I also expect that coal and natgas prices will continue soft.

If you want to have continuing oil exposure, it's best to play the highly levered companies. I would recommend something like Canadian Oil Sands. This has a high breakeven oil price, but would generate huge profits in a blowout. Note that this is a pure spec on the crude price - not the kind of commodity/equity relative value that we mostly do here.

Not much happening...

2007-09-10T13:46:00.001-07:00

...this week. Once again, a lot of vol., but not much actual movement. We've seen this for about a month now, and I suspect we will see a fair bit more.

The market reminds me a lot of the period after the 1987 crash. In both cases we had extreme worry/fear on Wall Street, but good market valuation. I find a really good fear index is the performance of the financial sector stocks. If they are going down, wall streeters fear for their own jobs (rightly so) . As most people know, most of the decline in the S&P 500 is due to the financial sector. I doubt this will go away any time soon. It's not just a question of unknown losses from subprime and LBO paper. The big profit drivers for the street, debt packaging and M&A, are down for the count. I bet volumes will be a quarter of what they were (might even be zero for awhile). Gloomy stuff.

Now you might say "So what? That's just the street, not the real world." Well, the wall streeters are the salesmen for the market. If the salesmen are demoralized, it's unlikely that we will get much interest from the buyers. I know it sounds cynical, but we need people with a vested interest in a bull market talking it up and selling it.

OTOH, the market has real value. Click on the chart for the current state of the Fed Model. See previous posts for an explanation of what this is. We are certainly in the value portion of the spectrum. Another thing: the US dollar is finally beginning to fall against the Asian exporters. This will be highly beneficial for big cap multinat's, esp. GE, BA, and a lot of our commodity favorites.

The result of all this will probably be more of the same. I'm hoping that we get a real capitulation by the longs. This would probably happen if some of rumored losses among the big houses turn out to be real. In the meantime, just wait it out. I'm still hedged with S&P futures. I also wrote a few S&P calls (Sep) to play the enormous time decay right now.

I took off the cocoa position. The new crop looks quite good. I still like the market longer term, but it may have to wait another year.

Railroads

2007-09-04T14:20:00.000-07:00

OK, I've been promising a post on US railroads for three weeks. Here it is.

The US is running out of transportation capacity. Most of you who live on the coasts already know about this in your daily lives, but it is occurring in freight as well. There's a lot of reasons why:
-Most importantly, the change in the automobile from a family vehicle to a personal one.
-Movement of the population from the heartland to the coasts
-Continued economic and population growth

"America runs by truck" as the slogan goes, but trucks are slowing down. According to the stats I could find, they have fallen by about 5% in the last few years. In the past this would have been rectified by building more roads. This is no longer possible: skyrocketing costs, eco-opposition, and the near end of eminent domain have closed this out. As far as freight expansion of the airlines - don't even ask.

Rail is the one mode that still has significant excess capacity. I know - you are going to tell me about the rail traffic jams of a few years ago. Those are history. The fact is that the US railroad business was very poorly run after the mergers of the 90s. Even on the long-haul western RRs, speeds were less than 25 mph. This has now changed. Speeds are up; dwell times are down. Remember, trackage is the limiting factor in US RR capacity. An increase from 25 to 35 is 40%.

This has gone along with a general improvement in RR management and Boards. I believe that this is the reason Buffet, Chris Hohn, Ican and such have gone in. The change is industry-wide - even pathetic losers like Amtrak are doing better. The most important result of this is that they are using their duopolies (two RRs in the east; two in the west) for shareholder return, not competition for growth.

Along with the improvements in mgnt. and capacity, commodity trends have favored RRs. Two of their biggest customers are agriculturals and coal. Both of these have had increases in volume, with more to come. The growth in ethanol has led to high revenue tank cars being substituted for hoppers. Intermodal (trailer piggybacks) will also rise with increasing road congestion.

But the biggest trend will be in an increase in RR margins because of operating leverage. Remember, this is a very high fixed cost industry. For example, BNI's operating margin (net) has gone from about 15% to 22% in the last few years. It's hard to disentangle operating margin from pricing power - to a certain extent they feed on each other since a duopoly can reduce unneeded capacity.

OK, what to buy? Realistically, you can probably buy the whole ector. I chose one western (BNI) and one eastern (CSX). A buy-side analyst I read and respect claims NSC as the cheapest, but I deferred. Of course the risk in BNI is that you wake up one morning and find Buffet has reduced his position. I judge this to be unlikely since the position is getting too large to exit. There is no RR ETF.

This position is unhedged. I expect to keep it for a very long time, and I don't want to bet that the stock market goes down over the next five years.

Commodities, not here....

2007-08-28T08:01:00.000-07:00

I know it's a little strange that a blog dedicated to commodity-related investments has had mostly financial-sector trades recently. However, that's where the values are. I was going to spend most of this post talking about the railroads, but credit got in the way.

Last week I recommended buying closed-end loan funds big time. So far it is up 5%. The trade was in the WSJ yesterday, adding to the gains. I believe this has more to go, maybe another 7%. However, 5% in a week is a lot. So I am:
1. Taking a little off, making it only a "big" trade not a "pig" trade.
2. Hedging it with S&P futures, face value delta about .5.

more to come.....

Wholesale Repositioning

2007-08-20T13:11:00.000-07:00

Lotsa stuff to go through today....

First, I took off the VIX trade on Friday. This has been a great winner, one of my best in several years. However, there are a couple of reasons to book it:
- Value. The VIX has come a long way, and it hasn't gotten much above these levels except in true crashes like 1987 or 2002. Of course we might be going into one of those (who knows?), but I'm not willing to bet on it.
- Fundamentals. Until last Friday the Fed was staying out. In fact Poole said as much as "screw you" to the problem. That has now changed. Whether or not they will have the will or skill or bullets to fix the problem is a question mark. But at least they are trying. So it's probably going to be more of a two way situation until things clear up. (BTW the market was almost unchanged this week, once again.)
You may remember that I first put the VIX on as a hedge and then decided to ramp it up as an independent position, a big one. Taking it off leaves the position unhedged. I sold some S&P index futures to compensate. This is purely a hedge; I'm not betting the market will fall.

Loans: I put on another trade, unrelated to commodities. The price of bank loans in the secondary market has fallen sharply. Why? Just another fallout of over leveraged hedge funds.
Now bank loans are very senior obligations. In the event of default, they almost always recover 100% of their value. Yet AAA loans are going for 90 cents on the dollar. This is nuts. To make it even juicier, there are closed-end loan funds that are selling for a 15% discount to NAV. I bought two of these, EVA and BGT. I really believe in this trade, so I hit it hard. Note that loans have already recovered somewhat from their lows (click on the picture to enlarge). Data is from Markit.

Railroads: Finally a commodity-related trade. There are a lot of reasons to be bullish on US railroads, and they all don't have to do with Warren Buffet of Chris Hohn. I'll go through the details next week. I bought Burlington and Chessie.

Starting to calm down?

2007-08-13T12:07:00.000-07:00

Once again we had a week with a lot of action, but not much actual change. The VIX made a new high on Friday, but fell off today. I have been taking the VIX trade off slowly, still have about half.

The GS Sep put trade worked out great. It's now worth about 600 points. Probably best to book it now, or at least to roll up the bottom strike from 130 to 150. I'm getting out. In the future I'll detail these sorts of things as full trades, not afterthoughts.

Little to say in the relatively quiet world of commodities. However. I've bought cocoa again. Like last time, it's best to stay with the pure commodity, not equities. The basic rational is the same as before: this is a long-run demand-pull bull market that will give good long side trading opportunities. I have discussed this several times. The only thing that has changed is that speculative selling has pushed the price down to a cheap level.

I'm also thinking of adding to the oil trade. The hell in the quant space has led to a lot of forced selling, and these things are cheap. If I do, it will be on a market-neutral basis.

Wheeeeee....

2007-08-06T13:18:00.000-07:00

Last week I said I was bullish. Well, the market is almost exactly equal to what it was then. Somehow, that doesn't seem to be the real story. Anyway, I BEGAN taking off some of the volatility trade here. Still keeping most of it on, though. Not much else to say.

I have another trade, not related to commodities, that bears looking at. The price of credit default swaps (CDS) has skyrocketed. This is known as "tail risk." In fact it's gotten so high that I am selling this and shorting the underlying corporate bonds to hedge. Unless the world goes down the crapper, this is a very good trade.

Note that to trade CDS's you need an ISDA. However, you can do essentially the same thing by buying at the money puts and selling a multiple of deep out of the money. For example, the Goldman Sachs Sep. 180/130 put 1 by 4 will cost about 2.90. If they don't look like their going broke in the next few weeks, that should at least double.

Rocky Road Indeed

2007-07-30T19:29:00.000-07:00

When I said last week that you should get set for a rocky road, I didn't know the half of it. Well, at least I was mostly immunized by the long VIX trade. I'm leaving this on, even though I think the worst is over, since I don't believe there is much downside to the VIX.

Here's why I think the stock market is going up:

1. Private sources have told me that there is active bidding for the large banks' portfolio of bridge loans made on behalf of private equity. Note in the Journal today that Citadel took over Sowood's book. I know of other efforts along the same lines.

2. There is a big difference between a liquidity squeeze and a recession. If the current paralysis in the credit markets were to persist for awhile, that would be a problem. Buy as I said in 1., I don't think it will. In fact, the return to normal risk premia in the credit markets is a good thing. Loans were being make at rates and terms that were simply ridiculous. Nobody will make that mistake again - at least for a couple of years.

3. Finally, go back to the "Fed model" of treasuries vs. equity yields that I published several posts on. The 10-year is at 4.80%, and the equity yield (inverse of P/E ratio) is at about 6.20%. We have found value.

Trade Changes and "The Basic Trade"

2007-07-23T10:41:00.001-07:00

1. I got stopped out of the natgas about ten seconds after the last post. I still believe in the trade, but you have to respect your stop. There are a couple of ways of continuing this. First, natgas vols are quite low, so you could just buy options. Second, you can buy a long Mar/May spread. This probably makes the most fundamental sense. The low price of NG vs. CL will undoubtedly bring demand increases, but it might take awhile. When it comes it is not likely to be short-lived. Just like visible stocks have gone up above average for a few months, they will fall in the same way. Remember, many of the users are buying 3 - 6 month contracts.

2. Today's drop in sugar was what I was waiting for. I added outright futures, not options. I will probably finish off my position another 40 points down.

3. I sold some more of the AA on Tuesday. Partly this was just luck, but I'm getting pretty nervous with this. It was trading exclusively on buyout possibilities. OTOH, Al metal prices have continued to rise for the forward positions, a very good sign. I'll probably buy some back around here.

4. The VIX just keeps on going. This has been my best trade in quite awhile. The stock market is near its high, but the hedge (VIX) is up about 20%! I still have the position, but have rolled forward.

Now is a good time to evaluate the prospects for all commodity equities. So far in '07, they have had a wonderful run, far outstripping both the overall stock market and commodity prices. In my view, most of this was due to an undervaluation last year. The market simply didn't realize that commodity prices were going to stay high for long enough. Also, these are mostly high beta stocks, so the overall equity move has helped.

My valuation work still has them as cheap, based on a DCF/risk analysis. Obviously the undervaluation is not as severe. Given the significant long positions in the market, you have to expect some minor crashes. I have chosen to counter this with a hedge in the VIX. Some of the readers might prefer the more direct route - buying puts on the stocks we are long. Since I think that all vol. is going up, that's maybe even a better idea. However, the important thing is to keep your eye on the longer term - the basic trade is still good and should be kept on. Just get set for a rockier road.

New Policy and Trade Update

2007-07-16T08:29:00.000-07:00

I've gotten some negative feedback from readers on the occasional nature of these posts. They are right; readers should expect some consistancy in posting. So starting now, I will post on a regular basis - every Monday. Normally this will be sometime during the day. If you check the blog on the Monday close, you will get the update. Sorry.

I'm still in the long natural gas trade, but barely. Since the last post, Dec. natgas has fallen from 8.78 to 8.43. Ugg. I'm giving it a bit more time.

I hedged my short in HGN7 with long in PCU. This has done great. HGN7 is only up a few cents since the short; PCU is up 20%! Go PCU.

I'm getting more bullish on sugar. I would start buying outright futures right here. Also, an activist investor has put on a position on both CSR and MSF. It is believed that he wants to combine the two. This would be a great outcome - we'll see.

The VIX has been my best trade in quite awhile. It is reaching a chart point where it might stall for awhile. If you were smart enough to have your position in the August, roll it forward. But don't take any off.

More to come.

Two Opportunistic Trades

2007-06-27T12:08:00.000-07:00

Readers of this blog know that I generally believe that there is no "commodity supercycle." Instead, I think the big moves up in the last few years are simply due to underinvestment in basic industries for the last 15 years. (Oil may be a little different; political problems make it unlikely that any amount of investment will clear the shortage up.) Nonetheless, there are a couple of bull trades that I think make sense here.

First is natural gas. NG prices are cheap: cheap relative to history and cheap against oil. There's a good reason for that. The weather in the northern US has been mild so far, leading to less need for gas use. Also, coal prices have fallen. NG competes with coal in the electrical generation market. Finally, we are in the hurricane season and so far -- nothing.

I think the time has come for a value trade in NG. As we approach the winter, the market will probably put a risk premium in Dec futures onward. Also, NG competes with some oil products for commercial/industrial demand. These users will undoubtedly do some switching. So we could see a pretty good move up in a month or two.

Two problems. First, it's always hard to buy a market in free fall. OTOH, that's what chart patterns and stops are for. You have to keep trying. Second, we might get to a situation where stocks are so high that they pressure storage capacity. If that happens, the nearbys could get destroyed.

The equity markets are giving some indication of value. NG equities have not had a (market-adjusted) retreat. So this is non-confirmation. Nonetheless, I think this is better as a commodity play. The snap-back in NG futures is likely to be severe.

to come - corn....

Position Updates

2007-06-27T07:32:00.000-07:00

I've made a few changes to the portfolio. But first: isn't the VIX trade just great? As I mentioned before, this is not just a hedge but a stand-along trade. It's moved from about the 13 handle to the 16 handle. My best guess is that the stock market will have a rally here. This will probably work against the trade short-term. Even so, I think vols have reached a major turning point. Keep the trade on - perhaps roll some from Aug into Nov.

Other changes -
I am getting out of the chocolate trade. As I wrote a few weeks ago, this is pretty well advertised. Over the long term, these stocks will probably do better. However a lot of folks are in, and there will be sharp reactions. Use these to get back in.
I am keeping some of the cocoa position that was an (expanded) hedge. The long term for cocoa is quite good, and I expect it to trade higher over time. OTOH, it is also a crowded trade, and I have taken some off. Trading from the long side, rather than buy and hold, will be the way to go.

Bought natgas futures - see above post
Looking to short ADM, buy corn. more later...

Sugar, Aluminum

2007-06-18T12:57:00.000-07:00

Sugar had what looks like a breakout from an exhaustion bottom. We will see. I'm behind on this one, so I'm rooting for it.

I took off a little (25%) Alcoa today. It's gotten close to my objectives, and the metal price has come off. This is not textbook trading; you are supposed to let your profits run on a big move like this. Oh well........

That was fast...

2007-06-05T11:53:00.000-07:00

Last week I posted that the stock market looked OK, except if rates got to 5%. Well it just about happened today! Now what? Note that stocks are about the same level they were, even though rates are up almost 20 basis points.

I think this means 1/ The upside is somewhat capped for awhile and 2/ volatility will continue to increase. I've continued to increase position in CBOE VIX futures. My guess is that these may be good even without a sharp retraction. The market is getting confused on how to interpret the current situation, and vol should go up more. I've been adding in a nearer month - Aug '07.

I've never had more arguments about a position than I have had with my short copper trade. No one likes it; some get mad. They all make the arguments about China, India, etc. My guess is that these are in the market. As I said, I may be premature, but maybe not. Also, there is a big (and very savvy) long in the market. I think he is aware of how illiquid his position is, and is scaling out accordingly. He was dead right at the bottom; in fact he was part of the reason for the long copper trade at $2.50. Of course this market is in backwardation, so there is a cost to my position.

Stock Market Valuation

2007-05-31T11:49:00.000-07:00

On Jan. 1, I did a post on stock market valuation. At the time I claimed that stocks were about 10% too cheap. This is a good time to reevaluate.

A number of things have changed, including:
1. The S&P 500 has risen almost 10%.
2. Corporate profits have grown five percentage points above my estimates.
3. Treasury yields have moved up from 4.7% to 4.9%.
4. The worldwide political environment has gotten slightly better, particularly in West Europe.
5. US inflation and growth have come down.
6. We had a major worldwide panic in late Feb/early Mar that had no lasting effect.

Going back to the "Fed" model that I attached in Jan., the market is still on the cheap side, but not as clearly undervalued as it was. Still, I would say it's supportive.

The stock market is about "fairly valued" against US real estate, crude (click on graph 2), and world markets. Nothing to worry about there.

The market is cheap against inflation (This is presented like the Fed model, click on 1. I believe this was Abby Joseph Cohen's fav. chart.) and corporate bonds. As the news tells us daily, it also cheap against the private markets.

Contrary opinion indicators continue to be very bullish. These include rising short interest (at all time records), continued flows into alternative assets, and much much more! One of my current favorites is the TickerSense blogger poll, which shows financial bloggers are solidly bearish. Some folks never learn.

So I'll have to say that the market still looks quite good. The major cloud would be a move in rates over 5%. We'll cross that bridge when and if we get there.

Copper non-confirmation

2007-05-24T08:32:00.000-07:00

Ever since the copper trade of a few months ago, I've been watching this market particularly closely. It looks to me like we are sort of getting a bear signal now. Look at the chart on the left (click to expand). There's an obvious divergence between copper futures (solid line) and PCU. In my view, PCU would have also broken down, except for the relentless bull market in equities. However, my valuation measures are saying that stocks are not badly undervalued (more on this tomorrow), although still not too high. A short on HGN7 or PCU might be just the ticket here. As readers know, my gut is to short the metal rather than the stock, but they should move pretty much in line.

This is the first commodity-related short I have put on for almost three years. I must say that I am definitely not a believer in the the long-run raw material shortage hypothesis (also known as the Clubheads of Rome). To me, the current bull market is just another cycle, brought on by underinvestment over the last ten years or so. Oil might be a little different, because of the political issues. However I have no doubt that we will see MUCH LOWER prices for things like copper, nickle, and soybeans three years from now. Maybe I am being a little premature in putting on a short here, maybe not. I'll keep trying, using stops.

Also, this position effectively puts me into a long aluminum, short copper position. This is not a bad position to be in. The two metals compete in several major markets, and right now aluminum has a big price advantage. This will also work out over time.

Yet More on Alcoa....

2007-05-10T12:29:00.000-07:00

This is getting somewhat complicated. For those of you following it: the street thought that AA was a takeover target. Instead it is now bidding for Alcan. Of course it would have been better if some PE whale had bid for AA at a 25% premium. But the current situation is actually quite good. As part of the deal, AA will divest most of its non-metal production operations. That means it will be solely focused on being the largest and lowest cost aluminum producer. This is what shareholders want. If I'm right about the long-run aluminum situation, AA could turn out to be a very profitable company.

In the short run there may be a pullback as the market reacts to the confusion. If so I will buy some more.

New hedging strategy

2007-05-08T11:27:00.000-07:00

I am hedging my overall stock market risk with CBOE VIX futures (rather than S&P500 futures). The numbers look quite compelling. The market is quite overextended (although I still like the long term). VIX futures are a great way to hedge. I think that vol. is about as low as it's going to go anyway, so there is little downside. OTOH, a steep correction would probably blow it out again, giving you a pretty good hedge. Of course if the market slowly sinks little by little, the hedge will not be as good. Unlike selling S&P futures, if I'm wrong and the market continues north, there should be almost no cost.

PORTFOLIO CHANGES AND SUGAR(2)

2007-04-26T10:54:00.000-07:00

I added a couple more ideas to the sugar trade of a few days ago. It's at the end of the sugar post.

I also took off half of the chocolate trade. Partly it's because it has done very well, and I wanted to book something. More important though, I get the feeling that the trade has become well advertised. Everyone I speak to knows about it. I have also seen it touted in various blogs and analyst reports. So some of it is clearly in the market. Also, cocoa prices have flushed. Now partly this is because of the return of rains in West Africa, exacerbated by spec liquidation. However, US grind was not that great. It might mean that the consumption story is slowing down. I don't think so, but it's wise to take some off the table.

Alcoa's management is finally doing the right thing. The recent announcement (selling off the consumer businesses) shows that they must realize that a pure metal company is going to be more highly valued than a conglamerate. This is very good news. However, I shouldn't gloat - AA still down 1.9% on a beta-adjusted basis since the trade went on.

SUGAR

2007-04-22T15:15:00.000-07:00

I believe that sugar is going to have a big bull market in the next two years. Of course two years is a long time in the commodities business. But that's part of what this blog is all about: finding ways (usually through equities) to participate in long run commodity fundamentals. We want these trades to be no-carry or positive carry. That's the idea here.

According to the analyses I have seen, sugar to energy has the most favorable economics of all biofuels. It may be the only biofuel that can be planted for fuel without government support. (There are a lot of crops that will work with a biofuel byproduct.) Sugar to ethanol has worked in Brazil since at least the '70s, when I used to go there to buy cocoa. Its technology is well known, stable and easy to implement. Its costs are predictable.

Sugar is a staple crop around the world. It has various levels of production cost and government support. The cheapest sugar in the world comes from Brazil. Most industry people I have spoken to say the cost of new production there is about 15 cents a pound. The current cost of existing production is of course much lower. Brazil has plenty of area for increased production. It also has a plenty of ways to switch sugar cane between sugar and ethanol depending on economics. So Brazilian sugar output can actually fall with no acreage or yield reductions. Other countries can also increase production, but the costs are higher.

Sugar ran up in late '04 and '05, partly because of supply/demand, but mostly on the back of the oil price and biofuel value. This was followed by the inevitable disappointment. New ethanol facilities (and facilities for ethanol consumption) take a long time to develop. The US, to protect its own ethanol industry, has a tax on Brazilian imports. Supply reacted to the higher prices the way it always does, and we now have a four or five million tonne surplus.

If you look at the history of sugar cycles, it seems to take two to three years to work off a surplus caused by production increases. My guess is that this one will take less. The Brazilians are already diverting cane to ethanol. The EC is sharply reducing the subsidies that drove farmers to produce for world export. (Exporting at French costs to 3rd world markets. That's gotta be the worst ag distortion of all time.) More important, the ethanol story makes sense. This will provide a rising floor under demand that will cause continued periods of tightness. I'll bet that sugar prices will overreact on the upside once again.

OK, how to play this? The classic commodity trade is to follow the fundamentals, watch the charts, and buy major breakouts. There will be some false ones, so you have to use stops, and you have to keep trying. This should work, but given the time frames involved, you may lose interest and/or hope. Another way would be to buy out of the money '08 calls. I don't generally like to buy options. I'm a good enough trader that I can control my risk more cheaply with careful timing (in effect doing my own delta hedging). Additionally, the sugar chart still looks bad and counts to under nine cents. Nonetheless, if a bull market does come, options volatilities could expand a lot. So this might be a successful strategy.

But I think even better is to buy shares of sugar companies. Many of these companies have facilities that has long been depreciated. They can and do make good money at current sugar prices. They have no plans for expansion, so they tend to pay good dividends. There's a real positive carry here. Of course if sugar prices don't go up, there will be no growth. But that's the bet.

As far as I can see there are no US companies with significant exposure to world (#11) sugar. The biggest name is an Australian company CSR (Yahoo symbol CSR.AX). CSR is about half sugar, but it is also a major force in aluminum and building products. Readers of this blog know that I like aluminum companies. Building products are a little more problematical. CSR sell in the US, and has had some liability issues. Nonetheless it's a good conservative issue with a P/E of 14 and a 4% dividend. I like it.

This was added on April 26 --- Here are two small caps with high exposure to world sugar. Illovo Sugar is a S. African company with sugar interests there and in other African nations. It's selling for about 3.2 times book. It is majority owned by British Foods. That would be a red flag, but S. Africa has western-level accounting and corporate governance standards. So you may be all right.

Another is Maryborough Sugar (AUS), a Queensland refiner. This is quite a small cap, but pays a good (10%) dividend! Remember though, that Queensland is low on rainfall, so there may be production problems.

Agriculture to Energy

2007-04-13T08:42:00.000-07:00

This is the first in a series of posts on this subject. Today I'll talk about the general situation. Next post I'll fill in a trade or two.

For the last couple of years the prospect of of using crops for alternative energy has been thought of as a "game changer". The potential added demand for the crops is so large as to dwarf traditional food uses. According to many, there are not enough acres in the world to satisfy this demand. Grains and sugar go to ethanol, oilseeds to biodiesel, etc. Not only is this economic, but the political powers around the world are almost always protective of their farmers and agribusiness. So once the capacity for ag to energy has been put in place, it will get used. In other words, capacity growth is a one way street. Therefore we will get pretty much a permanent bull market in this ags (baring a fall in energy prices, which I don't believe).

I missed out on the initial bull market in ags; I was concentrating heavily on the energy markets and didn't want to increase my risk. Now that many of them have settled back (from a 0% pullback in bean oil to about 20% in corn to over 50% in sugar), I want to look at them again.

The first thing to remember is obvious, but it bears mentioning: food is essential to mankind. The most important goal of an economy is to get enough for people to eat. So if alternative energy starts impacting people's diets, it will be reduced. We saw a little of this in Mexico last year. Of course prices are made on the margin, so the energy demand will provide a floor in surplus times. But if energy demand starts cutting in food, it will be dealt with.

Second, the economics of ag to energy are not nearly as clear cut as commonly believed. For example, the process that produces ethanol from corn also produces byproducts that are used for animal feed and compete with oilmeals.

Third, many of these processes are definitely not economic. I won't bore you with the detailed numbers, but according to the analyses I have seen, all US processes require government subsidies/tariffs/tax breaks to work. (My sources are internal financial plans of some of the projects going up.)

What this means is that many of these schemes are subject to considerable political risk. A change in government policy to be less pro-ag could decimate them (and take the floor out from the corn market). Remember that the Democrats are likely to get full control of government in '08. Sure, higher oil prices would bail things out, but if you believe that - just buy oil.

So I'm a skeptic on a lot of this. However there are a few areas where this does make some sense, and we get some pretty good trades. Tomorrow I'll talk about sugar and later about biodiesel.

Update on Current Trades

2007-04-04T13:09:00.000-07:00

I know I haven't posted for a while - just too busy. Today I'll go through the state of my current trades. Tomorrow I'll put up a new one.

COPPER
This has been an enormous home run. I've got 90 cents in this one. Get out now, and put a little more in the collection plate this weekend.

ALCOA
Hasn't done much of anything. Since the original post the stock is about unchanged, although the beta-adjusted return is down 1%. Stay with it.

CHOCOLATE
On March 14 (day after the post) I added BARN at 890. It's now 908. I also added some cocoa futures, but I've been trading these actively - too much for this blog. Stay with everything. This is a long term play. One more thing. HSY has moved up on rumors that Cadbury (foods) wants to buy it. It won't happen, but that doesn't mean they can't work together in some other ways. If so this could be big.

OIL
This thing goes from strength to strength. April/May futures were rolled at a $2 credit - and that wasn't even the top! Like chocolate, this one is long-term, so make sure you are scaled back accordingly.

The Chocolate Position Going Forward (Longish)

2007-03-13T11:42:00.000-07:00

Since the chocolate position was put on (Dec 19), it has done pretty well:

Long 500 HSY @50.52, Currently 53.67
Long 1 Lindt @ 30900 , Currently 31655
Long 1 May Cocoa @ 1726 , Currently 1804
Short 1 Mar mini-S&P500 @ 1436 , Currently 1378.75

Total Gain $5,781 or 10.5% of initial investment (assuming your futures broker charges 3.5% of face value for margin)

Note: The opening price for the cocoa futures is adjusted for an unfavorable 35 point roll. The Lindt is adjusted for conversion to Swiss Francs.

Not too bad for a three month investment! However there are a few details of the trade that are worth thinking about:

First, you may remember that I analyzed Barry Callebaut (BARN) but decided it was not quite as attractive as the other equities. That was a big mistake. Since Dec. 19 BARN has risen 51%. The primary reason was their decision to sell their US Brach's subsidiary. They bought this several years ago on the theory that they could use it to make private label chocolate for big retailers like Wal-Mart. That didn't work; US consumers like branded chocolate. So Brach's was a disappointment. I thought they would keep batting their heads against the wall on this one. Instead they decided to give it up. Good move. Also, they will be able to recognise a substantial gain upon the sale of this asset. BARN's management is proving to be a lot more shareholder-friendly than I gave them credit for.

Second, I am quite encouraged by the continued bullish tone in cocoa futures. I entered into this part of the trade with trepidation - I though the CFTC speculators would be forced to sell out. That has not happened, despite the strenuous attempts of the floor and their allies. Maybe the manufacturing buyers are seeing the same long-term setup that I do. Maybe the weather problems in west Africa really are serious. Whatever. The failure of the inside clique to break this market is probably telling you that the bull market is serious. I intend to add on either dips or strength.

At this point, I want to modify the trade somewhat and turn it into a longer term trade. To do it I will:

Include BARN in the portfolio. Hard to set an entry point. Hopefully it will dip tomorrow.
Increase the cocoa futures long position.
Take off the S&P 500 hedge. As I mentioned in a previous post, I don't hedge my long-term positions.
Scale back a little bit. You can't have as much leverage for a long-term as for a short-term position (nor do you need to).

I intend to do this opportunistically. I'll give you the prices when I finish up.

Update on Alcoa and How I Hedge Positions

2007-03-07T08:58:00.000-08:00

Well, this one started out OK, but unfortunately I didn't take profits. It was up nicely on the day of the big crash, but is now down 1%. This graph ignores the 10% aluminum hedge. I hedged with the LME 15-month forward - it is exactly unchanged. If you used nearby, you did better.

For the record, I consider myself a mostly market-neutral trader for my short term trades. I study the commodity markets and try to find opportunistic stocks that will out or underperform. My hedges are usually simple S&P 500 futures. I'm not a general stock analyst, and I don't have a list of companies I want to be long or short. On AA, I started out with an unhedged position, but sold futures when the market broke down. (I've adjusted the trade in the Feb. 19 post to account for this.) AA's beta is 1.43. The orange line shows how this trade has done, slightly below breakeven. I'm keeping it on, but I do have a stop in mind. Knowing some of the bastards who read this blog, I am not publishing my stop.

I do not hedge on long-term long equity trades. My view is that stocks go up long-run. Hedging reduces your potential. Now, hedging will reduce your volatility. However, I am trading my own money, and my leverage is pretty low. So short-run vol. is not a big deal to me. As an extreme example, I've been long oil stocks since 2001, and I've had the oil futures hedge on since it went into carry.

Alcoa

2007-02-19T09:05:00.000-08:00

Trade Unit:
Long: Alcoa (AA) $650,000
Short: 1 LME 15-month Al (about $65,000)
Short: 9 mini Sp500 futures (not for long-only traders)

Alcoa has been in the news a lot recently, mostly because of purported takeover attempts. The hard names mentioned have pretty much said no, but smoke keeps rising from this particular slag heap.

Slag heap is a good metaphor here. AA has underperformed virtually all its peers and the aluminum market as well. The graph on the left (click on it) shows AA indexed to nearby aluminum and the SP500. Pretty bad - you would have thought the bull market in Al would have helped this name. Why has this happened? The earnings models give a lot of reasons, mostly having to do with cost increases and capital spending. The nut of it seems to be a typical entrenched management story - empire building and valuing stakeholders over stockholders.

In the past, management like AA's would probably be able to get away with this. However, the flood on money into activist hedge funds has made even big caps like AA targets. There seems to be no question that the assets of AA, both fixed and long term contractual, cannot be duplicated for the current stock price. So I'll bet the takeover story has some good legs.

The other thing I think the market is missing is the effect of the price of aluminum, which has just had a (belated) bull move. This is definitely not factored into AA's price. This is a big deal because AA has a lot of operating leverage. Analysts are estimating about $3.05 this year, based on about $1.00 LME aluminum. If you factor in current futures prices, this rises to about $4.50. Note: This number comes from a detailed earnings model, not published here. This would give a forward P/E of 7.7 and a price to free cash flow of about 6.5! In reality, these are too high: we can count on AA's management to waste part of this away.

OK, how do we trade this one? The standard commodityequity trade would be to buy AA and sell Al. In this case however, I would keep the commodity hedge pretty small. The case for AA is mostly one of a principal-agent problem that the market will fix, not a pure commodity one. For this post I'm arbitrarily putting the hedge at 10%. In fact, smaller accounts could do fine by not doing it at all. In any event, don't use the normal 3-month forward. AA's price will vary more with the longer-dated forwards.

Update on copper

2007-01-23T20:33:00.000-08:00

Well that was fast. It took less than 24 hours from post to breakout! If I'm right, the thrust happened so quickly that few large specs are in. This one could be major; Friday's close is technically key.

Copper: the chopper becomes the trender

2007-01-22T10:44:00.000-08:00

Normally the best position in commodity/equity spreads is to be long the equity and short the commodity. Over the long run, this has led to great risk-adjusted returns. Why? you ask: because over the long run stocks tend to go up by more than the risk-free rate, while cash commodities tend to go up at less than their carry. So that's the default position. But of course this blog involves shorter-term trades, so we have to swing all sorts of ways.

Another way that we can swing is by using the info in the charts for non confirmation. Right now, there is a substantial non-conf in copper. Look at the chart for copper vs. PCU (my favorite pure copper play). It's indexed so that Oct. 1, 2006 = 1.00. Note that copper the metal is down about 25% (this chart includes all carry and backwardations), while PCU is near its highs. How do you square this?

Looking at the supply/demand for copper, the outlook is still pretty bullish. This is reinforced by widespread reports of renewed Chinese buying (corroborated by the stiffening of Asian premia). OTOH, the market still has an enormous long position of new non-traditional money. There's no telling how low the price will get until this is sufficiently flushed out. However, I have been talking to several large copper specs in the last few weeks. Most keep trying to buy it, but get cut by the falling knife.

I think the strength of copper equities is telling you that this is in fact the way to go. However, it also tells you something about timing. The longer-term money goes into the equities; the shorter-term money is being run out of the metal. When the fog of new money spec selling lifts, the fundamental specs will rush back in. At that point, we are likely to have a violent turn. Whether this will come from $2.50, 2.30 or 2.00 is any one's guess.

I intend to play this by buying minor breakouts in the futures. I'll use a tight stop, so I can keep trying. One of these days, the turn will catch, and it will be almost impossible to enter.

Stock Market Valuation

2007-01-01T14:53:00.000-08:00

Some traders I know think the US stock market is overvalued. The argument goes something like this: Volatility is very low (the VIX is slightly over 10%). This means that the risk premium is low; everyone is too complacent. If anything negative should occur, the market will put a more reasonable risk premium in and thus the selldown. I don't agree; I think they are confusing risk with volatility. The chart to the left is one reason why (click on the chart for a larger image).....

Over the years, I've found it impossible to get a hard DCF-type number to value the market. Earnings are pretty visible for a couple of years or so, but beyond that it's tough. You wind up having the result dominated by whatever terminal value you assume, and that is true guesswork. So I feel I do better if I look at relative value. The most important relative value is stocks vs. bonds.

The chart is a graph of the so-called Fed Model basis year-end since 1960. The x-axis is the yield on 10-year treasuries, and the y-axis is the earnings yield on the S&P500 (This is the inverse of the market P/E ratio.). One would expect an upward-sloping cloud of points for this and that is exactly what you get . Now what does this say about the risk-premium in the stock market. I would argue that when a point is above the upward-sloping cloud, there is a high risk premium. At that point investors are only willing to buy the market if the earnings yield is far above the 10-year note yield. Such points were seen in 1974, 1979 and 1982. Not surprisingly, they were also good buying opportunities. The points below the cloud, including 1992 and 1999-2001 had low risk premia and were bad times to buy.

Right now the market is in the high part of the cloud, indicating a slightly undervalued stock market. This is a big change from mid-2006, when this model gave a screaming buy. (I use a more sophisticated version of this for my own trading that includes other assets and a cyclical adjustment. I'm not posting that.) This indicates we should see a 10% or so gain in stocks this year. Not great, but not worth betting against either.

Chocolate Position

2006-12-19T09:30:00.000-08:00

Two of my friends mentioned that I didn't actually give a trade in the chocolate post. Fair enuf. Here's one unit of the trade:
Buy: 500 shares of HSY
Buy: 1 (one) share of Lindt (these are trading for about 30,000 CHF)
Buy: 1 lot of March cocoa
Sell: 1 mini S&P futures (Long-only traders will not want to do this.)

The March cocoa is a hedge against input prices for these companies running up. I am a little hesitant to do this since the commitments of traders shows that the big funds are heavily long, and that is usually a bearish sign. So you may have to take some short-run pain on this - but of course it is a hedge.

Update on crude/oil equity

2006-12-14T13:36:00.000-08:00

This trade has done fabulously (I use the word "fabulously" in a completely hetero way). Since the last post Jan crude is up 2.5% while COP is up by 12.6%. That's an enormous gain on an esentially hedged position. Time to take profits? Well, the foward carry on the NYMEX is off, lessening the conceptual basis for the trade. OTOH, the trend is your friend. I'm staying with it for now.

The bull market in chocolate

2006-12-14T12:59:00.000-08:00

Commodity traders have been forecasting a coming bull market in cocoa since about forever. It may be materializing now. The real story however is the bull market in chocolate. People around the world are eating more of it and are eating a greater percentage of dark chocolate (which contains more cocoa). People are also using chocolate as a small luxury and spending quite a lot on "upscale" chocolate. I put upscale in fright quotes because much of what goes for quality chocolate is actually pretty bad (Dove, Hershey's Gold). However folks are buying it, and the money is running in. Note that the true high-grade cocoas (Columbian, Ven., etc.) have seen their prices go through the roof.

So how to play this. First, I guess I buy the long term cocoa story. If consumption keeps growing at 3.0% - 3.5% a year, there's no way that production will keep up. OTOH, stocks of cocoa are still quite high, about half a year's worth of consumption, and almost all these stocks are safely in store in consuming countries. Moreover the cocoa market is in absolute full carry so it's hard to wait around for the long term.

Much better I think is to buy the stocks of chocolate companies. That way you gain directly from the consumption increase. Which to buy? Here are some ideas:

Lindt (Swiss, Yahoo symbol LISP, also trades on US pink sheets) - These guys are superbly positioned to take advantage of the new upscale market. It's also run by a first rate executive team. However its P/E is not cheap, and I hate growth stocks.
Barry Callebut (Belg., BARN, and pink sheets) - These guys make industrial chocolate which they sell to chocolate companies and other end users. Not as well run, but with great African operations. A push into consumer sales might be a call option.
Hershey (US, HSY) OK, I know all the chocolate purists are saying that their products stink. True. And I know that Hershey is literally the textbook case of a company screwing up its supply chain. However, they have the best franchise in the business. Right now the stock is very depressed because of a bunch of tactical mistakes. Looks good to me.

Buy oil producers, sell crude futures

2006-11-28T13:15:00.000-08:00

Trade Unit:
short: 1 Jan NYMEX crude
long: $80,000 of a pure producer like APC or DVN, or.....
$120,000 of an integrated major like XOM or COP

The key to this trade short term is that WTI crude futures have about a $1.40 front month to second month carry. This type of carry has held for over six months. I believe it is due to the huge amount of outside money that has come into the commodities markets. This new money is long only, and it plans on sticking around. In fact, since much of the money has gone into closed end vehicles like EFTs, there is no way for it to exit. This money is going to be rolling every month, and that should keep the carry large. Note that $1.40 a month is equivalent to about 27% a year!

OTOH, I don't want to be short crude after a 25% or so fall. The long term is just too bullish, and you can never tell what kind of political risk will pop up. So I hedge the trade by going long oil equities. Note that long term, this has been a fantastic trade since you also get the long run return on the stock market. But I'm thinking shorter term here. If oil goes up, oil stocks will also. If oil goes down, oil stocks will fall with them. However declining oil prices tend to be very good for the overall stock market, so there is a natural cushion. And of course there's that 27% carry you get just for holding on.

The problem in the trade is deciding what the hedge ratios should be. My statistical work shows that the beta of pure producers (Anadarco, Devon and such) is slightly over 1.00 on a day to day basis. That would imply equal dollar amounts in crude and equities. However, if you look longer term, the betas go down substantially. This makes sense: over the long term these companies costs go up with oil prices. However this means there is no way to hedge yourself for the duration of the trade (I'll hope to be in this for six to nine months) without accepting significant short-term volatility. So keep the leverage down!