This past week saw a stabilization in commodity prices, with the S&P GSCI Total Return Index logging its 2nd straight week of gains after the huge 11% drop 3 weeks ago.
Posted below are charts of the CRB Raw Industrial Index and the GSCI Total Return Index.
As can be seen, both indices have stabilized in the past week and gained slightly after their severe correction earlier this month. We believe that the drop was nothing more than a correction in an ongoing bull market.
The weekly moves of the indices are in line with an ongoing bull market. After the big drop, commodities are grinding their way higher with slow, gradual gains. This is exactly the type of action one would like to see in a bull market, with sudden pullbacks and grinding gains.
However, some commodities are better positioned than others, and we continue to favor the industrial and precious metals sector over energy.
Let’s start with natural gas.
Natural Gas
Natural gas has remained an incredibly depressed market due to massive oversupply and abundant domestic production. The problem for natural gas producers is that is simply too cheap to drill for natural gas domestically. With the cheapest producers profitable down to even $3 and in some cases less, there is little incentive for natural gas producers to shutter production even though prices remain almost 75% lower than they were at the peak in 2008. The Commitment of Traders data posted below reflects this situation.
The chart shows the price of natural gas in amber, the net Producer position in green and the net Managed Money position in white. Note that both the Producer and Managed Money position are negative, so the lower on the chart they are, the more short contracts these groups hold.
As can be seen, Producer short remain among the highest in the last 4 years, even though prices remain very depressed. We believe the preponderance of Producer shorts indicates that Producers are highly willing to hedge at current prices, and are giving up on the hopes of a further rally to lock in higher prices.
Also interesting is that Managed Money net positions are actually on the high side of the range they have been in over the last 2 years since the bubble burst. This indicates that renewed Managed Money shorting could push natural gas prices significantly lower.
With cost of production of natural gas very low, and with new fields being found every day, the outlook for the natural gas market is at best neutral and at worst highly bearish. With that in mind, we have formed our trade recommendation.
We recommend selling call options on natural gas between the 4.6-5 level over the next 2 months. The July 4.65 calls could be sold for 0.065, or $650 per contract. Such a position would be profitable as long as natural gas is below 4.65 on June 25th, or 10% above current levels.
A similar trade could be executed by selling the June 11 calls on UNG. While we normally do not recommend using the UNG to express views on natural gas, if views are bearish, then shorting the UNG should actually be a relatively attractive option given the bearish disposition to the ETF.
Copper
Copper has taken a large hit as of late, falling 13% from its peak of 4.65 on February 15th to 4.05 today. We believe that despite the pullback, copper remains attractive going forward due to Chinese and emerging market expansion.
Shown below is a chart of copper futures and aggregate open interest.
As can be seen, open interest on copper futures has taken a dive since prices peaked, and is now at the lowest level since 2009. With Chinese tightening measures and efforts to cool real estate speculation, the mood in the copper market has become decidedly bearish. Shown below is a chart of copper in white and Managed Money longs in amber.
Futures traders sentiment has dove to almost net short levels, with the Managed Money long interest at only 3,745 net long contracts. This is also the lowest Managed Money net long position since the large pullback of summer 2010.
Also interesting is that while copper prices have pulled back, it seems that prices have not been as sensitive to Managed Money bailing as in the past. Shown below is a chart of Producer net shorts.
As can be seen, Producers were at their most net short in January of 2010 and again in January 2011, very close to medium term peaks in the copper market. It seems that Producers are timing the market well, as they greatly reduced their net short position in the summer of 2010 when prices were at their lowest as well. The net short position currently stands at the same level it did in the summer of 2010 before copper experienced a 60% rally.
The inventories of copper on the London Metal Exchange have also been a good indicator of medium term buying opportunities in copper. Shown below is a 5 year chart of copper prices on bottom and copper inventories on top.
As can be seen, peaks in the copper inventories correspond well to copper market bottoms, and present great buying opportunities. Shown below is a 1 year chart of inventories.
Inventories appear to be topping out, and if they start to turn decidedly down, the bull thesis on copper will only grow louder.
Fundamentals
While copper bears point to tightening out of China as the primary reason for not wanting to own copper, we view it as a long-term bullish development. Governments only tighten monetary policy when growth is very good, and they never do so to such an extent that they choke growth. The point is to slightly tame inflation, which it appears they have accomplished for the time being.
Furthermore, all the recent tightening actually gives the Chinese government more room to encourage growth long-term. If there is any hiccup in growth, all the Chinese central bank has to do is decrease reserve requirements or drop interest rates, and both have quite a ways to drop with how vigilant China has been in raising them. Contrast this situation to the US where the Federal Reserve has extremely limited options to promote growth, with interest rates already at zero percent and quantitative easing becoming more and more politically untenable. We believe China, as well as the rest of the emerging markets, will continue to grow and tighten monetary policy, but not to the extent where growth is compromised.
As long as we do not re-enter recession, copper should remain a coveted commodity. Construction and growth in emerging markets should keep supplies tight and prices supported.
We recommend the purchase of copper futures at a price of 4.05 or better. Such a position entails significant risk from the possibility of copper experiencing temporary weakness on bearish headlines out of Europe and/or severe US dollar strengthening, but we believe the time has come to begin building a bullish position in the metal.
Alternatively, one could buy stock or calls on FCX. FCX is trading more than 20% off its peak and is trading at only 9.3x trailing 12 months earnings. We think the stock is cheap even just going off of fundamentals, but it will also experience a serious boost if copper prices begin to rebound.
ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
