Thursday, August 9, 2012

Burning Up...

The Grains Markets May Offer A Speculative Opportunity

A brief google search or a perusal of the financial news will tell you that the extreme drought conditions currently experienced by much of the US are wreaking havoc on 2012 crops, especially corn.  More recently, some areas have received some rain, but it is likely too late to revive the scorched corn crop.  Other crops are suffering as well.  Other than potential increases in food, energy and other prices, what does this mean to the average investor?

Commodity markets have certain dynamics that make like very difficult for commodity producers, but present occasional opportunities for investors.  Of most interest given the present conditions in the the agricultural sector is the tendency for commodity prices to overshoot on both the upside and the downside when supply and demand get out of balance.  These overshoot events may be relatively brief, but they are often fairly predictable and can be lucrative speculative opportunities.  Using upside overshoots as an example, typically what happens in these excessive price movements is a supply shortage confronts inflexible demand.  Since the market rations a scarce commodity to those willing and able to pay the most for it, prices can spike far and fast, sometimes exacerbated by short-covering and momentum speculators chasing the trend.

So how can one spot an emerging potential outsized commodity price movement?  There are certain necessary preconditions that can clearly be identified.  First, there must be relatively inflexible demand for the commodity, at least in the short term.  For example, heating fuel in the winter and food are commodities for which there is extremely inelastic demand in the short term.  Consumers simply do not have many alternatives and are effectively forced to buy these commodities regardless of price.  Second, there must be a supply shortage that cannot be easily or cheaply remedied by imports or alternative supplies.  Natural gas in the continental US is a convenient example.  In 2005 a great deal of natural gas production capacity and infrastructure in the gulf of Mexico was destroyed by a series of hurricanes.  As the US does not have significant natural gas import infrastructure in place, there was literally no way to replace the shortage until the damage could be repaired.  Finally, there must be little or no stockpiles available to tide the market over in times of shortage.

It appears that the grains market is potentially approaching an overshoot, especially the corn market.  The three preconditions appear to be present.  Demand can certainly change over time, but at least in the short term it is relatively inflexible.  The most obvious sources of reduced demand are livestock feed and ethanol production.  However, it will take time for the beef industry to materially reduce the herd during which time the cattle still have to be fed.  The ethanol industry can shut down plants in favor of other gasoline oxygenates or the US government can grant an exemption for oxygenation, but these steps will require time (months, most likely).  Supply has been badly impacted by the drought.  I recently drove across the heart of the corn belt in the US Midwest and the crop destruction is simply astonishing.  Dry land corn is largely a near total loss in many areas and even some of the irrigated crop does not look terribly healthy.  Alternative supply would normally come from South America (especially Argentina), but South America's crop was also affected by a bad drought in 2012.  Finally, corn stocks are at multi-year lows, estimated as low as a 2 month supply on hand.  The corn market appears at risk of a large price spike if the news on supply or demand is slightly worse than expected.

What does this mean for us as investors?  There are plenty of companies that will be winners and lowers due to movements in grain prices and it might be worth watching some of the losers for a potential buying opportunity.  However, there is another opportunity that is probably best regarded as a speculation that should only be hazarded with high risk, high potential return capital that you are willing and able to lose.  I typically try to keep 1% of my portfolio for speculative bets like this, but any allocation may be inappropriate for many investors so make sure that any such bets you make are appropriate for you and your risk tolerance.  That said, there are commodity futures ETFs available that allow investors to take positions on corn, soy and wheat (tickers CORN, SOYB and WEAT, respectively).  Of particular interest, there is also a market for options on CORN, with options quoted but not yet traded on SOYB.  So if one wished, one could take a speculative position either by buying or selling a position in one of these ETFs or in options on CORN.  In a market environment where prices appear to be potentially primed to significantly overshoot, a leveraged position in CORN via options could provide an outsized return on a relatively modest capital commitment.

To give an idea of the potential risk and reward of a speculative trade in CORN, if one bought options on CORN the potential risk is every dollar you pay for the options.  By their nature, options can and often do expire worthless.  Upside is highly magnified by the leverage inherent in options.  For example, if you bought February $55 calls on CORN and the price of the commodity rose enough for the ETF to double from its present price to about $105, your $3.50 per share options could be worth $60 per share.  Considering that wheat is currently at $9 and at one point in 2008 rose to over $25, a large price move in a tight stocks and poor supply situation is possible.

What could go wrong in such a trade?  Simply, the underlying commodity could fail to move in the direction you expect in the timeframe you expect.  If that happens a position in the ETF would lose money and an options position would be a total loss.  The risk of loss is significant, as this is an outright speculation rather than an investment.  So be very, very careful and you should be very risk tolerant indeed to consider playing this game.  That said, if you are willing to take a gamble and can afford to lose every penny you stake on such a wager, the market seems poised for a potentially large price movement.

As always, consult your advisors, do your own due diligence, take your own risks and be careful.  Trades as described above are extremely risky and you can lose every penny you put into them.  Caveat emptor.  The above is not intended as investment advice.

Disclosure: I am long CORN call options.

No comments:

Post a Comment