‘Over the summer’ trade on commodities

Not so long ago, prices of oil, steel and gold (just to name a few) were thought to continue floating upwards forever as China entered its third decade of growing with breakneck speed. However, commodity prices have been deteriorating since 2008-2009, in line with sluggish growth and fall in demand in the developed world. This fall was interrupted by a spike in demand coming from emerging economies (especially China) in 2010. However, since the second quarter of 2011, things have taken a downturn again. According to Bloomberg, commodities are down by 16% since a peak in April 2011. We believe this bearish trend is here to stay.

On a more ‘long-term’ line of reasoning, we point out that oil prices are being attacked from two fronts. First of all, technology-induced efficiency in the consumption of oil is to be emphasized. We have seen since the turn of the century trends such as electric-cars, fuel efficient machineries, natural gas plants becoming more and more of a reality. Agriculture as well is becoming more productive with the introduction of ethanol economics. These phenomena will tend to suppress the demand for oil.

Secondly, from the supply front, technology improvements are making progresses on exploration side as well as on extraction side, making a lot of oil available and cheap in extreme environments with installation of platforms over deep waters – 3000+ m below sea level – or in Arctic Sea. There probably is way more oil than we used to think and more fields are being discovered. Furthermore, the United States, the world’s biggest consumer of crude oil has been going through an energy revolution thanks to its shale gas technology. This has boomed the output of oil for US which has seen rising inventories, thus creating a supply shock for the rest of the world. We doubt that oil prices will see any sustainable increase (even though volatility may be experienced) as long as this kind of supply cushion is in place.
Both these factors are however a bit long-term, and the degree to which they are incorporated into the prices in the following couple of months is hard to estimate.

If you want to hold a more ‘short-term’ perspective (i.e. ‘over the summer’ horizon) to analyze the negative trend in commodities it is enough to follow the first page news. The persisting sovereign debt crisis and the halt of the Chinese economy are what you hear every day. They are strong signals of a continuation in the downward trend of these prices. HSBC’s China May manufacturing purchasing managers’ index fell below 50 for the first time in the last 7 months.

In order to profit from such a fall, we have thought of entering into a combination of trades including FX and certain industries.

1. Trading in the world of FX is not just about demand and supply. Factors such as interest rates and economic growth are also very important.  Many countries export/import huge amounts of commodities, thus making their economies vulnerable to the huge swings in prices in the volatile commodities markets. Countries such as Canada for example, who is a net exporter of oil (Canada has the largest oil reserves in the world after Saudi Arabia) profit from an increase in the price of oil and vice-versa. Also, it is a large exporter of aluminum, wool, timber, natural gas. Other countries, such as Australia, profit from an increase in the price of gold. Australia is the third largest producer of gold in the world. But that’s not all. Australia is also the world’s largest exporter of farm products, wool, coal, zinc, tin, iron ore, barley. This leads to a very interesting fact: the currencies of these countries are highly correlated with the prices of their ‘respective commodities’.  You can see in the graphs below the relationship between the ‘aussie’, ‘loonie’ and a basket of commodities.

Source: Bloomberg

Correlation between the Canadian dollar and the price of oil has been approximately 80% between the years 2006-2009. Also, correlation between the Australian dollar and the price of gold has been around 84% for the past 15 years. Notice in the graph below how the USD/CAD exchange rate closely follows the price of oil. This is because US is the biggest import partner of oil for Canada. Moreover the Canadian dollar is clearly overvalued according its PPP with the USD and vulnerable because of the strong suspicion of an upcoming housing bubble burst. It is also interesting to mention that  the Bank of Canada will have a new governor in one week, who has been introduced as “pro-stimulus”.

Source: BSIC

That is why, in anticipation of a fall in commodity prices, we construct a strategy based on shorting the AUD/USD and going long on the USD/CAD pair.

2. Many industries are heavily dependent on commodity prices. Airline stocks are usually correlated with oil prices given their high dependence on the commodity. Given that the airline stocks would benefit from depressed oil prices, we recommend going long on a basket of airline stocks such as the Guggenheim Airline ETF – FAA which owns 22 airline stocks, or the Direxion Airline shares ETF – FLYX.

3. Hedging – Even though we believe commodities are going down because of negative outlook on the world economic growth, demand for commodities is still high in developing countries, which always generates upward pressure on prices. Also, there is always the risk of the strategy not playing out exactly during the desired horizon. Thus, a hedging strategy must be created. We think a good proxy could be going long the S&P 500 which will go up in case of temporary news on the economy, or just in case market sentiment in general, improves.