Commodity Trader

Commodity Trader: Resources, Naturally
A Daily Reckoning Whitepaper Report
By Kevin Kerr

The commodity market mystique is alive and well. Stellar successes and dismal failures in these markets are the stuff of legends. From an outsider’s perspective, commodity markets can be intimidating, even scary. In this excerpt from his new book, Kevin Kerr aims to dispel some of the common myths and misconceptions about these markets…

Commodity Trader: History

Commodity markets in various forms have been around forever, or at least since the time of ancient Greece and Rome. They even survived the Dark Ages, and reemerged at local fairs in medieval times, arranged by trade associations formed by merchants, craftsmen, and promoters.

Over the next few centuries, these markets evolved into exchanges, or bourses, in England and Europe, as well as in Japan and the New World. U.S. cash commodity exchanges first appeared in New York for trading in domestic produce. Though none of these markets exist now, they were the foundation for the commodity markets as we know them today. Since 1848, when the Chicago Board of Trade was formed, commodity futures have given producers and consumers a way to even out price moves and protect against market risk, as well as giving investors a way to capitalize on market moves.

In their early days, futures markets were used primarily to make or take delivery of the actual commodity; today, fewer than 1 percent of all futures contracts actually result in delivery against the contract. So there’s really no truth to the myth that you’ll end up with 200 head of hungry cattle grazing on your front lawn, or 50,000 gallons of orange juice cooling in your fridge, or a boxcar of grain dumped in your backyard! Unless, of course, that’s what you want.

Commodity Trader: Boom

Right now, the world is experiencing a commodities supercycle – a boom in resources that’s likely to last for at least another decade. The market for raw resources is raging – because of China, because of India, because of surging oil demand and plunging energy supplies and the crushing effect of hurricanes on offshore U.S. oil. It’s time for you to get in on the profit cycle!

History is full of gear-turning, gut-churning events, each with its own importance. But each is connected to the others by an endless cycle of supply and demand. As the world scrambles for resources, the opportunities for the savvy investor to profit are endless. And because these products are finite, we can expect demand to continue to grow. At this moment, you’re looking at one of the best times in history to make money by trading resources.

Let’s face it – trading commodities is not for the meek or faint of heart. You need sound judgment, guts, and an appetite for risk, not to mention available capital. These markets move, and they move quickly. Just take a look at all the markets over the past few months – gold, oil, grains, stock indexes, tropical markets, all of them with wild swings in both directions. There are huge risks but incredible rewards for the savvy trader or investor.

Commodity Trader: Cycles

Cycles in commodities can be very predictable. There are no CEOs on the inside cooking the books. There are no accounting firms puffing up profit reports. You just have the commodities on the move. Trading on those moves, you can make money no matter which way prices are headed.

I often refer to commodities trading as “the last bastion of pure capitalism on earth.” I mean, where else can you sell something you don’t own, buy it back half an hour later, and walk away with 100 percent profit? Few investment vehicles offer the excitement, flexibility, and tremendous profit opportunities of commodities.

It’s unfortunate, but profit opportunities often are greatest when things go wrong. Look at the devastation from Hurricane Katrina. When hurricane season is in full swing it can be a very long summer indeed. Often, Gulf Coast residents have barely picked up the pieces from the previous year’s debacle when it is time to batten down the hatches yet again.

In 2005, four Category 3 storms – Dennis, Katrina, Rita, and Wilma – left a trail of havoc and destruction through a large part of the United States. Hurricane Katrina’s strong winds and heavy waves devastated the Gulf Coast in late August. The storm and resulting flooding caused more than 1,300 deaths and an estimated $100 billion in damage, making it the most expensive natural disaster in U.S. history.

Nobody can predict for sure what any storm season will hold, but some experts say we are in the beginning stages of a hurricane supercycle, which usually lasts 15 to 20 years. Stockpiling positions in some of the key commodities that may be adversely affected can be a very profitable strategy. As certain industries brace for each new storm season, traders can hedge themselves by adding specific commodities to their portfolios on a limited basis, using options or even futures to some extent.

Don’t feel guilty betting on a rough hurricane season; after all, like any type of hedging, it’s insurance. When we purchase fire insurance on our houses, we don’t hope they’ll burn down, at least not usually. No, we take out insurance to protect our investment – that’s all we’re doing.

The vulnerable markets include everything from natural gas and sugar to orange juice and crude oil. Take sugar, for example. Sugar crops have sustained hard hits in Florida and elsewhere from recent years’ hurricanes. Sugar has the added benefit of being a key ingredient in the production of ethanol and is already in high demand, so there’s a double whammy here. Another market likely to be heavily impacted by a rough hurricane season is natural gas. Remember, natural gas is used for heating and cooling – again, a double-edged sword.

Another good risk/reward scenario heading into an active hurricane season would be adding some unleaded gasoline call options to your portfolio. Whoa! I know what you may be saying: “Oh, no! There he goes using all of that trader jargon – calls, puts, straddles, strangles, and so on.” No worries; in my book, and in my trading service, it’s all about speaking plain English. We will learn what calls are, and all the other trading terms, later.

All of these commodities and many more are almost certain to experience intense volatility heading into and during hurricane season. But keep in mind that volatility drives the commodity markets. The fear of what “may happen can be more of a factor than the actual storms, so it’s best not to be greedy. Use a hedge for what it’s for: protecting your overall portfolio from the losses other holdings in your portfolio and property may take as a result of the storms.

Another thing about hurricanes is that they do a lot of damage and leave a mess to clean up. In 2005, more than 113 oil platforms were destroyed and over 400 pipelines were damaged. Sometimes the best way to play resources is to buy equities related to the companies that harvest the resources as well as provide the drilling equipment and, eventually, the transportation of the finished goods. For example, while not a direct resource play, buying stocks related to transport of oil workers from oil platforms and terminals was a very good investment that year. Even heading into the 2006 hurricane season it proved fruitful. Smaller stocks in companies that transport workers to and from rigs and facilities – specifically, boat and helicopter companies – were a very good investment.

This play was good globally, too. In the Scottish newspaper The Scotsman, Frank Urquhart wrote about it just prior to the hurricane season in 2006 (“Copter crisis threatens oil industry,” 6/30/05):

“North Sea helicopter companies are struggling to meet a surge in demand for their services because of a shortage of aircraft and crews to fly them, it was revealed yesterday. The soaring price of oil has led to a sudden and major increase in helicopter operations in the offshore oil and gas industry.”

Helicopters and transport are commodities in their own right in times of need. This is only one example of the many investment opportunities available that are simply associated with the commodities themselves. Shipping, rail, storage, you name it – if it hauls, plows, hips, builds, or refines, we can relate it to commodities and it can be a profitable addition to our portfolios.

It can be as important to understand the psychology of the markets as it is the mechanics. At the start of hurricane season nobody knows for sure just how bad it will be. One thing is certain, though – a lot of attention is being paid to it. This can often have the reverse effect on a trading market should the hurricane season be relatively light. The old adage “Buy the rumor, sell the news” certainly applies here.

In other words, put your positions on early and take early profits simply on the back of the fear of what might happen, not what actually does happen. Being married to a weather position is never fruitful for a portfolio. Simply get in and get out. A smart trading strategy would be to add one or all of the vulnerable commodities; then as you enter the season, with a bit of luck, grab fairly quick profits, even before the first winds start to really hit. There are many different scenarios – at least as many as there are weather patterns – and we will address them more thoroughly later. Remember, timing is everything.

It’s always important to be four to six months ahead of the regular calendar when trading commodities. Keep in mind that we’re trading futures not “currents”; it’s vital always to be looking forward and thinking about the impact of news, weather, and geopolitical events months in advance.

Regards,

Kevin Kerr
for The Daily Reckoning