How to Make Money with Commodities (PERSONAL FINANCE & INVESTMENT) - Hardcover

HECHT

Hardcover

ISBN 10: 0071807896 ISBN 13: 9780071807890

Publisher: McGraw Hill, 2012

Synopsis

Generate steady returns in one of the world's hottest markets

How to Make Money with Commodities offers proven strategies and tactics to help individual investors capitalize from the commodities market as global demographic shifts drive prices up.

"How to Make Money with Commodities sets out in crystal-clear language how the commodity markets affect you every day, and in every way, and why your understanding of the market is essential to your portfolio. An incredibly valuable resource for investors of all levels!" -- Ed Weis, Dean, School of Business at Mercy College; former Managing Director, Merrill Lynch

"This book gives fascinating insight into the high-octane world of commodities trading. It unravels the mysteries of the market, layer by layer." -- Ian McConnell, Business Editor, The Herald (UK) and award-winning journalist

"Andrew Hecht has taken the world of commodities and presented a compelling picture of the various markets from past to present to future. The comprehensive nature of the book makes it a must-read for anyone who is or hopes to be a trader or analyst. . . . Andy's writing is engaging, and he has written a book for everyone, as we are all commodities consumers and intimately affected by these markets." -- Josef Schroeter, President, CQG Inc.

Given demographic trends around the globe and the increasing demand for staple goods, the commodities market has transformed into one of the hottest new mainstream investment sectors. If your portfolio neglects commodities, now is the time to change it.

How to Make Money with Commodities gives you a fully rounded understanding of the market so you can make the very best investment decisions based on your individual strategies and goals.

One of the most sought-after commodities and commodity options traders and analysts in the world, Andrew T. Hecht explains how commodities relate to stocks, bonds, and foreign exchange, and how they affect the average person’s world every day. Bolstered by case studies, historical trends and examples, and Hecht's personal experience, How to Make Money with Commodities explores the fundamentals and technicalities that determine commodity prices and shows how you can use that knowledge to your advantage.

Learn everything there is to know about all the major commodities markets, including:

ENERGY--oil and oil products, natural gas, electricity, coal, alternative energy

PRECIOUS METALS--gold, silver, platinum, palladium, and others

BASE METALS--copper, aluminum, nickel, lead, zinc, tin

AGRICULTURE--corn, wheat, soybeans, rice, cattle, hogs

SOFT COMMODITIES--coffee, sugar, cocoa, orange juice, cotton

OTHER COMMODITIES--steel, fertilizers, rare earth metals, lumber, emission allowances, and more

Hecht explains the ins and outs of every market and provides an expert's insight into government regulations, speculators, traders, and the role China will play in shaping the market's future--and he explains how to invest directly in commodity-related instruments such as physical commodities, futures contracts, and options on futures contracts.

How to Make Money with Commodities is the perfect one-stop resource for building a solid financial future on a market that promises to remain active and vibrant for the foreseeable future. Get started with commodities today and watch your profitability soar.

About this title

About the Author

ANDREW T. HECHT spent nearly 35 years on Wall Street, including two decades at the trading desk of Phillipp Brothers, which became Salomon Brothers and ultimately part of Citigroup. Over the past three decades, he has researched, structured, and executed some of the largest trades ever made, involving huge quantities of precious metals and bulk commodities. Hecht contributes to Traders Magazine and consults for CQG and other companies involved in trading, producing, and consuming commodities. He is a member of the Mercy College MBA program executive network.

Excerpt. © Reprinted by permission. All rights reserved.

How to Make Money with Commodities

By Andrew T. Hecht Mark S. Smith

McGraw-Hill Companies, Inc.

Copyright © 2013 Andrew T. Hecht
All right reserved.
ISBN: 978-0-07-180789-0

Contents

Chapter One

A "Technomental" Approach FUNDAMENTAL AND TECHNICAL ANALYSIS IN THE COMMODITIES MARKETS

Human sacrifice, technicians and fundamentalists living together ... mass hysteria!

—GHOSTBUSTERS (MOVIE, 1984)

I borrowed the above opening quote from an article in Futures magazine, published on July 15, 2008. The author, James T. Holter, wrote:

All right, so maybe Dr. Peter Venkman (a.k.a. Bill Murray) didn't foretell exactly that in the 1984 movie Ghostbusters, but such a proclamation would have been just as ominous.... Over the years, the relationship between technicians and fundamentalists, who examine supply and demand data to forecast future prices, has been just as strained as that of felines and canines, with both often derisively attacking the others' approach. Technicians call fundamentals "funny" mentals. Fundamentalists refer to technical analysis as "voodoo science."

Holter hit the nail on the head. He goes on to describe that with respect to both forms of market analysis, the sum is much greater than the two parts individually. Fundamental and technical analysis in concert create a more vivid picture of the price structure of a market and are a far more effective investment and trading tool.

In this chapter we review how these two forms of analysis used together will enhance your understanding of commodity prices. We also demonstrate how, used independently, both forms of analysis are flawed.

FUNDAMENTAL ANALYSIS

Commodity fundamentals are defined as an equation involving supply and demand. The equilibrium price of a commodity is the price that occurs when sellers and buyers meet in a free marketplace. The goal of fundamental analysis is the estimation of total production compared to total consumption of a commodity over various time periods.

When the supply of a commodity is greater than the demand, a surplus is created and, according to fundamental analysis, prices will fall. Fundamentalists regard surplus conditions as bearish for prices. By the same token, a deficit is bullish, and prices will rise. A deficit in wheat, for example, may be the result of poor or damaged crops in major growing nations such as China, India, Russia, or the United States.

Deficits can create dangerous social situations for individuals and governments alike. Imagine making a trip to the grocery store and finding no bread for sale because of a sudden deficit in the global wheat market. Picture no gas at the pump because of a sudden deficit in crude oil. Such situations have the makings of social unrest; therefore, governments often hold stockpiles of commodities as safeguards.

While stockpile levels are easily obtainable from some countries, such as the United States, or the nations that comprise the European Union where there is a higher degree of transparency, other countries, such as China and Russia, regard the data on their commodity stockpiles as strategic state secrets. In the United States, the Department of Energy periodically releases data on supplies of crude oil and natural gas in storage, and the U.S. Department of Agriculture releases crop reports and data on stockpiles of various grains and other agricultural commodities. For example, the United States currently holds more than 700 million barrels of oil as its strategic petroleum reserve (SPR). At the same time, the International Monetary Fund releases data on reserve assets, such as gold and silver, held by nations around the world. It is nearly impossible to calculate accurately the global stockpile of any one commodity at a particular time. Analysts make estimates in each market, but these are, at best, educated guesses. Fundamental analysis becomes more of an art than a science when it involves a commodity-producing country that holds its cards close to its vest.

The job of a fundamental commodity analyst is to "guesstimate" a commodity's total annual supply, annual demand, and the level of stockpiles. These are the calculations that reveal whether a commodity is in surplus, deficit, or equilibrium. Many companies rely on this analysis to make key business decisions and projections involving the availability of commodities for their manufacturing processes, future costs, and pricing calculations for consumers. A producer sensing a market deficit in a particular commodity may postpone sales in anticipation of higher prices. At the same time, a consumer expecting a deficit may stockpile at present prices for fear of future price hikes and availability problems. The consumer, for example, might be a manufacturer that needs to source aluminum to make cars. A deficit in aluminum could have serious consequences on the business because if the company is unable to purchase the aluminum below a certain price, the cost of finishing the car could end up higher than it can be sold for. Analysts go to great lengths to understand fundamentals, and industries around the world depend on the accuracy of their data and forecasts.

Commodity Production

Fundamental analysis usually begins with the calculation of the annual production of a commodity. This tends to be concentrated in a few areas of the world. For example, just as there are a limited number of countries with arable land suitable for growing certain crops, there are a limited number of countries with mineral deposits for certain metals. Many of these countries, such as Chile for copper, Ukraine for wheat, the Ivory Coast for cocoa, and Nigeria for oil, are not on the radar of many investors. However, there are times when it is highly profitable to keep tabs on these countries. When attempting to understand commodity risk that will affect a specific investment, it is important to pay attention to events in countries that are significant producers of that commodity.

A fundamental analyst can sometimes be the most powerful force in a market. The Ivory Coast and Ghana, two small African nations, routinely produce more than 50 percent of the world's cocoa beans. The control of a market that produces one of the world's most beloved products, chocolate, puts those two countries in an enviable position. One would think they would be the most powerful forces in the global cocoa market, but this is not the case.

The most powerful force in the cocoa market over the past 50 years has been Johannes "Hans" Kilian, a German cocoa-pod counter, who turned 75 in 2012. Kilian, a fundamental supply-side analyst, started his career in the 1960s at a German cocoa trading company, and over the course of his career has worked for numerous cocoa trading firms, hedge funds, and chocolate manufacturers, including Swiss giant Nestlé. Each season, Kilian visits the cocoa-producing fields of West Africa, Indonesia, Brazil, and other countries, counting cocoa-pods as he goes, one by one. Since 1991, his company J. G. Kilian and Co. has forecast the annual global cocoa supply in reports that move the price of the commodity. In an article by Emiko Terazono from April 3, 2012, the Financial Times described Kilian as, "The man who could single-handedly move cocoa prices 10 percent higher or lower in the space of a few seconds." Kilian has developed a granular method of information analysis for which hedge funds, huge food companies, and cocoa producers pay handsomely. However, Kilian is only one example of the many fundamental analysts who toil to produce reliable production statistics on global commodities.

The supply side is often impacted by exogenous issues, such as weather, politics, and civil unrest. A producing country engaged in civil war, for example, might have a bumper crop—an unusually bountiful harvest of a particular crop—but getting it to market might be impossible and, in spite of its abundance, the crop might rot. Corruption in certain locations also plays a role in crop size and the flow of currency to pay for it.

To complicate matters further, the potential for commodity production is also an issue for the fundamental analyst. How much oil is in the crust of the earth at certain locations around the world? How much natural gas exists between rock formations? What is the best way to quantify the level of reserves of copper, gold, bauxite, silver, nickel, lead, and other metals and ores? How much arable land is available on the planet for corn, wheat, soybeans, rice, sorghum, sugar, cocoa, coffee, and other food staples, and how much will this land yield under perfect and not-so-perfect growing conditions? Together, the compilation of annual supply, worldwide stockpiles, and proven, probable, and potential reserves will yield a snapshot of a commodity's global supply.

Commodity Demand

Fundamental analysts investigate the demand side of the equation to estimate the annual usage of individual commodities. Just as almost every country across the globe consumes chocolate, the same holds true for energy sources, such as oil, natural gas, and coal. And just as building infrastructure requires metals, agricultural commodities like grains help sustain life across the entire face of the earth. While global economic, demographic, and political conditions influence the demand side of the equation in fundamental commodity analysis, these components are virtually useless as a sole tool for forecasting the price of any commodity. Mining, agricultural, and energy technologies all sit on the supply side of the equation, and each of them is a form of objective science. Conversely, economics, demographics, and politics on the demand side are all social sciences, and these are subjective and unquantifiable by nature. When you balance physical science on one side against social science on the other, the result will be less than accurate.

Nonetheless, in spite of its imprecise nature, demand is just as important as supply when it comes to understanding commodity markets and prices. As countries build infrastructure, such as new roads and buildings, companies expand and individuals buy more consumer goods. Economic growth increases demand for staples on a global basis. At the same time, the opposite is true during times of economic contraction. As national investment in infrastructure decreases, companies slim down and individuals are more careful about the amount of goods they purchase.

Every microeconomist will tell you that demand for a commodity, or any goods for that matter, decreases as prices rise. Economists call this price elasticity, and it is part of the basic laws of supply and demand. Even if the commodity is a staple, human beings will adapt and find cheaper alternatives if prices become too high. For example, if bread prices were to go through the roof, as they have in many parts of the world throughout history, demand for rice increases; rice is a less expensive starch. By the same token, when the price of a commodity rises, producers increase production as long as production costs do not rise so high that they negate profit margins. Meanwhile, if the price of a commodity falls, demand tends to increase. Imagine, for example, the increased mileage U.S. motorists would put on their automobiles each year if gasoline prices suddenly dropped to $1 a gallon.

Finally, when commodity producers have the opportunity to choose between different commodities to produce, they will generally opt for the one that yields the most profit. This is usually the thought process behind the choices farmers make when deciding which crops to plant. As you can see, the microeconomic behavior of both producers and consumers will affect the ultimate price that a commodity will fetch.

Demographics pack a big punch on the demand side of the fundamental commodity equation. The rate of population growth on planet earth is staggering. More people means more mouths to feed, more housing, and more consumers to whom products can be sold. Greater wealth and higher standards of living across the planet have also increased the demand for commodity staples. However, commodities are finite, and an expanding and wealthier populous will continue to vie for these precious products.

Politics are perhaps the trickiest part of the demand-side equation. For example, crude oil prices would probably fall precipitously if Saudi Arabia decided to flood the world market with oil and double its daily production. If Iran cut off oil supplies by blockading the Persian Gulf, as it has often threatened, oil prices would skyrocket.

Export and import tariffs also affect commodity prices, as do subsidies. A U.S. tariff on steel exports from the United States into China would dampen the demand for steel and might even start a trade war with deeper consequences. Tariffs are politically motivated policies aimed usually at one country and are often designed to level the playing field of trade. For example, politically motivated legislation in the European Union (EU) showers billions of euros in annual subsidies on beet sugar producers. This has served to keep the price of sugar unnaturally high and has resulted in food processors paying more than world market prices for the commodity. In the United States, farm subsidies have supported crop production and have kept the prices of produce at artificial highs for decades—all at a cost to the consumer.

Fundamental analysis often uses sophisticated econometric models to forecast the usage of a commodity by factoring in current and past data to predict future economic conditions. These models use indicators like the consumer price index (CPI), the producer price index (PPI), global currency and interest rates, and gross domestic product (GDP) to forecast demand. The Department of Energy, Department of Agriculture, and other government agencies in the United States and the EU provide demand-side analysis. At the same time, the world's top consumer, China, also releases reports on its economy. There are much data to keep track of when it comes to the demand for individual commodities, and it is often difficult to ascertain whether increased demand for certain commodities is simply the result of increased stockpiling.

Production-Consumption Dilemma

The chief problem with fundamental analysis in the commodities markets is the nature of the markets themselves. Because production is concentrated and consumption is widespread, producers tend to sell regularly and in large quantities. As such, producers depend on the cash flow from production to fund future production. Consumers, on the other hand, tend to buy hand to mouth. They buy commodities as they need them—whether it's mom on a grocery-shopping trip or a manufacturer buying for the manufacture of all types of finished goods.

Indeed, a producer's entire business often relies on the use of a single commodity. A business consumer, on the other hand, may use many different commodities to manufacture its product. This dynamic is also part of the calculus that causes volatility in commodity prices. In a perfect world, consumers would buy directly from producers at fixed prices that would allow a profit margin for the producer and a profit margin for the manufacturer. There would be total and complete transparency, no government intervention or influence, and centralized data on production and consumption. But the world is not perfect, and producers often want to sell at times when consumers do not want to buy; and sometimes consumers want to buy when producers do not want to sell. Hence, we have traders and speculators in the market who often serve to smooth price volatility and provide a constant market for producers and consumers.

As volatile assets, commodity prices tend to trade in a wide range, and predicting short- term movements is no easy feat. While fundamental analysis can provide important clues to long-term price trends, it can often be a blunt and imprecise tool for short-term analysis. The supply-and-demand flows of specific commodities will provide any investor with important clues to the risks and profit potential inherent in most portfolio holdings. It's all about improving an investor's knowledge base. The risk of higher or lower commodity prices can make or break a company, and many investors do not monitor these risks until it is too late. Understanding long-term fundamental commodity risks will not only provide clues to the future earnings of a company, but it can also reveal how its management handles such risk and uncover the expertise or shortcomings that will determine success or failure.

TECHNICAL ANALYSIS

In commodities markets, as in other markets, there are cycles. Understanding the history of cyclical behavior and past price movements can help predict the future. Fortunately, you will not have to pore over thousands of pages of prices and data. All the data required for technical analysis are contained in one picture—one simple price chart. Fundamental analysis examines numerous aspects of an individual commodity market, while technical analysis studies past and current price action in futures contracts.

One of my first bosses in the commodities business was a strict fundamentalist. He considered charts and technical analysis to be something akin to voodoo. That was back in the mid–1980s, and I wanted to buy gold. As proof of my analysis, I provided my boss with a chart. He turned the chart upside down and poured his cup of coffee on it. Then he laughed and demanded that in the future I bring him only fundamental data. He also told me that fundamentals revealed to him that my analysis was wrong. I was young and listened to my boss. I didn't buy any gold. A few days later, when the gold price rallied, my boss didn't say a word. I knew then there was a time and place for technical analysis.

The reason technical analysis works has little to do with commodities themselves, but because every technical analyst in the world is looking at the same price charts, and many of those analysts act on what they see. The more glaring the pattern, the more technically biased traders will act. At heart, this is an issue of mass market psychology. Even if fundamentals had not supported that rise in the price of gold my boss refuted, the chart pattern had created a self-fulfilling prophecy. One certainty in the volatile world of financial markets is this: they go up when there are more buyers than sellers, and they go down when there are more sellers than buyers. So the advice here is simple: ignore charts and technical analysis at your own peril.

A technician does not follow supply-and-demand fundamentals; a technician follows price patterns, price history, and market trading data to make trading decisions.

(Continues...)

Excerpted from How to Make Money with Commoditiesby Andrew T. Hecht Mark S. Smith Copyright © 2013 by Andrew T. Hecht. Excerpted by permission of McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Edition details

• Publisher: McGraw Hill
• Publication date: 2012
• Language: English
• ISBN 10: 0071807896
• ISBN 13: 9780071807890
• Binding: Hardcover
• Number of pages: 289