Commodities Second Quarter Overview And Outlook For Q3 2016

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Summary

A big winning quarter.

Divergence with the dollar – Do currencies matter?

Energy rebounds, and soybeans soar.

History – Results from my best bets for Q2.

Best bets for Q3 2016 and beyond – Commodities.

The raw material markets had a great second quarter in 2016. The overall commodity sector consisting of 29 of the primary commodities that trade on the U.S. and U.K. exchanges rallied by 10.75% for the three months that ended on June 30 and is 12.67% higher over the first half of this year. The overall winner for the quarter was natural gas, posting a gain of over 49%. Two commodities not included in the composite, iron ore and lumber, moved up 12.7% and down 2.19%, respectively. If I add these commodities and the Baltic Dry Index, which gained 59.42% into my calculations, the sector rose by 12.94% in Q2 and 15.25% so far in 2016.

The U.S. dollar is a major factor when it comes to commodity prices as it tends to have an inverse value relationship with raw material prices. Commodities displayed strength even though the dollar index fell, appreciating 1.72% over the quarter. Economic conditions around the globe continue to present an uncertain landscape across all asset classes. The economic slowdown in China continues to plague demand for raw materials around the world. At the same time, the accommodative monetary policies of the world’s central banks continue to keep interest rates at historically low levels, which have been a supportive factor for commodity prices.

After the late 2015 and early 2016 lows in many raw materials, things turned around. Commodities posted a marginal gain in Q1 followed by a strong performance in Q2. Many commodities posted double-digit gains.

A big winning quarter

There were so many winners over the course of the last three months, so first I will outline the few commodities that dropped over the second quarter. The worst-performing commodity was live cattle that declined 13.62% on fears that rising feed prices will cause early processing of cattle, causing a temporary glut in the market. Feeder cattle futures lost 8.13% over the three-month period. The only other commodity that posted a loss was wheat. KCBT hard red winter wheat lost 15.12%, making it the worst performer of all raw material futures markets. CBOT wheat was down 8.92% while MGE wheat shed 6.47% of value. KCBT and CBOT wheat are down 13.71%, 8.24% for the first half of the year while MGE wheat is up 0.41% over the last six months. Wheat, cattle, and soybean oil, which was down just over 8%, were the only losers over the period.

One of the best-performing commodities of Q1 was natural gas, which gained 49.26% while NYMEX and Brent crude oil futures gained 26.06% and 26.93%, respectively. Luster returned to the yellow metal as it posted an increase of 16.41% in the quarter. Heating oil gained over 25% while gasoline posted a small gain of just under 4%.

While LME copper added only 0.31% in the quarter, zinc was up more than 17% and nickel gained over 13%. Aluminum moved around 9.5% higher, and lead was up more than 4%. The highly volatile tin market was up a little under 1%.

In the meats, cattle had a rough quarter, but Chinese demand for pork led to gains of 21.84% in the lean hog futures market over the three-month period. Soft commodities all rallied, with sugar leading the charge and moving 32.44% higher, followed by FCOJ futures adding 20.35% and coffee, which gained 13.06%. Cotton was up 7.49% in Q2 and cocoa gained 1.83%.

Grain markets picked up volatility. While wheat fell, soybean and soybean products exploded higher on drought conditions in Brazil and floods in Argentina. Soybeans were up 29.01%, but soybean meal rallied by 49.94%. After posting gains earlier in the year on palm oil shortages in Asia, soybean oil fell 8.3%. Corn was up by 2.06%, with oats rising 10.64% and rice adding 8.41% in value over the course of Q2.

Precious metals continued to add to gains in 2016. Silver led the sector with a 20.62% gain and gold followed adding another 7% in Q2. Platinum and palladium were 4.88% and 5.91% higher respectively. Fear and uncertainty in the global economy led to gains in all precious metal. While the dollar strengthened, the precious metals markets paid more attention to central bank accommodative policy, terrorism around the world and a growing trend of citizens rejecting the political status quo. The June 23 referendum in the U.K. resulted in a 52-48 vote to exit the European Union, which shocked markets, sent the pound reeling and caused the sitting Prime Minister to announce his resignation. This uncertainty has been highly supportive for precious metal prices, which continued to rally on the first day of Q3, taking silver $1 higher on the session, while all other precious metals prices added to gains in 2016.

Divergences continue to be a common theme in the precious metals sector. While the silver-gold ratio moved lower, platinum’s discount to gold increased over the quarter and traded at a new all-time low of a $345 discount to gold in June in the post-Brexit frenzy. While gold continues to be historically expensive against both platinum and silver, the price action in the markets over the quarter highlights that all precious metals have returned to bullish trends on a long-term basis.

Divergence with the dollar – Do currencies matter?

It is worth mentioning that the continuation of historically low interest rates around the globe has caused all currencies to fall in value over 2016. We are trained to measure currency value by looking at one currency against the other. We often refer to the dollar as strong or weak when it moves against other foreign exchange instruments like the euro, pound, yen, Australian dollar, Canadian dollar or other currencies. However, gold has had a dual role over the course of history. The yellow metal has been both a metal or a commodity and a means of exchange or currency for thousands of years. To that point, central banks classify their gold holdings as “foreign exchange reserves.” As such, the performance of gold in is a statement or better yet, a failing report card for global central bank policy as it tells us that all currency values are dropping against the precious metal. Moreover, the over 60% appreciation in bitcoin, a cryptocurrency, over Q2 is another sign that alternative means of exchange are attracting capital as faith in paper-fiat currencies has decreased around the world.

Therefore, even though the dollar strengthened over Q2, commodity prices shrugged off the greenback and rallied as the dollar and all paper currencies have declined as an asset class.

Energy rebounds and soybeans soar

It is worth taking a moment to talk about two important commodity sectors: grains, which are food and energy, which powers the world. These two raw material groups have one thing in common: people around the globe require them for daily life as necessities.

After almost two years of a brutal bear market in energy prices, crude oil and natural gas have both recovered. These energy commodities were in the late stages of a bear market that caused high-cost production to become uneconomic and output to slow at a time when demand started to rise due to low prices. The overriding reason for the price recovery in the energy sector was declining production and the cyclical nature of raw material markets from a supply and demand perspective.

In the grain sector, the action in soybeans over recent months should serve as an example of the fickle nature of weather and its effect on our food supplies. A smaller-than-expected South American crop due to weather and shortages of palm oil in Asia because of El Nino caused a vicious rally in the soybean and soybean product markets. Beans have gained over 35% in the first half of 2016.

The world’s population continues to grow; at latest count over 7.33 billion people share our planet. That means that more people are chasing finite raw materials, mainly food. In years where there are bumper crops and availability of agricultural raw materials is plentiful, like the years between 2012 and 2015, agricultural commodity prices moves lower. However, in years where supplies decline due to weather issues, crop diseases or logistical problems of bringing crops to market, we are likely to see dramatic demographic strains on the demand side of the fundamental equation for these commodities. Soybeans are not the only commodity teaching this lesson in 2016, the price of sugar has doubled during the period from August 2015 to June 2016.

Low interest rates via central bank monetary policy and political events around the world have increased the chances for a buoyant commodity market in the weeks and months ahead. Chances are we will see volatile trading conditions with many raw materials making higher lows and higher highs in Q3 and throughout the balance of 2016.

History – Results from my best bets for Q2

The results of my best bets for Q2 from my Q1 report are as follows:

I believe that buying copper scale-down so long as it remains above $2 will yield profitable opportunities over Q2. Copper did not trade below $2 per pound during Q2, but it came very close falling to $2.0180 on June 9. There were three significant rallies over the course of the second quarter. The first came at the beginning of March when copper moved from just over $2.10 to highs of $2.3295 on March 18. Copper then headed down to the lows of $2.0860 on April 7, only to recover to $2.3060 on April 22. Then, copper fell steadily to the June 9 lows and recovered to the $2.20 level at the end of Q2. Scale-down buying in copper and taking profits on rallies yielded positive results during the quarter.

Silver is cheap relative to gold; I like buying silver with a stop below $14.50 per ounce. Silver traded to the lows of $14.95 per ounce on the very first day of Q2 and never traded at that level again over the three-month period. Silver closed Q2 at over $18.60 – an increase of more than 24% for the period. On the first day of Q3, silver was closing in on the $20 per ounce level in explosive market action.

Platinum is cheap relative to gold. If you are looking to purchase physical precious metals, platinum offers the best value. Platinum gained 4.88% in Q2, closing the quarter at the $1,024 per ounce level. On the first day of Q3, platinum traded to $1,060 and made highs of over $1,092 during Q2.

Buying nickel scale-down for a recovery could be an interesting play in this volatile commodity. Stops are necessary. Nickel was one of the best performing base metals over Q2, posting a gain of over 13% in a volatile market action.

I continue to favor CBOT wheat and believe that the price will move higher over the course of the next few months. I was dead wrong on wheat; I should have recommended soybeans! CBOT wheat was down almost 9% during Q2, making it one of the few losers in the commodity markets.

Crude oil will move after the April 17 meeting in Doha; prepare for volatility. Crude oil moved following the Doha gathering, rising from $40 per barrel to highs of over $52 on the August NYMEX crude oil futures contract, an increase of 30%.

Equity prices continue to be expensive; I believe the market will try the downside again. Equity prices were volatile as they traded for most of the quarter on either side of unchanged because of central bank policies that are making interest rates artificially low. The DJIA was up 1.38% in Q2, with the S&P 500 up 1.9% and the NASDAQ down 0.56%. While I was wrong on a quarter-by-quarter basis on stocks, there were plenty of profitable opportunities for those holding short positions over the three-month period.

Sugar, coffee, cotton, and cocoa are interesting buys on price dips. If you do not trade futures or options on futures, look at SGG, CANE, JO and NIB EFT/ETN products for long positions, but use stops. All soft commodities rallied during Q2 with sugar leading the charge and coffee posting a double-digit gain. Cotton added to value, and cocoa was only up marginally over the period.

We had some winners and some losers in Q2; I will reiterate what I said at the end of Q1:

Market volatility means that we cannot look to hold positions for long periods. These are trading markets that require tight stops for protection. When profits present themselves, take them as there will always be an opportunity for another trade.”

Best bets for Q3 and 2016 – Commodities

So many issues facing the world are likely to drive commodity prices over the coming months. I expect volatility to continue to be the hallmark of all raw material prices and other asset classes for that matter. Economic weakness in China, currency volatility and economic weakness across the globe are likely to cause periods of extreme weakness and strength. The contentious presidential election in the U.S. kicks into high gear with the conventions and first debate in Q3 and the actual voting in Q4. Markets are a reflection of world events, and this election is likely to be a heated and volatile affair, which will influence market action across all asset classes. Always remember that commodities are very volatile assets. Often, the worst-performing commodities in one-quarter turn out to be the best performers in the next and vice versa.

My best bets for Q3 are:

  • I believe that precious metals will continue to make higher lows and higher highs. Initiate positions during periods of weakness or profit-taking and sell on new highs or rallies to capture gains.
  • I continue to believe that wheat and corn have limited downside risk and huge upside potential. Use options or ETN/ETN products to limit risk.
  • I believe crude oil is likely to trade in a $45 to $55 range on the active month NYMEX futures contract.
  • Platinum has explosive potential – I prefer platinum for physical precious metal purchases.
  • Equity prices continue to be expensive; I believe the market will try the downside again.
  • I believe cotton is building cause for an exciting move higher.
  • While I am friendly to sugar and coffee, I would only buy on price weakness using options for risk positions to protect capital.
  • Gasoline and heating oil crack spreads are likely to strengthen against crude oil.

Q3 2016 will probably see more volatility and opportunity in commodity markets. Keep your eyes on the dollar, against other currencies and gold and bitcoin as these alternative means of exchange. At the end of Q1 I wrote:

I believe that commodities will outperform the dollar in the future as raw material markets are starting to attract attention once again. Trading rather than investing on a medium or long-term basis is likely to yield the best results in these crazy markets.”

Be careful out there – we could be in for a wild ride in Q3 and the rest of 2016!

SOURCE: Seeking Alpha