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Trader Savvy Newsletter

December 5, 2006

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Trading the Commodities Bull Requires Research

Name: Chad Butler

Company: RJOFutures

Learn More About Today's Author
Years Trading: 16

Favorite Movie: Glengarry Glen Ross

Trading the Commodities Bull Requires Research

As I have written many times this year, I believe the commodities bull market continues, and it is likely to continue for the foreseeable future. If you have been following my material regarding this unfolding saga, you know that you need to pay attention to sectors within commodities. A study of past long term cycles will show you that not everything simply moves higher in a secular (long term) bull market. The savvy trader will be watching for the sub-sectors that have the greatest opportunity.

The grains continue to be not only one of the sectors driving forward in the commodities bull market, but also one of the most overlooked areas of the market. I think that is due in part to a lack of understanding of the market. Many traders stay away from more agricultural markets because they feel they do not understand enough about those markets to trade them. This does not necessarily need to be the case.

Think of it this way – if you are a stock trader diversifying into futures and you stay away from the agricultural markets because you do not understand the fundamentals, do you really understand the fundamentals of every market you have traded before? Do you really understand the production and marketing of shoes enough to be able to trade Nike stock? How about knowing enough about the production, sale, and maintenance of switches and routers to be able to trade Cisco?

The agricultural markets are no different. A little extra study and some common sense will get you on your way. Access to quality research, like that provided by RJOFutures, is also a key factor. If you already trade other markets, you probably already have a sense for learning the information you need and a knack for analyzing fundamental research. You can apply those skills to any market you trade.

With that in mind, let’s talk about the grains. The grain complex is currently in a strong bull market. This trend does not show signs of stopping, at least not in the near term. Certainly, there are likely to be pullbacks along the way, but the general trend is likely to remain sound. The reasons for this are found by looking at the fundamentals of the market.

First and foremost is the continuing ethanol story. With consistently high energy prices, the demand for alternative fuels continues to be strong. Ethanol production is scrambling to meet this demand. However, this will require massive amounts of corn. Farmers know this and are stepping in to produce more corn.

The laws of supply and demand would normally tell us that this production increase would stabilize prices or push prices lower. But this increase in production has two factors that keep that from happening. (1) There is a finite amount of crop production land in the United States and that amount of land will need to be used for additional crops other than corn. (2) There is competition among the commercial interests for the corn produced. Ethanol is not the only place this corn is going. Commercial feedlots use grains to fatten cattle. Nearly all commercially raised meat (beef, pork, chicken) uses grain as its primary feed. And have you ever taken a look at how much corn syrup is in our food supply? It is likely that the majority of the food you eat today will contain corn in some form or another.

With competition for the purchase of corn, we have the makings of a bull market that has not been seen before. Certainly, we have to consider that one of the greatest cures for high prices is high prices. If the end product becomes to expensive due to higher input costs, we would expect demand to decrease. But it is my opinion that we will not see that for some time; at least not while we continue to see increased global energy demand.

So what other factors will drive the grain market story? Remember the finite number of acres available for corn production? If farmers increase their production of corn, they will be taking acres away from other crops, namely soybeans and wheat. Now, that may not seem immediately significant, but stop and think about that for a minute. How much of the food you eat today will contain not only the corn syrup we mentioned earlier, but also products made with wheat and soybeans?

Soybean oil is one of the most widely used cooking oils in the world. (Other uses for soy products include soap, cosmetics, plastics, inks, solvents, and biodiesel.) Wheat is used for not only bread, but also pasta, crackers, pastries, and tortillas, to name a few. As long as people need to eat, there will be a demand for these products, just like corn. But if we have increasing demand for corn used for energy and increased acres to meet that demand, that means we have decreased acres available for bean and wheat production. If the demand for food remains constant or the same during all of this, we would expect higher prices not just in corn, but beans and wheat should follow. As far as world production/consumption is concerned, China continues to be a major factor (as it does for all commodity markets). Currently, China is a net importer of grains from around the world. This increasing demand will pressure supplies in the US, helping to drive prices higher.

Beyond just the demand picture, we have to consider other factors that could potentially reduce crop yield. A lower crop yield would mean less supply to meet demand. There is a possibility for an outbreak of soybean rust (rust is a fungus that infects crops) in the United States. Even a mild outbreak of rust in the US bean crop could drive prices considerably higher.

Let us not forget that we are currently experiencing an El Nino. El Nino is a weather condition of rising oceanic surface temperatures in the Pacific Ocean. This condition is known to affect the weather patterns of the entire planet. How long the condition continues past this winter will determine whether we can expect an effect on grain production. Typically, if El Nino continues through the winter into spring, we can expect dry conditions in the major growing regions of the US. In the past, this has led to bull markets in grains.

If grain prices continue to run, another set of markets to watch will be the meats. Cattle and hogs will certainly be driven higher with higher corn input costs. These animals are feed a diet consisting mostly of corn so higher costs of feed will be passed on in the price of the meat. The meat markets, along with grains, will continue to boost the ongoing commodities bull market.

If you are a trader, you should be nimble enough to trade the markets that are moving, focusing on the markets that have opportunity. For now, that means paying close attention to the grain markets (and other agricultural markets). Study the fundamentals that drive these markets, include some common sense and knowledge of trading in general, and you should certainly be able to formulate a solid plan.

At RJOFutures, we provide our clients with access to solid institutional research. Having access to quality research is vital to the process of developing a sound trading plan. In my opinion, trading without research is like trying get somewhere without a road map. I use technical analysis to determine trades, but analysis based on research of the market fundamentals comes before that so I can determine the direction I wish to go.

The importance of this cannot be overlooked. That is why RJOFutures places such a high value on providing clients with access to a variety of high quality research. That is why RJOFutures places such a high value on providing clients with access to a variety of high quality research and trading strategists that can help convert that research into a trading plan. Take two weeks to review the material we have to offer – not just for grains, but for all markets.

About Today's Author

Chad Butler is a Senior Market Strategist with RJOFutures, a division of R.J. O'Brien. His 16 years of market experience includes option spread trading, diversified trend following, and development of a number of index arbitrage programs. Chad’s published work appears in McGraw-Hill's Complete Guide to Single Stock Futures, Futures Magazine, and other trade publications.  He currently writes for various commodities newsletters, including RJOFutures MarketNews and has been a featured seminar speaker teaching his various trading techniques to audiences large and small.

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