Crude Awakening

It's indeed a crude awakening for Qaddafi, Libya's leader for the last 42 years...and given that Libya supplies nearly 1.6 mbpd (mmn barrels per day), or nearly 2% of world's oil demand, it is literally so too for the rest of the world. Crude prices are on the boil again (touching $ 100 / barrel) after being under control since the 2008 crash. Take a look at the historical crude oil (WTI, NYMEX, in USD / barrel) prices:

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And considering the impact crude usually has on the rest of the asset classes, the whole world is sitting up and taking notice of events unfolding in the African country.

The global markets not impressed, with most markets going down by 2-2.5% in the last 2 days. 

Take a look at the Dow Jones Industrial Average (DJIA) chart for the last 5 days for instance:

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Gold is moving up smartly again, touching $ 1415 / ounce, slightly below its recent multi-year high of $ 1431 / ounce. US treasury prices are moving up, implying that people still consider US T-bills safer during times of global crisis. 

A whole host of other commodities will start moving up too, since this rise in crude oil is going to trigger a rise in demand for bio-diesel (an alternative to crude), which needs, among other things, ethanol...made from sugarcane...sending the prices of sugar higher. Elsewhere in the world, import duty paid to bring in bio-diesel in the country is by-passed by bringing in bio-diesel as blended oil...for which some portion of palm oil is mixed with bio-diesel to pass it off as "blended oil". Later, through some fractionation process, these two are separated, and pure bio-diesel obtained. [That's what I've heard from some of my sources in this industry, can't confirm it though]. So an increase in demand for Bio-diesel also increases the demand and prices of palm oil, and since soybean oil is a good substitute of palm oil (for cooking), that too moves up in tandem...and since soybean oil is derived from soybean seeds, the prices of those  move up as well...and so it goes.

Given inflationary issues in almost all the countries world-wide, with an exception of the US among the bigger ones, this increase in crude prices is going to further aggravate the situation. Already high unemployment in US is going to go further up, as squeezed margins force companies to go even leaner. In India, already another price hike for diesel and petrol is being talked about...and it might come sooner rather than later.

However, at such times, solace comes from such pronouncements as given by an organization, that crude might hit $ 220 / barrel if Libya and Algeria stop oil production / exports. Usually, such "eye-catching" forecasts are given only at the end of a rally...so may be...just may be, the top is near. Let's wait and watch...and yes, in the meanwhile, stock up on cooking oil if you want to save a few bucks.

Margin Requirements hiked - Effect on Global Markets

There was one other point that I did not cover in my last post (Rumblings of Markets...), due primarily to 2 reasons - one, the post was getting too long for audience's perceived comfort (in my view) and two, this is a lesser known, less talked about, but an extremely important point nevertheless, which needed a separate coverage.

And the point is about exchanges increasing margin requirements on various contracts.  Margin requirement is the minimum amount that a trader needs to deposit with her broker / exchange in order to take a futures contract. This is apparently being done to remove some of the speculative money from the markets. We'll jump in into the dense world of commodities, but first, some news for those of you who have skipped this important piece.

As per Bloomberg, "Ice Raises Margins on Sugar Futures by 9.9% as of Close Nov. 12" which lead to a sell-off in raw sugar prices that was so sharp, that it beat all records set in the last 22 years ! Simultaneously, ICE also increased margins on cotton, leading to a 2.7% sell-off. CME raised margins on soybeans, while Chicago exchange did so for Silver (which tanked 7.1% later). If you would like to, read this good piece from WSJ Online here.

Back in 2006-08, when authorities in India accused commodity futures for pushing and keeping prices of physical commodities higher, the ones who did not support this view said that futures prices are in fact determined by the physical prices. So if sugar demand goes up / supply goes down, the mandis / local markets will push the physical prices of sugar up, and thereby the futures prices will also go up since physical prices are an input to calculating futures prices. If this does not happen, there is an arbitrage opportunity which allows prices to come back in sync. This is another way of saying that the tail (futures market prices) cannot wag the dog (physical market prices).

But going by the events listed above, it seems like the futures prices were actually being held up to some extent by speculators and it wasn't entirely tied to physical prices. Such a sharp sell-off in various commodities underlines the fact the speculative money can in fact, keep the prices artificially high. The margin money is the life-line of traders, its what they calculate ROI on, its what is churned n times a day to make money. E.g. if we assume that the margin required for  1 futures contract is around Rs. 25000, a trader with Rs. 50000 will be able to take only 2 contracts in either 1 or 2 different assets. On the other hand, a trader with Rs. 10,00,000 (ten lakhs) will be able to take 40 such contracts. Assuming both are normal, disciplined traders, its an easy guess who will make more money. Thus, margin money determines your churn, which affects your profitability directly. Any increase in margin money requirements slows the churn cycle so if 0.5% daily returns were good earlier with X margin money, nothing less than 0.75% daily return is good with 1.5X margin money.

Besides, the margin money requirement also has a contagion effect: You need more margin money, you decide to pull out some money from some other trade, ----> that asset prices goes down, ----> traders holding that asset get margin calls ----> they sell something else -----> that asset prices goes down...and so on. Besides, stop losses start getting triggered, which leads to further sell-off, leading to further downslide...and so on...not just in the same market / asset class, but in others as well.

This is probably one of the major reasons (apart from the ones given in my last post), which has lead to a sharp sell-off in various asset classes across the globe. It looks likely that this sell-off will continue for some part of next week as well, till traders re-align their portfolios again.

But notice how all these margin requirement hikes are happening across exchanges across geographies simultaneously...giving an eerie feeling of an implicit dictum from the big daddy of commodities...(but its just my guess, I could be entirely wrong here). Also, notice how these requirements have been upped in commodities which China imports heavily...(sugar, cotton, soybeans). [Co-incidence anyone?] 

They have good reasons to do so - one, they are faced with inflation issues just like in India (any they're hoping that this move will cool down prices which will be reflected in lower inflation figures), and two, with their currency appreciating against dollar, their exports will take a hit and so they might have wanted to make some downward adjustments to their import bill as well (to keep trade deficit in check). If these are indeed the reasons, expect margin tightening in more commodities, in more markets.

There is just one thing which can derail the above tactic - the producers / sellers of these commodities, who will not be very happy with the falling prices (some of these players are really really big in the market). Besides, typically, their sale contracts are not based on end-of-day prices, but more on monthly average / quarterly average prices, which will come down drastically with the effect of such falls. Also, with falling prices, the chances of defaults by the buyers increases drastically (not very uncommon) further putting in question the actual sales figure done by these producers / sellers for this month / quarter.

Expect these players to come back big time to push the prices back up again. If they need to borrow money to put in the markets, they will. Expect banks to increase their lending to these guys and to usual trading companies to make good their increased Working Capital Requirements (due to payment of higher margin money). Whether and how soon the prices come back up will really depend largely on such players in the market. 

But till then, it'll be the case of the tail wagging the dog.

World Markets - Step on the Gas

Recently Mark Mobius said on Bloomberg: The U.S. Federal Reserve’s bond purchase plan will further drive the rally for global stocks and push commodity prices “higher and higher,”...

Couldn't agree more...with Gold to its highest price ever recorded (pushing USD 1400 / ounce) [Note: Its not an inflation adjusted price - any idea where to get that figure for the latest prices?] and Oil also looking to break-out, it looks increasingly likely that it is going to be interest rates, inflation, and growth running around in spirals trying to catch each other...with Currency dynamics popping surprise hurdles in the game.

If crude goes up, inflation mostly will...and so will related commodities like Sugar (used in ethanol - which is used in Bio-diesel - a substitute for crude oil for energy requirements), Palm Oil (with bio-diesel demand going up, Palm oil - an input in Bio-diesel also goes up), and so does Soy Oil (an alternative to palm oil in cooking), and Groundnut oil (an alternative to palm and soy oil) and others. The cost of transporting and cooking food goes up...stoking inflation further. And then people rush to Gold, traditionally considered a hedge against inflation. A depreciating dollar would help but only to a certain extent...beyond that, its upto the central banks to manage inflation.

However, consider this - while the selling price of most commodities goes through the roof, the cost of producing these commodities does not...resulting in increased margins for most commodity producing companies...(plantation, mining, drilling, etc.). So if I were to stick out my neck, I'd say go long on global commodity producers' stocks. And unlike Mobius, still avoid Airlines stocks - as for them Crude Oil is an input cost, and market share is as big a worry as margins. So increased volumes (due to increased economic activity) might just get offset against depleting margins....net result - stunted growth. Unless, of course, the airlines are hedging their input costs (intelligently)...so lets look-out for some smart financial managers in airline companies.

We're going through a rough patch, but its nothing to be worried about,...please return to your seats and put your seat belts on and enjoy the journey...!