Commodities plunge offers trading opportunity

May 11, 2011 2:19 pm

Central banks raising interest rates

Jean-Claude Trichet said this week that the bank will monitor inflation risks “very closely”. The European Central Bank (ECB) President suggests that it may wait until after June to raise interest rates again.

The ECB raised interest rates on April 7, joining China, India, Poland and Sweden in seeking to control inflation. The cost of living in the US rose at its fastest pace since December 2009 in the year ended in March, the same month when Chinese consumer prices rose by the most since 2008. In India and China, inflation is rising rapidly.

Industrial commodity prices drop

The Euro dropped the most against the dollar in two weeks. A strengthening US dollar means that commodities for investors outside the US will be more expensive and vice versa. Copper, aluminum, nickel, zinc, tin and lead also declined severely. Gold and silver were also slaughtered on the futures markets.

Silver futures recently reached a high of nearly $50 an ounce, and declined almost 30% since then. CME Group raised margin requirements by 84% in less than two weeks, which put also selling pressure on silver prices if traders were to close futures positions.

Oil prices drop

While oil prices (and distillates) soared the last months, the crack spread followed suit and shot trough the roof as well. From oil, products can be extracted like heating oil and unleaded gas. It is interesting though that the crack spread which I analyzed one year ago, remained stable during the sell off in the oil market.

For instance, the 3:2:1 crack spread reached almost the all time high of 30 in 2007. Buying this spread means: buy 1 heating oil futures contract and 2 gasoline futures contract and meanwhile selling 3 WTI futures. This is done in a certain ratio and this way you own a virtual oil refinery. Other ratios could be 5:3:2 or even 2:1:1.

Crack Spread 1:2:3

The 3:2:1 crack spread is double weighted in gasoline, thus it tends to outperform the 2:1:1 spread when gasoline prices rise more than heating oil. The other way around is also possible: diminishing demand for petrol, can push the 3:2:1 spread into a discount. As we can see now, the crack spread (according to the Bloomberg chart), this spread is reaching the all time high.

This is interesting: the oil price did not even hit the all time high, while this spread is almost at record level. This means that gasoline and heating oil are outperforming WTI.
Is it maybe time to go short this spread? For contrarians a nice counter strategy. Thus buying WTI and sell the components gasoline and heating oil.

The current correction in the commodities market is indeed substantial, but the prices were already soaring in the past years. Perhaps this sell off can offer investment opportunities, provided that a bottom is found and the prices recover.

Charts courtesy of