From time to time, we show charts drawn from the Commitment of Traders report to show when speculators (hedge funds and CTAs) are holding extreme positions, either long of short, of say a fixed income or FX instrument. Indeed, we showed one last week when explaining why we felt that the Euro was at an interesting juncture. This week, we want to draw attention to a set up in soft commodities that has not been seen for several years, if not a lot longer. Our work has indicates that soft commodities may well be forming a major low, and we have bought a modest exposure to Cocoa, Coffee and Sugar in our multi-asset fund. Let us explain our thinking.

Usually when we show charts from the commitment of traders report to illustrate our analysis of financial futures, we show what speculators have been doing. However, when it comes to commodities, it is often more interesting to look at what the other main type of futures trader has been doing; the commercial traders. When we talk about commercial traders, we are talking about traders who need to trade in the underlying commodity (mostly for hedging purposes), whereas speculators choose to trade in particular commodities.

So let’s start with Cocoa. Who might these commercial traders be? We can split them into two camps. First, we have those that effectively produce or sell Cocoa. These traders need to sell at some point, and they may choose to sell/hedge their production by selling in the futures market to either secure a price that guarantees a nice profit or when they think the price has gone too high. Second, we have commercial traders who use Cocoa in say the production of chocolate. These traders need to buy Cocoa at some point, and they may choose to buy/hedge in the futures market to guarantee a price that ensures they can make a profit in selling their chocolate or when they think the price is too low.

These commercial traders are at the sharp end of the market. Collectively, they will know far more than any single hedge fund can about the supply/demand of a particular commodity. Furthermore, when a good portion (perhaps even the majority) of speculators base their decisions on trend following rules only, and trade without any knowledge of the fundamentals of supply and demand, we have to respect what commercial traders are doing in their trading activity when it comes to judging the fundamentals for a particular commodity.

Chart 1 below shows the current activity of these commercial traders for Cocoa. In terms of reading this chart, the white line is the price of Cocoa and the blue bars show the net positions held by all commercial traders combined. In the lower panel, we illustrate separately the number of long and short contracts held by these commercial traders.

Chart 1 – Cocoa price and Commercial Traders positions on IMM

So, what do we see in this chart? Well, first, we see that commercial traders collectively are holding the biggest long position ever in Cocoa. This is interesting as not only does this indicate that this group think that the price of Cocoa is too low, but they also have a pretty decent track record when they make these kinds of bet. Historically, not long after commercial traders have accumulated a net long position, the price of Cocoa begins to rise. Furthermore, price having fallen from above $3000 to below $1900 is approaching levels that have historically been seen as cheap.

If we analyse the long and short positions in the lower panel, we can see that commercial traders have been steadily accumulating Cocoa on the way down in recent months, and their long holdings are the largest on record. Perhaps these guys have bought/hedged a lot of their future needs as they see the price as being attractive to do so.

We can also see that in recent weeks, commercial traders short positions have been reduced. Remember, these are the guys who sell/hedge future production. When their short positions fall (outside of contract expiry), they are probably closing out their hedges, a) at a nice profit after a large price decline, and b) because they think the price is too low now and they no longer want to have their production hedged – they are willing to accept whatever price is available in the future, because they think it will be higher than today.

We would make the point that commercial traders net activities are pretty much the mirror image of speculators net activities, as can be seen in chart two below. Collectively, speculators have been net short of Cocoa during a significant price decline; they must be very happy with this. But these guys are only motivated by profit, whereas commercial traders, because they are hedgers, are motivated by the profit margin on their production and therefore somewhat less sensitive to shorter term swings in the price.

Chart 2 – Cocoa price and Speculators positions on IMM

If we look at the long and short positions held by speculators separately, we can see that during the decline from last summer, speculators have been increasing their short positions markedly. In recent weeks, long positions have been cut back; possibly a sign of capitulation by those speculators who have been playing for a bounce? The real question is when will the speculators holding short positions take profits? Well, as noted these guys are motivated by profit and we doubt they will want their profits to evaporate, and so they will start to buy when price starts to rise. Furthermore, with many of these guys being trend followers, they will cover their shorts when their models tell them the down trend is over. Indeed, if price rises enough, they may switch quite quickly from being short Cocoa to being long.

So, the real crux of the matter is that even if commercial traders are positioned correctly, and Cocoa is cheap, we need to see the price moving higher to force speculators to buy. Chart three below shows the daily chart of Cocoa. We have also shown the 14 and 21 day moving averages and in the lower panel the daily volume. What we think we have developing here is a multi-month base building pattern. Support appears to be coming in just below $1800 and resistance is about $2100 and then again at $2200.

Chart 3 – Cocoa September ’17 futures contract price

Now, we may be jumping the gun before price starts breaking out of this base building or bottoming pattern. However, on the most recent test of $1800 the volume stayed relatively muted compared to when price last tested resistance at $2100. This hints at selling pressure abating.

This base building pattern has been developing for at least three months now, arguably a bit longer, so clearly downside momentum is dissipating. Is this loss of momentum enough to force the trend following speculators to buy back their shorts? Probably not, we suspect that a price break above $2100 would be the real trigger. But given the record bullish positioning of commercial traders, we are willing to dip a toe at current levels. We are thinking that Cocoa could be near the start of a major bull market, and if price can get above $2100 we will be adding to our current modest position. If price breaks below the recent lows just below $1800 then we are wrong and we will sell out our position.

As for coffee and sugar the setups are very similar. Commercial traders are holding record long net positions after a significant price decline towards historically cheap levels. Chart 4 shows the commercial traders positions.

Chart 4 – Coffee price and Commercial Traders positions on IMM

Chart five shows the daily price graph for coffee. Price has clearly fallen a long way, and if we squint hard enough, we can argue that an inverse Head & Shoulders bottom has just been completed. Nothing in trading life is perfect, and we would like to have seen higher volume on the break above the neckline of the Head & Shoulders bottom pattern. However, given the record long position held by commercial traders, we are again willing to dip a toe here, and will not hang around if the low around $115 is broken.

Chart 5 – Cocoa September ’17 futures contract price

And finally onto sugar. Chart six shows the position of commercial traders activities and they are holding record net long positions.

Chart 6 – Sugar price and Commercial Traders positions on IMM

In chart seven we show the daily price chart for sugar. Similar to coffee, price has seen a significant decline and if we squint hard enough we can argue that an inverse Head & Shoulders pattern is close to completion. Again, we have dipped a toe here hoping that the commercial traders record net long position is a sign that a new bull market will soon begin. If price trades below the recent low around $12.75, we will be wrong and will exit our position.

Chart 7 – Cocoa October ’17 futures contract price

Taking a step back, we have never written about soft commodities in our weekly commentaries, and perhaps some of you may think we have taken leave of our senses. What possible edge do we think we can have in trading these commodities? Well, we would make the following argument.

First, central bank monetary policy has led to such distortions in mainstream assets. These assets are in a bubble that refuses to break, and it is difficult to make money whilst also controlling risk. We strongly suspect that commodity markets, outside of the energy and metals markets, are some of the least manipulated by central bank policies, and therefore easier to understand in terms of judging supply and demand and price discovery.

Second, we made the argument above that no single hedge fund or money manager is going to know more about the fundamentals of these commodity markets than the collective knowledge of the commercial traders. Of course, commercial traders aren’t perfect, and being hedgers, their motivation is slightly different than that of pure speculators. Yet, they have a very canny track record of being right shortly after they have accumulated big long positions especially when price has fallen to historically cheap levels.

Thirdly, historical analysis proves that the best time to side with the commercial traders is not only after a significant price decline during which they have accumulated long positions. We also need to see price form a base building pattern and turn around to the upside. We think we are on the cusp of new bullish trends in these commodities as price has either been building multi-month bases, or is already displaying technical signs of reversing the previous downtrends.

Finally, managing money is as much about managing risk. Or put another way, it’s not necessarily about how much you make on your winners, it’s about how much you lose on your losers (and all money managers make losing trades – let’s not kid ourselves). So, as long as we know how much we are risking, and that we believe our potential gains are significantly more than our potential loss, then it makes sense to put the trades on.

So here we go. We have dipped a toe in the Cocoa, Coffee and Sugar markets, risking a bit less than 1% of our fund’s capital. We put the trades on in the markets on Friday morning and by the close we are a bit more than 1% in profit across the three trades. As price patterns develop, we not only hope to tighten our stops, we hope to add to the trade if it looks like new multi-month bull markets are developing. We will of course keep you updated on how this trade progresses.

Stewart Richardson
RMG Wealth Management