All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

The dynamics of currency markets have been altered significantly by the continued zero interest rate policies (ZIRP) and massive quantitative easing programs of the US Federal Reserve (Fed), European Central Bank (ECB), Bank of Japan (BoJ), and Bank of England (BoE). In this environment, our perspective is that exchange rate movements between members of the ZIRP club are likely to be determined by the interplay of domestic politics and economic growth, rather than relative interest rate policies. By contrast, exchange rates between ZIRP club members relative to emerging market nations and smaller industrial countries are more likely to be influenced by interest rate differentials and how interest rate policy might respond to currency movements. Moreover, the general state of play in the currency markets is likely to be greatly affected by whether global financial markets appear to be trading in a “risk-on” or a “risk-off” environment.
Politics Can Trump Fundamentals in the ZIRP Club
Exchange rates between any of the ZIRP club members of the US, Europe, UK, or Japan simply do not depend as much on interest rate differentials as they once did, because the differentials have disappeared and are not likely to reappear until years into the future. The BoJ invented the zero interest rate policy option in 1995, and Japan was considered a special case that could not happen in the US, UK, or Europe, until it did happen when the Great Recession struck in 2008. Now, in the post Great Recession world, there is effectively little difference in the interest rate policies of the US, UK, Europe, and Japan, although there are differences in how quantitative easing has been applied.

Figure 1.

There is not much difference in 10-year government bond yields either (Figure 2, below) for members of the ZIRP club. Yields on Japanese Government Bonds (JGBs) are lower than their counterparts in the US, UK, and Germany (the benchmark for Europe), but that is mainly because Japan has been battling deflation for 20 years and has had zero rates since 1995. As one can see in Figure 2, 10-year Government bond yields for the US, UK, and Germany are closely correlated and have converged since 2008 toward lower yields. In short, there is very little relevant information for exchange rate determination in the shape of the yield curve for these four major currencies. And, this is likely to continue through 2013, into 2014, and possibly beyond.

Figure 2.

With interest rates and yield curves having been severely diminished as relative determinants of exchange rates between members of the ZIRP club, market attention has shifted to the interplay of politics and economics. Let’s go through the four countries on a case by case basis to illustrate this point.
Euro (USD/EUR). The onset of the European sovereign debt crisis weakened the Euro relative to the US dollar. This slide was halted at USD 1.20 per Euro when in the summer of 2012 ECB President Mario Draghi vowed that the central bank would do whatever it took to preserve the single currency and to stabilize financial markets in Europe. Over the next six months, the Euro rallied back to USD 1.35, until the messy and inconclusive Italian elections reminded market participants that voters do not necessarily like the austerity imposed on them by technocrat governments and German-dominated European Union (EU) bail-out plans.
Europe has more electoral uncertainty ahead of it. Italian politics promise a steady stream of good theater, and the German elections in September 2013 may contain some surprises for market participants.
Chancellor Merkel’s Christian Democratic Union (CDU) looks sets to win more seats than in the 2009 election, yet not enough to form a government without a coalition partner. Chancellor Merkel’s problem is that her current partner, the Free Democratic Party (FDP), has lost voter support, at least according to the latest polls. There is a reasonably good chance that the FDP might be shutout of the Bundestag completely, or the FDP might just get a few seats, but not enough to push a Merkel-led coalition over the 50% mark. What that means is the Chancellor Merkel may need a new dance partner. The most likely partner is the Green Party, and it is not clear at all what the Greens might demand in policy initiatives to allow Chancellor Merkel to form a new governing coalition. Currency markets do not like uncertainty, especially when the Greens might tie Chancellor Merkel’s hands in dealing with the EU and debt bail-out plans. After all, many German voters would rather focus on their own internal economic and environmental issues rather than spend their hard-earned taxpayer money subsidizing weaker European countries.
Figure 3.

Japanese Yen (JPY/USD). The yen traded in a tight range over the summer of 2012, between 77-79 yen per US dollar. The slide of the yen started in the fall of 2012 when market participants realized that former Prime Minister Abe had a very good chance of winning a large majority in the December 2012 elections, and that he was quite serious about adopting an aggressive policy stance to achieve a 2% inflation target which would in part be accomplished by weakening the yen. Once Abe won the election convincingly, he immediately moved to put his team in place at the Ministry of Finance and later the Bank of Japan. Market participants had little choice but to take the new inflation target and the weak yen approach to heart. In short, the December 2012 elections changed the course of the yen.
Figure 4.

British pound (USD/GBP). In the aftermath of the financial crisis in 2008-2009, the voters in the UK in May 2010 dismissed the Labour party and a new Conservative Party-led coalition government was installed. This Tory-led government has consistently argued that strict austerity and smaller budget deficits are the best path to a more robust economy. Yet, several years later, as the UK economy continues to struggle and the decline in the budget deficit has been smaller in GDP terms than desired, the popularity of the Conservative Party has declined. The Labour Party now holds a majority in the opinion polls. Although elections are a long way off, scheduled for May 2015, market participants have come to question the commitment of the Conservative Party to its budget reduction plans, and the risks associated with owning British pounds have increased. In this case, as in the Japanese case, it is the interplay of weak economic growth leading to the possibility of political change that has worked to weaken the currency versus the US dollar.

Figure 5.

US Dollar (USD). Politics have been driving markets in the United States as well. During 2012, all eyes were on the Presidential election and whether the outcome would facilitate a fiscal policy compromise or whether the US would fall off the proverbial fiscal cliff of automatic tax hikes and spending cuts. While the initial reaction by markets to the victory by President Obama was to crush equities, it was not long before signs appeared that the fiscal cliff might be avoided. The New Year’s Day tax deal took the worst of the fiscal cliff off the table. The equity markets gained confidence, shifted to a “risk-on” mode, and have not looked back, which helped underpin US dollar strength against the Euro, pound, and yen in the early months of 2013.
Figure 6.

Certainly, economic fundamentals continue to play an important role in the determination of exchange rates of ZIRP club members among themselves. Yet, for currency analysts, the market interpretation seems to hinge on the political decisions that are influenced by economic data and not the economic trends themselves. This post-recession dynamic has forced currency analysts to spend more time studying political trends and handicapping potential shifts in party popularity, which is not necessarily the analytical strength of currency specialists. And, the nature of political decisions is much more of an on/off switch than the inherent evolution of fundamental economic trends. That is, political decisions or elections can lead to dramatically different exchange rate impacts depending on the outcome, which raises the potential for trend reversals and for quick and severe price jumps. All of this underscores the complexity of analyzing currency markets during the era of zero interest rate policies.

Emerging Market and Small Country Exchange Rates are All About Rate Differentials

Outside the ZIRP club, exchange rate determination analysis could not be more different. There is effectively a decision tree. The first question is whether one believes global markets in general are in a “risk-on” or “risk-off” mode. Emerging market nations and smaller industrial countries are generally considered more risky, so they may experience selling pressure and weakening currencies in a “risk-off” trading environment. Interestingly, there is also another factor as work. In a “risk-off” environment, market participants are usually deleveraging as they reduce risk-taking. Deleveraging means paying back the liabilities, which are mostly denominated in the zero-rate currencies, and selling the risky assets that may be located in emerging markets, smaller industrial countries, or simply further out the perceived risk spectrum. That is, deleveraging and reduced risk-taking tends to favor the currencies of the ZIRP club, since they are the “funding” currencies that are being repaid.
Once markets shift to greater risk-taking, the analysis puts a spotlight on the short-term interest rates of emerging market and smaller industrial countries. If currency market participants are willing to entertain the assumption that the exchange rate of a higher rate country versus the US dollar can remain stable, then the expected returns are determined by the interest rate differential. For example, a 6% interest rate for an emerging market country relative to a 0% short-term rate for the US, generates a 50 basis point (0.50%) return each month, assuming exchange rate stability, and that is without leverage. As more market participants in a “risk-on” world gravitate to this exposure, known as the FX carry trade, a reinforcing cycle can be created that leads to the emerging market currency appreciating, which adds to the potential returns.
Currency carry trades come with significant risks. For example, if global markets abruptly shift to “risk-off”, the resulting deleveraging activity can result in a sharp downward move in the emerging market currency on the long side of the carry trade that is being unwound. Months and months, even years, of accumulated profits from the interest rate carry can be wiped out in just days or weeks.
Another risk for the FX carry trade is associated with the possibility of the central bank of the emerging market or small industrial country cutting its short-term interest rate target. Rate cuts have the potential, if there are too many or too large, to cause some carry trade investors to cut their positions. Indeed, as FX carry trades gain favor, the risk of rate cuts rise, because many central banks are appropriately fearful that too much currency strength can have a negative impact on exports and economic growth. What ZIRP in the US, UK, Europe, and Japan has done has made central bank policy making in emerging market and small industrial countries incredibly more difficult.
For example, a country such as Brazil broke the links with its inflationary past by adopting a strict policy in the late 1990s of maintaining a comfortable premium for its short-term interest rate above the prevailing inflation rate. As Brazil has earned its credibility, it has also attracted capital inflows and in “risk-on” markets has become attractive to currency market participants for its relative high and stable interest rate policy. For Brazil, and countries like it, their central banks have been put in the position of having to narrow the gap between short-term rates and inflation more than they otherwise would have preferred to do. In effect, the zero rate policies of the US and other major countries are acting like a magnet, pulling rates down all over the world.
Figure 7.

Emerging market countries such as Mexico and India face the same pull for lower rates as Brazil. Smaller industrial countries such Australia, New Zealand, or Canada, already have modestly lower rates, but they feel the same pull for even lower rates. Arguably, when short-term rates fall as low as they are say in Canada at 1%, then these currencies are more likely to experience some weakness. Whereas relatively high rate currencies, such as India, have the potential for some currency appreciation even though they have much more inflation pressure than most other emerging market countries. In a “risk-on” market environment, wide short-term interest rate differentials have the potential to trump inflation pressures in the currency markets.

Appreciating the Risks and the Opportunities of a Zero Rate World

The realities imposed on currency markets by an extended period of zero interest rate policy from the US and other major nations have changed the dynamics of exchange rate determination. In summary, our research suggests the following:
 Exchange rates, between the currencies of the US, UK, Europe, and Japan, are influenced by the interplay of politics and economic growth aspirations since interest rate differentials are effectively non-existent.
 Political decisions and election outcomes, by their nature, are more on/off or either/or events, that may often lead to abrupt trend reversals when compared to the inherent evolution of economic fundamentals.

 Exchange rates between the US dollar relative to the currencies of emerging markets and small industrial countries are influenced first by the general tenor of global markets. That is, what matters is whether markets are generally characterized as “risk-on” or “risk-off”, with the emerging market and small country currencies generally weakening versus the US dollar in a “risk-off” environment.

 When global markets shift in the direction of greater risk-taking, emerging market and smaller industrial country currencies with their relatively high interest rates may gain favor as the long side of the FX carry trade.

 Considerable risks are associated with the FX carry trade, including the possibility of a return to “risk-off” markets in general or the possibility of rate cuts in the emerging market or smaller industrial country should their currency be perceived by their central bank as having appreciated too much and possibly hurting exports and economic growth.

Q: Let’s start with the basics: What is AlphaFlash Trader?
A: AlphaFlash Trader is a trading application that allows users of popular trading platforms to automate their trading based on macroeconomic news. A clear benefit is that it doesn’t require additional technology infrastructure or programming skills. The user interface is easy to use and intuitive. Orders can be entered into the market instantly at the release of an economic event. The application is currently live on Trading Technologies’ X_Trader Pro and will be available on other platforms shortly.

Q: Can you give an example of how AFT works?
A: Sure. Let’s look at the US nonfarm payroll report. The number is published the first Friday of the month at 8:30 am EST. If the number is higher or lower than expected, it can have a huge market impact. As an example, let’s say the market expects the number to be 100,000 [new jobs created]. If you are using AlphaFlash Trader, you can preconfigure trades that are executed if the number is below 80,000 or above 120,000. You can further tailor your participation in a trade according to how far out of line a figure comes out – trade small and tight on a marginally out of line number and significantly larger on market surprising results, all from a single setup. We use a simple drag and drop methodology. So you choose the indicator, input your indicator range and then select the instrument you want to trade and specify the trade. Then as soon as the number is released, the trade is entered into the market automatically within milliseconds. Now compare this to a traditional trader, who has to read the release first and then send the order. Even if he’s fast, it will take him seconds to place the order. AlphaFlash Trader can massively streamline trader workflow. Trading parameters can be configured for multiple economic indicators and instruments in advance, delivering multiple automated order entries. At a stroke, event driven trading has become democratized.

Q: That sounds very interesting. How many indicators can traders chose from?
A: AlphaFlash Trader offers over 300 global economic indicators. You’ll find headline indicators such as employment figures, central bank interest rate decisions, housing statistics, CPI, GDP, industrial output etc. etc. We cover the U.S., Canada, Europe, Australia, Japan and China. We have just recently added the USDA releases. Once the CME expanded their trading hours, we knew that our clients would be interested in trading on the USDA releases. So we added the USDA WASDE and quarterly grain stocks figures to our range of indicators.

Q: Why is AlphaFlash Trader so fast?
A: AlphaFlash Trader makes use of the high speed AlphaFlash technology developed by Deutsche Börse, Need to Know News and MNI. It was designed to deliver machine-readable macroeconomic indicators for direct consumption by trading algorithms. Our journalists have direct access to sources such as the U.S. Departments of Treasury and Commerce, The Conference Board, National Association of Realtors, Bank of Canada, European Central Bank, Bank of England, Z.E.W., Institute for Economic Research Ifo, German Ministry of Economics, Eurostat, People’s Bank of China, Chinese Ministry of Commerce, Bank of Japan, Bank of Australia and more.

Q: What does it cost to use AlphaFlash Trader?
A: Subscriptions to AlphaFlash Trader start at Euro 250 per month. We offer a free 30-day trial so traders can test the application and see how easy it is to automate their event driven trading.

www.alphaflashtrader.com
E-mail: sales@alphaflashtrader.com

In looking back at industrial commodity supply and demand patterns during the years immediately following the sub-prime crisis, it is clear that global demand was less elastic than would have been expected in the face of economic turmoil. Slow economic conditions over the last four or five years have not resulted in any significant rebuilding of commodity stocks, and only a couple of commodities have exhibited anything resembling burdensome supply.

Clearly, the fear of ongoing slow growth and even a recession tempered the prospects for inflation for most of 2012, but seeing the U.S., Europe and China enter slightly less turbulent waters could rekindle inflationary expectations in 2013. Some may argue that increased U.S. oil production has taken the bullish edge off global energy prices, but tightening supply situations in the gasoline and distillate markets could result in firmer energy prices than one might have expected if they focused only on the crude oil supply.

U.S. grain prices have fallen back to levels which suggest that there was little lasting damage to the global supply from the 2012 drought, but drought conditions have persisted in the central and western United States and there is no guarantee subsoil moisture deficits will have a chance to recover ahead of the 2013 growing season. Therefore, we would expect grain prices to be highly sensitive to any evidence of dryness or above-normal temperatures through the winter months. We also think that a period of extremely tight physical supply will be seen in the soybean market during February and March and extreme tightness in the corn market in April and May.

Another element that weighed on commodity prices in 2012, which we don’t expect to be repeated in 2013, was the slowdown in China’s economy. But with Chinese inflation levels falling back to acceptable levels and a new generation of leaders in place, the world is watching very closely for evidence of revived growth in China and/or signs of fresh government stimulus efforts aimed at kick-starting prosperity in the country’s interior. China also wants to stimulate domestic demand so that its reliance on foreign economic activity is reduced. Therefore, traders should expect China to shift from being a negative factor in commodity pricing for 2012 to being a positive factor for 2013. A modest increase in China’s economic growth could result in a re-tightening of commodity supply, which could foster expanded speculative interest and higher prices.

Energies 

While the supply of crude oil in the U.S. reached its highest level in 18 years in 2012, product stocks continued to tighten, at one point falling to their lowest levels since the beginning of the sub-prime crisis. This seems to have been the result of a long-term decline in U.S. refinery activity, but idled U.S. ethanol production and soaring Chinese gasoline demand could have been factors as well. Traders who limit their analysis strictly to the crude oil market might start 2013 with a bearish view toward energy prices, when the real focus of the energy trade for the year is likely to center on the gasoline and distillate sectors.

Low U.S. gasoline stocks, declining refinery operating rates, periodic disruptions in ethanol production and news that Chinese gasoline demand is more than making up for weakness in developed-country demand should put gasoline in a bullish posture in 2013, especially if the U.S. and Chinese economies manage even minimal forward momentum. Three years ago, China surpassed the U.S. in annual car sales figures. Analysts think that by 2015 China’s sales will be greater than the U.S., Japan and Germany combined. A recovery to pre-sub-prime levels in U.S. gasoline demand coupled with the estimated jump in Chinese gasoline demand could send global consumption to a new high in 2013.

U.S. and European distillate stocks are also very tight, especially considering that the U.S. is attempting to move out of a recessionary condition. Rising gasoline demand may keep refineries more focused on gasoline production at the expense of distillates in 2013. With East Coast supplies a potential flashpoint and distillate prices capable of benefiting from any prolonged shutdown of U.S. ethanol production, it is possible that early in 2013 nearby heating oil prices will reach their highest levels since August 2008.

In the wake of $140 crude oil, a number of analysts predicted the world had seen peak oil prices and peak oil demand. However, we maintain that peak oil demand type pricing could be seen in 2013, as tight gasoline supplies collide with fresh records in global demand.

Equities

Stock market performance in 2012 clearly outperformed most expectations, as the Dow Jones Industrial Average forged a gain of roughly 730 points, while the S&P 500 posted a surprising gain of approximately 165 points. At times, the Dow had managed a very impressive gain of 18.6%, while the S&P at its highs peaked out with an impressive gain of 11.8%. However, towards the end of the year the equity markets were undermined by the lead-up to the election, the approach of the U.S. fiscal cliff and uncertainty regarding the transition of power in China.

Another source of concern may have come from inflated earnings expectations for 2013. Traders might be thinking that the S&P 500 may have difficulty achieving a 13% gain from 2012 given the slowing global growth outlook. Without knowing the endgame of the U.S. fiscal cliff battle, it is difficult to project price levels for 2013. Further uncertainty comes over the fate of capital gains and dividend tax rates. We anticipate a downside reaction in prices as lawmakers come to an agreement on the fiscal cliff. We think a downdraft in the S&P 500 during the first half of 2013 into the 1225-1175 range would present a buying opportunity.

Treasuries

From the beginning of the sub-prime crisis to the peak of the reaction to it, Treasury bonds forged a contract value rally of roughly $47,562.50! In prior market tops (1989 and 1993), Treasury prices saw extended consolidation patterns before beginning to fall in earnest. Some traders might suggest that there was a false consolidation top signal in late 2011/early 2012, but with the 2012 consolidation sitting at 28 weeks and counting going into December of 2012, the chance for a slide away from historic highs is certainly possible in the coming year. As nearby bond prices have already made it down to the 116 to 119 zone a couple of times in 2010 and in 2011, it is possible that the high could already be in place and that a series of lower highs will be seen throughout 2013. Certainly the bull camp holds out hope that the U.S. will at least temporarily fall over the fiscal cliff, but if it avoids that scenario, the bull case for Treasuries could be seriously damaged.

Currency Markets

From just ahead of the sub-prime crisis to the peak of global financial turmoil, a single Yen futures contract managed an appreciation of $64,000. In a nutshell, a combination of Japanese repatriation and almost no alternative currency resulted in an epic run up in the Yen exchange rate. Eventually a return to economic normalcy and serious ramifications from the ultra high exchange rate (and severe deflation) will set in motion what could become a historical liquidation.

Precious Metals

Into late 2012, gold prices were sitting at an impressive $1,043 per ounce above the sub-prime lows. The bear camp might point out that gold prices were only $166 below the 2011 highs, with a combined spec and fund long positioning waffling between 250,000 and 330,000 contracts! While some traders think that gold is capable of another significant run-up in the event that the U.S. falls over the fiscal cliff, they should bear in mind that during the second half of 2012 the market spent most of its time tracking classic market fundamentals and not behaving like a safe-haven instrument. Therefore, gold looks to be presented with a critical pivot point into the beginning of 2013.

As in other markets, the breadth and duration of the fiscal cliff debacle will have a major impact on gold for the coming year. In our opinion, the surest path to $2,000 gold is a positive and relatively quick resolution to the fiscal cliff and a return to global confidence and growth.

In the 4th quarter of 2012, silver and platinum seemed to outperform gold on a number of occasions. This might have been pointing to their tighter supply and demand scenarios. Silver and platinum might be expected to trade in sync with gold, but if either the U.S. or EU financial troubles moderate, it could shift both of those markets into a faster gear. If we were pushed into the market, we would prefer to be long platinum over being long gold in 2013. The platinum market is plagued by supply problems, and it could see greater demand from auto catalyst production. This could leave platinum supply very tight. However, if there is a major financial meltdown and gold prices soar, platinum could simply be dragged along with other precious metals. We see fairly significant value in nearby gold prices at just above the $1,650 level, and we see similar fundamental value in platinum prices at $1,550.

Copper

With the International Copper Study Group predicting a 2012 global copper deficit of 400,000 tons and many months of 2012 registering deficits greater than 21,000 tons, it would seem like the copper market has been able to transverse one of the worst economic debacles of modern times without building a burdensome supply. With signs of a recovery in the U.S. housing market and ongoing infrastructure spending in China, a modest improvement in industrial demand could make nearby copper priced below $3.55 per pound an extremely attractive “buy” for hedge funds. Clearly the downshift in the Chinese economy throughout 2012 weighed on copper prices, as indicated by the nearby chart showing a decline of 76 cents per pound from its high to its low. In looking back, one might suggest that the $3.26 to $3.45 pricing was only justified in the face of economic turmoil. Nearby copper prices in a $3.55 to $3.62 range should be considered cheap in the year ahead, and a return to $4.00 could be seen early in 2013. After all, nearby copper managed a move from $3.30 a pound to $4.02 in the face of the false global recovery view in February of 2012.

Corn

After the drought of 2012, the extreme tightness in the corn supply for the first half of 2013 should be a key factor guiding prices and spread relationships. In years when the corn supply is tight into the spring, the May/July corn spread tends to invert (the May contract trades at a premium to the July) as end users tend to need summer coverage and cash markets tend to get the tightest into early May. With the possibility of 2013 exhibiting one of the tightest stock levels on record, a major inversion is possible. Similar years to 2013 include 2012 (+45 cents May over July), 1996 (+26 cents May), 1986 (+22 1/2 May) and 1973 (+14 3/4 May). Look for May Corn to trade to a premium of at least 20 3/4 cents to July, with a possible target of +35 cents May.

Perhaps the U.S. drought is over, the weather will return to normal in 2013 and corn prices will see a range of $5.50-$6.65 per bushel into the summer. But if that does not happen, the impact on corn and feed grain prices could be dramatic. Normal yields are needed for the February-April harvest in South America, and then an excellent start is needed for the U.S. crop in order to avoid a massive weather premium for the December 2013 Corn contract. The U.S. will need trendline yields to avoid a resumption of the longer-term uptrend.

Soybean Meal

Soybean meal spreads are already inverted on expectations for acute protein tightness for the first half of 2013. The market has also priced in record soybean production for 2013 in Brazil and Argentina, so any weather glitch in South America could be a catalyst for another leg higher in meal. As of late November 2012, cash meal was trading at a $45 premium to the July 2013 Soybean Meal futures. If South America has any production or shipping problem, July Meal should see higher trade ahead. Consider buying the July Soybean Meal 400 Calls and selling the July Soybean Meal 450 Calls.

Wheat

September and October weather in the northern Delta and the southern Corn Belt was nearly ideal to restore moisture to those previously dry areas. This should help the soft winter wheat crop get off to an excellent start for 2013. The hard red winter wheat areas in Nebraska, South Dakota and northwestern Kansas stayed dry into the fall and were seeing germination problems after planting. This could pose a significant problem for the crop, as both topsoil and subsoil moisture was lacking. In addition, old crop hard red winter wheat ending stocks for the 2012/13 season were tightening, while demand for soft red winter wheat was lacking. The hard red crop entered dormancy with record low crop conditions at just 33% good to excellent. Consider buying July KC Wheat and selling July Chicago Wheat, looking for KC Wheat to take a 105-cent premium to the Chicago contract.

Live Cattle

Beef supply could be historically tight into the spring of 2013, as drought in the central U.S. in 2012 and in Texas for the past few years have left the supply of young cattle tight. High corn prices also discouraged placements onto feedlots. On-feed supply as of November 1, 2012, slipped to 94.7% of the previous year, and placements of cattle into feedlots in October 2012 came in at just 87.5% of the previous year. On-feed supply had reached 102.7% of the previous year just when the drought was beginning on July 1. Cattle placements were down from the previous year for June, July, August, September and October of 2012. If weights slip from the record highs that were seen late in 2012, the shift to lower beef production could be more significant than previously expected. Look for upside price targets of at least 140.15 cents for April Live Cattle and 135.35 for the August contract. Consider buying calls on breaks into early 2013.

Lean Hogs 

The pork shortage for 2013 has been well advertised, and April Lean Hogs had been in a strong uptrend as of late November 2012. The foundation of the rally was the idea that pork producers had already completed a breeding-stock liquidation cycle in the summer of 2013. But if U.S. corn demand is higher than the current USDA forecast (as of October 2012), corn supply could be very tight into the 1st Quarter of 2013. This could spark further breeding stock liquidation and put pressure on hog prices. Consider buying the April Lean Hog 90.00 Put if the price of the option slips below 175.

Soft Commodities

Global money managers are looking for commodity markets that have a chance of showing a production deficit for 2012/13, and cocoa may be a good candidate. Traders are looking for a deficit of 150,000 metric tonnes or more, and that is before taking into account the possibility of an El Nino weather pattern that could significantly disrupt Indonesia’s and West Africa’s production levels. Consider buying May Cocoa 2650 Calls near 65 with an objective of 233.

We expect coffee prices to bottom out when global supply peaks, and this could occur in the 4th quarter of 2012. World production for 2013 looks to come in well under the 2012 level, and as long as outside forces are not too negative, we look for a gradual uptrend.

The sugar market looks to remain in a downtrend into the first quarter of 2013, as another global surplus of 5-7 million tonnes for the 2012/13 season may be enough to pull global ending stocks up from the relatively tight level they have exhibited since 2008.

After one look at a weekly chart for cotton, traders seem to believe that cotton prices are just too cheap. In late 2012 nearby futures were trading around 73 cents per pound versus the 2011 highs of $2.2409. However, global supply is extremely burdensome. Traders should keep in mind that nearby futures hit lows of 66.55 cents in 2010, 40.01 in 2009, 37.05 in 2008 and 46.10 in 2007. Global ending stocks and stocks in China are set to reach an all-time high in 2012/13. Global ending stocks represent a full 270 days of usage, another all-time high. Traders might consider owning May Cotton 70.00 Puts.

To learn more about David Hightower and to subscribe to The Hightower Report, please visit www.futures-research.com.

***This report includes information from sources believed to be reliable and accurate as of the date of this publication, but no independent verification has been made and we do not guarantee its accuracy or completeness.  Opinions expressed are subject to change without notice.  This report should not be construed as a request to engage in any transaction involving the purchase or sale of a futures contract and/or commodity options and/or options on futures thereon.  The risk of loss in trading futures contracts or commodity options can be substantial, and investors should carefully consider the inherent risks of such an investment in light of their financial condition.  Any reproduction or retransmission of this report without the express written consent of The Hightower Report is strictly prohibited.

Electronic trading transformed the futures industry over the past decade. The players have adapted and evolved to suit the new technological landscape.  How have open outcry traders made the leap to a world of microseconds, colocation, algorithms and automation?  To understand the transformation, I sat down with two of the best: John Richards, founder of Webster Capital in Chicago, and Job Spetter, a NYMEX commodities trader.  It was amazing to learn the scope of responsibilities these traders manage on a daily basis. While the lay press may dismiss futures traders as glorified gamblers, they are in fact true professionals who excel at their crafts. They deal with recruiting talent, technology, programming, managing teams and business planning every day.

PIT TRADING

Examining and appreciating the differences between pit trading and electronic trading is the first step to understanding the evolution of today’s trader. Richards experienced serious disadvantages early in his trading career on the floor. He started as a clerk for a market-making group in the late 1980s, during the peak of open outcry. “In the pit, it didn’t really matter how smart you were. It depended on your position and physical presence.” Richards found that his height and position on the floor were problematic. He also recognized that brokers dealt with guys they liked and everyone seemed to hire their neighbor or friend.

While seemingly archaic behavior was the norm in the pit, newer traders had distinct advantages. As Richards pointed out, “I can learn a lot faster in the pit. I could learn from others a lot more and benefit from more sounding boards.” Additionally, Richards easily recognized the level of competition in other pits. The options pits, for example, were a relatively new development; thus, competition was less and a physical presence was not as important. After becoming an options trader, Richards started managing positions and learned how to run inventory—a skill that he believes was instrumental in his success as an electronic trader.  Job Spetter began his trading career as a clerk on the NYMEX floor around 2007 and eventually saved enough money to open his own account. “At the time, there was more flow on the floor and it was busier. The decline of the floor wasn’t a gradual thing; however, people were just gone.”

Spetter echoed some of Richards’ comments in that before electronic orders, he had to “deal with and know the guys on the floor.” He noted that the move from the floor to electronic trading had passed its tipping point: “They began combining all of the rings in NY because there just weren’t enough people.” Spetter started trading electronically from the floor and quickly realized there was no longer an advantage to maintaining a physical presence. There was, however, a huge advantage to trading from an office near his home–22 miles from the NYMEX building.

TRANSITION TO ELECTRONIC TRADING

Electronic trading has been referred to as the “great equalizer” in that so many of the variables that existed with floor trading have been eliminated. The move to electronic trading, however, goes beyond the proximity, physical presence and relationships. There now exists a level of complexity that was never seen on the floor. While the learning curve was steep, traders who adapted seem to have embraced the change.  Richards put it bluntly, “Change only sucks for someone who has everything.” When asked how he kept up with the change and new access to limitless information, Spetter responded emphatically, “I’m a professional and I treat my position as such.” Historically, traders have not been viewed as business professionals, but today—more than ever—that descriptor is appropriate.

On the surface, it appears that one of the most drastic changes from trading on the floor to trading in an office is the lack of camaraderie. While electronic trading doesn’t necessarily provide the same in-your-face competitive adrenaline, the day-to-day environment of today’s traders is more diverse and team-oriented. Traders who transitioned to single offices or traded alone struggled during the transition.  Both Richards and Spetter surrounded themselves with other traders as well as support staff. They agree that with other people in your office, you are more likely to keep up with the steep learning curve and turn to others when things aren’t going well.

HIRING TALENT

One area where today’s trader can really make a difference in their trading success is in the hiring of talented individuals. As Webster Capital has grown over the years, Richards has spent a great deal of time thinking about hiring strategies. “It used to be that you would look to hire an Ivy League hockey player someone who was smart with a physical presence. After the transition to the screen, physical presence is no longer relevant.” He now looks for math and engineering undergrads with an affinity for gaming because they understand strategy.  “Undergrads only, because graduate students think they know too much,” he noted with a smile. A poor hire can cost you a lot in a very small amount of time, so hiring is critical.  While Spetter is still in the infancy of his trading business, he echoed the need for “MIT-types” to help build his business.

TECHNOLOGY

Technology is one of the more obvious challenges for today’s futures trader. Computers, software providers, connectivity and server colocation are just some of the considerations critical for the success of an electronic trader. Spetter has leaned heavily on his clearing firm, Advantage Futures, for technology support. “Advantage has provided a lot of knowledge and suggestions on what I need to be successful,” remarked Spetter. “You are only as good as your support staff.” As he transitioned his business operations to Florida, he sought out additional guidance: “We did our homework. With Advantage, we figured out the best route to go from Florida to Chicago with a minimal amount of hoops to jump through.” Technology has allowed him to easily manage his positions in multiple markets and products.

Increased trading risk is an added factor inherent with electronic trading today. Risks include fat finger mistakes, coding errors and strategy or trade design flaws, as well as software glitches if you are writing your own software.  Despite these added risks, traders seem to like the tradeoffs.  “I can capture and synthesize information more quickly in my market and in other markets,” suggested Richards, while Spetter added that “there are inherent pitfalls and hurdles with electronic trading; however, as long as you can mitigate those obstacles, you can be in many more places at the same time.  I often trade European products vs. theirU.S.counterparts—something that physically would have been impossible if trading wasn’t electronic.”

FLEXIBITY WITH A PRICE

Better technology and 24-hour markets allow traders a greater amount of flexibility in setting up their trading operation in terms of location, opportunities and times of operation. “We’re on the job a lot more hours, but we can be on the job from almost anywhere,” Richards stated. “The physical day in the office is shorter, but the time in front of the screen is longer.” Access to global markets increases the complexity and number of trading strategies or products in play at any given moment.

For Spetter, the flexibility of electronic trading allowed him to move his entire trading operation to Florida. He proved he could trade from a remote office, and the physical location of his trading became irrelevant. In addition, he has diversified his trading products to include additional CME Group products, ICE products and other cross-exchange products.

GLOBAL COMPETITION

The competition for futures traders has gone from those in a 40-mile radius of the exchange floor to a global community of traders. Traders who moved to electronic trading early had the advantage of speed and connectivity options. But with the growth of colocation services, the playing field has become increasingly crowded and technology has become the great equalizer. There was a greater likelihood of finding trading opportunities before the migration to electronic platforms.  Since the markets trade more efficiently, the skills of today’s trader are tested more than ever. Both Spetter and Richards commented on the importance of being ahead of the curve and seeing opportunities before they arise. “The guys that used to be good are still good because they can see it coming,” Spetter stated.

KEYS TO SUCCESS

Today’s futures traders exhibit a higher level of professionalism than their predecessors. They learn to manage their trading as a business. They see the global picture, as opposed to focusing on a single domestic market. Efficient infrastructure and support, along with risk management, are requirements for a successful trading operation. Traders are very concerned with costs and always looking for creative ways to share those costs when possible.  The fixed costs of trading are higher now, and managing those expenses when business is slow is critical. While there isn’t the same opportunity to learn from the traders in the pit around you, clearing firms and support staff are providing an increasing level of service that can accelerate the learning curve. Spetter mentioned that he “wasted a lot of time and money not knowing enough.” Newer traders have the unique advantage of learning from others’ mistakes. In many ways, the reliance on others for successful trading has never been more important. “Be humble. Listen as much as you can.  There is always something to learn,” added Spetter.

THE FUTURE

Looking ahead, the electronic futures markets can provide endless possibilities for today’s futures trader. The flexibility of trading from anywhere in the world allows traders to continue to trade for as long as they like. As he reflected on the changes and opportunities ahead, Richards remarked, “It was more fun before for the wrong reasons. These days, it’s much more interesting. Everybody can be a junior economist now.” Both Spetter and Richards talked about expanding their teams over the next few years. While they’ve experienced a great amount of change in the last decade, it’s clear that they are more excited about the future. Richards cautioned younger traders, “It’s a great job 99 percent of the time, but that means that one in a hundred happens three to four times a year. You want to hide under your bed about three times a year, and you think you’re losing it all… but I’m an adult, and I realize the path I’ve chosen.”

There are significant regulations in Dubai that provide a tax favorable environment for traders to conduct business there. More recently, with consolidation in the industry, we have seen a large increase in the number of traders looking for alternative futures brokerage firms. In conversations with these traders, we learned that most were using virtualized servers rather than dedicated hardware. We quickly realized that they could improve their trading through colocation and server hosting.

In addition, we worked with existing clients to help them sell their decommissioned servers to these new Dubai traders in an effort to reduce upfront hardware costs for colocation. As these traders learn the benefits of colocation and dedicated hardware, we have seen a dramatic increase in interest for server hosting and colocation from the Dubai region. 

What types of products are traders in Dubai trading? Are they exchange specific or category specific?

Our clients in Dubai appear to favor tangible products such as metals and crude oil. Most trade CME Group products and, as they learn about other exchanges that offer like products, are expanding the number of exchanges they utilize. We have been introducing them to similar products available through NYSE Liffe US and ICE. TheDubai Gold and Commodities Exchange (DGCX) and the Dubai Mercantile Exchange (DME) are also popular as they offer products within the categories these traders are most familiar.

What connectivity solutions are Dubai traders leveraging?

A high percentage of our client base in Dubai connect to Advantage’s infrastructure using a Virtual Private Network (VPN) connection and use Remote Desktop Protocol (RDP) to command and control their servers. They primarily manage algos via the internet and make changes to their parameters as necessary. They have largely colocated at the Equinix and Telx facilities at 350 E. Cermak in Chicago, although many are also considering colocation options at the new CME Group Aurora Data Center. Many of the traders spreading products between the CME Group and DGCX are evaluating the cost/benefit of colocating with the CME Group versus 350 E. Cermak.

What sets Advantage Futures apart from other futures brokers in meeting the needs of Dubai traders?

The number one advantage many Dubai-based traders experience with Advantage Futures is our ability to communicate with them in their native language. They are comfortable with the fact that we have six employees who can speak Hindi or Gujarati, which are some common languages spoken in India. In addition, our responsiveness to their needs is something they have not found with other futures brokers. Many have commented that other clearing firms shuffle their inquiries through a London office or a Frankfurt office and don’t address their needs directly. At Advantage, we have a number of employees who can answer their questions in Hindi, Gujarati or English without having to pass them along to different departments.

Do you expect growth out of Dubai to continue?

Yes. With the transition from floor to screen, we’re seeing more traders on a global level. Traders out of Dubai, specifically, are now realizing the benefits of colocation and server hosting, thus, enjoying the benefits of a more level playing field. They are spreading the word. Currently, they primarily trade commodities and products that they know. They are starting to learn there is more—it’s only a matter of time until they expand what they are trading.

What kind of support does Advantage Futures offer traders in Dubai?

Advantage offers 24-hour support to clients. At any time, we can remote into their PCs and help solve any issue that may arise. We are also able to log into their server and make changes quickly. We find that many new Advantage clients appreciate this high level of service. Advantage clients benefit from one phone number and often find several people to help solve their issue. This extends to all clients, but many of the Dubai-based clients prefer the ability to converse with several Advantage employees in their native language.

What is Advantage Futures doing to help further educate Dubai futures traders?

We’re starting to introduce these clients to additional exchanges and products. We will be in Dubai in November hosting a seminar to help further educate traders on the benefits of various technology solutions including hardware, colocation and software options. We want to expand our presence in Dubai, and look forward to introducing them to new ways of trading. They can evolve their trading to include new technology solutions as well as new exchanges and products. The more we introduce traders in Dubai to opportunities to which they may not be aware, the more growth we will see come out of that region.

Adam developed Keyboard Trader initially as a tool to enhance his own trading experience. Using his trader’s intuition to guide the development, he looked for patterns in his trading style and repetitive actions that could be lumped together. By programming macros for individual keys, Adam was able to perform trading tasks that might have taken multiple clicks all with one keystroke. He also optimized the layout of the keyboard–which keys should be grouped together and how best to split the workload between his hands for faster speeds.

As Keyboard Trader went from concept to production, Adam realized it could provide a valuable tool for many futures traders looking to improve their speed and execution performance. The system required multiple components, of which the most significant is the software. Keyboard Trader includes an impressive and very credible software package that works seamlessly with the Trading Technologies X_ TRADER API. In order for the software to be most effective, Bionic Trader Systems also offers programmable keyboards which are easily configurable for various trading styles, as well as over 300 customized trading keys. Put these components together, and you’ve got a powerful system for actively trading single or multiple products simultaneously, spread trading, and portfolio management.

In a world that is moving toward touch screens and automation, is an old-school keyboard (albeit re-engineered for the trading community) the next great development in futures trading? Either way, it is impressive to see how traders have evolved not only their trading, but are looking at ways to improve the entire trader experience.

Our current perspective includes several key observations:

- For producers and consumers, we may be at the beginning stages of a long-term narrowing phase of the BTU per dollar price spread between crude oil and natural gas.

- For hedgers and investors, we may see increased activity in the price spread relationships between different combinations of energy products.

- For the portfolio managers there are opportunities for diversification away from “beta” returns where directional risks may be rising in the crude oil sector with more emphasis on “alpha” or spread trading possibilities.

MARKET DYNAMICS

At the 10,000 foot level, the key medium to long-term theme of increasing energy supply is colliding with the shorter-term theme of slowing demand. At ground level, there is the short and medium-term theme of how to manage the risks associated with delivery bottlenecks and refining capacity. The fact that these themes are in play simultaneously is a much more severe complication for analyzing energy markets than casual observers might assume.

The medium and the longer-term theme of increasing supply is due to a variety of sources. In North Dakota and Montana, the Bakkan Formation is now considered the largest source of oil in the United States, with production climbing from next to nothing in 2000 to about 500 million barrels per day from the region by the end of 2011. Canadian tar sands reserves are also booming with expanded production, from 600,000 barrels per day in 2000 to 1.6 million barrels per day in 2011. Libyan oil is coming back online faster than many thought was feasible given the political instability in the country, and Iraq is also pumping increasing amounts of oil. And, of course, it is not all about crude oil. Benefitting from new fracking technologies and sideways drilling, natural gas production is increasing as well in the U.S., with production up a little less than 20% over the decade and with the rate of growth increasing in recent years.

At the same time as we are witnessing a literal revolution in fossil fuel supply, the shorter-term theme on the demand side has to do with the fact that Europe is stagnating and the economic booms in the emerging markets are decelerating rapidly. Emerging market countries are especially important to the demand for energy, because they tend to grow their demand at a faster pace than their real GDP growth, which is not true for the mature industrial countries. Thus, when the emerging market countries see a simultaneous slowing of economic growth, the impact on energy demand is even greater.

The price implications of the evolving trend toward rising supply and decelerating demand growth was hijacked in February 2012 by the rising tensions associated with Iran’s perceived or potential nuclear ambitions which put upward pressure on crude oil prices as investors’ fears were stoked higher. We wrote back in March 2012 [See “Oil Market Dynamics and the Fear Factor”, www.cmegroup.com/ education/featured-reports/oil-market-dynamics-and-fear- factor.html] that geo-political tensions can and do trump supply-demand fundamentals in the short-run; however, our view then was that the price disruption would be short- lived. We took the contrarian stance (at the time) that refined product, such as gasoline prices at the pump in the U.S., would probably be declining ahead of the summer driving and vacation season, which has proven to be the case.

Now at the beginning of June 2012, the geo-political tensions have clearly eased, and if anything, economic growth is decelerating more rapidly in emerging market countries from China to India to Brazil than the consensus view was back at the end of 2011. China’s 2012 real GDP growth may be around 7.5%, which is down from its 20-year average of +10%, and the long-term rate may be more like 6.5% average annual real GDP. India is decelerating abruptly toward 4% real GDP growth in 2012, from the 7% to 9% range of recent past. Brazil may grow only 1% to 2% in real GDP terms in the first half of 2012. And all the while, the Euro sovereign debt crisis has halted economic growth in Europe as well as raising investor fears of global financial instability. That is, as the fundamentals of supply and demand reassert themselves, demand deceleration is even more emphasized, while supply expansion continues unabated.

POSSIBLE PATHS TO THE LONG RUN

Energy sector analysis also has to come to terms with the price dynamics of different sources, and of course, crude oil and natural gas are in the glare of the headlights. On an energy content basis, a barrel of crude oil would trade at roughly a 6:1 ratio to a million BTU’s of natural gas, or crude oil priced at $100/barrel would imply that natural gas would be $17 per million BTU’s for energy equivalence. Or put another way, natural gas trading at $3 per million BTU’s implies crude oil at $17.40 per barrel. While this energy content per dollar comparison highlights a massive price discrepancy [See Figure 1], they do not tell one anything about which prices might bear the burden of adjustment or even if we are moving in the direction of shrinking the energy content price spread between relatively expensive crude oil and relatively cheap natural gas.

The problem is that infrastructure bottlenecks have arrived hand-in-glove with the expansion of production, especially in the U.S.. Moreover, all of the actions by the production, distribution, refining and consumption segments of the energy complex that would work toward pushing the market prices in the direction of energy equivalence involve billions of dollars of investment, huge time horizon price risks and substantial regulatory challenges. Given these real world constraints, it would be almost pure luck for market prices to stabilize around energy equivalence even for a short period of time. Nevertheless, we can analyze fundamental developments as well as futures prices and their behavior to gain an understanding of whether market prices are moving in the direction of energy equivalence or moving further away from it.

In the distribution sector, we are seeing a number of key developments. Regarding crude oil, the Seaway pipeline from Oklahoma to the Gulf of Mexico has been reversed and will provide a faster and cheaper way of getting inland excess crude oil to refineries on the Gulf Coast. The Enbridge Line 9 pipeline in Canada is expected to be reversed in early 2013. There is a rapid increase (and probably underappreciation) in expanding rail delivery capability that will allow North Dakota and Canadian crude oil to move more easily to east or west coast refineries. Rail capacity at the end of 2011 was estimated at approximately 200 million barrels per day, but rail expansion may more than double to over 550 million barrels per day by the end of 2012.

With regard to natural gas, the difficulties in being able to export natural gas are the key driver of the price to energy content differential with respect to crude oil. Some coastline facilities built originally for importing natural gas will be converting to export facilities; but all this takes time and money, and probably some delays related to regulatory issues that may arise in the process.

In the refining sector, there are plants being readied or expanded to convert natural gas to diesel fuel. We would note that the ability of refiners to take the risk that billions spent building a natural gas to diesel conversion plant will be profitable depends either on their confidence that a sufficient price spread will remain in place for 5 to 10 years after the plant is built or on their ability to hedge some of these risks in long-dated swaps or futures contracts. The existence of futures markets to price the time horizon risks are integral to the ability of the actors in the energy sector to close the BTU pricing gap over time.

And in the consumption sector, more electrical power plants are switching from coal to natural gas and more intra-city transit fleets are acquiring buses that can use natural gas. Both of these substitutions also involve time risks, although not necessarily quite so large as those in the refinery conversion arena.

With all of these developments involving enormous time horizon risk, the pricing of long-dated futures contracts provides considerable information about how the market views these trends and which sectors will bear more of the burden of convergence toward energy content equivalence, if such convergence even occurs. Figure 2 shows the spread between the 5-year out futures price and the nearby month futures price. A positive spread, for example, as is currently occurring in natural gas, indicates that the market consensus is expecting rising natural gas prices.

As the summer of 2012 begins, the spread between the nearby natural gas futures contract price and the contract price for 5- years out was over 50%, while in the WTI crude oil sector, the similar 5-year maturity spread was close to flat. That is, the long- dated 5-year futures contracts are implying an expectation of movement in the direction of energy content equivalence and that natural gas prices will do most of the adjusting. Our perspective based on the adjustment factors cited earlier and already in progress is that, if anything, the market may be underestimating the demand slowdown being caused by the decelerating economic growth in emerging markets while at the same time not fully appreciating that an inflection point has been reached regarding the resolution of infrastructure bottlenecks and that process is now moving rapidly to take advantage of the BTU/$ price spread opportunities. Hypothetically speaking, both of these observations would work together, should they come about, to suggest that the burden of adjustment may be split much more evenly between crude oil prices falling and natural gas prices rising.

There are caveats, however, as only time will tell. In the energy sector, the politics can be brutal, there is heavy regulatory scrutiny of every project and there are often trade restrictions or other impediments to consider over the long run.

PORTFOLIO MANAGEMENT CHALLENGES

From a portfolio management perspective, we want to examine volatility and correlation patterns for key energy products as well as certain product price spread and calendar price spread relationships. Our observations strongly suggest current volatility patterns are probably not stable, that recent correlation patterns may also enter new phases and that the dynamics of product price spread relationships offer interesting risk-return opportunities over time to diversify crude oil directional risk or global macro equity risk.

Volatility Dynamics. Starting with volatility, in Table 1, we present the annualized standard deviations of daily price changes for three distinct time periods: 2012 to date, the height of the financial panic from September 2008 into March 2009 and a pre-crisis sample from the year 2006. The table is ordered with the current highest volatilities on top.

For 2012, the highest volatility is occurring in the natural gas sector. Volatilities are currently running around 50% for nearby natural gas futures. By contrast, crude oil nearby futures (ICE Brent or NYMEX WTI) has settled into the 20% volatility territory in 2012, although historically they have been higher. We do not view the recent volatility patterns for crude oil as sustainable. Of course, history may not be an appropriate guide, but in the current case we would not ignore it.

Infrastructure bottlenecks have been playing a very large role in the inability of markets to move toward energy content pricing equivalence in the face of large production increases. These bottlenecks have been very severe in the U.S. As we have seen, they have served to produce a very wide energy equivalence pricing gap between crude oil and natural gas. The energy content pricing gap means that crude oil is likely to bear the brunt of global macroeconomic demand impulses. However, as the pricing gap starts to narrow as infrastructure bottlenecks are slowly resolved, we think there is the possibility that volatility may move from natural gas to crude oil. That is, we see the possibility of the following implications:

- More of the current price volatility from natural gas will impact crude oil possibly raising crude oil price volatility as natural gas volatility declines, and

- Crude oil is currently more susceptible to economic demand factors than natural gas, although this may change in the next few years.

Spread Relationships. An important spread relationship that was hit by U.S. infrastructure bottlenecks was the WTI crude oil price compared to North Sea Brent. The inability to get expanded North American Mid-continent oil production (WTI pricing) to the East, West, or Gulf Coast efficiently by pipe or train is often blamed for the partial breakdown of the price relationship with North Sea crude oil. We see this story as a good deal more complex.

As noted earlier in our general discussion of supply trends, for more than a decade Canada and the U.S. have been significantly increasing their crude oil production. This has come at the same time that North Sea oil production has been experiencing a serious decline. The comparative difference in the supply situation has put pressure on the relative prices between oil delivered in the U.S. Mid- continent and the North Sea; however, the price relationship between these two locations has been impacted by other factors as well.

There have been logistical bottlenecks in the U.S. and Canada, which are now being relieved by the marketplace, with reversal of pipelines and added rail capacity, as we discussed earlier. In addition, there have been important increases in storage capacity: storage capacity at Cushing, OK, has nearly doubled over the past five years and is currently at 70 million barrels (and growing).

Then, there is also the problem of getting a handle on North Sea oil pricing in the first place, since “Brent” is actually based on the arbitrary combination of the four streams of oil. Moreover, these four streams are not necessarily fungible. The four streams are Forties, Brent, Oseberg and Ekofisk, of which Forties is considered the least valuable of the four streams. Since cash market and forward market contracts confer the choice of delivered crude stream on the seller, it is Forties that has consistently priced what is referred to as Brent or North Sea oil for about the past decade. One of the problems for analyzing the pricing for Forties is that it suffers chronic disruptions from unscheduled interruptions in its production and loading schedules. Moreover, because there is anticipation of disruptions (even though they are unplanned), there is belief by some analysts that Forties and, therefore, headline North Sea Oil prices reflect a premium to compensate for an undependable delivery mechanism, not market fundamentals.

All of these special factors for WTI and Brent have come to a head in the past two years and have combined to make the WTI-Brent price relationship extremely complex. There are plenty of signs, however, that market forces are at work to correct fundamental price discrepancies, even if that takes time and money and involves some risk.

Importantly though, whether Brent or WTI, crude oil is much more exposed than natural gas to the global macroeconomic implications of the deceleration of growth in China, India, and Brazil, as well as the economic stagnation in Europe. And, markets appear to have persistently underestimated the economic growth slowdown in emerging markets, although we presented a different and more pessimistic perspective back in December 2011 for China, specifically. [See “China: Slower Export Growth, End of the Infrastructure Boom Years”, www. cmegroup.com/education/featured-reports/ china-slower-export-growth-end-of-the- infrastructure-boom-years.html] The global macroeconomic developments are pointing to downward pressure on crude oil prices as well as heightened price volatility.

Diverisification Potential. Our final set of observations focuses on the overall diversification potential of the energy sector to mitigate risks in either a global macro portfolio or an equity portfolio. To examine diversification potential, we focus on correlations and present in Table 2 a summary of the correlations between different energy products and spread relationships to the U.S. S&P500 Index. As in the case of volatilities, we present three distinct time periods: 2012 to date, the height of the financial panic from September 2008 into March 2009 and a pre-crisis sample from the year 2006. The table is ordered with the current lowest correlations on top.

What stands out in the correlation analysis is the exceptionally low correlations to equities from the natural gas sector and related spreads. By contrast, with its directional risk more tightly linked to global macroeconomic conditions, crude oil does not provide nearly the same degree of diversification. The implications for global macro portfolio management are as follows:

- There are exceptional diversification opportunities with natural gas and natural gas spread relationships compared to crude oil.

- Energy spread relationships, in general, whether calendar spreads or product spreads, offer diversification potential with their decreased emphasis on “beta” or directional developments.

Taken as a whole, for those with the expertise to study and appreciate these markets, the energy sector presents important opportunities to diversify a global macro portfolio or to mitigate equity risk. To manage the risks in the global macroeconomic environment, a greater emphasis on natural gas and on spread relationships may well pay large dividends, especially relative to long-only commodity portfolios with a greater share of risk coming from crude oil directional movements.

* Risk Disclosure. Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment and, because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade.*

Bluford (Blu) Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. He is responsible for leading economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy. He also serves as CME Group’s spokesperson on global economic conditions and manages external research initiatives.

For our income-oriented careers — We speak in transactional, competitive, entrepreneurial lingo, exhilarating and emotional. We succeed by being the fastest, smartest or luckiest players in a zero-sum contest that turns on a dime, and is measured against the ticking clock. If we don’t act fast and on the right side of the trade, somebody else will. The goal is to make the utmost of every perceived opportunity.

For building durable personal wealth — It’s like you’ve entered another country. To achieve our personal life goals, we must be patient, team-oriented investors, calm and well- reasoned. We must speak in the language of decades (or longer), measuring our growth by that which is expected to endure and thrive in our capital markets, regardless of who is winning or losing on the individual trades involved.

Marginal utility of wealth and risk management become the critical, if initially alien priorities. For investing, we measure our risk-taking against what is necessary to achieve our most important life’s goals and what is sensible for offsetting the increased risks we’re taking within our careers. As financial author and Wall Street Journal columnist Jason Zweig has observed:

“Investing is not a struggle, a battle, a game or a contest; it is a continuous process that lasts a lifetime. Whether you are winning or losing at any given moment is beside the point. The only thing that matters is whether you prevail in the end — and the factors that determine long-term victory are the exact opposite of the ones that tend to create short-term success.” ¹

As trading professionals, we find this level of bilingual fluency a particular challenge — not despite but because of our distinct experiences. It’s as if every rule we’ve learned in our homeland as traders plays against us in the foreign world of investing; many of the skill sets that reward us the most in our daily careers conflict directly with the essential tenets of sound investing, depicted below in “A Strategy for Sound Investing.”

¹ Jason Zweig, “The way of the calm investor,” Money, August 2, 2004.

The CME’s DC3 Data Center colocation offering has brought the speed from client to matching engine to microseconds down from milliseconds. Advantage invests and designs our network to maximize colocation benefits by minimizing time spent on Advantage infrastructure.

CME Groups Data Center Features Include:

• More than 428,000 square feet of space (bigger than 7 football fields)
• Two 138,000 volt transmission quality utility services from two separate power plants
• Environmentally green, cutting-edge HVAC and electrical distribution equipment

CME Server Colocation Hosting Services – Power and Space

• 12.5 MW of usable power to colocation customers in initial phase
• Tier 3 design with additional security, fire protection and infrastructure enhancements
• Two tiers of power capacity per licensed cabinet, including licensed space, power and data center environmentals

CME Server Colocation Connectivity Services – Lowest Latency and Equidistant

• CME GLink – Equidistant Cross Connect to ensure location neutrality for all customers, 10GB option or 1GB option
• Multiple diverse entrances, redundant carrier rooms
• Carrier-neutral, open access telecommunications policy provides for flexibility, including CME GLink, Cross Connects, Bulk Transport and Utility Networks

CME Server Colocation Support Services – Convenience and Responsiveness

• Flexibility in maintaining and servicing equipment • Onsite technicians for routine maintenance as well as emergency assistance
• 24/7 Customer Support Team, including remote hands, shipping and receiving, customer support portal and customer amenities

Thankfully, Advantage Futures has an individual dedicated to assisting you in the process of applying to the various exchange memberships. Meet Margie DeLorme. Margie works closely with our clients as well as the futures exchanges and has helped countless traders work through the process of applying for exchange memberships.

So if you are having trouble understanding the difference between an IOM seat or an IMM seat or whether you qualify for a 106R or 106H, be sure to reach out to your client service representative who can put you in touch with Margie. To learn more about how we can help with your trading business, please email contactus@advantagefutures.com/afdev.