Vol 2/5, 18 February 2011


Investors sharing our view that financial assets in general are fundamentally overvalued in real, purchasing-power terms naturally seek to preserve wealth in alternative assets, including commodities. However, while commodities may indeed be more fairly valued, that does not mean that they can decouple entirely from developments in financial markets. Should equity markets suffer a major correction, commodity prices are also likely to fall, in particular those for industrial commodities. But even non-industrial commodities can be subject to speculation from time to time and there is some evidence that this is the case at present. Defensive investors should take note.
DEFENSIVE NOTES ON THE MARGIN In recent editions of the Amphora Report we have discussed why we have become defensive with respect to equity markets and also certain industrial commodities. In brief, the key reasons are the following: · Rising commodity prices are not only creating rampant price inflation in many countries around the world; they are also severely compressing corporate profit margins; · Many emerging markets are now raising interest rates to slow their economies and control inflation; · The stock markets of the most dynamic economies, including those of China, India and Brazil, peaked several months ago and have performed poorly year to date; · Governments in developed economies are seeking ways to reduce deficits. While entirely necessary, this is negative for corporate profits during the current cycle; · As discussed above, bond yields have risen substantially in the developed economies, implying a tightening of credit conditions; · Developed-world stock market valuations have reached levels normally associated with major asset bubbles. The continuing rally in developed-world equities thus appears something of a puzzle. But rather than providing an indication of economic strength, perhaps rising valuations merely reflect fiat currencies that are weakening in real, purchasing-power terms. Indeed, in a world in which currencies are not reliable stores of value, it is distracting, perhaps even dangerously misleading, to think in absolute terms, as if any base currency is an objective frame of reference. Rather, we prefer to think in relative terms. Yes, the US stock market might be “overvalued”, but what do we mean by this? Overvalued versus what exactly? Versus the dollar, which represents a claim on a shrinking portion of an expanding money supply, printed at will by a pathological central bank

in pursuit of higher inflation? Versus Treasury bonds, which are growing exponentially in supply as the US government continues to run massive deficits in a counterproductive attempt to create jobs amidst huge structural economic headwinds? The challenge in claiming that something is overor undervalued is that it must be demonstrated to be over- or undervalued versus something else. Traditionally, this has been a base currency, such as the US dollar. But if the dollar is being devalued, we need to find an alternative. This is where commodities can play a role. They cannot be printed, devalued or defaulted on by governments. As such, in a world of fiat currency instability, we believe that commodities provide a superior benchmark for comparing relative asset values. We can’ t help but chuckle when some equity or bond analyst argues that commodities are “speculative” in that they don’ t represent claims on future cash flows and, as such, cannot be properly valued. Perhaps that is true in nominal terms. But in real terms, commodities can be compared to currencies and financial assets, which naturally carry some combination of devaluation and default risk. As those risks necessarily grow as monetary and fiscal policies become more unsustainable, so does the relative attractiveness of commodities. (As an aside, we continue to take comfort in that so many otherwise smart people still don’ t understand this point. How can commodities possibly be in a bubble if investors in aggregate prefer holding financial assets notwithstanding the sound of printing presses whirring in the background?) That said, this does not imply that there is zero speculation taking place in commodities markets. But please, show us a market in which there is no speculation! For an investor concerned about chronic fiat currency debasement and rising government deficits, is it really a speculative act to reduce


Consider that food prices. sometimes they lose. be they up or down. We doubt that we will have much success convincing them that such a world would be a rather grim place. Futures contracts enable both producers and consumers of a given commodity to manage the price risk inherent in their businesses. or an automobile or appliances manufacturer requiring substantial metal inputs. thereby providing a liquid market in money. the more potential for 2 speculation . or a mine owner selling various metals futures for the same reason. who would prefer to live in a world without speculators. it would appear that. Speculators may have a bad name but. there are those who believe that speculation is simply evil. without banks and without free markets. but also the denominator. in practice it is actually quite difficult to make. are a function of supply and demand. 18 February 2011 www. not the speculators. In much the same way that a bank matches depositors (lenders) with borrowers. that grain prices are likely to rise over the coming year and. At present.063 $39. In the table below. or prices for any essential commodity for that matter. gold is perhaps the commodity most open to speculation and natural gas the least. There is another way.730 $6.510 $5.250 $11.751 $154. leaves his grain input costs unhedged. In the same way that commercial banks transmit central bank money into the economy through lending. with the lowest percentage margin requirement. which is driving prices higher. we suppose. however. which is providing liquidity for the commercial buyers and sellers.750 $5. It is all too easy to blame speculators seeking to profit while the less fortunate starve.670 $4.725 $113. We then divide this measure of risk by the margin requirement. investors should always be wary of markets in which speculation appears excessive. but not only for the numerator.9 7. There are those. Think of a farmer. Within commodities markets. higher food prices around the world are placing the poor in a growing number of countries at risk of malnutrition or even starvation.736 $137. they are seeking to profit from price fluctuations. Speculators. as measured by the amount of margin (collateral) that the speculator must put up on the exchange in order to open a position in a given commodity futures contract. we list the initial margin requirements for a selection of major commodities and also the current notional contract value for each. Prices as of 16 Feb 2011 This is an important topic in of itself and we cannot do full justice to it here. then it is the monetary authority.613 $5. A farmer might believe. To blame speculators for pushing up food prices is thus akin to blaming banks for lending. If the interest rate for the base currency is held artificially low and/or the money supply is rising. But regardless. there are various ways to try and estimate the degree of speculation taking place. for example. Taking a look at the far might column. we calculate the annualised volatility of the commodity as a measure of risk. respectively. so the thinking goes. holding out for a higher sales price come harvest time.amphora-alpha. rather than simply divide spot contract values by initial margin requirements.THE AMPHORA REPORT Vol 2/5.8 7. at present. But briefly. in percent. pushing prices higher rather than lower. they create a larger. Regardless. Producers and consumers of all manner of commodities have tremendous flexibility.138 $98.363 $4. There is thus great potential for commercial speculation which cannot be measured by a facile distinction between commercial and noncommercial accounts. Sometimes the speculators make money. 1 rather than lock in a sales price for his crop at today’s futures prices. A similar decision could be made by the miller who. On the other side. But this approach is incomplete in that it does not take into account the volatilities (risk) of the respective commodities.7 5. One popular way is to compare the positions of commercial vs non-commercial trading accounts on the major commodities exchanges. In the table below.7 Source: CME Group.600 $35. deliverable commodity by virtue of its business.0 4.9 5. Rather. believing for whatever reason that grain prices are going to fall. in practice. to hold a speculative position in each commodity. he can leave his production unhedged. so commodities traders transmit central bank money into commodity prices. thereby creating credit and price inflation. they perform an essential function. Commercial accounts are those that trade on behalf of an entity which has a natural exposure to the underlying. as this has been the trend with essentially all major commodities over the past year.375 Margin in % 6. in fact. that exposure to currency and bond market risk by holding some commodities instead? Hardly. are those who have no commercial need to either purchase or sell a given commodity.113 $2. This is to look at the “cost” of speculating. the commodity itself. Commodity Crude oil (WTI) Natural gas Copper Gold Silver Cotton Corn Soybeans Wheat Contract Initial margin value $84. Some commodities are much more volatile than others.725 $44. who might systematically sell various agricultural futures on an ongoing basis to lock in a sale price in advance. for whatever reason. the base currency. One reason for this is that commercials can speculate. that is.8 6. We then calculate the margin required. more 1 liquid market for all .0 11. 02 .025 $3.025 $69. think of the miller or the meatpacker seeking to lock-in purchase prices for their grain and livestock. But this view is false. thereby holding profit margins more stable over time. to try and estimate the degree to which certain commodity price increases are being driven by speculation rather than commercial supply and demand. as such. to determine just how much of their production or consumption costs to either hedge or leave unhedged. The less it costs to speculate.2 5. This risk-adjusted margin (RAM) calculation gives a more complete picture of the “cost” of speculating in a 2 In this discussion we assume that the speculation that is taking place is in the form of buying rather than selling. While this distinction between commercials and non-commercials is nice in theory. however. etc. so speculators can be understood to help match buyers and sellers of various commodities.

6 $69.3 $39.3 $ given commodity. such as agricultural products. The higher the RAM. would not impact the results meaningfully. First.1 $98.073 $47.5 32. gold has by far the highest RAM at present. Prices and volatility calculations as of 16 Feb 2011 There are several observations we can make here. but then again. corn and wheat have quite low RAMs. among agricultural commodities. As copper is both an industrial commodity and one with a low RAM at present. it would appear to be particularly vulnerable. Commodity Crude oil (WTI) Natural gas Copper Gold Silver Cotton Corn Soybeans Wheat Contract Volatility value (%) $84.137 $17.4 Source: CME Group. It may be pure coincidence that these commodities with low RAMs are amongst the top performers over the past few months. are possibly attracting significant speculative interest.363 22. should now consider underweighting industrial commodities.113 31.972 $33. however.016 $21. Gold. cotton.510 34.2 16. 3 Those familiar with the commodities futures markets are also aware of the roll yield (or carry cost) as a factor which can influence speculators. Investors sharing our view that financial assets are fundamentally overvalued in real.7 $113.3 $35. copper has the lowest RAM. Finally.553 RAM (%) 21. which tend to be highly correlated to equity markets.THE AMPHORA REPORT Vol 2/5. as such.3 $154.670 44.789 $11.329 $16.0 23.6 18.amphora-alpha. potentially inviting speculative attention. are normally uncorrelated to equity markets and are likely to remain so. implying that speculators are unlikely to find gold particularly attractive. Bloomberg. In this analysis. Non-industrial commodities.6 18. contract values could be adjusted higher (or lower) according to their positive (or negative) roll yields for a more precise analysis.2 30. Defensive investors.732 $31. Those claiming there is rampant speculation in gold at present should consider this important fact. importantly.9 26.613 27.750 27.We have not included roll yield calculations here because roll yields are currently much lower than volatilities and. 18 February 2011 www. according to the calculations above. appears unattractive to speculators from a RAM perspective at this time.096 $15. Second. However.025 37. concerned that equities and risky assets in general are at risk of a major correction. of the metals.1 $44.250 31.730 15. is not only essentially uncorrelated to equity markets but. however.8 20.6 Risk $23. it may reflect a potentially dangerous degree of speculation having entered into these markets. defensive investors may now also want to consider underweighting even those non-industrial commodities which. purchasingpower terms should continue to hold a diversified exposure to commodities as an alternative to a more traditional portfolio of stocks and bonds. the higher the 3 “cost” . 03 .

investment products or other financial instruments. All express or implied warranties or representations are excluded to the fullest extent permissible by law. This report is produced by us in the United Kingdom and we make no representation that any material contained in this report is appropriate for any other jurisdiction. ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London. All rights reserved. having worked for European and US investment banks in London. where he and his team were voted #1 in the Institutional Investor research survey. quantitative strategies. New York and Germany. These terms are governed by the laws of England and W ales and you agree that the English courts shall have exclusive jurisdiction in any dispute. © Amphora Capital John Butler has 18 years’ experience in the global financial industry. and under no circumstances shall we be liable for any direct or indirect losses. John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London. costs or expenses nor for any loss of profit that results from the content of this report or any material in it or website links or references embedded within AMPHORA: A lateral-handled.amphora-alpha. JOHN BUTLER john. where he was responsible for the development and marketing of proprietary.butler@amphora-alpha.THE AMPHORA REPORT Vol 2/5. Nothing in this report shall be deemed to constitute financial or other professional advice in any way. tools and material presented herein are provided for informational purposes only and are not to be used or considered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities. 04 . He is a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences. DISCLAIMER: The information. 18 February 2011 www. Prior to joining DB in 2007. Amphora Capital is registered in England and Wales under the number OC345497.

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