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PAPER ON:

“Forecasting Commodity Future Prices”

Written by; Mr. Mane Pramod Student PGD-ABPM, Indian Institute of Plantation Management, Jnanabharati campus, Bangalore -560056 AUGUST-2009 Email: pramodmane96@gmail.com

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Executive Summery

Fluctuations in the prices of various commodities are very volatile due to sliding global economy and uncertain financial happenings, which is generating high risk for commodity future market participants; hence, it is important to develop accurate price forecasts, which can work out profit booking calls and keep investors away from losing money. This paper discus about the forecasting of commodity future starting from basics of

forecasting. And also reveals various type or method generally followed for forecasting with their considered error correction. Quantitative forecasting method will be discussed in detail in this paper and also have only overview on qualitative method because of its limited use in commodity future forecasting. Though these models provide valuable insights into the causes of price movements, but they are not necessarily the best suited for forecasting given the multiplicity of known and unknown factors that affect supply and demand conditions in these markets. There are two main bases for forecasting Fundamental (demand and supply) and Technical analysis which will discuss in second section of report. In Indian scenario traders are widely using some technical indicators like MACD, RSI, BOLLINGER BAND, and RETRACEMENT, which is quantitative forecasting and comes under econometrics and this, will be discussed further by using CRUDE OIL as an example. Finally in concluding part paper discuss about difficulties in present methods and reliability, accuracy, durability and economy of information(data) and its sources available for forecasting and challenges in forecasting of commodity future in present situation like recession, shrinking Pricing cycles of commodities, supplier consolidation and pricing volatility.

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Chapter Scheme

Chapter 1

Introduction to forecasting ………………… ..04    Definition Methods of forecasting Error correction

Chapter 2

Fundamental and technical analysis ……….09  Fundamental analysis  Supply Demand

Technical analysis MACD (moving average) SIGNAL LINE BOLLINGER BAND RSI RETRACEMENT

Chapter 3

Commodity CRUDE OIL…………..16

Chapter 4

Conclusion…………………………..22

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Chapter: 1 INTRODUCTION TO FORECASTING Definition: FORECASTING: Planning tool which helps future analysts in his attempts to cope with the uncertainty of the future. It starts with certain assumptions based on the persons experience, knowledge, and judgment. These estimates are projected into the coming months or years using one or more techniques such as moving averages, regression analysis, candle stick charts and trend projection. Since any error in the assumptions will result in a similar or magnified error in forecasting, the technique of sensitivity analysis is used which assigns a range of values to the uncertain factors (variables).

TYPES OF FORECASTING METHODS: 1 .QUALITATIVE FORECASTING METHODS These types of forecasting methods are based on judgments or opinions, and are subjective in nature. They do not rely on any mathematical computations.

Qualitative Methods

Executive Opinion Approach in which a group of managers and analysts meet and collectively

Market Research Approach that uses

Delphi Method Approach in which a

surveys and interviews to determine demand.

forecast is the product of a consensus among a group of experts.

develop a forecast.

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2 .QUANTITATIVE FORECASTING METHODS Quantitative forecasting methods can be divided into two categories: time series models and causal models.

Quantitative Methods

Time Series Models Time series models look at past patterns of data and attempt to predict the future based upon the underlying patterns those data. contained within

Causal Models Causal models assume that the variable being forecasted is related to other variables in the environment. project based They upon try to

those

associations.

2.1 TIME SERIES MODEL

Time series is a series of observations collected over evenly spaced intervals of some quantity of interest. e.g. prices per hour, volume per day…

Let yi = observed value i of a time series (i = 1,2,…,t) yhati = forecasted value of yi ei = error for case i = yi – yhati

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TIME SERIES MODELS

Model

Description

Naïve

Uses last period’s actual value as a forecast

Simple Mean (Average)

Uses an average of all past data as a forecast Uses an average of a specified number of the most

Simple Moving Average

recent observations, with each observation receiving the same emphasis (weight) Uses an average of a specified number of the most

Weighted Moving Average

recent observations, with each observation receiving a different emphasis (weight) A weighted average procedure with weights declining exponentially as data become older

Exponential Smoothing

Trend Adjusted Exponential Smoothing

An exponential smoothing model with a mechanism for making adjustments when strong trend patterns are inherent in the data

Seasonal Indexes

A mechanism for adjusting the forecast to accommodate any seasonal patterns inherent in the data

Linear Trend Line

Technique that uses the least squares method to fit a straight line to the data

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2.2 PATTERNS THAT MAY BE PRESENT IN A TIME SERIES

Level or horizontal: Data are relatively constant over time, with no growth or decline. Trend: Data exhibit a steady growth or decline over time. Seasonality: Data exhibit upward and downward swings in a short to intermediate time frame (most notably during a year). Cycles: Data exhibit upward and downward swings in over a very long time frame. Random: Erratic and unpredictable variation in the data over time.

2.3 ERROR CORRECTION: Sometimes the forecast is too high (negative error) and sometimes it is too low (positive error).

The accuracy of the forecasting method is measured by the forecasting errors. There are two popular methods for assessing forecasting accuracy:  (MAD) To eliminate the problem of positive errors canceling negative errors, a simple measure is one that looks at the absolute value of the error (size of the deviation, regardless of sign). When we disregard the sign and only consider the size of the error, we refer to this deviation as the absolute deviation. If we accumulate these absolute deviations over time and find the average value of these absolute deviations, we refer to this measure as the mean absolute deviation . MAD = (  | ei | )/n Where n is the number of periods in the forecast Units of MAD are same as units of yi

Mean Absolute Deviation

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 MSE = ( ei 2 )/n Units squared  Tracking Signal

Mean Squared Error (MSE)

A tracking signal (T.S.) is a tool used to continually monitor the quality of our forecasting method as we progress through time. Each period a tracking signal value is calculated, and a determination is made as to whether it falls into an acceptable range (much like we saw with control charts). If it drifts outside of the acceptable range, that is an indication that the forecasting method being used is no longer providing accurate forecasts. Tracking signals help to indicate whether there is bias creeping into the forecasting process. Bias is a tendency for the forecast to be persistently under or persistently over the actual value of the data.

Tracking signal is calculated as follows:

algebraic sum of forecast errors (ASFE) Tracking signal = MAD

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Chapter: 2 FUNDAMENTAL AND TECHNICAL ANALYSIS There are two basic approaches to forecasting prices in commodity markets: fundamental analysis and technical analysis. While they are often presented as substitutes or competitors in price forecasting, the two can be complimentary. Most market analysts pay attention to both fundamental and technical factors even though they may emphasize one over the other.

FUNDAMENTAL ANALYSIS Fundamental price analysis is based on the notion that the underlying supply/demand conditions in a given market ultimately determine price. Since the futures market is attempting to discover prices that will balance supply and demand in some future time period, there is uncertainty in initially establishing an equilibrium price. The market may be “shocked” by new information; resulting in traders’ changing their assessments of what the equilibrium price will be in the future. Fundamental analysis is attempts to both anticipate changes in supply/demand information, and to evaluate the direction and range of price movement resulting from new information. Fundamental analysis may be simple (intuitive), or complicated (using quantitative statistical or mathematical models), In both cases, analysts are attempting to asses price implications of economic variables including:

1) Seasonal use patterns 2) Seasonal supply patterns 3) Prices of substitute goods 4) Prices of compliment goods 5) Market structure

Intuitive analysis uses a basic understanding of economic principles to hypothesize about price changes. Quantitative analysis combines knowledge of economic theory with mathematics and statistics to establish explicit relationships between economic variables and price.

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Price movements in commodities using fundamental analysis can be broken down into these simple formulas:
 

Demand > Supply = Higher Prices Supply > Demand = Lower Prices

Supply of Commodities: The supply of a commodity is the amount that is carried over from previous year(s) of production and the amount that is being produced during the current year. For example, the current supplies of soybeans would include the amount of crops in the ground and the amount that is left over from the previous season. Typically, the more that is carried over from the previous season, the lower the prices will fall. There are many factors that can impact the supply of commodities like weather, amount of acres planted, production strikes, crop diseases and technology. The main thing to remember when using fundamental analysis is that high prices for commodities will lead to an increase in production, as it is more profitable to produce commodities when prices are higher. As you might expect, demand will typically drop as prices move higher. Demand for Commodities: Demand for commodities is the amount that is consumed at a given price level. The rule of thumb is that demand will increase when the price of a commodity moves lower. Oppositely, demand will decrease as the price of a commodity increases. There is an old saying among commodity traders that low prices cure low prices. This means that more of a commodity will be consumed at lower prices, which lowers the supply and thus prices will eventually increase. Using Fundamental Analysis to Forecast Future Prices of Commodities: Prices will fluctuate in the short term, so it is not easy to make fundamental forecasts of commodities prices and make short-term trades. It is even more difficult for new commodity traders to do this. I recommend that new traders, and even experienced traders, use a longterm strategy when using fundamental analysis to forecast commodity prices. You should look for trends that are developing that will cause a shift supply and demand factors.

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It may seem like a daunting task to find all the current data and compare it to previous years and see how prices reacted under those conditions. Worse yet, you have to forecast in the future as to what the supply and demand scenario will be. I can tell you it is almost impossible to do this. What you want to do is look for trends in production and consumption and trade with that bias. For example, if the supplies of chana are at a five-year high and we just planted a record amount of acres of chana for this season; it is likely that chana future will trade with a downward bias. You would be likely want to trade from the short side. Now, at some point, the price of chana will get too low and demand will increase. Or, there might be weather problems during the growing season that will lower the production of chana. In these cases you have to be flexible and realize that prices won’t go down forever. The longer-term trends in commodities are easier to spot with fundamental analysis, but I prefer to use technical analysis to capture shorter-term movements in commodities prices. Most professional commodity traders like to know what the big picture is with commodities using fundamental analysis and then they use technical analysis to time their entries and exits.

TECHNICAL ANALYSIS: Technical analysis is a method of evaluating commodity future prices by analyzing the statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a commodities intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Technical analysis takes a completely different approach; it doesn’t care one bit about the “value” of a commodity. Technicians (sometimes called chartists) are only interested in the price movements in the market.

Despite the entire fancy and exotic tool it employs technical analysis really just studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor.

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The field of technical analysis is based on three assumptions: 1. The Market Discounts Everything 2. Price Moves in Trends 3. History Tends To Repeat Itself

Study of Various Tools Used in Technical Analysis Technical tools: Moving Averages MACD (Moving Average Convergence Divergence) One of the most popular technical indicators, the moving average convergence divergence (MACD) is used by traders to monitor the relationship between two moving averages. It is generally calculated by subtracting a 26-day exponential moving average from a 12-day EMA. When the MACD has a positive value, the short-term average is located above the long-term average. As mentioned earlier, this stacking order of the averages is an indication of upward momentum. A negative value occurs when the short-term average is below the long-term average – a sign that the current momentum is in the downward direction. Many traders will also watch for a move above or below the zero line because this signals the position where the two averages are equal (crossover strategy applies here). A move above zero would be used as a buy sign, while a cross below zero can be used as a sell signal Signal/Trigger Line Moving averages aren’t limited to just stock or commodity prices; Mas can be created for any form of data those changes frequently. It is even possible to take a moving average of a technical indicator such as the MACD. For example, a nine-period EMA of the MACD values is added to the chart, in an attempt to form transaction signals. Buy signals are generated when the value of the indicator crosses above the signal line, while short signals are generated from a cross below the signal line. It is important to note that regardless of the indicator being used, a move beyond a signal line is interpreted in the same manner; the only thing that varies is the number of time periods used to create it.

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Bollinger Band A Bollinger band technical indicator looks similar to the moving average envelope, but differs in how the outer bands are created. The bands of this indicator are generally placed two standard deviations away from a simple moving average. In general, a move toward the upper band can often suggest that the asset is becoming overbought, while a move close to the lower band can suggest the asset is becoming oversold. Since standard deviation is used as a statistical measure of volatility, this indicator adjusts itself to market conditions. The tightening of the bands is often used by traders as an early indication that overall volatility may be about to increase and that a trader may want to wait for a sharp price move. Bollinger Band Tactics The Bollinger Bounce One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the Bollinger bounce. If this is the case, then by looking at the chart below we can say, price will go down. As you can see, the price settled back down towards the middle area of the bands.

That’s all there is to it. What you just saw was a classic Bollinger bounce. The reason these bounces occur is because Bollinger Bands act like mini support and resistance levels. The longer the time frame you are in, the stronger these bands are. Many traders have developed systems that thrive on these bounces, and this strategy is best used when the market is ranging and there is no clear trend.

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Bollinger Squeeze The Bollinger squeeze is pretty self explanatory. When the bands “squeeze” together, it usually means that a breakout is going to occur. If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break out below the lower band, then the move will usually continue to go down.

Looking at the chart above, you can see the bands squeezing together. The price has just started to break out of the top band. Based on this information, we can say price will go up.

This is how a typical Bollinger Squeeze works. This strategy is designed to catch a move as early as possible. Setups like these don’t occur every day, but you can probably spot them a few times a week if you are looking at a 15 minute chart.

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Relative strength index:
 

It indicates overbought and oversold conditions. When RSI is above 80, it means that the market is overbought and we should look to sell.

When RSI is below 20, it means that the market is oversold and we should look to buy.

RSI can also be used to confirm trend formations. If you think a trend is forming, wait for RSI to go above or below 50 (depending on if you’re looking at an uptrend or downtrend) before you enter a trade.

Fibonnaci Retracement:

Traders usually study charts, Fibonacci ratios may be applied to the Price scale, and also to the time scale of charts. My focus here will be on the price scale for now.

Prices never move in a straight line. Look at any chart, you will see many wiggles, as price advances and retraces. Commodity futures, Forex, all instruments which are liquid, will often retrace in Fibonacci proportions, and advance in Fibonacci proportions. Not always, and not precisely to the penny. But very often, and reasonably close. This happens often enough that profitable trades can result.

Use Fibonacci ratios with a few simple indicators to help determine probable price turning points, optimum entry, exit and stop-loss levels.

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Chapter: 3 CRUDE OIL Crude oil is a key commodity for global economy. As a matter of fact, it is a vital component for the economic development and growth for industrialized and developing countries in a likely manner. Moreover, political events, extreme weather, speculation in financial market, amongst others are major characteristics of crude oil market which increase the level of price volatility in the oil markets. The effect of oil price fluctuation extends to reach large number of goods and services which have direct impact on the economy as well as the communities. Therefore, to reduce the negative impact of the price fluctuations, it is very important to forecast the price direction. Unfortunately, fundamental variables such as oil supply, demand inventory, GDP are not available on daily frequency which adds additional difficultly to the prediction. Although it could be argued that the era of oil is about to be over. However, some studies have indicated that the global demand will continue to rise for the long-term despite the fact that oil demands from OECD countries have decreased, however, the overall demand for oil has increased and this to a large extent due to the increasing demands of non OECD countries, especially China. Furthermore, the fact that significant amount of oil come from the unstable Middle East means more price fluctuations are expected. Therefore, Forecasting oil price direction is very useful for market traders and for individuals.

Short term forecasting of crude oil by using technical chart analysis: MCX crude oil chart on 22 July 09 of contract ending on 14 Aug ,2009 Observation Following 1 year daily candlestick chart shows, • Highly volatile from three days. • High volume is concerning for rally. • MACD is showing crossing over, a bullish signal. • RSI 53.92 at sideways. • Likely to give breakout above 3222 a weekly on. • 20 DMA became a good support from last three days. • Strong support is seen at 3145 to 3150 in weekly chart.

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Forecast:

Major trend is uptrend likely to consolidate in range 3110 to 3200. Call for tomorrow: sell 3180 Stop loss 3222 target 3110 Here for giving the tomorrow’s call we need to observe what is major trend and other thing like any inventory data, unemployment data, housing data, OPEC announcements, GDP of various countries ,Dollar value against other major currencies, rig count-new oil field, oil consumption data etc which may be helpful for future calls.

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Long term forecast for crude oil:

WORLD ENERGY TREND

Oil prices: Oil prices have roller-coastered: starting 2008 at US$92/b, the OPEC Reference Basket rose to a record $141/b in early July before falling to $33/b by the end of the year, the lowest level since summer 2004.and smoothing in 2009 starting with US$ 35-40/b and presently trading in range of 65-75US $.For the first time since the early 1980s, world oil demand contracted in 2008, by 0.3 mb/d, and it is expected to further decline by a hefty 1.4 mb/d in 2009, according to OPEC’s April Monthly Oil Market Report (MOMR). The rapidly softening fundamentals, with burgeoning stock levels accompanied by a rise in production capacity in OPEC Member Countries has clearly contributed to the drop in oil prices. This is in addition to the now recognized fact that the unsustainably high price levels observed in the middle of 2008 were to a large extent due to significant speculative investment inflows in oil and product futures and over-the-counter (OTC) markets.

Medium-term economic growth: All institutions, including OPEC, have revised downward drastically their projections for Gross Domestic Product (GDP) and oil demand growth in 2009. Following fig, illustrates the rapid reassessment for short-term economic growth in the OECD. In the July 2008 edition of the OPEC MOMR, real GDP growth for 2009 in the three OECD regions was in the range 1.3–1.6%, but by June 2009 the US, the Eurozone and Japanese economies were shrink by 2.8%, 4.2% and 6.4% respectively. Over this period, developing country growth expectations have also been dramatically lowered.

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Long-term economic growth

Demographics Population Growth rate of world can be used as major instrument for forecasting long term futures, because it gives idea about overall consumption and its increase in oil consumption pattern.

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Annual demand growth: By considering all things like population growth ,its consumption, GDP rate we can forecast what is the growth rate which oil can have demand in future.

World oil demand Present oil consumption is 83mb/d, by analyzing the population growth rate, industrial use rate, demand supply factors, substitute use pattern we can calculate the demand in three cases: reference case, lower growth and higher growth.

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Oil rig counts If the forecasted future demand is growing at low rate then rig count will be go down, because there will be no demand for the entire field to operate at full capacity. Main thing is cost of production if, it more than the price of crude oil then there will be no chance of making profit for oil producers.so result rig count go down.

So, by studying all this factors related to starting from oil prices & its trend, population growth & consumption pattern globally, demand and supply of oil, rig counts, various OPEC and non-OPEC oil producing countries policy, available oil inventories at various countries and substitute for oil in future time etc, all this make the forecast reliable and provide input for forecasting long term pictures.

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Chapter: 4 CONCLUSION Forecasting of commodity future is very challenging more than that measuring accuracy & plausibility of forecast is very difficult. Presently due to global economic recession prices of fluctuating like anything beyond the imagination in such scenario traders should able to forecast which can generate true calls .in Indian scene traders are unable to access all the data released by various organization related to various commodities which results lack of information for prediction process. By using econometrics-quantitative technique one can generate good risk: reward ratio call, Moving averages can be effective tools to identify and confirm trend, identify support and resistance levels, and develop trading systems. However, traders and investors should learn to identify commodities and time period that are suitable for analysis with moving averages and how this analysis should be applied. Don't expect to get out at the top and in at the bottom using moving averages. As with most tools of technical analysis, moving averages should not be used on their own, but in conjunction with other tools that complement them. Not necessarily quantitative will always true but traders also have to keep watching on various fundamental factors. After all the future commodity trading more affected by market sentiments and traders psychology one should able to understand this market sentiments come up with own strategy plan of trading. And remember…..

If you fail to plan, you plan to fail.

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