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Where next for commodities? Will supercharged demand from the new economic giants continue, or are peak prices heading for a precipice? David Burrows reads the signs and looks at how traders can profit from the situation

Futures traders have not been shy of commodity markets of late. Much has been happening in commodites with record price rises in steel, nickel and copper predominantly driven by an insatiable demand for raw materials from rapidly modernising China and India.

But not everyone is convinced this rosy picture of rising commodity prices will continue. For instance Jeff Chowdhry manager of the F&C Emerging Markets (which is a top 20 performing fund over both one and three years according to LIPPER) has heavily sold commodity stocks and has taken his fund into a significant underweight position in China.

The China Syndrome

‘I think it is highly questionable whether high commodity prices are sustainable in the short term,’ Chowdhry argues.’ Take for example the Chinese economy – it would only need to slow down from 11% to 8% for China not to need to import any steel at all – that in itself would trigger sharp price falls, the type of which we have not seen as yet. I think the key point here is that it doesn’t take all that much to change the supply/demand balance. I think China faces issues over inflation and I think we will see a slowdown in the short term, which will affect commodity prices. I think long term the supply/demand equation will be strong again but at the moment I think there are too many people being bullish on commodities.’

Hamza Hamza, fund manager at Sucden Asset Management agrees that commodities futures are a treacherous place to be at present. ‘If you are asking me whether I would buy oil today at $105 a barrel, the answer would be no. Would I buy copper? No. I wouldn’t be surprised to see a big correction, there is far too much speculative froth and there is a lot of interest in ‘buying’ at the moment.’

Hamza’s views are largely shared by Sandy Jadeja, chief market strategist at ODL Markets. ‘To see what is really going on you need to look at the commitment of traders report. This will show whether speculators or institutions are bullish. Indications are that speculators are bullish whereas institutions are far less so – and bear in mind that speculators are frequently wrong!’

Jadeja continues: ‘Speculators have been extremely bullish on oil and gold. The problem is when you get extremes, for instance when gold reaches $1,000, traders who have been anticipating that round figure, offload at the same time and that is what is happening. I think the market currently is being driven far more by greed and fear than it is by the fundamental supply/demand equation.’

Jadeja makes the point that speculators have been active when commodity prices have come off in recent weeks. ‘We are seeing speculators buying into a falling market and the danger with this sort of impulse is that any further correction could be far more dramatic and sharper.’

The longer-term trend for commodities may well be bullish and this is something that Chowdhry concedes. ‘I think we are probably looking at a short period where the supply/demand equation changes its dynamic and metal prices fall as a consequence. However, over the longer term it is difficult not to see demand increasing again and commodity prices rising.’

Jadeja believes the futures market is difficult to read at present. ‘I agree the longer-term trend is bullish and monthly and quarterly charts are all pointing up. But the daily and weekly charts are pointing down. So we are in a neutral position, with no true trend in any direction.’

He adds: ‘Speculators are saying commodities are cheap, but institutions are getting a little cautious now. They have experienced the lofty heights but are now concerned that key support levels have been broken – this may have an impact. It is a day trader’s market now: we are seeing 10%-20% swings in platinum and gold. But it is not just in metals we are seeing these types of price swings – cocoa has gone down 18% and oil by 10% in the past month alone. Oats since February have gone down 17% so commodity prices across the board have been affected.’

Jadeja suggests the early warning signs are out there for what could possibly be a prolonged downward trend on prices. ‘We are not seeing buys on our weekly charts. Markets have been overbought for over a year, so any downward trend is not necessarily going to end quickly.’

From a technical point of view, Elliott wave analysis says corrections always develop in three overlapping waves that have a characteristic ‘messy’ look. Elliott describes a fixed number of corrective wave patterns. This means that once you have identified the type of correction you’re in, you can make a reasonable forecast of the path prices will take from here. So where do we currently stand in regard to the cycle of waves?

‘We are currently waiting for wave two. Personally, I think we will see a 20% correction, then a corrective rally, but the next wave will tell us a lot more. Wave two could be a lot swifter and sharper,’ Jadega suggests.

Robert Gray, head of institutional at Saxobank, does not subscribe to the argument that traders in commodity futures have been over-bullish, nor does he see a major downward trend in prices.

‘If you look at gold, zinc and platinum, they are steadily going upward, and while I would accept that they have been bought heavily, I would also make the point that they have been dramatically undervalued in the past. It is true that gold sharply declined over a four-to-five-day period but it is now climbing back up again. You have to take into account that there is not an unlimited supply of most commodities (such as oil or gold) so from a resources perspective there is nothing to suggest that the market won’t keep going up.’

Futures market opens up

Certainly futures markets have been busy with an increase in interest from the retail sector in particular. ‘The decline in the housing market in the US and the Fed’s interest rate cuts has meant that savvy investors who had been in real estate are looking for other ways to make money,’ Jadeja says. ‘With interest rates at 4% there is little interest in cash deposits, so they have been looking at the futures market, in particular commodities. And let’s face it, people have been seeing 40%-60% gains in these markets, so it is hardly surprising.’

The futures market is certainly not what it used to be: it is no longer the preserve of the institutions as Gray explains. ‘Retail investors are quite happy trading three-month contracts, and not just metals but soft commodities such as wheat, potatoes and soya. People are quite happy at the moment to trade the june market. What is also interesting is that investors are looking to use base/precious metal futures as a way of hedging mining stocks they may hold in their equity portfolios. The bottom line is that for the retail investor the futures market is more accessible than ever. I would also argue that a vanilla futures contract is no more complex than a vanilla stock. Investors are wising up to how straightforward futures contracts are and also what a valuable investment option they are during volatile markets.’

Gray adds: ‘You only have to look at how oversubscribed the futures seminars we hold at our Canary Wharf head office are to see just what growing interest there is in the futures market.’

Fundamental versus technical analysis

Trading futures is all about predicting price movements going forward – obviously it can never be a precise science – if it was, you’d only ever make money! There are two basic forms of research used by futures traders – fundamental analysis and technical analysis.

Hamza at Sucden explains the basic principles of technical trading. ‘There are three key elements: one is that the market has already discounted known fundamentals (all that is known is reflected in the price); another is that prices move in trends and a third, that history repeats itself. Technical traders will use sophisticated charting models that work from the basis of these elements.’

Fundamentals on the other hand are a whole different ball game. ‘With fundamentals it is taking other factors into the equation – supply/demand, micro economics, domestic/global political events, weather, crop reports the list of variables goes on. What futures traders predict is how these variables will affect prices.’

Which form of research is more successful and how, if at all, can they be used together?

‘To some extent they are used together,’ says Hazma. ‘Fundamental traders will always look at price charts at least, so there is a cross over. With technical traders, on the other hand, fundamentals may not matter so much. Fundamentals tend to matter more on longer-term time horizons. No method can ever be perfect; for instance, you can spend years doing research analysis, but then a war or natural catastrophe comes along and throws everything out of kilter. Even though some technical analysts will insist they take little notice of fundamentals, they have an appreciation of the fundamental background anyway by following the news and markets.’

Futures market evolves

As Hamza explains, there are as many successful fundamental traders as there are technical traders, but the problem nowadays is that the reason for buying and selling commodities is different.

‘There are far more reasons for price movements now, with a greater number of speculators, but also fund managers constructing portfolios along the lines of X% commodites, X% bonds and X% equities. Also, the arrival of electronic trading has led to a huge increase in futures trading across the board. An uncertain geopolitical climate and the emerging markets of China and Brazil have had an impact too. The landscape is different now and I think the motives for trading futures are far more varied now than in the past.’

The important thing for futures traders, regardless of whether they use technical or fundamental analysis, is to understand the dynamics of the sector or the market in which they are trading.

‘Our SMART trading platform will provide traders with real-time prices, newsfeeds, risk management and advanced charting tools,’ Hamza says. ‘Retail investors now have the resources to trade futures efficiently, but if they are trading in oil futures, say, they need to understand the dynamics of that market. Also, in the climate we see now, markets are moved increasingly by fear and greed, so can move further than people think. There is a saying that ‘markets can remain irrational a lot longer than people can remain solvent’.