Commodity Chaos: Volatility Is Running Amok

Volatility exists in all asset classes, but it can be most unruly in commodities. This is because most commodity investors are buying and selling on leverage. Leverage is great when things are going your way, but it can be devastating when they aren't. Thus, the emotional highs and lows for commodity traders tend to be excessive, and that roller coaster of fear and greed bleeds into the price discovery process. I've been a commodity broker for nearly two decades, and I've seen a lot ... but I've never seen this type of market disfunction, illiquidity, and sheer chaos. On the surface, it seems reasonable to attribute wild price swings in commodities to the geopolitical risk and the subsequent sanctions levied on Russia. But that only tells part of the story. Beneath the fundamental story lies a trail of margin calls, financial strain, blown-up trading accounts, and the need for capital preservation. In other words, the motivation to buy or sell commodities in recent weeks has been dominated by pain and risk mitigation rather than supply or demand. Naturally, this delays the ability of the market to come to an equilibrium price and exacerbates moves on both sides of the trade. Ignoring nickel, which is a thinly traded commodity, the three markets impacted the most by the invasion of Ukraine by Russia, and more so by the global response to the event, are wheat, crude oil, and gold. Traders with positions on in all three, regardless of initial directional positioning, likely suffered both financially and emotionally. Let's look at each of these to see what might be in store for traders moving forward. Wheat's a Basket Case You have probably read that Ukraine and Russia account for a third of the world's wheat. Although the current year's crop was in the ground before war broke out, there is a significant threat to the ability of farmers to cultivate what they have planted. Not only are they contending with personal safety and financial issues, but they are facing extraordinary energy costs needed to harvest. Even if they can get the wheat out of the ground, ports in the Black Sea are not operating properly, which could interfere with the ability to get their product to the market. There are a lot of ifs that cannot be quantified until after the fact, but the looming threats should be supportive for wheat in the coming months. From a technical perspective, despite wheat trading at what have been historically unsustainable prices, the path of least resistance is likely higher for now. The corrective move from the March 8 high, which was made possible by six consecutive limit-up moves, equates to a 50% retracement of the rally that began in early February. Further, the price decline managed to hold above the 20-day simple moving average. We have also seen the Relative Strength Index retreat from the overbought territory, but maintain a positive momentum stance. Accordingly, assuming support near $10.30 continues to hold, we believe wheat has another run at the highs in the coming weeks or months. Oil Can't Defy Gravity for too Long West Texas Intermediate Crude Oil futures traded on the CME Group, the major derivatives marketplace, underwent both a bear and bull market in a single session earlier in the month. Not only that, but the contract has jammed a year or two worth of volatility into a handful of trading sessions. Both the bulls and the bears were put through the wringer. Unfortunately, I am speaking from experience. The intense volatility caused both futures and options traders to be pushed to the brink and even directional futures traders struggled to manage risk (stop-loss orders were guaranteed to get filled with slippage, unless they were deep enough to risk the value of a small car). In the end, traders opted to make their way to the sidelines to stop the pain. Open interest (the number of open futures contracts held into the close of a session) has dwindled substantially, suggesting most speculators, and even hedgers, have pulled their hands away from the stove and are content watching from the sidelines until things calm down. In the past, this type of capitulation in volatility and reduction of speculative order flow has led to a sharp decline in price velocity. I, for one, would love to see just that. Like wheat, oil market fundamentals aren't clear. The U.S. boycott of Russian energy might extend beyond the war. Conventional wisdom suggests sanctions will be relatively permanent, as long as Vladimir Putin is in charge, but we are hearing whispers of a political uprising that could change that. Of course, that is speculation, but such a sudden turn of events could shave $20.00 off the price of oil quickly. Nevertheless, the world is different today than it was just a few short weeks ago. Oil in the ground is plentiful, but usable extracted oil is relatively scarce. Thus, $100.00 oil isn't as expensive as it appears to be in the short run. In the long run, we suspect supply will come and oil will do what it always does when it trades in the triple-digits ... it falls apart. Whether it is demand destruction or supply coming to market via the Iranian nuclear deal, black market Russian sales, Saudi Arabian production increases, or U.S. production increases, gravity will eventually take its toll on lofty prices. Remember, the cure for high commodity prices is high commodity prices. We see sharp technical resistance in the May contract near $109.00 and again just under $113.00. We suspect oil will run into selling somewhere within this range. On the way down, support will be provided by previous resistance and an uptrend line which happen to come together around $96.00. If $96.00 holds, the bulls are in charge. Ideally, the market will be able to carve out a range between $113.00 and $96.00 as we wait for the fundamental picture to clear up. Even so, a break below would likely mean $75.00 to $80.00 oil. Obviously, trading oil is a high-stakes endeavor; particularly, in the current environment. I have heard whispers of experienced traders and commodity funds being completely wiped out this month by the extreme volatility. There is no room for complacency. Gold Could Be Polished Despite wild volatility, the precious metals have been an utter disappointment. The gold bugs will tell you gold is a hedge on inflation and a place to store wealth when other assets are struggling. Yet, with inflation at 40-year highs and both stocks and bonds cratering earlier in the month, gold failed to break above the 2020 high and immediately dropped precipitously by almost $200! The reality is gold isn't a great inflation hedge, but it is a good diversifier. The correlation of gold to other major asset classes (stocks, bonds, commodities, and currencies) is dynamic. That constant change in relationships with other assets is precisely why many financial advisors suggest holding a small percentage of a portfolio in precious metals. It is simply a diversifier. Nonetheless, it is a sadistic market for buy-and-hold investors and even more so for breakout traders. Even when gold breaks out, it isn't a clean break and bull markets come with massive price swings capable of shaking out those with the highest convictions. Looking at the chart, the rejection of a breakout above $2,100 was a blow to the bull camp, but as long as prices hold above what was previously trendline resistance (about $1,920), the bulls are in control and the uptrend is intact. A break above $1,963 would suggest another attempt at a new all-time high. But if $1,920 fails to hold, continued selling could see $1,874, and maybe even the $1,800 area before the bulls will have another chance at redeeming themselves. For now, we believe $1,920 will hold and are looking for a move above $2,000.

Commodity Chaos: Volatility Is Running Amok

In 20 years, I've never seen this type of market disfunction and illiquidity.

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