Big Picture Framework

Throughout history we’ve become accustomed to the fact that periodically Commodities tend to steal the spotlight in the global financial markets and as a result attract maximum investor attention. The reason why these have been more of episodic and sporadic occurrences throughout the years, rather than a steady and continuous trend is because commodities are largely driven by supply and demand, and volatile price spikes tend to occur only when there are serious dislocations and imbalances in the commodity markets. Such imbalances on the other hand usually occur in times of geopolitical tensions, uncertainty and conflict. Since commodity production, distribution and usage is unevenly distributed around the world it is easy to see why when conflicts between countries, regions and/or even continents occur, this automatically brings serious supply-chain disruptions causing economies that need a certain commodity to not be able to get enough or even any of it. As economics 101 has taught us – when the supply of a certain good or service goes down, and demand stays the same or increases, then prices always go up and vice versa. However, over time supply-chain disruptions tend to get resolved as a result of either conflict resolution, innovation, alternatives etc. Thus, over time commodity prices end up returning closer to their historical means and resume trading within their multi-year or decade trends.

History Teaches Us

Let’s look at a relatively recent example of what drastic supply and demand imbalances could do to commodity prices. You probably remember that Crude Oil (WTI) went from $65 per barrel to -37 dollars per barrel in the period January – April, 2020. Yeah, negative 37 dollars you heard correctly.

This literally meant that for a short period of time not only that Crude Oil was free but that market participants were willing to pay you if you took one barrel of oil from the market. We know, that this sounds really confusing and don’t worry about it if you can’t wrap your mind around negative Oil prices, since this was the first time in history and probably the last time that we would see something like that. The main reason for this historic move in the price came from the drastic decrease in demand for oil as a result of the COVID – 19 pandemic. You see, it was the perfect storm for Oil – the tanks were already full; everyone was expected to be driving less; planes were flying less, since people were staying isolated at home; there was less oil being used by manufacturing, since many factories and production plants had to shut down etc. However, at the same time oil was still getting pumped out of the ground in large quantities every single day. Understandably, that led to the massive build up in huge stockpiles of inventory which eventually started to cause massive storage problems, since Oil needs to be stored in special facilities under strict conditions. So, we got to a point where no one wanted to buy more oil as people had no place to store it and if you don’t have buyers at zero dollars, you have to go even lower. Market inefficiencies like that tend to be relatively short-lived because opportunistic traders and investors quickly jump in and take advantage of what the market has created as an opportunity. Thus, these opportunities get quickly exploited, which helps bringing assets prices back to more historically normal levels.

By June, 2020 the Oil price had returned to $40 per barrel.

Mindset Shift

So what does that mean? Does it mean that you have to be able to forecast the next major geopolitical conflict or natural disaster and place your trades before it happens? No, definitely not. As a matter of fact attempting to do that would most certainly result in negative returns over the long term as no one is able to predict systemic events like war, natural disasters, revolutions, elections etc. So, what should you do in order to capitalize on such rare and volatile market inefficiencies?

Risk oriented investors are intrinsically fascinated by volatility as in their mind above-average returns could only be generated in periods of elevated volatility when prices are moving fast. While there is a certain truth in that, investors tend to forget that trading in highly volatile times could also lead to massive losses if done in the wrong way. You need to remember that wealth never simply disappears from the market as a result of a specific price movement (except in the case of using leverage) but rather gets transferred between market participants during such volatile times. Intelligent investors are always ready to buy heavily undervalued assets and sell highly overvalued assets. In the Oil example above, an intelligent investor would have stepped up and started buying aggressively when Oil prices came close to 0, recognizing the short-term market inefficiency and taking advantage of it.

A new market inefficiency developing – Crude Oil

The ongoing war between Russia and Ukraine is the most serious and frightening geopolitical crisis in Europe since WW II. In these difficult times for Europe, thousands are dying, hundreds of thousands are running for their lives and millions are frightened around the world on what could happen next.

Russia’s horrible attack on #Ukraine and the terrifying images, news and updates that the world sees day and night of military actions taking place at the heart of Europe have irreversibly changed the old continent and possibly the world forever.

As every geopolitical crisis before, the ongoing conflict has caused massive supply and demand imbalances worldwide and has seriously disrupted the global supply-chain. This in turn has led to highly volatile price movements in the commodity, currency and equity markets.

  • Crude Oil (WTI) prices are up nearly 50% year-to-date (YTD);
  • Wheat prices are up 43% YTD;
  • Corn prices are up 28% YTD;
  • Natural Gas prices are up 36% YTD etc.

On the energy side Russia is the 2nd largest crude oil producer in the world only behind the US. On the agriculture front, Russia and Ukraine combined account for more than a quarter of the world’s wheat exports. Thus, the Russian invasion of Ukraine has had a meaningful impact on the supply and demand balance of the global energy and agricultural markets.

With close to 11 million barrels per day of crude oil output, Russia uses roughly half of it for its own internal demand and exports anywhere between 5 to 6 million barrels per day. Up until recently, energy trade with Europe accounted for half of Russia’s exported oil, with 2.5 million barrels per day shipped to European countries, including Germany, Poland, Netherlands, Finland, Greece, Romania, Bulgaria and Italy. One-third of Russian Oil arrives in Europe through the Druzhba Pipeline from Belarus. With the increased sanctions towards Russia in recent days, these 700,000 barrels per day coming as pipeline shipments from the Druzhba Pipeline could be the next sanction target. Such a move would further disrupt the energy market in Europe in the short-term, but would be a step towards stopping any meaningful capital inflows in the Russian economy, in an attempt to weaken the aggressor’s financial position.

Our approach

We’ve developed a 10-step process for exploring significant market imbalances and inefficiencies as a professional:

1. Identify the macro drivers – war, natural disaster, politics etc.

2. Understand the economic implications – GDP growth, Inflation etc.?

3. Identify high-probability resolutions and set realistic time frames. – How will the world react?

4. Choose a highly liquid assets that has been directly affected by the crisis

5. Look at historical price levels – 20+ years charts

6. Analyze the current trend and identify potential turning points – former meaningful resistance or support levels

7. Don’t fight the trend. Join it, if the price is still far from the next potential turning point. However, wait for at least a 10% correction, and use tight stop loss orders.

8. Raise liquidity and be ready to react once you see the first signs that the price has started to turn at your predetermined turning points. Don’t hesitate. Use tight stop losses and remember the risk-reward ratio is in your favor.

9. Use 1/3 of your planned trade size in the first signs of weakness in the trend, and then add the rest once the reversal is confirmed and is underway.

10. Collect profits and scale out of your positions 1/3 at a time once the market returns to its historical means.

Technical Analysis

We can clearly see the incredibly strong long-term bull trend in Crude Oil prices on both the Monthly and Weekly charts. The Monthly RSI is pushing above 80, which shows the immense strength behind the recent price appreciation. The monthly volume for February was also one of the highest in recent years, further supporting the upmove. On the weekly chart we see a pretty similar picture with RSI sitting deep into oversold territory showing no signs of stopping for now. We also see a volatile expansion of the Bollinger Bands taking place at the moment on the weekly chart, which is a strong indication that there could be another strong move to the upside in the days and weeks ahead. However, when we turn our attention to the Daily chart we can see first signs of weakness right at the $110 multi-year resistance. Considering, the heavily overbought conditions for the commodity at present, together with the strongly bullish weekly and monthly charts, we could see a short-term correction for Crude Oil in the coming days, taking the price down from $110 per barrel to somewhere in the $95-100 vicinity before making its next push higher. Today’s OPEC + meeting could cause some intra-day volatility, which opportunistic traders should take advantage of by buying any short-term weakness. Our long-term plan is to ride the bullish wave upwards towards the all-time highs in the $140-150 range, where we believe prices will find a lot of selling pressure and would most likely reverse.

Conclusion

Russia’s president, Vladimir Putin as a true dictator is very unlikely to stop until he gets what he wants, which unfortunately means that there will be more serious military confrontation between Russian and Ukrainian forces in the coming days. The west will continue to press on Russia’s key pressure points trough more heavy sanctions but will avoid military conflict with Russia at all costs. Thus, further disruptions and dislocations in commodity markets should be expected. However, Putin knows that he doesn’t have the resources and/or finances to have this war continue for a long time. Thus, he would do whatever he can to end it one way or another rather quickly. The moment there are signs of a potential resolution of the conflict, investors will start pricing in an expected improvement in the global supply-chain, which will lead to major movements in the commodity market.

We are praying for Ukraine and all Ukrainians to have the strength to get through this together and reach the other side as a free and democratic country.

Sincerely,

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