Wednesday, July 24, 2013

Smart(er) money betting on copper

The terrific Asbury Research recently featured how commercial hedgers have made a huge bet on copper. Although some may disagree, it's generally accepted that in the world of futures, commercial hedgers tend to be the smarter money. Granted, much of their smartness or ability to be more right than wrong comes from simply being on the other side of trades that tend to be more wrong than right. In the zero-sum game of the futures market, commercial hedgers are frequently on the opposing side of an increasingly popular trade, and as we know being contrarian is very often a winning strategy.

I would also emphasize that the timeliness of commercial hedgers greatly improves at extremes, meaning when their position size approaches levels that have rarely been attained over time. And if you read the Asbury Research piece (strongly urged), it's quite evident this is one of those times, with commercial hedgers at "their largest collective net long position for copper in the 30-year history of the contract."

The weekly futures chart of copper further illustrates the ups and downs of contract flow.

Source: Finviz

Note the red circles signifying levels where commercial hedgers established very large net long exposures -- and more often than not these levels have coincided with bottoms for copper. And vice versa, at levels where commercial hedgers have been very net short, as was the case at the start of 2011, copper has tended to be at a peak. I would also point out that the round-number of $3.00 appears to be a meaningful level of longer-term price support.

Is there a way to play copper without having to open a futures account? I would say yes and no. Yes, there is an ETF, the iPath Dow Jones UBS Copper Subindex Total Return ETN (ticker: JJC), which looks to track the price of copper. However, as with many of these ETFs that use futures contracts to replicate or track a given commodity, there does exist a "roll" problem. As the futures contracts age and expire, the ETF must roll its assets into new contracts and in so doing, the ETF price may gradually diverge from the price of the commodity due to contango. This effect is not a big problem in the short-term, but over many months the shortfall can become quite pronounced.

Notice in the chart above how over time the ETF (JJC, red line) gradually falls short of the commodity (copper, black line). Again, this is not a major issue for those who wish to trade the JJC within a shorter-term horizon. However, it seems clear that such ETFs are not for buy-and-hold purposes.

As for my opinion on copper, as much as I fully respect what is being inferred by the outsized net long position by commercial hedgers, I prefer to wait for the price of copper to exhibit a more bullish behavior. Currently copper appears to be holding at the $3 support level, but as shown in the weekly futures chart above, my inclination is to wait for price to successfully break through the triangle formation at about $3.50. Otherwise copper could continue to base or consolidate sideways, effectively tying up assets in dead money. As always, stay tuned!


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