This past year has certainly been an extraordinary one for futures markets based on just about any criterion. We saw significant trending action in many sectors and a fair share of major surprises, too. But most noteworthy was the dramatic growth in participation in commodities by new investors, leading to record after record in volume and open interest. All these factors marked 2006 as a special year.

As is typical of any trend, the major increases in volume have had several important drivers. Technical improvements, especially speed of market access and fill confirmations in the big grain, metals and energy markets (which are all electronic, night and day) are certainly a factor. Better access has increased worldwide participation in a similar fashion to what had already occurred in the currency and financial markets. A glance at share prices of the publicly traded futures exchanges reflects a pretty good shorthand picture of the substantial growth in participation and money flowing into these markets.

It's the growth in passive index fund commodity investing, driven partly by opportunity but also diversification issues, that is probably key to the increased overall level of trading. Money flows have had had an unmistakable impact, and the sheer number of big trends and major price adjustments occurring month after month this year rivals that of any period in the last thirty years. Targets of this capital include crude oil earlier in 2006, and more recently grains, especially corn.

Impact of Funds

The phenomena of commodity-based exchange traded funds (ETFs) are also a subset of this macro picture of diversification into commodities markets through securities exchanges. A major portion of current valuations in, for instance, the gold and silver markets, can be traced to these funds. Over 110 million ounces of silver and 14 million ounces of gold are tied up in these vehicles. The long futures positions favored by the funds tend to be more stable than long-side participation in futures by traditional hedgers or speculators, due to a lesser degree of leverage and the longer time frame typical of equity market commitments.

Since this relatively new participation is such a key factor of valuation, one place to focus our thinking about what comes next is on expectations of future growth in this flow of money, and what, if anything, could happen out there to make these funds pull back. Is their increased exposure sustainable? Is there a possibility of some of this allocated money finding its way into discretionary accounts? Will the passive long exposure of recent past change? Will fundamentals shift because of the recent period of relatively high prices?

Painful corrections in commodities (such as sugar mid-year, and the collapse in crude in the third quarter) reflect the danger of ignoring real-world supply increases in a particular commodity. I don't believe in any "new paradigm" in these markets, regardless of China, India and all the other reasons the demand curve is higher than ever before. If high prices eventually increase production and cut real-world demand, prices can and will reflect that reality--regardless of new capital that may show up and create paper demand to trade in our markets. A good example is the bearish price action in copper last few months, and current price action in a number of other commodities, including the psychological bellwether silver, indicates a possibility that the decision to pull back from commodities as long-side only investment may already be underway as we head into the New Year. Hopefully this will end up as a bout of normal profit taking, setting up some opportunity into 2007. Time will tell.

Regardless of all the significant technical improvements exchanges have provided for short-term trading, the objective of successful commodity speculation remains getting on the right side of a trending market long or short, and sticking with the position as long as the trend has legs. Leave scalping to the market makers. Work on getting a methodology that gives you a chance to sit on a trade that's working.

Let's take a look at the condition of a few markets headed into the New Year, with the goal of targeting some sustainable trends.

Outlook for Crude Oil

Crude oil probably gained the most volume and open interest from investor diversification into commodities over the past couple of years, it's where I'll start. During the first half of the year, demand for crude from "paper" participants, or the long-based funds, kept the market extremely firm regardless of the fact that real-world inventories were building significantly above their five-year average. The market was pushing toward $80 a barrel at the start the hurricane season this year. As so often happens with any market, the disruptions that occurred in the previous two storm seasons were fresh in people's minds, and so were thoroughly discounted. As we got through the end of August into early September 2006 without any trouble in the Gulf of Mexico, the bottom fell out as earlier storm-related fears turned out to be unwarranted. Now let's fast forward to the current situation. The market has bounced off weekly chart support around $55 - $56 per barrel and stabilized, thanks to the Organization of Petroleum Exporting Countries' (OPEC) 1.2-million-barrel cut in October and announced plans for another 500,000 barrel cut in February 2007.

However, just as natural gas has remained in a year-plus-long bear market due to recognition of higher supply (after a ridiculous peak in December 2005), I think crude will eventually succomb to similar pressures. I seriously doubt any new highs in crude are around the corner, and would look for serious resistance around $66 - $67. All OPEC is likely to do is provide shorting opportunities from slightly higher levels, as relatively high price levels will induce cheating within OPEC. Oil production outside of OPEC is already increasing. Higher prices will work their magic and stimulate increased investments in production worldwide, and global production may not peak for decades.

Outlook for Agriculture

The next segment I would like to touch on is the grains. Obviously, the story here is related to energy prices. Ethanol production was mandated and subsidized by the government in reaction to last year's high gasoline prices, and in an almost hysterical way, has (excuse the pun) turned the corn market on its ear.

Very high sustained prices are in the cards for corn, as long as the U.S. government has decided to meddle in the market in such a gigantic way. It's interesting that the Chinese government is taking a different tack. It has suspended new ethanol projects that use corn because they recognize the primary purpose of the crop is to guarantee domestic food supplies.

Currently, grain prices are correcting a bit, having set off some short-term technical sell signals by nicking at some moving averages in the front months. I see this as normal profit taking after prices reached 10-year highs during fourth quarter of the year, and not anything that is likely to see followthrough or turn the major trend. The real picture is in December 2007 corn. I believe this contract is unlikely to fall back substantially because the supply/demand equation going forward will keep tightening. That should leave carryover at record low levels as a ratio to total consumption. Wheat is the exception to tightening carryover ratios, as worldwide production will bounce back and usage will uptick--but not as dramatically as was the case with corn. The market needs to buy as much as eight or more million acres of corn!

Soybean prices will benefit also because total soybean acres will likely have to fall--maybe as much as four or five million acres. There is an important developing complexity to the energy story and soy prices, besides the fight for acres in the U.S. farm belt. Bio-diesel fuel, distilled from soybean oil, looks to be of increasing importance worldwide and may make soybean oil a good candidate for long position into 2007. The U.S. Department of Agriculture (USDA) has forecast world vegetable stocks to fall as low as 7.2 percent of usage, the lowest in 32 years. Bio-diesel usage could reach close to 23 percent of total consumption for 2007-2008 season.

There will also be important ramifications in our export markets and livestock sector due to these shifts. It could lead to increased price volatility and some unpleasant longer-term consequences as a result of this headlong rush to turn what was basically a food crop into a quasi-energy source.

Stay Tuned for More Action!

One thing is sure: higher commodity prices should stimulate production around the world as the U.S government, looks to be putting in a near-terrm floor, for all practical purposes. To see a great example of how hyperbole leading to a price spike leads to greater production--just look at price action in sugar.

Action will not be in short supply for next year in the agriculture markets, as of course no one can know what crop yields will be until we get through July 2007 at a minimum. I feel the corn and soybean markets will be the place to focus on in 2007. I started my career in the grain markets back in the late 70s, and it's been a lot of fun seeing those contracts take center stage this past year. I do see a lot more opportunities ahead in 2007, so stay tuned and keep your eye on commodities!

Best wishes to everyone in 2007, and feel free to call me with any questions you might have about these or other markets at 866-419-7698, or contact me via email at jbarrett@lind-waldock.com.

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