Inter-Market Spreads: Current Trade Candidates

by Jason Pearce

Trading At the Margins

Commodity markets can sometimes shoot to the moon or crash into the abyss. Price trends can also persist for years at a time. Yet, history shows that commodities are mean-reverting over the long run.

It’s somewhat intuitive that this would be the case. Supply and demand adjusts to accommodate the price. When price is at multi-year highs, producers ramp up production to take advantage of the profit margin. Buyers start backing off or, in some cases, find cheaper substitutes. Eventually the market gets saturated as a supply glut starts to build and prices plunge.

Conversely, low prices will squeeze and sometimes even eliminate the profit margin. This can cause some producers to start stockpiling supply instead of selling it. Or they may reduce production of that particular commodity and focus on something else. You see this happen when farmers switch which crops they plant because of the change in price. Then there are the producers that don’t have deep enough pockets to endure a prolonged period of operating in the red so they eventually get forced out of business. On the demand side, buyers may start to increase their buying to take advantage of the bargain prices and build their stockpiles when it’s feasible. This lessens supply over time and the commodity’s price eventually goes back up.

Even Better For the Spreader

Spreads between correlated markets tend to show an even stronger tendency of mean revision. This is why I’ve always focused more on the spreads than just the outright markets. When a spread between two highly-correlated markets hits price levels that it has rarely seen over the last couple of decades, we know it is on borrowed time. The probabilities favor a major reversal.

The persistence of regression to the mean is the whole reason why some of the best trading opportunities can materialize when commodity spreads are trading at the margins. At the very least, you should not have to worry too much about getting in and then getting stuck with ‘dead money’ where your position just drifts nowhere for months on end. The prevailing fundamentals have to maintain their momentum in order to justify the extreme prices, or else the move will run out of steam and the inevitable reversal starts.

To that end, there are some inter-market spreads currently trading at or near levels that are historically extreme. Some of them have already shown signs of a reversal and some are still trending as statistical outliers, but they are all worth monitoring. If you are a spread trader, you will want to keep close tabs on these potential trading candidates. Investigate how your trading methodology could be applied to take advantage of these situations extract profits from these opportunities.

Metals

Here’s the major theme in the metals sector: Either gold is just too darn expensive or else the rest of the metals (precious and industrial) are a screaming bargain down here. This is an anomaly that will eventually be corrected.

The good news is that, as a spread trader, you don’t have to guess which of these metal markets are priced correctly and which are not. You are simply betting on the return to normal in the relationship. If gold crashes while the other metals sit there, the spreads converge. If the other metals explode higher and catch up to gold, the spreads converge. There are actually five different scenarios of how the spreads can converge. Kinda like the old saying “Heads I win, tails you lose”. That’s a pretty good position to be in. Take a look at the charts and see for yourself.

The gold/silver spread tagged 80:1 at the end of August and began to retreat. As you can see on the monthly timeframe, the last couple of time the ratio reached 80:1 it quickly rolled over and began a major decline. If history were to repeat, the strategy would be to short gold and buy silver.

The ratio between 50,000 lbs of copper and 100 oz. of gold dropped just below 1:1. Over the last couple of decades, this has proven to be a temporary event and, therefore, a great buying opportunity. Be careful, though. You can see that the ratio has the potential to move substantially lower before recovering. The lows of the financial crisis prove this.

The platinum/gold spread inverted and hit a record low this year. The ratio hit the second-lowest level on record. We wrote a more in-depth post on this one earlier. It has been a favorite trade on the long side anytime you can buy the platinum under the gold.

Energies

The relationships between crude oil and its products have been in transition. The products reached historically unsustainable premiums over crude oil this summer and came crashing down. Rebounds could provide short sale opportunities. In addition, gasoline traded at a significant discount to ultra-low sulfur diesel fuel and it is now on the mend. Seasonal support kicks in soon, so buying a pullback in the gasoline/ULSD spread might be an appealing opportunity.

FYI: Until the spring of 2013, the ULSD was actually the heating oil contract. The only thing that changed is that the futures contract specs are now based on 15 PPM (sulfur content) rather than 2,000 PPM. This was done to comply with changes in the EPA rules that require lower sulfur content in distillate fuels. So don’t freak out about this being a new market. The ULSD is strongly correlated to heating oil so the historic price data should still serve as a good guideline for price boundaries.

Anytime the ULSD/crude oil ratio has hit 1.45:1 or higher, it has eventually petered out and then dropped back under 1.2:1. It appears to have peaked out months ago. However, there may still be plenty of downside ahead. Selling rallies in this spread could be the way to go.

The RBOB gasoline/ULSD (formerly heating oil) spread tends to be a good candidate on the long side once the ratio between these two markets drops to 0.85:1 or lower. The March 2016 ratio was already this low a couple of months ago. The spread is already in an uptrend and seasonal patterns will start to reinforce the rally this month. Take any pullback as an early gift from Santa!

Livestock

After the historic 2012 drought spurred a significant liquidation in the US cattle herd, the beef market turned into a raging bull as prices rocketed higher for a couple of years. Since then, price has been on the defensive.

The big run-up pushed livestock spreads and livestock/feed spreads to record highs as well. Although the spreads are now working their way lower, history suggests there’s still a long, long way to go on the downside. Spread traders should be watching for short sale opportunities.

Both the ratio and the spread between feeders and live cattle topped at record highs last year and have been on a south-bound train since then. It’s still quite a ways off until the median level is hit. This could be a spread worth shorting on the rallies.

Judging by the current live cattle/lean hog ratio, beef is way too expense. Or is the pork too cheap? Could be both. Historically, the live cattle/lean hog spread has been a short sale candidate whenever the ratio was above 2:1. It’s above there now. Look for a setup to get short.

Livestock & Feed

More than half of the production cost in the livestock business is feed. Corn is the most popular feed for the animals. Therefore, it only makes sense to trade the spread between livestock and feed costs.

The stampede to record highs in feeder cattle, combined with bumper corn crops, caused the spread between feeders and corn to reach record highs by the end of 2014. This created a huge profit margin and encouraged more beef production. Since then, the feeder/corn spread has been working its way lower. As you can see on the long-term chart, the current bear market is still at historically high levels. This could keep the downward trajectory intact. Selling rallies may continue to be what the smart traders are doing.

The feeder/corn ratio made a record-shattering high of nearly 7.5:1 last year. It has been working its way lower since, but the long-term charts show that a drop below 3:1 from here is still quite a reasonable expectation.

In comparison to the cows, it’s the pigs that are really getting slaughtered. It’s not quite there yet, but the current trend could push the value of a lean hog contract below the value of a corn contract. If that happens, it could quickly turn into a great buying opportunity. Keep this one on the back burner for now, but move it to the front burner when you can buy 40,000 lbs of hogs for less than the cost of 5,000 bushels of corn. The hog/corn spread may not sound very sexy, but it’s been a reliable money-maker for us in the past.

Grains

Somebody better call Dr. Phil because the relationship between the byproducts of a crushed soybean (meal and oil) is historically out of whack and the relationship between Kansas City and Chicago wheat is completely upside down. History suggests that there will be reconciliation, even without therapy.

The soy meal/bean oil spread appears to have formed an epic double top between the 1973 historic high and last year’s new record high. Previous excursions to the upper price boundaries have been followed by meal completely surrendering its entire premium over the meal. The spread still has several thousands of dollars of downside ahead of it if history is to repeat.

The Kansas City wheat/Chicago wheat spread pops up on our radar screen anytime the KC wheat trades at a discount to the CBOT wheat. The recent plunge to -40 cents (premium CBOT wheat) really has our attention since it’s at a low we’ve only seen three other times in the last forty-five years. This rubber band is really stretched. Being long for the snapback could be something worth getting positioned for.

Softs

The price difference between good coffee (Arabica) and the ‘cheap stuff’ (Robusta) continues to shrink. At a certain point, coffee roasters may take advantage of the narrowing price difference by adjusting their blends to use more of the Arabica coffee. Or maybe the consumers will figure out that Robusta is over-priced on a comparative basis and consume more of the Arabica drinks. Regardless of how it plays out, something will happen to reverse the narrowing price gap when it gets tight enough. This coffee spread is not too far away from where prior reversals have materialized. If the ratio between the value of one Arabica coffee contract and one Robusta coffee contract drops below 2.4:1 it will be time to start stalking the java spread.

In the Hunt

I was sitting in the trading room of a well-respected trader several years ago, and he had a sign on the wall that caught my attention. It read: A good hunter never chases. He waits. Boy, does that sure have everything to do with trading!

The spreads that we discussed are the big game right now. They offer some great potential profit opportunities. Continue to stalk them, but wait until you have an actual trade setup before pulling the trigger and entering a position. No cross-hairs, no shot. No setup, no trade. Be patient and wait for the clean shot, lest you waste your bullets and, more importantly, your capital.