22-Sep-2022 by Luis A Rangel LRangel@DinoGroup.eu
Despite the constant hype around food and fuel inflation in the news media, commodity prices have been falling from their late Q2 highs, suffering a combination of soft demand and a drain of liquidity from futures markets.
The drop in consumer demand has had a big negative impact on prices for crude oil, refined crude products, grains and metals, with much of the softening likely being driven by the squeeze on purchasing power or the decline in real wages.
Just as concerning is the steady decline of futures contracts for the Top 28 Traded Commodity Futures in North America where the total amount of open contracts has been trending lower for over 4 years, with that decline accelerating since Q1 of this year. This drain on liquidity is now a major headwind for the commodity bulls.
Looking at the graph below we can see the contraction of the aggregate open contracts for the Top 28 Commodities falling to a 7-year low in recent weeks. This contraction is happening across all categories tracked by the CFTC, including end users, producer-merchants, bank traders and managed money traders. Without any fresh injections of liquidity, sustained rallies in the commodity sector will be near impossible.
THE DRAIN ON LIQUIDITY
Regarding the drain of liquidity from the Top 28 Commodity futures markets, here are some key observations:
1) Aggregate Futures Open Interest peaked at 14.147 mln contracts on the week of 29-May-2018.
2) On 30-Aug-2022, the Aggregate Open Interest fell to a 7.5 year low at 9.422 million futures contracts, a decline of 32% from the peak.
3) Since the peak Aggregate Open Interest was recorded in 2018, the open interest for 27 of the 28 commodities in this survey has declined by an average of 30%, with the one exception being the CME’s Class III Milk futures contract. This suggests that the huge decline in trading interest is not specific to any single market fundamentals but is rather a macro-economic driven phenomenon.
4) Fewer Traders. The number of unique trading entities across all categories as reported by the CFTC also declined by 18% from the 2018 peak.
TOTAL MARKET VALUE
Naturally, the drain on liquidity from the markets is also suppressing the Total Market Value of the aggregated open interest for these 28 commodities. See the table below:
The Total Market Value of the Top 28 commodities peaked at $898.52 Billion USD on 01-Mar-2022, the week following the invasion of Ukraine by Russia. Even though the major commodity indices continued to rise to an 8-year high on the week of 07-Jun-2022, the steep decline of the aggregate open interest fell fast enough to pull the total market value down by $21 Billion USD to $877.64 Billion USD.
Between 07-Jun-2022 to the present, we have seen weaker demand pull the major commodity indices down by 11.3% while open interest declined by another 10.9%, causing an additional loss in market value of another $221.2 Billion USD. All told, despite the massive spike in value in Q1 of this year, the Total Market Value of these commodity markets is little changed from the 2021-year-end value of $634.70 Billion USD.
ADDITIONAL HEADWINDS FOR COMMODITIES
All told, the persistent drain on liquidity from the major commodity markets will continue to weigh on prices in the short term to medium term. In addition to the lack of inflows, new capital and new entrants, the commodity markets are also facing additional headwinds from the following:
1) A surging US Dollar, making these key commodities more expensive for non-USD denominated buyers
2) The decline of emerging market currencies which will incentivize exporters to sell more commodities for hard currency
3) The expectation of additional and more aggressive rate hikes by the US Federal Reserve and other central banks, increasing borrowing and carrying costs for buyers
4) The surge of the US 10-Year Treasury Note yield to a new 12-year high, further reinforcing the challenge on financing costs but also potentially attracting investment away from commodities and into higher yielding treasuries
5) Fear of an economic slowdown or recession, giving buyers and consumer pause when seeking to take additional long cover
6) Massive losses suffered by commodity traders in the LME Base Metals markets in Q1 (not included in this study). Following the invasion of Ukraine we saw extreme Q1 price gains of 57% for Nickel, 27% gains for Aluminum, and a 19% gain for Zinc. Since the end of Q1, however, those spectacular price gains have not only been fully erased, but the open interest for all these base metals has plummeted to new multi-year lows, and in the case of Aluminum, falling to a new 15-year low in July.
One key point. It is simply not enough for long investments to come into the commodity markets in order to sustain price gains. We also need a substantial increase in the number of producer-merchant hedgers whose short positions provide the “funding” needed to reward the longs in a rising market. Because the futures markets are a “zero-sum” game, rallies cannot be sustained without them.
SUMMARY
Commodity asset class prices will likely continue to deflate as long as the macro-economic headwinds persist and as long as the liquidity from both long and short traders continues to evade the markets.
Commodity Markets included in the above study.
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