Deconstruction of a Speculative Attack on the Chicago Mercantile Exchange Class III Futures Contract

Dr. Cameron Thraen, Milk Marketing Specialist, The Ohio State University, Additional milk marketing information by Dr. Thraen

After being out on the road Friday, January 6, I returned to the office on Monday, January 9 and in reading my email news letters, I found these two very interesting discussions. The first was provided by a very knowledgeable colleague and professional in the dairy markets, Mr. Phil Plourd, Vice President Economics, Blimling & Associates. In his January 6 newsletter, Mr. Plourd writes (italics mine):

"When making a shopping list for commodities to buy early in the New Year, at least one speculative fund apparently decided not to skip the dairy aisle. Not long into Tuesday's first-day-of-2006 action, reports from the Chicago Mercantile Exchange (CME) floor indicated that a broker representing a large commission house was eagerly buying February Class III milk contracts.

It didn't make any difference in the cheese market. Blocks closed the week at $1.3675/lb and barrels at $1.3400/LB - both unchanged. And, no loads of either product changed hands. The buying spree did, however, create more than a little excitement. All morning on Tuesday, prices ratcheted higher, exhausting sell-side interest in the process. A one-two-three closed cheese market session did little to slow things down, as nervous locals stopped selling futures and started buying. By noon, February had traded at as high as $13.20/cwt, up $0.29/cwt on the day. Other months moved higher as well. When the day was done, February had closed at $13.17/cwt, with volume in that month alone at 596 contracts.

Wednesday saw some follow through from the same buyer. Nervous commercial buyers also seemed to join in the fray, with the market bid higher from the opening bell. On-floor speculators were buyers, as well. The cheese market featured a bid at unchanged for blocks, making some market participants all the more edgy. On Thursday morning, however, speculative buying interest did not materialize early. While an unfilled bid for three cars in the cheese market raised some questions (Is someone short? Where is the sell-side interest?), the rally began to fizzle. Outside selling was gathering above the market and commercial buying was a bit more cautious. Locals began to sell strips of contracts in an effort to quietly lighten their load. By the close, prices were down on the day across the board. For example, after making a new life-of-contract high in the morning at $13.29/cwt, February settled at $13.13/cwt, down $0.12/cwt on the day.

Opening bell buying by floor traders on Friday morning was beat into a quick retreat by broader outside selling and an absence of commercial buying interest. Values eroded further when no bids were posted in the spot cheese session."

After reading this paragraph a couple of times to let it sink in, I began to ask myself the following questions: What is a 'speculative fund'? and Why does it have an interest in buying in the dairy futures market?; who are commercial buyers and why would they wish to tag along with the speculative fund?; ditto for on-floor speculators and floor traders (see Figure 1 for the Class III price over its contract life.

Figure 1. February 2006 Class III Futures Prices.

So, what is a Speculative or Hedge fund?

A hedge fund is a private investment limited partnership that invests in a variety of securities. Hedge funds are pooled investments; all the partner's capital amounts are pooled together for the purpose of trading in securities. All hedge funds follow some sort of trading strategy and are pretty much free to use any financial instrument they wish. Hedge funds are similar to mutual funds in that they both are pooled investment vehicles that accept investors' money and generally invest it on a collective basis. Hedge funds differ significantly from mutual funds, however, because hedge funds are not required to register under the federal securities laws. They are not required to register because they generally only accept financially sophisticated investors and do not publicly offer their securities. In addition, some, but not all, types of hedge funds are limited to no more than 100 investors.

Why would such a fund or pool of investment dollars be interested in the February CME Class III futures contract?

First of all, note that this is speculative investment money, and second, it is in the market to make a profit. Hedge funds are buying contracts; therefore, they must be of the opinion that the price tomorrow will be higher that the price paid today. As Mr. Plourd points out, this interest and buying behavior received no support from the direction of the CME cheese market. In fact, everything looks like it is slowly sliding in the opposite direction. Last year, at this time, the February contract was trading at $11.50/cwt and finally cashed settled $ 0.39 higher at $11.89/cwt. On a 2,000 cwt contract, this is a gross gain of $780. If repeated this year, this is not a bad return for a marginal investment. Just figure, for each 100 contracts, this is a gross gain of $78,000. Ok in my book. The March contract could be purchased at $11.50/cwt and settled out at $14.49/cwt, with the April at $11.65/cwt and May at $11.65/cwt. The March contract earned a gross $5,980. April's settle was $19.61/cwt, a gross gain of $15,920 per contract and May's $20.58/cwt for a gross gain of $17,860. On a 100 contract batch, this 'strip' of February through May would have earned $3,515,800. Now you can see why the speculative or hedge fund managers are paying attention to the dairy markets.

So are others. As Mr. Plourd points out, commercial (non-speculators) and local on-floor speculators, guessing that the hedge fund might know something that they had missed, began to buy also. The rally continued through early trading on Thursday. But, without confirming support, that is, without the cash cheese market making a supporting move upward, those same buyers rethought there earlier buying enthusiasm and began to SELL 'strips of contracts' (this is a basket of contracts with different cash settle dates). By not selling just the February contract, which they may have purchased near the peak of the price rally, this 'strip selling' is designed to mask ones panic from the market as one tries to get out of what now appears to be an unsupportable position.

Is this interest by speculative hedge funds a good or bad development?

This is a question that I am asked repeatedly. I think folks at Valley Trading in their January 6 market commentary do a good job of addressing this question. Read below the commentary on this same hedge fund activity as presented by the fine folks at Valley Trading. They wrote, in their market news letter covering the week ending January 6, 2006, the following (italics added):

General Market Comment:
"When discussing/trading the commodity markets, and specifically the dairy markets, it seems that words like "surprising," "amazed," and "unexpected" are used quite a bit. You would think that when trading commodity futures contracts, we all would expect the unexpected.

With that said, most were surprised by a sudden rally in the milk futures markets, especially since cheese prices held unchanged all week. No one seems to know for sure what happened, but it appears that a hedge fund came into the milk market as a buyer. As a result, the "locals" reacted and became buyers as well. In the end, without a supportive rally in the cheese markets, the milk market gave back some the early week gains.

Currently, hedge funds and index funds are active in the commodity markets and recently have been in a buying frenzy. Over the years, these funds have grown tremendously and are becoming a major player in the markets. At times, they create price distortions in a market, which has added an extra variable to commodity pricing.

As a final perspective, commodity markets are not as flexible when absorbing investment money as the stock market. Case in point, currently the total value of all Google Inc.'s stock in the marketplace is worth ~$135 billion. This is only one company of the thousands listed in the New York Stock Exchange alone. To put this into context, you would "only" need ~$25 billion to be able to purchase the entire 2005 U.S. corn crop!

With many billions of dollars flowing to these funds each year, they keep looking for markets to trade. Possibly this week, a fund "found" the milk market and decided that it was too cheap. This type of action might become commonplace in the future. As long as these funds remain buyers, it could be a welcome development for dairy producers by possibly creating great selling opportunities, just like this week has been."

If, after reading the commentary by Mr. Plourd, and my exposition on this hedge fund activity, you are ready to decry the nasty speculator, keep the Valley Trading comment in mind. Hedging requires two sides to the short-sell transaction. Price risk must be transferred to someone, and this requires the speculator, interested in earning a profit, to be willing to BUY the short-sold CME Class III contract, just as it happened last week for the February contract. Last week, the savvy hedger could have locked-in or put a floor under the Class III price above the $13.00/cwt mark. This is substantially above the upper 25% price of $12.56/cwt for February Class III milk. So, keep in mind that without speculative interest and willingness to buy, there would be no opportunity to sell at this higher price and no opportunity to lock in a price or floor a price $1.50 to 2.00/cwt over the long term median price.

Next time, I will look at what we know about the habits and motivations of small scale speculators. This is a very fascinating topic.

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