Strategic Market Analysis Reduces Risk
Best to focus on what type of market exists, not where the market is going
—By Darin Newsom, DTN Senior Analyst
DTN has developed a new way of analyzing commodity markets, a methodology called DTN Six Factors™. By focusing the analysis on six simple factors, much of the noise and fluff present in the marketplace can be done away with. This methodology provides a clear and concise system to answer the most important question facing risk managers: What type of market exists? This is far different from the standard question: Where is the market going? That is a question without an answer because nobody knows. The Six Factors lead to a more logical conclusion as to what type of market exists, and therefore, what type of risk management strategy should be employed.
DTN's Six Factors are trend, noncommercial (speculative) trader activity, the commercial traders' take on underlying fundamentals as indicated by futures spreads, the seasonal cycle of the commodity, the historic price range of the commodity, and the volatility of the market.
A brief explanation of DTN's Six Factors:
1) Trend: The trend is the price direction in the market and reflects the consensus of opinion of all market participants regarding market price over time.
2) Noncommercial activity: Noncommercial traders have a large influence on the direction of the market as they make or lose money on the up and down swings of the market. Monitoring their positions in the market gives an indication of whether they are bearish or bullish.
3) Commercial outlook: The commercial outlook toward the underlying fundamentals is shown via their positions in the markets as evidenced by price spreads between futures contracts. These spreads allow for a behind-the-scenes look at what the real supply and demand situation is in the market, as opposed to the more commonly used government reports.
4) Seasonal Cycles: Commodities move in cycles over the course of a marketing or calendar year, reflecting normal changes in supply and demand.
5) Historic Price Range: The historic price range of commodities, particularly in energies, has been skewed over the past year due to longer-term changes in demand.
6) Volatility: The volatility of the market indicates many different things, including how wide of price ranges can be expected and what type of trade activity is occurring.
The crude oil market of 2006 is a good example of how this methodology can be applied. To begin with, the market has been in an uptrend since March 1999. Noncommercial traders have adjusted their net-position back and forth, but in early January 2006 held a net-short futures position of about 15,000 contracts. In July as futures were setting historic highs these same traders now held a net-long position of over 60,000 contracts.
However, the interesting truth behind the market lies in the futures spreads. Most analysts are quick to jump on the "tight supply, strong demand" bandwagon and ignore what the market has been saying during the course of the rally. The market itself through a wide contango (deferred contracts hold a large premium to nearby) is indicating that the underlying supply and demand situation is in fact bearish. There is adequate crude oil supply to meet demand and events such as the recent Alaskan pipeline shutdown did nothing to change that.
Therefore, using just these three factors, a conclusion can be drawn about what type of market exists. The uptrend has been driven by noncommercial (speculative, investment) traders who are buying on the idea of possible supply shortages or using crude oil futures as a geopolitical hedge. Since the underlying fundamentals do not support the market, crude oil remains vulnerable to large selloffs if these traders decide to liquidate a portion of this position. This last aspect is confirmed by the high implied volatility of the market, a factor that also indicates speculators are active in the market.
That's the methodology in a nutshell. We are simply reading what is evident in the market and drawing a logical conclusion. As you can see, it eliminates so much of the other noise and paints a clear and concise picture of the market situation.
For more information on how you can access DTN MarketWire® market news and analysis, please call 800-391-1175.
Meet Darin Newsom, Senior Analyst DTN
Darin Newsom has more than 15 years of experience analyzing commodity markets and developing risk management strategies. In his position at DTN, he provides DTN customers with market insight, analysis and advice on an hourly, daily and weekly basis.
Newsom provides analytical insight and commentary on the various markets, explaining how the structure of the market -- both technical and fundamental -- and the price relationship between contracts indicates what type of market exists and therefore what strategies are appropriate.
Prior to joining DTN, Newsom was a producer risk management consultant for FCStone. Previously, he was a grain merchandiser at the Great Bend, Kansas, Cooperative.
Newsom's market openings and closings, commentaries and news analyses have been heard on radio stations for many years. He also regularly appears on the Iowa Public Television Program "Market to Market". He wrote a monthly column in the regional publication “Central Kansas Farmer” and taught courses on agricultural marketing at Barton County Community College. He began his career at the local cooperative in his hometown of Lewis, Kansas.| DTN: 9110 West Dodge Road Omaha, NE 68114 www.dtn.com |
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