From Basserdan on Zeev's thread, IHub :
Posted by: basserdan
In reply to: None Date:4/27/2008 12:54:37 PM
Post #of 589994
Don Coxe Conference Call for April 25, 2008
Click here for the audio version of the CC:
events.startcast.com
Don Coxe
Winnipeg, Alberta
“How Much Is Real, How Much Is Speculation?”
Thank you all for tuning in to the call, which comes to you from Winnipeg. My apologies for those of you who didn’t get the conference call notice for the fact that this is unusual hour. This completes for me two weeks on the road in connection with the offering of a new fund that has my name on it. So, we’re moving around location to location, I just finished speaking at a breakfast meeting here in Winnipeg, that is the reason for the adjustment of the time on the call.
So, the call subject is, we sent out the charts of corn and wheat and the title is “How Much Is Real, How Much Is Speculation?” And I’m going to address this in terms of the hearings in Washington this week about the breakdowns within the grain markets and with screams from Congressmen and from farm groups that speculators are ruining the markets and hurting farmers. And it’s in the context also of everywhere I’ve been on this tour, people have asked “Well, how big a factor in this commodities boom has speculation been?”
Now I’ve touched on this from time to time in the past but since this is a major theme going forward, I thought I should bring you up to date on what we know and what I think.
First of all, the hearings themselves in Washington. If you only read these quick press summaries about this, you’d think this was a crisis and the commodity futures markets were at bay, that is, the Chicago Board of Trade, which is two blocks from where I work. And that there were going to be massive new legislation to stop speculation in commodities.
Nothing like that when you actually read the texts of the speeches. There are real issues here. And it’s quite clear that a system which has been around for about a hundred and fifty years in Chicago, it was the center of world grain trading, is under strain and they’re going to have to adapt. But they’ve done that with other kinds of futures contracts over the years and it can be done.
There are several issues. First is that as you know, and you’ve heard it now for those of you who are faithful listeners at least a thousand times, the greatest investment opportunities come from an asset class where those who know it best love it least because they’ve been disappointed most. And we have, over the years, not stinted in our ridiculing of CEO’s of major mining and oil companies who sold forward in what they call hedging and blew billions of dollars of their stockholders equity in the process.
Well, the same process has been at work in agriculture. On the other hand, I;m not going to spend my time denouncing the farmers who did what seemed to be the logical thing, which was selling forward. And this has been done for years. In order to get money in the spring, when you have to buy fertilizer and seed and to pay rents on the farms, what you do is you lock in returns by selling forward a big percentage of your production. Or a small percentage, whatever you can afford. And you use the combination of the Chicago Board of Trade mechanisms and the Commodity Futures Trading Corporation’s rules and you get help from the local bank on meeting margins. And this is done to reduce risk. Then all you do is buy crop insurance to guard against the possibility of a crop failure which would mean you couldn’t deliver on to your contracts.
Look, this is why futures markets first developed and why they developed in Chicago. Which was farmers were assuming all these risks for themselves. And also to attract capital to farming from people who themselves would not want to have a hundred bushels of wheat dumped in their front yard.
So why is it gone wrong now? Well it’s gone wrong now because everybody was caught off side by the gigantic move in grains prices. Well, I’ll call that back. Listeners to this call and readers of Basic Points have known for more than a year that the crop carryovers were lower than the year before and we were going to have a big rally in grain prices. But, the farmers in particular, because farmers by nature are realists/pessimists. On the other hand, nobody would stay in farming if they weren’t residual optimists, but they’ve survived by being pessimistic and not taking excessive risks.
And so, what’s happened here is those farmers that were most involved in reducing their risks by selling forward were caught the most particularly by what happened in wheat, when it’s more than doubled. And we’ve had various grain elevators going bankrupt because they also were hedging. So along the supply chain, what we’ve had here is a situation that’s totally extraordinary.
See, when we’re talking about metals and oil, the fact that Phelps Dodge, you know, was underwater a billion and a half on its forward position, they were a financially strong corporation and although they were taken out at three times earnings by Freeport because of that, there was no doubt about their ability to deliver eventually on their copper hedges.
The difference here is that although you have a relatively small number of speculators with some size of capital that are moving in to these markets, on the other side you have hundreds of thousands of sellers. Because they are using the mechanisms to reduce their own risk or lock in spreads between their costs and their returns.
So therefore the grains markets are different in their essential dynamics from the oil and the metals markets. Because there is no such thing as, you know, a producer of corn or soybeans that’s so gigantic that it has a big market share and can help set the price on that. It doesn’t happen.
Therefore what we have on the one hand is all these hundreds of thousands or maybe even millions of people who one way or another are tied in to the Chicago Board of Trade on the sell side. Then what we have is, on the consuming side, oddly enough, it’s smaller. What you have is the bakeries and other users who use the markets for hedging. And then you have the speculators.
Now, one of the times that all of you who listen to this call should put your hands on your wallet to protect it, is when you hear Wall Street piously protesting against the evils of speculation. And when you have Congressmen doing it, what you know is that their constituencies have been caught off side in this. After all, I didn’t see massive demonstrations in Washington by the National Farmers Union, protesting against $6 corn and $10 wheat. No, no, no, no.
No. What they are protesting about is that, first of all, the sheer scale of the rises has meant that farmers who are well capitalized ordinarily are caught off side and it may mean that another amendment is required to the Farm Bill, only one that might actually have moral defensibility, which is to supply more capital to help them meet margin contracts.
But the big thing that they are complaining about, and this shows you why the model is broken, is that we are getting contracts expiring and the price of the contract is much higher than the actual cash price that the farmer gets if he delivers his corn, barley or oats to the local elevators.
Now, this is really serious because the reason why the Chicago Board of Trade became the leader in this was because of their ability to tie in transportation systems, grain elevators and everything, so that the expirees of contracts meant that cash was cash. You got just about that price, less a small discount if you were a long way away from being able to get a barge on the Mississippi.
So what we have here, then, is something like parallel universes. You don’t want to have that in the futures markets. So they are looking into it. And what there was, was testimony showing that one of the things really was that the transportation systems in particular proved to be inadequate.
So, I would call these mechanical operational difficulties, but what they don’t do is challenge the basic thesis, which is that what you’re seeing in the price of the grains…is real.
Now, the argument is “Ah, but these speculators have driven it up.” Well, if you look at all the statistics about who’s actually on the buy side and taking deliveries on to this, what you see is, yes, there are some big pension funds who’ve increased their exposure to commodities and they do it the way the futures fund that we created last year for Canadian retail investors works, which is roll the maturing contracts into the next month contract.
What that does though on a net basis is supplies capital to that particular commodity asset class. Okay? And because of the fact that it’s rolling each month, what it is not doing is creating distortions in the nature of the futures curve. So the futures curve is still driven by supply and demand, it’s just that there’s, you know, a few zeroes extra on the value of the supply and the demand.
Where you get massive speculation is what we saw in the 70’s. And that is when you move curves into contango, which means huge amounts of capital are being moved out to take a bet on inflation farther out the curve. And that has nothing to do…those people have no intention of ever taking delivery of what’s involved. This has not happened except with a couple of grains, we do have contangos, small contangos. But even there, this is not necessarily evidence of massive speculation. To some extent, it’s short covering. Or hedging by consumers, who are worried that prices could go even worse and they can buy options on futures, to hedge against that. And then the market makers on the Board of Trade will, when you get those option contracts sold, bid up the price of the futures contract for that month.
Now I don’t want this all to sound technical and everything, but it’s really important for all of you. Because, as I say, the intensity of the questioning that I’ve been getting on this, I really believe that if you haven’t really studied these markets carefully, do not rely on these press reports of speculators and hedge funds that are destroying the markets and creating the potential for a crash. That’s balderdash.
What’s really happening here is Economics 101. When you’ve had, in the case of wheat, as Bill Doyle pointed out yesterday, in six of the last eight years, world wheat production was less than demand.
Well it shouldn’t take any genius to say that if you’re continually producing less than is being consumed, then either what you need is a miracle, or what you need is the price mechanism will adjust upwards. And that’s what’s been happening.
As a matter of fact, I would argue the exact reverse. I would argue that what we’re seeing in these commodities is that the skepticism has been overwhelming, partly because of the Triple Waterfall Crash, so therefore those who refuse to believe that there could be commodity rallies like this, the defense that they’re using is “Oh, it’s all shadowy speculators, hedge funds, market manipulators.” And this is proved by what’s happened in oil where the best known forecaster of all, Daniel Yergin, who won the Pulitzer Prize for the book “The Prize” has maintained year in, year out that oil will not go past $35 and if it goes past $35, it’s all speculators.
It is astounding to me that people still believe this claptrap, but it’s because he has such a big reputation and because he’s on the payroll of the major oil companies that he’s taken seriously. But he’s been wrong! Seriously wrong! I mean, this has to be an amazing thing that we’ve got an $80 differential in price between what he says it’s worth and what the market says it’s worth. And that’s done in a contract which is in backwardation, which means that apparently the way it’s been achieved is that billions upon billions of barrels of oil are being put into underground caverns or in tankers floating at sea to drive up the spot price by speculators.
Well, that’s just not happening.
So, overall, I believe that you’ve got to assume that in the commodities markets, that yes, you’re going to have speculation. That’s good! The next time you hear somebody from Wall Street who's never been a bull on commodities dismissing this as going on as just speculation by hedge funds and by long buying of pension funds say, "Well, now about speculation you're against that?"
"Well," furrowing of the brow.
"The margin debt on stocks in the United States is I don't know how many hundreds of billions of dollars. Would you agree that somebody who buys stocks on margins is a speculator?"
"Uh…yes, I guess I would."
"So let us suppose that as a result of your moral principles being applied to the stock market here that we force all stockholders to stop being speculators that they must pay full cash. What do you suppose that would do to the stock market? And would that be a good thing?"
So, in other words, the people who are giving you this kind of pious protestation are frauds. So ignore them.
Now, with that out of the way what we're looking at here in the markets is that those of you who have been doing short term trading based on my advice have been losing heavily, because the bank stocks have been going up and we've got gold and some other commodities going down.
So, once again I have to tell you that, and I certainly hear this on this road trip, is people saying, "Well it looks like the bank stocks have bottomed." And I just don't believe that. Because, I guess I was partly influenced by my conversations with Nasim Taleb a couple of weeks ago in California, but also by frankly talking to enough people who are actually involved in credit derivatives recently - real experts - and we are really in a situation where the level of unknowability about the real situation of the financial system has not improved. And the fact that the stocks are behaving this well is amazing, because each time that we get massive write downs by the big banks what we actually get then is a bounce in the stock market, because it is therefore proclaimed that all the bad news is out. So you buy on the bad news.
Well, if you had a relative in the intensive care unit and from time to time the doctor would say, "Well, she's doing better." Then he would say, "Oh, she's having another crisis. Well, she's come out of it," and you say, "Great! She's come out of it then she's ready to leave hospital." No, no, no, no. You can't assume that.
By my informal count, the rally we're seeing now is about the ninth since this crisis really became labeled a crisis, where we had a good rally because people said all the bad news is out. And I could be wrong on this. I would love to be wrong on this. Because I don't take great delight out of the misery that this financial crisis inflicts on real people and the fact that those people who caused the crisis are escaping the misery. No, this is an asymmetric crisis and therefore it's not a question of the winners offsetting the losers and that sort of thing.
No I would like it to be over. But I really believe that investing in the stock market is about investing intelligently where you can assemble data to make an assumption. And you invest on the basis of that evidence. And what makes the capital markets great is now the degree of information that stockholders get compared to what they got in earlier cycles.
The irony is that the great financial stocks now are more opaque and give you less real information about their position then occurred in the days when these were semi-private institutions dominated by gigantic capitalists such as JP Morgan who would have disdained to give information out. So that although they file their 10ks and all of these, what you really want to know is what this stuff is worth. And I cite again as I did last week that wonderful interview with Warren Buffett in Fortune, where he pointed out that to analyze just one collateralized debt obligation involving subprime mortgages involved 700,000 calculations.
Well, what we have here is the equivalent of somebody in the medieval period who could be put to death for failing to give the right answer to the question how many angels can dance on the head of a pin? Because that's what you do if you're betting your fortune now on the idea that the latest figures for what all this stuff is worth turn out to be valid or invalid.
So, as long as we have such opacity and mendacity coming from the street that I believe the risks go on. And those of you who want to argue with me notice that what we're still seeing despite unprecedented levels of short term lending by the Bank of England, the ECB and by the Fed, that we still have a premium being paid for interbank loans over what the target rate is. Which means that when it comes to a question of the banks lending to each other, they show much more skepticism about the ability of the banks to repay that loan then they do when they're making announcements through their research departments about how you should buy their stock.
So it's not over. And the great advantage, I believe, in the kinds of stocks we've been recommending is: you know the details. You assume commodity price risk but you know what the drivers are of that. You know that the drivers are the economy of the Third Word led by China and India. You know it's production versus consumption. You know about political risks. All of these things allow you to make a decision in which you can still have a big price swing.
Gosh knows, look we took oil from $52 to $119 and did that in thirteen months. So we're not talking about something where you can sit down and say, "Well, I know exactly what these things are going to be worth twelve months from now," because there are risks, but what they are is you can write down on one side of a sheet of paper all the kinds of risk you're exposed to with these stocks. And then you can look about how much lying or distortion there is in the information you've got. And since our mantra is you invest on the basis of unhedged reserves in the ground in politically secure areas of the world, those figures are readily available. They don't change much.
The only thing that does happen is, of course, if you've got what was considered formerly a political secure area of the world like Ecuador which suddenly is taken over by a Marxist fanatic. And then you see from the gold mines there that it's a pure disaster. But, as far as assigning political security, what you always do is assign a risk factor in any country which you have an election campaign in which there's two contenders, one of whom would loot them.
I mean this is equivalent of the Lady and the Tiger story, okay? If you’ve got a situation of two doors and one of which is a lady who’s going to marry you and behind the other is a tiger, it's not the kind of game you want to get into unless you are, you know, compensated for that risk.
So therefore the Peruvian election where the good guy won or the Ecuadorian election where the good guy lost, illustrate that there was political risk there that you should have been allowing for anyway. But seeing what happened to some of the stocks this week as a result - and this fellow only did what he had promised to do in the election campaign. It's a sad state of affairs when you've got mining company executives beating their breasts and complaining because the president of the country did what he promised to do.
So wrapping this up, I've had the experience on this tour, of course, of getting to meet a whole new sets of friends which is stockbrokers from other firms than Nesbitt Burns. Because this offering of what they call the Coxe Commodity Strategy Fund is being syndicated here in Canada.
Now I am instructed under pain of death and torture from the lawyers not to recommend the fund but I'm just telling you those of you particularly in the United States and Europe who hear the call and don't know about it that that's what I've been doing. And I'm also telling those of you who haven't had your e-mails answered for weeks that we had a pretty heavy workload, Angela and I, before this happened, but then adding on the tour to talk to representatives about the fund has meant that yes, we are somewhat overstressed.
So, anyway this offering expires in a few weeks and then life will get back to normal. But frankly I've benefitted from it in another way which is the level of questioning I got about issues out there that investors face. Because, frankly, most of my meeting times are with sophisticated institutional managers and the range of questioning tends to be much more narrow.
So it brought home to me that those that I talk to who are really smooth and sophisticated and knowledgeable, they have to answer to their own clients. And I think these are the kind of questions that they get. So I hope this is helpful.
That's it. Any questions?
Question 1 (Bill Chamberlain): Hi, Don. It's Wayne. So, in terms of the fertilizer story making the front page of the papers and sort of raising awareness globally even though you've had prices up for a few years, are you seeing any sort of supply response in terms of greater farming globally?
DC: Thank you. Well there's no question that what's happening is we're starting to draw in land from set asides. That's already happening in the US and will probably happen in Europe. As somebody who grew up as a member of Ducks Unlimited I'm not happy about this because I don't regard a lot of those set aside lands as just a boondoggle. It's paid to farmers and across the Midwest of the US this is the…those properties are basically the main reproductive grounds and nesting grounds for waterfowl. And like I said, we're going to be losing them because of $6.00 corn.
Similarly in Europe, there are sites that are used as natural habitats for wildlife and I guess it's sorry that we're going to have to squeeze them out. But we can't add many hectares to the world's capacity, because they're not going to destroy all the rain forests in Brazil. And most of the land that would be available if they could add in theory has serious problems of irrigation or it's being swallowed up by urbanization or industrialization.
The odd thing is that whereas my thesis is you invest in unhedged reserves in the ground, this time in agriculture where we need so much more food now - because of the emerging middle class in the Third World - what we need now is unhedged land. In other words, land that can be used for agriculture and then use better technology and better farming methods to get high yields from it.
So we have a shortage now…of everything. Now when you talk about the fertilizer price run up clearly that wouldn't happen if we had lots of excess fertilizer on hand. Okay? And so, there's screams about what's happening there because there's not that many people in the market and the fertilizer market is some what oligopolistic. But the fact remains that the Bill Doyle’s of this world know that the price that they're charging for their fertilizer is recoverable for a farmer of any reasonable skills and capital, in terms of what they get for their output.
So, I believe that this is going to attract more capital to production of farm inputs. We need that badly. And I was delighted to see how well the Intrepid Potash offering did, because again people say it must be the top of the market when you get something frenzied like this. Oh, dear, no. No.
This is still an undercapitalized industry and it's the industry that the world needs most. And, you know, if you compare its capital to industries that we can get along without, what you see is this is not price distortion. This is not mania. This is not frenzy. This is not a phony trend.
So, I think that we're going to have ups and downs on these things because there are still so few real believers and we still have people from Wall Street talking about all the things that are wrong with this and that you can't believe these prices and these are people who couldn't tell a heifer from a steer.
So, until the level of knowledge of the critics rises, I think what you can predict is the stock prices in the agricultural sector will most of the times continue to rise.
Thank you. Next question.
There are no further questions registered.
DC: Thank you all for tuning in. We'll talk to you next week.
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Dan
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