How to Profit from the Coming Commodity Supercycle ft. Hari Krishnan

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0:58Welcome to Real Vision. I'm Ash Bennington. Harry, my old friend, welcome back. It's a pleasure. Thank you, Ash. It's always a pleasure to have you here. I really enjoy these conversations and I'm really excited. I know you have a new idea to discuss with us, something I've been looking forward to talking about on this show for some time now. But Harry, I guess we should give full disclosure. You and I have known each other for some time. We're friends and we've written a book together. All of the above. Yes. We are friends. We've known each other for a long time. And you were kind enough to help me write Market Tremors.

1:33so yes well you were you were kind enough to uh let me piggyback uh on the process for your idea that you come up with uh because you really are one of the most original inventive thinkers uh you really do think about things from first causes one of the reasons why i always enjoy having you on this show uh to talk about your ideas harry let's set this one up by the way i should say also full disclosure you and i have talked about this i've seen the slide deck but we haven't rehearsed this which is always fun because we get to discover this together. The audience gets to discover the idea along with me.

2:05Big picture, Harry, frame it up for us. What's the new idea? Well, I'd call it virtual commodity warehousing, which means if you believe that commodities are in the beginning phases of a super cycle and yet you don't have access to the physical, you don't have all the logistics that the major companies have in the grain space and the energy space in metals and so on how can you gain exposure using listed futures and options in such a way that you don't pay prohibitive carry costs and it's what there are a bunch of stylized facts and i'll rattle off a few let me jump in there real quick just because that's a lot for people to digest just to get a sense picture uh the point that you made uh you just made there is such an important one this idea of without incurring excessive carry costs that really is the trick and the magic behind most of what you do is not just finding a way to express the idea but expressing the idea in a way that isn't overwhelming in terms of cost so that you don't lose bleed the the potential gains that you have on the trade in the future yep that's correct So if I were a farmer and I grew corn, I'm going to make up some numbers here.

3:25It might cost me 30 to 40 cents per bushel to store the corn in the farm. And it might cost me about 10 cents to take it to the local elevator via a truck. That includes fuel, labor costs, and so on. However, if corn is at$3 on average historically, let's say since the 80s, it would cost me about one dollar to buy and roll the front month five times a year and so my break even if i wanted to buy corn when it's cheap let's say three dollars a bushel is four dollars or over 30 above the price so even though it seems attractive given that many commodities especially in the agricultural markets are cheap now uh it's it can be very expensive to express a long-term view by buying and rolling futures.

4:18And that's the problem that I've tried to solve. Yeah, very well said. And by the way, implication is that it's actually cheaper to store the physical corn than to pay the financial carry. Yes, absolutely. And you know, farmers have a real option. They can keep the corn in the bin or they can sell it on and they have advisors and they have their own experience, which leads them to try and take profits along the way. So as prices go up, they can either sell their inventory or go into the futures markets and sell forward in order to convert their more speculative position in physical to a more carry based.

4:57Well, that's financial innovation for you. It costs you more to store cord on paper than it does in reality, to actually physically take it to an elevator. Can do, yeah. Yeah. Let me ask you one more question before we unpack the thesis, because when you started that, when you made your thesis statement, you began with the word if you said, if you believe that commodities are at the beginning of a super cycle. Is that, in fact, a belief that you do have yourself? I do, but I never have been in the business of bringing out a crystal ball and saying X is going to happen in the next month or even in the next year because there are plenty of people who do that for a living.

5:38And my job is more to say, if you believe something and you want to express it as efficiently as possible, maybe I have a solution for you. Now, there are a lot of good reasons to be bullish. I wouldn't say bullish in the short term, but in the longer term. And I'll give you both arguments. The long-term argument has to do with geopolitics, for one thing, deglobalization, an increased emphasis on food security, energy security, the potential dangers of remilitarization globally, which require lots of metals and energies. the green revolution which requires rewiring large swathes of the electric grid which takes a lot of copper and so on electric cars again which require a lot of copper all sorts of things that require the sorts of things that really exist in the physical world not shares not derivatives but real physical things and with all the demographic changes with people rising to the middle class in Asia, notably China and India, their food habits are changing.

6:46So that is putting pressure on many commodities that have been depressed for quite some time. We could throw in the large amounts of liquidity that have flooded the global financial system that often find themselves in resulting in inflationary forces. Now that may have been suppressed for a long time, but since 2022, things have changed a bit. And that money, which does lead to headline inflation, often trickles back into the commodities markets. And I can go into that too, if you like. So the back of the envelope, lots of reasons to be bullish here, though you don't take a formal position on that yourself.

7:29But the important point, the takeaway for our listeners and our viewers to understand is that if you are bullish, you've constructed this solution as a novel mechanism to express that view in markets. Yeah, all true. And I never thought I'd come on sounding like Warren Buffett, but I will. Because in commodities, I've found that the biggest margin of safety is when you buy something cheap. So if I buy corn at$3 a bushel instead of$6, I would argue that my margin of safety is far greater. And that's true statistically, as well as from a common sense approach. So statistically, it's true because if you look at the skewness, or the tendency for big surprises, most of the surprises are to the upside when something is cheap.

8:18Whether it's oats, corn, natural gas, you can go down the list. Whereas when the price rises, as we saw notably in the cocoa markets recently, the risk becomes more two-sided. You have big up moves and big down moves. So if cocoa is trading at a 10-year historical low or close to that, all the risk is to the upside, or most of it. Whereas if cocoa is rallied 200%, 300%, 400%, now if you get into the market, you're facing a lot of downside risk as well as upside. So my view is that if you want to get into the commodity markets, especially certain markets now which are depressed, the risk-reward is hugely in your favor if and only if you can manage the carry costs.

9:06Well, that makes perfect sense. I hope so. I mean, my goal in this is not to necessarily ride stuff that is already expensive to the moon, although I'm not looking to take profits quickly. it's more to get in early where the risk is in my favor or in the client's favor and to uh just manage the control the timing risk in the position so that even if we're a bit early the client won't bleed too much along the way and there are various ways to do that and i can explain the high level picture and how that's been extended in the past uh few months as well in some new research but The high-level picture is that people who really engage in commodities, forget about speculators for a moment, need to hedge on both sides.

9:55And I'll start with oil. Oil is the easiest case study. Producers are worried about declining prices. End users are worried about sharply rising prices. so producers tend to sell futures or otc contracts on the way up because they're in the business of controlling their revenues rather than trying to make lottery ticket type payouts on production so really what they want to do is sell futures on the way up or sell equivalent swap or forward contracts to control the volatility of their revenue streams end users notably airlines are not in the same position. They're not worried about a$1 rise in the price of crude, namely because they're not buying crude, but because their business involves other factors as well.

10:49What they're worried about is a very sharp increase. And if you look at the airline's industry, it's typically, or in recent history, has been in bad financial shape. So what does that mean? Airlines are unlikely to take high directional risk when they hedge against upside moves. So they're usually advised to buy things like call options, out-of-the-money call options. Those are insurance contracts that pay out if the price goes up a lot or if the price becomes significantly more volatile. Now, what does that mean? It means that there's an asymmetry. There's a force that producers are exerting on price that pushes it down most of the time by taking profits on the way up.

11:34And there's an asymmetry in the sense that the end user is more likely to be a buyer of insurance rather than a seller, which raises the cost of out-of-the-money insurance probably beyond fair value. So the trick in this game of managing carry is to maintain a long position, sell those expensive out-of-the-money options, and then buy other options around it that still maintain a long payout profile while paying for the costs of carrying the position in the futures. Now, in oil, you're actually in the lovely position where the forward curve is in backwardation. 2025 oil is cheaper than spot WTI.

12:212026 oil is cheaper still. So you actually get paid to hold such a position. But my main point was that there's an asymmetry in the way users of a commodity behave and manage their financial risk and producers behave producers have one to one exposure to the markets they're involved in uh and users give you another example because it amuses me cereal manufacturers if i buy a box of cereal that has a lot of corn in it maybe 10 cents of the cost is actually corn and related grains or sugar the rest is really uh marketing manufacturing all of the other things that go into it. So you have much less direct exposure, but you do have exposure to very severe price rises, which creates that asymmetry.

13:13That's what I'm trying to mind, that difference in behavior between end users and producers of a given commodity. That asymmetry is implicitly what pays the carry cost for keeping a long position. and there's a lot of technical stuff to it that I won't go into in great detail but I'm always open to questions and comments in the chat so with that said, shall we dive into the deck? we can, I wanted to go a little off-piste just to keep you honest here I know it can scare the both of us I want to give a little bit of credit to a good friend of mine and three students he had who did a wonderful piece of work in the commodity space that I think is highly illuminating.

14:07And I have a little story, a little fictional story about it. And please stop me as I go through it. But the professor's name is Stefan Storm. He is a math professor at Worcester Polytechnic Institute in Massachusetts. He and three very smart students did a little exercise and here was my exercise i had this hypothetical situation i know there are lots of doomsdayers out there so i will indulge them for a moment imagine that civilization died out and all that was left was a series of futures prices no names just prices going up and down um no time scale either. All you saw was this, a big stack.

14:52Now, could a machine reasonably distinguish between corn and natural gas or copper and wheat or something like that? In other words, is there some ground truth in the same way that if you gave a machine a stack of images of cats, machines are pretty good at identifying cats, even if they're in the shade, bigger or smaller from a different angle or so on. But they do the same thing with time series. It turns out that they could. And using some fancy methods that I will talk about in another lecture somewhere else, they were able with 90 degree plus percent accuracy to distinguish between storable and non-storable commodity prices purely based on the price series.

15:41No labels. And so there is some characteristic movement in different markets. And that lends itself to the storage strategy that I apply across various markets. So metals are highly storable, gold particularly, grains less so, oil even less so, and things like natural gas and power or electricity are non-storable. The beauty of this is that we've developed strategies that cover even the non-storable case, which is a lot to unpack. But I'm happy to go into that too as you prod me on.

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17:25so does your friend's research represent uh or demonstrate a continuum along a sort of storability axis so that you can see different price behavior depending upon its degree of storability correlates with the factors that they've discovered absolutely and you actually see that in the options markets that's the cool thing there isn't just a pie in the sky or a fanciful exercise um in other words the story that i gave you about oil which is a storeable commodity where the producer has the has a bunch of real options to either keep oil in the tanker or in the ground or take it out. For non-storable commodities, that isn't true.

18:08So there's a very high premium paid for hedging in those markets, far beyond what you see in the copper markets, which are relatively tame for the gold markets. And that requires a different set of warehousing strategies to satisfy. And again, I can go into that in more detail, But I just wanted to give the audience the idea that these markets are not all one, but the same techniques apply given the level of storability of the underlying asset. very metals where metals are the most durable followed by as i said grains and softs followed by energies that require a huge amount of volume natural gas which requires more volume still and effectively cannot be shipped in its gas form and electricity where the current has to be flowing at the point where it's required and you can almost you know someone who's interested in commodities in the audience, you can almost back this out intuitively.

19:11It's great that we did it scientifically, but from the idea that if you can't store something, then the amount of supply that's, the risk of a major price shock is far higher than if you can't store it. Right. Because you can always bring that extra inventory to market. You cannot store it. A slight demand imbalance can cause a huge movement in price. And you see that in prices. Natural gas is much wilder. than copper is, or than aluminum is, or something like that. Electricity is wilder still. And being able to give clients exposure to all of those things using option strategies plus an awareness of positioning risk, I think, is a powerful concept.

19:59Really interesting stuff, Harry. I hope so, yeah. I'm happy to wrap it on about this But maybe we could go to a few slides in the deck just to give to bring things down to earth a bit. Yeah, I think it's always helpful for people to be able to visually see it as well. How long did it take you to begin to apply your friend's research to, you know, actually building a strategy? Obviously, a friend who's a math professor is doing this in a very abstract way. How did you begin to take that information and apply it to an actual strategy where you could put trades on? Well, I have a strategy that works cross-sectionally very well across most markets.

20:40So it works for corn, beans, soybeans, wheat, copper, silver, gold, WTI oil, and Brent crude. But it failed that same strategy, which has similar parameterization, similar options, strikes and maturities, similar quantities of futures. didn't work at all for natural gas, Dutch gas, German power, French power, and so on. And so I knew something that was dynamically or qualitatively different. To use an overly fancy phrase, the economy of physics or the nature of price movements in non-storable commodities look different. So I wanted to gain a good understanding of why those structures failed.

21:30and how to address it. The real reason that these structures fail is because when a commodity is non-storable, you have to pay a huge premium to buy it in the forward market when the commodity is cheap. For example, natural gas typically trades at a huge premium in deferred months, especially winter months, to the stock price when gas is cheap. It's very much like the VIX, which is how I kind of factored into this. The VIX, when things are calm, tends to trade at a big premium in deferred months, further out months, to the spot VIX. That's because it's very hard to replicate, nearly impossible for the average investor.

22:12So since there is an imbalance between people who want to hedge using the VIX, the world and their dog is along the S &P 500. or dogs along the S &P 500. So there's a premium on hedging. And the thing isn't storable, so it's hard for it to be supplied in a physical format, which in the case of the VIX means by buying and owning every out-of-the-money strike on the S &P in the front two months. That tends to create a huge premium, which is why some of the strategies which require buying at-the-money insurance to sell out of the money insurance don't work. The at-the-money insurance is just too expensive when the physical asset isn't storable.

23:00I know that sounds like a lot, but it actually all comes out in the wash when you just look at the steepness of the forward curve for natural gas or power when supply is abundance in the short term. Harry one of the reasons why you and I work so well together is because you're the genius who comes up with these ideas and I'm the guy who's never afraid to ask the dumb questions so let me just ask you this what a simpler way of saying this be to say this the less storable a physical commodity is the more reliant market participants are on financial mechanisms of replicating price moves to either hedge the position or speculate it.

23:44Or I guess hedge the position might be the better way to say it. So in other words, if you're reliant for something in your supply chain on a physical commodity, if the commodity is storable, you're able to lock in price action on a forward basis or a future basis at a lower premium because there's physical supply that can come onto the market. If it's non-storable, then the only mechanism that you have of mitigating your exposure risk is essentially through synthetic financial derivatives. Correct, yeah. And the fact that there's no guarantee it can be supplied in sufficient quantity in the future leads to it being very expensive when purchased in the forward markets.

24:24That's a crucial thing. Something like copper, I know that we may have a shortage of copper in five years or even two years, but copper not only is storable but it's also recyclable so scrap can be put back into a super hot furnace melted down and then copper can be reused and very little copper goes to waste so the supply is not only physically storable it's also recyclable natural gas once you've used it it's electricity once the current flows it's flowed it's um you can't get the electrons back so um it's a very different market where the premium is far higher and where the virtual warehousing skill skill set is much more severe took me a lot longer to make significant progress in that space now you mentioned the idea of a theoretical mathematician doing this now i'd like to give him and his three students um torah kathleen and adam a huge heads up but um in addition to that i want to say that he's been acutely aware of a lot of the applications and i was very aware of what he could do at least in principle and so i kind of had an idea in my back pocket that i threw their way without giving all the reasons why i wanted it done and i think that works very well um it's something I plan to continue to.

25:53By the way, I should say you are a very humble guy, but you are also a recovering mathematician by training. Some very impressive degrees in mathematics that you present. I guess, yeah. It's a long time.

26:11So, yeah, that's what I wanted to say about that. But if the slides are up, we can go through a little bit more concrete stuff. and I can talk about that. So the risk is hugely in your favor. So you can see long periods where the price does nothing, always followed by a big upspike. The upspike sometimes reverses. The timing is unknown, but the risk is hugely in your favor if you buy commodities cheap. And cheap for me means nothing more than at a low price relative to history and not trending down too rapidly. you don't want to catch a falling knife in these markets so that's the first chart we can go to the second one which kind of compares that to the futures market forget about the vix for now because this is a growth for uh corn if you look at buying and rolling the futures when corn is cheap which is the blue line you can see that even in the tale of a forgotten asset case, you lose money.

27:13Why do you lose money? Because when a commodity is cheap, in the spot market, the forward curve tends to pay to be punitive. So you have to pay a lot to buy and roll the position. And as I mentioned, it's like the VIX, a flatlining market, even though it's asymmetrically in your favor, in the spot price setup, actually works against you in the forward markets. And that's the problem that we'll try to solve because if you don't time the for the front month futures well and the commodity is cheap you just pay too much to break even so you lose the power of your bets and that's really that's really the problem right there yeah that's it in a nutshell uh buying stuff that's cheap is great but the forward market will make you pay for that for that privilege right how do you get around that so again just to repeat let's have to buzz through things a little quickly the green line is the spot market spot price for corn uh the blue line is the pnl the profit and loss from buying and rolling front month futures in corn so so just just looking at this chart what you see during the uh the period it's that bleed that you see there from say let's say uh december 14 to 20 something like that 2014 to 20 2015 to 2020 yep yep which is a kind of a flat period for the uh physical asset but a bad period for the futures flat period for the physical asset a bad period for the futures and that's the bleed that's the bleed that's the cost of buying high and selling low again and again and again five times a year which corresponds to the number of liquid contracts available i did an estimate that the average level of contango is around 20 cents at three dollars a bushel which costs you about a buck to do five times a year now some of the etfs or etps are getting around that i think two cream has some small exchange traded products that don't just buy and roll the front month.

29:31They do three different months on some weighted. They have some weighted average of three different months, roughly equally weighted. And then they roll them, which cuts your roll costs a bit, but it doesn't solve the entire roll. Hey, can you explain, Harry, real quick, the differences here between when these markets are in contango and in backwardation and what that looks like in terms of this bleed off that you see in roll yield? yeah if corn is at three bucks a bushel in the physical market at some elevator let's say in des moines i don't know my towns too well um uh then and we're sitting in august it may be that november corn is at three dollars and 25 cents a bushel i know there's seasonal effects and so so don't quote me on this which means that if i buy in november at 325 i'm going to be selling it as october approaches or into october and buying the next month which might be jam or something in 2025 and um that that's going to cost me about 25 cents to do or 20 cents to do because the 325 is going to roll down toward three, assuming that a bushel of corn costs the same in the physical market, but the premium will still be retained in the January contract.

31:04So I keep buying high, which means buying January, and selling low, which means selling November as it gets close to expiration. So I keep locking in that loss in an effort to maintain a long position. and that's the price of the of the of the forward contango as it rolls down the spot yes so in order to maintain a long position you need to actually trade periodically so as you get close to expiration you have to sell out of the front month which is going away you don't want to take delivery and then re-establish the position um further out yeah and that's just the definition of how you rule a contract yep that's correct and in the case of backwardation where you see it rising to spot well that's a glorious setup if the backwardation is sustainable so in markets like natural gas you'll you may have a price spike because there's a supply shortage that's instantaneous.

32:13And so the front month skyrockets and in principle you're paid to hold a deferred month and sell the front. The problem with that is that backwardation is not that sustainable a state for markets such as natural gas or the VIX, which I keep referring back to. So you're not able to keep monetizing that. Heating oil used to be a market that was consistently in backwardation. Crude oil currently is a market that's in backwardation, as I pointed out earlier, which is actually nice because structural backwardation is a setup where you don't need to be great at carrying the position. You just buy the deferred futures and you get paid to wait on the assumption that you think that, in this case, the price of oil is unlikely to go down substantially in the near future.

33:06So your break-even is actually in your favor. Hey, everyone. We're going to take another quick break and hear a word from our partners, and then we'll be right back.

33:18Adam Werner Assuming that the price of spot does not collapse dramatically, essentially you have positive role yield on the position in backwardation. Adam Werner Yeah. So if every commodity forward market were in backwardation, you wouldn't need me to come on the show and say, oh, I've come up with this bag of tricks for warehousing cheap commodities. You just go and buy deferred months, and it'd be done. But sadly, WTI is a pretty rare case. So yeah. Talking of your bag of tricks, we've got a slide we can pull up. I believe it's the next slide called Our Approach, which talks about precisely that bag of tricks.