Celina Jade
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Celina Jade in Markets at a glance,

Commodities raise more red flags

A bumper corn crop in the U.S., as well as an unexpected drop in oil despite a variety of geopolitical issues, together may be sending investors a sign.

All of the commentators looking for an oil-price spike due to escalating geopolitical situations — including this corner — must feel rather puzzled. ISIS fighters in Iraq have been protecting the energy infrastructure, so they might use it to fund their “glorious caliphate.” Ukraine has not yet blown up into a full-scale intentional confrontation, but if one can judge by the way a new front of fighting was opened this week in Novoazovsk and Mariupol, one could conclude that we are close to that inflection point.

I think the theatrical Russian troop withdrawal from the border in June was the bait that the Ukrainian military took in order to attack the rebels so that now we have a dire humanitarian situation that calls for Mr. Putin to intervene. The Ukrainian situation is starting to resemble Gaza, but with no end in sight. I am of the opinion that a bigger military confrontation is coming in Ukraine, which should have serious repercussions on government bonds (safe-haven buying), commodities (weak) and currencies (weak for the euro and the unfortunate Ukrainian Hryvnia which is already collapsing, and stronger for the dollar).

The German 10-year bunds are at 90 basis points as of Aug. 28, 2014, and the EURUSD cross rate is near a 52-week low. Bunds with maturities extending to 2017 all have negative yields. That means you have to pay the German government to hold your money for you, as otherwise that money might not be safe in the banking systems of smaller EU countries that are disproportionately exposed to the trade wars that have started because of this geopolitical situation.

The most important commodity of all — oil — is already showing the stress that this conflict has caused in Europe. Brent crude seems to be breaking below what traders call a symmetrical triangle consolidation. I know that every futures trader knows charts pretty well, both from a short- and long-term perspective, but here we appear to have been head faked with the ISIS blitzkrieg in Iraq in June, where Brent crude tried to break out to the upside of this triangular consolidation.

As ISIS has been rather careful with the energy infrastructure so far, Brent crude is weakening rather notably, breaking from that large triangular consolidation to the downside. Brent is the benchmark for crude in Europe, and the trade wars there are beginning to affect the fragile economic picture quite notably.

The Brent-WTI premium (red dotted line, right scale in linked chart above) is now vanishing, as demand in Europe is notably weaker. To a degree, it was the fracking boom that caused the Brent-WTI premium to go as high as it did in 2011 as U.S. production skyrocketed, up more than 50% since 2008. It is no guarantee, though, that Brent will keep sliding, as it may turn out to be a geopolitical weapon yet to be used in this escalating Ukrainian situation. The Russian counter sanctions are causing pretty serious issues in smaller EU countries with large trade relationships with Russia, and crude oil and natural gas are more potent weapons yet to be used, particularly as winter approaches.

It is not only Brent that is weak. All commodities have weakened this summer, and major commodity indexes are near 52-week lows. A case in point is theCommodity Research Bureau index, which has two reformulations — one where oil and energy are overweight (CRB, in black in linked chart), and one where the 17 commodity futures included in the index are equally weighted (CCI, in red).

Over the past three years, commodities have been gradually deflating. Non-energy commodities have actually been weaker, as the CCI equally weighted index shows. While energy and metals are highly economically sensitive, agricultural commodities depend much more on the weather as food demand is quite inelastic. The big outlier is corn. The ethanol boom pushed corn prices to $8.50 a bushel a couple of years ago, yet December 2014 corn futures closed at $3.71 on Friday. Corn has seen two back-to-back bumper harvests (we'll see the second one shortly) and the falling price reflects the swelling inventories.

This corn glut may hurt Deere DE, +0.14% sales over the short term. At one point during the corn boom, Deere was selling a lot of tractors with flat-screen TVs and built-in refrigerators and was probably on its way to offering massage chairs if corn prices stayed high. But the corn glut has boosted margins atGreen Plains Renewable Energy GPRE, -0.04% which at present corn prices, produces sugar that is the equivalent of eight cents per pound. By comparison, Brazilian ethanol producers that use sugar cane instead of corn now start off their ethanol production with sugar at a price of 16-cents per pound. This could give GPRE an advantage in the present environment, as its input costs are cheaper in the midst of the corn glut.

In that environment, I would be careful with companies that make their money on price, and I would look more carefully into companies that make their money on volume. The MLPs are the classic volume investments that have limited exposure to the price of oil or natural gas.

Long-term periods of depressed prices also affect volumes negatively, but we are nowhere near such a situation at the moment. The holdings of both Alerian MLP ETF AMLP, +0.57% and the Alerian Energy Infrastructure ETFENFR, +0.42% are prime pools for research on investments geared toward the fracking boom. The other benefit to these domestically oriented investments is the U.S. dollar, which has been getting firmer not only because the U.S. economy is outperforming many global economies, but because the Fed is getting ready to tighten while the ECB is doing the opposite.