Monday, January 30, 2012

Oxley, Extreme Weather and Financial Markets

Living in Connecticut, I rarely experience extreme weather. Last year was an outlier. The winter was brutal, then came the remnants of Hurricane Irene (not in itself extreme but nonetheless a week-long power outage), and finally the freak Halloween snow storm (and, yes, another week without electricity). Although there was undoubtedly a spike in generator sales, let’s face it: no investor is going to make much money betting on Connecticut weather.

In Extreme Weather and Financial Markets: Opportunities in Commodities and Futures (Wiley, 2012) Lawrence J. Oxley takes us to where weather is genuinely extreme and where real money can be made. Wending his way through the various commodities and ways to trade them, he focuses on five potential global climate shocks: excess snow and ice; flooding mines; farmland droughts, floods, and frost; hurricanes and tornadoes; and timberland fires.

Let’s take a look at a single commodity, which the author says “may well be [his] favorite weather-based investment”—platinum. Platinum enjoys strong global demand, the supply side is highly concentrated geographically (South Africa accounts for 76% of total platinum mine production), and these geographies have the potential for politically rooted supply shocks.

Assume there is a flood in South Africa. Who are the biggest winners? First, platinum futures, followed by ETFs and the stocks J. Matthey and Stillwater. If the flood is in Montana, the biggest winners are still platinum futures and ETFs. The same holds true if the flood is in Russia. “At this point you might be wondering why ‘platinum futures’ and exchange-traded funds (ETFs) in platinum are ranked higher than all of the publicly traded stock winners. The futures market and the ETF market do not care where the global climate event occurs. All they care about is the price of platinum. It makes life a bit easier if you do not have to worry about which names in the stock market are the winners and losers, but instead simply focus on the extreme weather events and the price of platinum.” (pp. 71, 75)

Oxley does not, however, confine his analysis to trading commodity futures. He gives examples of pairs trading in equities and explores opportunities in the bond and forex markets.

Event-based trading is notoriously difficult because everybody is responding to the same information. Think, for instance, of the recent run-up in orange juice after a cold snap threatened Florida’s crop, the FDA detained shipments of oranges imported from Brazil in which they found traces of an illegal fungicide, and Mexico’s crop faced damage from drought. Even with this perfect storm trading was still not easy. For instance, on January 10, when news of Brazil fungicide fears broke, orange juice surged 11%. The next day, as investors awaited more news from the FDA, orange juice futures fell 9.5%. Here’s the 30-day chart.

Oxley offers some tips for event-based trading, including when to sit on your hands. For example, if sugar spikes—which means that soda and chocolate are negatively affected, he recommends avoiding (not shorting) Hershey and Coca-Cola stock. And he cautions not to “buy excessively in the municipal bond market in hurricane regions during hurricane season.” (p. 179)

Oxley’s book is a worthwhile read for commodity investors, novices as well as the more experienced, who are in search of opportunities. It is also a cautionary tale for those who want to protect their portfolios. No one should trade commodities without understanding the impact extreme weather can have.

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