Commercials Recap By, Chuck Whitman

 

For a quick recap on Commercials, review the summary points below:

 

 

  • Every successful product exists because it has a legitimate business purpose for the commercial firms that utilize it. Without the commercial firm’s willingness to use the product, it will fail.
  • Commercials are the primary influence in any market that we trade.
  • Commercials are the participant for whom the market primarily exists.
  • Each market usually has a commercial user who is a natural long and a commercial user who is a natural short.
  • The easy way to determine who is long and short is to examine whether the commercial user holds the physical product (natural long) or needs the physical product (natural short) to conduct their business.
  • Commodity Markets:

Natural Long (Producers) – Farmers, energy explorers/drillers, and miners. They produce the physical commodity and use futures markets to hedge production pricing and risk.

      • The original futures markets were formed to help smooth pricing. In the United States, farmers would grow their crops every year and then bring them to Chicago to sell at the market.
      • However, every fall, all the farmers would arrive simultaneously to sell the crops, and the price of grain would collapse. It was so bad that there were years that farmers threw their grain into Lake Michigan in disgust.
      • By wintertime, there was no grain around, and the prices for grains exploded.
      • Every year, pricing went through a Boom/Bust cycle.
      • Futures contracts provide smoother prices. Farmers could forward sell their crop, allowing them to capture higher prices earlier in the year. Futures contracts kept prices from falling as much during harvest.

Natural Short (End-Users) – Food producers, industrial manufacturers, and transportation (airlines). They use the commodity to create their products or run their businesses.

      • If they are unable to buy the commodity, they are out of business.
      • There are times where they must buy, period!
      • End-User Example – United vs. Southwest Airlines
          • My father-in-law worked for Management Information Systems for United Airlines, and I remember when he came home and told me that United laid off their fuel hedging department. Crude was at all-time lows, and they didn’t see the need to waste money on hedging when crude was so cheap. Several years later, United filed for bankruptcy.
          •  Southwest Airlines, in contrast, had engaged in 10-year hedging programs. When crude oil skyrocketed over $50 and then $100 a barrel, Southwest had locked in crude at $28-$35 per barrel. Hedging allowed Southwest to surge to record profitability while the rest of the airline industry (including United) was crippled by high crude and jet fuel costs.

 

  • Commercials engage in the use of the product every day.
  • They know the most about its intrinsic value (fair value) and have real-time data to know when changes to fair value are occurring.
  • They are aware of large physical transactions.
  • They are aware of the costs of shipping, production, weather, supply/demand, etc.
  • Companies have information on their profitability, changes in outlook, issues with their suppliers and clients, financing issues, etc.
  • Commercials use the product to hedge their business needs. It is helpful for us to think about their hedging behavior.
  • I would say the smartest of the commercials are the commercial users who use commodities for hedging.
  • Because the cost of the commodity is one of the most significant factors in their success, Commercials tend to have a great sense of value, or they’ll end up out of business.
  • Commercials tend to exhibit behavior where they buy and buy more as prices move lower and sell and sell more as prices move higher.
  • Let’s examine why:
      • If I am a natural long, I will be a seller in the marketplace.
            • The higher prices rise, the more incentivized I am to forward sell because my profit margins grow as the price rises.
            • I am incentivized to hedge more and more as prices rise because I’m locking in more profit. 
      • If I am a natural short, the opposite is the case.
            • As prices move lower, I am incentivized to hedge more and more because I am buying an input at cheaper prices locking in larger margins to produce my product.
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