Kub's Den

Patterns don't usually get a chance to exist in modern commodity markets. If we could really predict that prices would rise after each time they tested their 20-day moving average (or pick any other arbitrary line), then all the clever computers that are reading and testing and learning the markets' behavior each moment would jump in and buy the market just ahead of each other, until tick-by-tick the pattern itself would be eroded and smoothed out entirely.

There is one exception, because there is one force stronger than logic. That force is human excitability.

Robert Shiller popularized the term "irrational exuberance" in his 2000 book of the same name, to describe how a bullish urge can overwhelm human traders' logic and lead to a surge in buying activity and a bubble in prices. If everybody else is buying stuff, the urge suggests, then I ought to buy that stuff, too. However, as you know, bubbles are prone to popping, and that's one pattern we do see repeated across a variety of markets.

The most recent example of this comes from the global edible oils market. Earlier this month, it was a strong enough force to overpower even the bearishness of an official USDA proclamation about record-high U.S. soybean supplies in the 2016-17 marketing year.

The Malaysian palm oil market was on a straight upward tear through early August, culminating in a bubbly high of 2,953 ringgits per metric ton (about 32 cents per pound) on the front-month futures chart on August 17. Therefore the nominally bearish August 12 Crop Production report from the USDA may have been overshadowed as the oil-led rally in the soy complex churned on, right in the final, strongest days of a panicky, bubbling market.

The supply and demand story in the palm oil market -- and thus, for edible oil prices globally -- has been a strange and twisted tale. First, there was some legitimate bullishness about supply after El Nino weather patterns caused global palm oil production to drop 3.6% from a year ago. In a Kub's Den column from late March, I covered the palm oil rally of the first three months of 2016 and suggested, due to a strong correlation between soybean oil and palm oil futures (the 26-week correlation can be as high as 0.86, according to a November 2015 publication from the CME Group), that strength in the soybean complex was therefore justified. Next, there was the expectation for palm oil production to recover, as agricultural production always tends to do after any period of high prices. Palm oil futures dropped through late July 2016.

They should have dropped even further when in early August the Roundtable on Sustainable Palm Oil (RSPO) lifted its suspension of IOI Group, a Malaysian corporate conglomerate that is one of the world's largest producers of palm oil. Except that environmentalists still weren't happy with that company or with another company called Felda, no matter what the RSPO said. The big traders -- Nestle, Mondelez, Kellogg's, Unilever -- who had shunned those two companies because of their deforestation practices, are currently still shunning them and thus cutting themselves off from about 20% of the available supply, in fear of their reputations amid consumers' sustainability consciousness. It may be artificial scarcity, but this idea of scarcity has driven palm oil futures higher than they ever were before the suspension was lifted by the RSPO.

The RSPO is a not-for-profit industry group that certifies 17% of global palm oil, according to environmental and social criteria. Most of that palm oil comes from Indonesia or Malaysia. An RSPO label on a product makes modern consumers happier to buy candy bars or toothpaste or lipstick or biodiesel that's less likely to be the product of slave labor or a slash-and-burn plantation. Seriously. Certifying our lack of slave labor may not be something that U.S. soybean farmers have to worry too much about ... yet ... but this whole palm oil bubble is a fascinating case study about the power of end users' desires.

I'm not saying that the environmentally-conscious consumers are the ones being irrational. If it's not sustainable to produce edible oil by burning rainforests or enslaving fellow humans, then I agree. Let's not buy those products. That seems perfectly rational to me. The August run-up in palm oil prices, however, as a pattern on a futures chart, looks an awful lot like a classic "bubble."

Irrational bubbles have happened throughout history. Tulips in 17th Century Holland and Beanie Babies in 1990s America are two colorful examples. For better data that translates onto a chart, I've looked at the wheat market during the Russian grain crisis of 1974, tech stocks in 2000, U.S. home prices just before the recession, and now Malaysian palm oil prices in 2016. They all share remarkably similar performances.

For a year or two before a bubble, a market may seem reasonably quiet. Then, for a period of six or eight months, prices build slowly but steadily in an upward slope, with an average of 1% to 3% gained per week. This may be a universal timeframe that demonstrates just how long it takes a bullish fundamental idea to cascade, person by person, decision by decision, through a market. Next, the peak hits, probably somewhere about double the original price before the bullish stimulus occurred. Prices fall, almost always, about 5% on the day immediately after that peak. And indeed, on August 18, 2016, Malaysian palm oil futures fell 4.4% off the previous day's peaky high.

And here is the relevant bit: After a bubble bursts, the price decay is much quicker than the build-up ever was. Losing an average of 4% to 8% per week, the market abandons its previously bullish mood over just a few weeks. Two months after the bubble's burst, prices tend to be higher than they were before the whole phenomenon got started, but they're typically 35% below the high. If Malaysian palm oil follows that pattern exactly (and no one knows if it really will do so through the coming weeks), then by the end of this year we might expect to see it priced back near its 2015 lows, somewhere near 1,920 ringgits per metric ton.

Will palm oil prices do that? Now that the exuberant, bullish bubble of mid-August has burst, will prices quickly erode in that recognized pattern that markets have displayed so many times before? Or, will palm oil prices continue higher as public opinion continues to make a huge chunk of the supply virtually unusable? The fate of the soybean futures complex may depend on that answer.

Palm oil has overtaken soybean oil as the world's most-used edible oil since 2008. The two edible oils are economic substitutes, each containing 120 food calories and roughly the same potential for biodiesel production. Soybean oil is considered to be more heart-healthy than palm oil, and the average expectation over the past five years has been to see a 20% premium for soybean oil over palm oil. Current bean oil prices have only a 5% premium over palm oil, dollar for dollar, so they may be somewhat insulated from bearish arbitrage trading as palm oil collapses.

Soybeans themselves may be even more insulated. After all, only about a fifth of any soybean ultimately becomes soybean oil, and you can note with a naked eye, that the soybean futures market itself is much less correlated than the bean oil market to Malaysian palm oil futures. Whatever universal pattern palm oil futures may be repeating right now, it's true that the implications haven't been positive for soybeans so far this week, but soybean traders shouldn't feel irresistibly fated to obey that pattern.

Elaine Kub is the author of "Mastering the Grain Markets: How Profits Are Really Made" and can be reached at elaine@masteringthegrainmarkets.com or on Twitter @elainekub.

ANSWERS TO QUIZ: 1 - A; 2 - D; 3 - C; 4 - B.

(CZ/BAS)

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