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Oil’s Connection with Other Commodities

Oil’s Connection with Other Commodities
June 08
17:30 2011

Whether you start to trade oil futures with an active day trading strategy or a longer-term buy-and-hold outlook, you must be mindful of how it fits within the rest of your portfolio. Will it exacerbate or smooth out the gains and losses in the rest of your account? The answer to this question will depend on what other positions you’ve taken, but in general, commodity futures are considered to be a good, non-correlated companion to a portfolio of stocks and bonds. Within the commodity world, however, oil is not only a match but a leader of the movement in other commodities. Energy futures are the most obvious example: natural gas, heating oil, RBOB gasoline, ethanol, and electricity futures will all tend to move in tandem with crude oil as the global supply and demand of energy itself changes.

Since the United States, Brazil, and the European Union started heavily promoting the ethanol industry in the mid-2000’s for environmental and domestic energy security reasons, the grain markets have behaved more and more like a member of the energy sector. This is appropriate – after all, grain itself is a form of solar energy that has been transformed into starch, sugar, and protein. Nonetheless, ethanol blending margins and gasoline refining margins insulate the direct relationship between crude oil and corn (the most common ethanol feedstock in the United States). Other grain futures, like those for wheat, soybeans, and rice, are even less correlated to the day-to-day movement of crude oil prices than corn.

The “softs” commodity sector includes coffee, cotton, cocoa, and sugar. You might not think right away that crude oil would be directly tied to any of these markets, but even this sector is growing more and more related to the energies. Sugarcane is the most common feedstock for ethanol in Brazil, for instance, and cotton’s relationship to industrial manufacturing makes it sensitive to crude oil prices, also.

In fact all commodities, even precious metals like gold and silver which have limited industrial use, are tied together with crude oil’s performance by virtue of how money flows in and out of the commodity sector. An investor might place money in a commodity index fund, for instance, and that money will be distributed in a certain weighting scheme across the whole sector: 18 percent in energy, for instance, and 24 percent in softs and 18 percent in precious metals. Therefore, as that money gets invested or as it gets cashed out, all those markets will experience buying or selling pressure at the same time.

Other Futures
Here’s just a word about how crude oil behaves compared to stock market indices, which can also be traded as futures and options. The correlation between crude oil and stocks is very weak. There are times when both markets experience gains because of increased overall economic confidence, but there are also instances when high oil prices are seen as a challenge to business profits.  Currencies, on the other hand, have a much stronger relationship with oil. Oil futures are priced in U.S. dollars and cents per barrel, so a weaker U.S. dollar directly translates into more dollars being needed to buy the same quantity of oil. The negative correlation between those two futures markets is very strong.

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