Have soybean shorts reached a critical mass?

Open interest in soybean futures is at an all-time record and large commercial hedgers hold an enormous net short position. This we can sees in the Commitments of Traders Futures and Options combined report published on Friday by the Commodity Futures Traders Commission (CFTC). Commercial hold nearly 72,000 more shorts than long contracts. This is not too shy of their record of nearly 99,000 set during the 2004 bull run. (Commercials typically are counter-trend traders, and the higher prices go, the more they sell.

Their net position chart, based on the Futures and Options report looks like this: COT-Supplemental Soybeans

The CFTC also publishes what it calls the COTSupplemental report and soybeans just happens to be one of the dozen markets the CFTC deigns to include in this expanded detail on the Futures and Options data. The Supplemental breaks out the commodity index trader as a separate category. As it happens most of these numbers are carried in the commercial category in the Future and Options report. When you break them out separately, you get a better idea of the enormity the current trader imbalance in soybean futures.

Soybeans Commercials are by far the largest player on the short side of the market, which has always been the norm, and currently hold 2/3rds of the short open interest. They don’t dominate the long side, however. The index trader category holds 31% of the long open interest to 24% or commercials. In fact, large speculators — commodity pools and hedge funds — range ahead of commercials, holding 25% of the long open interest.

When we talk about the net position, this is simply the difference between longs and shorts. For commercials this currently calculates as 67% – 24% = 43% net short. When you draw out the historical record (the CFTC only provided 1 year of historical data when they inaugurated the report 5 January 2007) the net position chart looks like this: (you can click these charts to enlarge them)

You’ll note on the chart that the black line, representing the CIT category is very steady. This is only one market out of the 2 dozen or so that most commodity index funds use. These funds are a new to this commodity bull market, so we don’t know what will happen when commodities fall back in a substantial way (as they always do). The concentration in the index trader category is another worry factor. There are only 17 traders holding these shorts–and from reports from the International Swap Dealers Association, the bulk of the position may be held by 4 or fewer swap dealers. This compares to the relatively small short positions held by 85 large speculators and 47 commercial firms.

The COTSupplemental report shows Commercials net short by 153,061 contracts–more than twice the net reflected in the Futures and Options report (before splitting out the index trader longs). We can’t tell whether this is a record because the data base is too short, but it is an enormous short bet. And commercials are masters at collecting on large bets.

All of this sounds interesting, but here’s the meat: large speculators (commodity pools, commodity (not index) funds, and hedge funds) are holding 93,805 more long than short contracts–an all-time record. These funds generally fuel trends because they rely predominently on momentum trading models. Buying by one fund’s computer will move prices far enough to get the attention of another fund’s computer, and these systems, in effect, serially click each other’s “buy” button. But at some point, funds run out of funds. You might wonder how his can be, since they operate at 20% leverage and accumulate profits to pyramid with. Here’s the rub. Most funds worry about concentrating capital in risk in one market or sector, so positions run up against risk formulas that over-ride system buy signals. Not only that, but as price rises, the risk to stops can dictate partial liquidations. Once the selling begins, the same mechanical systems that rallied prices last year, beat the market to a pulp this year.

So, when will the selling start? We can’t say with any certainty. This is a speculative blow-off. It could be Monday morning, it could be July 2nd. Unusual weather could extend the bull market even further. When it does begin to come apart, it appears that there will be a record speculative long position to liquidate, so it will very likely be quite an exciting downhill ride. And when (not if) the index traders get fed up with their “long term” commodity “investment” they could completely let the air out of this and most other physical commodity markets.

Prices this week bumped up against chart resistance at the June 2005 market peak. Markets (or at least traders) have memories, so every resistance level carries the potential for a reversal. There undoubtedly are a large number of bulls fretting this weekend over not getting out with profits intact at the 2005 top. Some will be selling on Monday based on that memory.

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