There is randomness

Defining the law as of randomness by Charles Seife in Edge.org 2011 question is good food for thought.

The First Law of Randomness: There is such a thing as randomness.

We are not able to predict everything. We may look for patterns as part of being human but sometimes there just is not a pattern. Randomness exists.

The Second Law of Randomness: Some events are impossible to predict.

we can try to handicap an event, but there are events that are difficult to predict and there are events that are almost impossible to predict. There are unknown unknowns. The only thing we can do is try and protect enough to make sure that some unpredictable event cannot lead to ruin.

The Third Law of Randomness: Random events behave predictably in aggregate even if they're not predictable individually

 The law of large numbers will always work. If we have enough events, we can make predictions in the aggregate but not about a specific event. I can predict the likelihood of an event like the roll of a dice, but not the actual number of the next roll.

World Bank stake in Armajaro - what are they thinking

The World Bank through the IFC its investment arm is taking a 6% stake in the Armajaro cocoa trading house. It will also lend firm $55 million in mezzanine debt. 

Is this supposed to help poor farmers? This seems to have some murky reasoning if the firm is supposed to still be a profit maximizer. If they have an opportunity for a quick profit from driving prices lower should they still take it? The conflict of interest or the potential to be on the wrong side of a pricing issue as defined by what is best for farmers is high. Is this better than a marketing board? What if the trading firm is in conflict with a country's marketing board? The change for confusion is extremely high.

The elusive creditability problem

Creditability like trust is often elusive. Once it is lost, it is hard to regain. The EU, UK, Japan and US governments are losing creditability and prices suggest that little they say can get it back. The lack of creditability means that investors will not commit for any length of time to an investment program. The animal spirits of optimism cannot work.

The EU may have the biggest creditability problem. If they stick to their commitments of austerity, they will be voted out of office. Hence, with each election there will be less creditability. Any compromise with voters causes a pull-back from any existing policies, so there is little that can be done to show creditability.  The government cannot be trusted, or they can be trusted not to follow-through on their plans once faced with opposition. So is there a solution?

A workable solution is an attempt at fiscal flexibility through short-term spending or investment subject to pre-commitment to future cuts. This has been tried but has not be successful at giving voters clarity of the choices. The fiscal flexibility approach means borrowing more at low rates. It also means flexibility at cutting expenditures on some programs while spending more on job creation. Entitlement cuts with government investing could work, if there is a framing of cuts to long-term programs in exchange for shorter-term job creation and growth. 

In Europe, the creditability problem is more structural and requires even more work. The structure does not allow for strong policy choices. In fact, because the US does not have structural problems with federalist government, it should be able to overcome the problems of creditability more easily.

Commodity equities - they are not all the same

There is a strong distinction between commodity futures investing and investing in equities associated with commodities. Specifically, there are differences in the type of firms that are associated with commodities. We classify four types of commodity equities firms. Classifying firms into different types of commodity equities helps provide context to the sensitivity of equities with the underlying commodity.

Producer equities - mining or exploration and pure production or extraction companies. These are the firms that mine, explore, produce or extract a commodity. There will be a close link between the price of the commodity and value of the equity. Value is determined by the difference between price and marginal cost times the production and level of reserves at the company. Price increases will lead to higher value. The difference in value increase across firms will be related to the marginal cost of production. Low cost producers will see a larger gain than high cost producers. The value will also be determined by the distance between the price and marginal costs. If there p[rice increase will lead a company from a loss to a gain because the price is now above the cost of production, there may be a greater change in value. This can be called the optionality of producer firms.

The simple fair value will be the discounted present value of future earnings. Producers in mining and energy E&P are, however, not infinite lived companies. The resource or production is exhausted over time, so the value is a combination of price minus marginal cost times the amount that will be extracted each year.

Nevertheless, the life of the equity producer is greater than that of a commodity futures. The value will have to discount future production not by the current price but by the stream of expected future prices. If the futures is an unbiased estimate of future prices, there value of the firm will be affected by distant futures prices more so than nearby futures prices.

The producer company will have characteristics of a bond because the cash flows are limited so the discounting has a finite life. There is also the potential for more leverage based on operating margins versus a futures contract. Like all equities, the company value is an option. Hence the value of the firm will be affected by volatility.

There is no reason to believe that a one percent change in the nearby futures price of oil will lead to a one percent change in the price of oil exploration company; consequently, the link between equities and futures should not be expected to be strong.

Intermediary or (refiner/processor) equities - firms like Bunge or ADM which are involved in a form of arbitrage  would fall into this category.  Let's take the simple example of ADM which is in the soybean processing business and ethanol business. In the case of soybean processing, an increase in the price of soybeans may not lead to an increase in margins associated with the soybean crush. The crush arbitrage may show a better link with ADM than soybean prices. The demand for meal and oil, while tied with the price of soybeans, will not move in lockstep with the underlying commodity; consequently, there could easily be a decrease in the price of ADM when there is an increase in the price of soybeans.

The same could be said for corn and ethanol production. The price of corn my change, but that does not mean there will a similar change in the margin from processing ethanol. Ethanol prices will be associated with gasoline demand as well as corn prices.

Now the profitability will be associated with the margins for certain arbitrage, but the link between commodity prices and stocks prices for these types of firms may be weak or contrary to the general direction of futures prices.

Commodity retail equities - firms that engage in the selling of commodities to end users. This type could include food companies which use agricultural inputs in their production process or gasoline retailers. An increase in the price of inputs like corn or sugar or cotton may have a negative impact on profits since the value of the firm will decrease if there is an increase in the cost of  production. However, the cost of the input may actually be a small relative to the cost of marketing, so the link between commodity prices and commodity equities on the retail level may be weak.

Accessory equities - firms that sell to commodity companies. This would include firms like Monsanto, the seed company or Caterpillar which sells farm equipment. Another example may be oil services companies which provide services to the producer. In these cases, the price of the equity will be associated with the level of wealth or earnings of the firms that would buy the services of the accessory companies. These firms will not be sensitive to short-term prices which do not change the level of wealth of a farmer of service buyer. If there is longer-term change in prices, there will be a boost in the commodity equity, but the link will only exist if there is a longer-term sustained gain in price.

Of course, firms that hedge will mitigate any of the change in price associated with a commodity. For example, airlines could be thought of in the retail space. they convert energy to transport and use oil as in input. If there is a hedging program, there will be less sensitivity to oil in the short-run.