Smart Money Positioning for Late Summer Commodity Rally

Discovering trends in options activity often leads to the highest probability trades, and the recent trend has been large opening positions in commodity names, mainly the metals.

The S&P has corrected more than 8% in the last 2 months, while Metals (XME) have corrected more than 19% in the same time period, notable weakness in Coal, Steel, Iron Ore, Gold, Copper, and Steel stocks, with many of the individual stocks down more than 30%.

Commodities are considered a risky-asset, tied more closely to global economic growth than other industries, and a heavy reliance on China, India, and other growth markets. However, the group does appear to be over-shooting to the downside, especially if the 2H 2011 improves from 1H 2011.

The recent data also supports a bullish fundamental view on the metals, with China showing strong demand for Coal, Steel, and Iron Ore, while Japan is also seeing a demand surge as the rebuild begins.

Some of the leading Wall Street Research shops are also starting to make bullish calls, Credit Suisse out with a very bullish Copper forecast last week, and Steel Market Intelligence making a positive Steel call, flipping from a bearish call that was spot-on.

In the last two weeks I have seen large institutional buying in upside call options across most of the metal groups, and will highlight that action below. Alcoa (AA) earnings will kick off Q2 earnings season, and is a potential catalyst for a resurgence in the metals, although aluminum fundamentals are not looking quite as positive as the other metals.

Steel
Arcelor Mittal (MT)September $35 calls were active the last 4 days of last week, with open interest starting the week at 207 contracts, and on Friday 5,013 contracts traded against open interest of 30,228 that accumulated in the contract throughout the week, and the implied volatility of the contract rose more than 15%. Arcelor has held up much better than its peers and have been basing above $31. The $39.2B Steel giant is trading 7.1X forward earnings, 0.85 PEG, 0.59X sales, and 0.8X book value, making it one of the cheapest names in the industry, and also a Company interested in acquisitions. Option traders are positioning for shares to gain more than 13% in the next 3 months.

Copper
Freeport Mcmoran (FCX)shares have held well above the $46 double bottom from earlier in 2011, and face resistance with a descending trend line at the $50 level. It has outperformed most of the names in the metals sector, and Copper, often seen as a leading indicator for economic growth, has held the $4 level very strong since rebounding sharply off $3.90 lows in early May, a bullish divergence versus other metals. On Friday, a large holder in call options extended his/her play out another month, rolling 25,000 June $42 calls to the July $43 strike, and another rolled 12,000 June $47 calls to 12,000 July $46 calls. Freeport is another value name at 7.66X earnings, 2.23X sales, 3.3X book and 11.3X free cash flow. Deutsche Bank noted last week that the Company is likely to return money to shareholders via special dividends and has a Hold and $65 target. Morgan Stanley also recently reiterated an Overweight, noting improving Copper fundamentals.

Iron Ore
Vale SA (VALE)is a $155.87B mining giant, often focusing on its Iron Ore business, but also a major player in other metals, and becoming a force in the fertilizer space as well. Shares trade very cheap at 5.8X earnings, 0.45 PEG, 3X sales and 2X book value. Goldman reiterated a Buy in April with a $45 target, citing a strong upcoming Iron Ore cycle, and the new CEO should lift the uncertainty. Recent speculation is the Company could announce a healthy dividend. Recent data out of China and Japan bodes well for Iron ore. Shares have been trying to base and remain in a channel down since January, current resistance at $32 and support at $28, while $29 remains major support from May lows and the September breakout level, so reward/risk is compelling. VALE August $32 calls were extremely active with buyers on June 16th, more than 30,000 traded including one block of 8,300 at $0.80 on the CBOE, and open interest in that contract doubled, now sitting at 61,376.

Coal
Arch Coal (ACI) shares have been under pressure since announcing the acquisition of International Coal (ICO), a longer term positive as metallurgical coal is the hottest coal group. Shares have fallen more than 30% off April highs. Arch Coal is trading 6.4X forward earnings, 0.42 PEG, 1.58X sales and 1.78X book value. On May 12th, Standpoint raised to Buy with a $37 target. Arch Coal was the focus of bullish option traders on three occasions last week. On June 14th, more than 10,400 July $26 calls were bought to open, while on June 16th 4,600 July $27 calls were bought to open, and finally on June 17th more than 11,600 July $25 calls were bought to open as $1.2 million in call premium was purchased. 30 day implied volatility in Arch Coal jumped 15% last week.

Gold
Barrick Gold (ABX)shares are trading 21% off a recent double top at $56, at August 2010 lows, while Gold prices are barely off all-time highs, a major disconnect. Barrick shares trade 9.4X earnings, 3.77X sales, and 2.1X book value. Stifel raised shares to Buy with a $70 target in late April. Barrick Gold saw a few large bullish option positions last week. On Friday, more than 2,500 October $43/$47 call spreads were bought at $1.53, a nice reward/risk trade. On June 16th, more than 11,350 July $45 calls were bought to open, looking for a nice run in shares in the coming month.


There are likely a few names I am not mentioning, but all of these took place within the last week, so the trend is noteworthy. If the market shows signs of bottoming this week, I would concentrate on being long metals for the reversal move.