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A combination of the lack availability of beef imports into the US from Australia and to the global market for Argentina, expanding US exports, a significant shift lower in US beef production for the next six months, and the possibility that US non-fed cattle slaughter will slow from its rampant pace of the past year leaves the supply outlook for cattle tight. In addition, expanding US and world economies and an inflationary tilt to commodity markets in general (which makes in easier for retail and thus wholesale prices to rise), are seen as bullish forces. While the recent jump to record high prices could slow demand for cattle, our observation in the past has been that when a commodity market surges to new all-time highs, it generally continues to advance to a more significant peak, 15-30% above the old highs, before topping out.

Hogs pushed to a new contract high last week, and nearby futures traded to their highest levels since August. Pork production is also tightening, and a shift to a more robust export pace could set the stage for a significant drop in per capita supply, down to 46.9 pounds in 2011 from 47.8 pounds in 2010 and 50.1 in 2009. If the USDA has underestimated the US export pace, per capita supply could end up being even tighter.

The USDA is forecasting beef production in the 1st quarter to be down 435 million pounds from the 4th quarter of 2010. This compares with a decline of 175 million for the same period last year and an average decline of 200-300 million. If this happens as expected, it will be is the second largest 4th-1st quarter decline since 1980 and the third largest going back to at least 1970. It suggests that the seasonal tendency for cattle prices to rally into the spring could be even stronger than normal this year. From the 1st to the 2nd quarters, beef production is only expected to increase by 185 million pounds. This would be the lowest increase for that period in 11 years. This is a positive setup for cattle prices, especially the April and June contracts, as the market adjusts to lower production in 2011.

For pork, the USDA is forecasting 1st quarter production to be down 465 million pounds from the 4th quarter, which is the largest drop since 1984 and the second largest back to at least 1970. It would also suggest that the typical “up” seasonal in hog prices into the spring could be stronger than normal this year. From the 1st to the 2nd quarters, pork production is expected to decline by 320 million pounds. This is a larger than normal decline and is also considered to be supportive. Hog weights remain high, and production in December and early January was higher than expected, but pork product prices still pushed sharply higher, with pork cutout values reaching their highest levels since October.

In December, China started importing beef from the US for the first time since 2003. Beef production in China for 2011 is expected to slip 2% to 5.45 million tonnes. The USDA is predicting that US beef exports for 2011 will be about steady with 2010 at 2.3 billion pounds, but many traders are calling for a stronger export pace, especially if China and South Korea start to boost their import pace. Slow exports out of Argentina and Australia have helped support the prices of lower-grade beef cuts and hamburger, and this has provided significant support to the overall beef market. Boxed beef cutout values reached $172.81 last week, which was the highest level since July 11, 2008.

Monthly pork exports for November were the highest since the spring of 2008, and export reached 19.8% of total production. The USDA believes 2011 exports will be up 9.1% from last year. South Korea has culled nearly 2 million pigs and reduced the pig and cattle population by about 15% so far in attempts to stop foot and mouth disease from spreading. Traders see this as a reason to expect a stronger US export pace ahead.

The Commitment of Traders reports as of January 11th showed non-commercial traders were net long 39,603 contracts in hogs, an increase of 5,793 contracts for the week. The buying trend of the funds is seen as a short-term positive force, and the net long level is still well short of the record high of 63,789, so the market is far from overbought. Open interest has reached its highest level since October, which is also seen as a positive technical factor.

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The grain markets are in need of a jump in planted acreage this year, and wheat got the early start after the Russian drought sent US winter wheat plantings up about 10% from last year. This leaves corn and soybean markets “in need” of more planted area for next year, with traders seeing 1-2 million more acres needed for soybeans and 4-5 million more for corn. However, this could be difficult to accomplish due to the increase in wheat plantings. Early surveys are showing a slight decline in soybean plantings and only a 1-3 million-acre jump for corn. This does not appear to be enough, and if the January 12th USDA Supply/Demand, Crop Production and Quarterly Grain Stocks reports show further tightening in either corn or soybean ending stocks, the markets could rationalize that higher prices are needed to encourage producers to plant more this spring.

On top of this already bullish setup, a lack meaningful and timely rainfall for Argentina during November and December has left traders adjusting their Argentina production estimates down for corn and soybeans and a little higher for wheat. Some traders have already adjusted corn production down to around 20 million tonnes from the 26 million that were expected at planting time. This is equivalent to a decline of 236 million bushels. Soybean production estimates have also been adjusted lower by about 4 million tonnes from the recent USDA forecast (equal to 146.9 million bushels), even though the key weather period for soybeans isn’t until late January and early February. When you consider that corn ending stocks in the US are only 832 million bushels and the stocks/usage ratio is the tightest on record, any more poor weather in Argentina into late January and early February could push customers to the US that traditionally buy corn from Argentina. Keep in mind that both China and Russia have already approached Argentina to book corn for future use, and this action, plus the reduced production, could force other customers to the US market.

Traders see an adjustment higher in ethanol production for the January Supply/Demand report. Historically, the January production estimate for corn (considered the “final” estimate for the season) has a tendency to come in lower when it follows a steady decline in the USDA’s estimates over the course of the previous fall. Traditionally, “small crops get smaller,” and it appears that the USDA could trim production slightly in the upcoming report. The quarterly stocks report will give traders a better indication of 1) whether there was any price rationing for the first quarter of the marketing year and 2) whether some of the beginning stocks for the 2010/11 season were actually double-counted as production. If the was some double-counting, stocks could be much lower than previously expected.

The January supply/demand report is expected to show a further tightening of US soybean ending stocks due to higher than expected exports for the first quarter of the marketing year. In addition, an adjustment lower in South America production should help to tighten the world ending stocks outlook.

On top of that, palm oil prices have surged to 35 month highs in the past few weeks as heavy rains in Malaysia have caused production declines. Palm oil stocks are expected to drop to a 5-month low for January 1st because production was down 15% to 1.24 million tonnes in December. Production is expected to push higher in Indonesia this year, but if Malaysian production is slow for the 1st quarter, vegetable oil tightness could become a significant issue.

Wheat could get dragged higher by higher grain markets, but it may take more supply issues to foster a dramatic move. The market may have already priced in production losses in Australia, and the Argentine crop is higher than expected. Plus, a new Indian crop will be harvested in a few months. The winter crops in the US and China are not in good condition, and traders will continue to monitor both of them for any winterkill damage. A United Nations economist has expressed concerns that food prices could continue to move higher if dry conditions in Argentina move develop into drought and if there are winterkill problems with the northern hemisphere’s wheat crop. The UN food price index hit a record high for December.

Index fund rebalancing, a surge in the US dollar and continued talk of the overbought condition of the gain markets sparked the start of a significant long liquidation correction in early January. We consider corrective breaks as buying opportunities, particularly in May corn, March soybean oil and November soybeans.

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As we enter 2011, there already appears to be a tendency to see inflation under every unturned stone. Last week, the markets saw what was labeled as a “hundred year rain event” in Australia, which launched a media frenzy of speculation that was primarily focused on coal, but at times the press attempted to extend the potential inflationary impact into the wheat and sugar markets. Just to highlight the ever-tightening linkage between commodity markets, some analysts suggested that a sustained disruption in coal exports from Australia to China could result in a shortage of power to Chinese factories, which in turn could derail the Chinese economy, which has become a very important cog in the machinery of the bull market in commodities. Other inflationary linkages have been noted in the markets over the last several months, as soaring cotton prices (to historically high levels) have prompted a huge spike in profits from wool, but the high price of cotton also has the potential to steal some acreage from the US soybean crop in 2011. In short, the markets in 2011 look to become even more intertwined, and that could point to even stronger volatility ahead.

While we count ourselves within the bull camp for most physical commodity markets in 2011, we have a special interest in what we call the “small” markets. We have expected physical demand for most commodities to continue to improve from the depths of the sub-prime recession, but we also think that investment demand for these assets will continue to expand. This might simply be too much for the smaller markets to handle without a significant appreciation in prices. As we see it, the key “small markets” for 2011 are platinum, palladium, oats, rice, coffee, orange juice, cocoa, milk and coffee.

We also think that markets like silver, bean oil, natural gas and sugar will behave like small markets because of the sharp ramping-up of physical and investment demand. In some cases this increase in physical and investment demand will be the result of alternative assets being historically high-priced, while in other cases it may result from a desire by investors to capitalize on the prospect of inflation.

Regulators are apparently poised to “take action” against speculation through new regulations that would tighten position limits, as they think that would curb the enthusiasm. Certainly speculation has increased prices for some commodities, but the key factor being missed by many “pundits” is that real demand is expanding and that so far higher prices don’t appear to have rationed demand. In fact, what the world is being presented with is an ever-lengthening string of adverse weather that has and will continue to crimp production. Therefore it doesn’t matter whether prices are artificially reduced or reduced for economic justification, reducing prices will have the impact of reducing production. And in the event that production is reduced, prices fall and the global recovery continues, there will be more acute shortages and even higher prices down the road. The American people wanted homes without equity, credit cards without jobs and health care for below-market costs, and now it appears that they want commodities to be cheaper than the cost of production! But the ultimate direction of commodity prices won’t be determined in Washington, Chicago or New York. Beijing, New Delhi, Sao Paulo and Moscow are the new market masters. When speculators are prevented from buying futures in a market facing long term shortages, look for the funds to “buy the cash!”

From a macroeconomic perspective, the odds of a significant, commodity-inspired inflationary spiral remain very strong. The odds of a “battle for acres” looms large in the US, and the US Federal Reserve has recently stated that they intend to continue to provide artificial support to the economy until it is on a track to repair its badly damaged employment situation. Even the Euro zone is seeing signs of inflation, despite a very suspect economy, and it’s only a matter of time before the EU is forced to implement either a bailout package or quantitative easing.

As for China, we can only suggest that the recent travails in Australian coal production areas looks to have contributed to even more inflationary pressures. However, because China can still be expected to battle against rising inflation and the US regulators look to quell investment in agriculture, the path to significantly higher commodity prices will be a rollercoaster affair.

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The sugar market appears poised to see new contract highs into early next year, as the cash market looks to tighten further into the 1st quarter of 2011. A sharp reduction in the available supply of sugar for export out of Australia, a significant production deficit from China for the third year in a row and expectations for a seasonal decline in Brazil production are all factors which could lend support. In addition, US production is threatened for next year due to court orders to avoid GMO seeds. Some traders see US planted area down 35% from last year. If so, the US could also become a major importer on the world market in 2011.

It should not take much in the way of demand news or reports of wet weather slowing the harvest in Brazil to spark an extension of the current uptrend. Sugar production in the key center-south region of Brazil is expected to reach 33.7 million tonnes, up from 28.6 million last year. But, about 140 of the 350 or so cane mills in the center-south region were closed by December 1st due to the onset of seasonal rains compared with 25 closed last year at this time.

Ideas that the Brazil crop in 2011 will be “steady at best” with 2010 just adds to the bullish outlook, as the market has gotten used to a steady rise in Brazilian cane production for much of the past decade. Once the Brazil production pace slows down for the season (in the December to February time frame) the cash situation could tighten further.

After a poor end to the growing season in Australia, the trade is now expecting the worst crop in nine years, and officials now believe exports will reach just 2.4 million tonnes for the 2010/11 season compared with expectations just a few months ago for 3.2 million tonnes. Demand for imports from China is likely to increase dramatically next year as China faces a deficit of more than 2 million tonnes. This would be their third season in a row with a production deficit. On top of that, China may also need to replenish its state reserve stocks, which are thought to be down to around 1 million tonnes from 2.9 million in 2009 and from a more normal level of 4 million, or about three months supply. Some traders believe reserves are down to less than 500,000 tonnes. Russian production from beets through December 6th has reached just 2.62 million tonnes, down 13.9% from last year.

The Commitments of Traders reports indicate that both trend-following fund traders and small speculators hold hefty, but not extreme, net long positions. As of December 7th, non-commercial traders (funds) were net long 140,743 contracts. This was still well short of the record high of 216,497 contracts and may have been partially offset by the relatively small net long position held by index funds. If index funds show more interest in owning sugar, the market may experience significant buying ahead. Index funds currently hold a net long position of 137,604 contracts, down from 180,000 this summer, and well off the 392,740 contracts they held in May 2008.

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The energy complex seems to be having trouble rising above the $90.00 price level for nearby crude oil, and that is probably a function of recent strength in the Dollar and also because the overall global economic outlook seems to have downshifted slightly over the last month. Apparently refinery margins reached a high enough level that US refiners felt comfortable in expanding their output, as the US refinery operating rate jumped by more than 7% in just two weeks.

It should also be noted that crude oil saw its spec and fund net long position carve out a new record in the December 7th COT reports. With the threat of rising Chinese interest rates, ongoing turmoil in the Euro zone and less than stellar employment activity in the US, one might suggest that crude oil is a sub-$85.00 item instead of a $90.00 item. With the US refinery operating rate in the December 15th EIA report showing yet another increase, to 88%, and rising above the 5 year average for the first time since late September, it does not seem like the market will be overly sensitive to minor product supply issues. Therefore, we see crude oil prices above 88.85 basis the February contract as overvalued, and we suspect that prices are capable of temporarily dipping down to the $84.20 level at some time before the end of the year.

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In the wake of a series of tightening moves by China over the past month, lingering Irish debt travails, persistent strength in the US Dollar and talk of new position limits in commodities, it would appear that the distinct upward movement in physical commodity markets from the June through early November time frame could be reversed “temporarily.” For the next two weeks, it is possible that further gains in the Dollar will result in a year-ending washout in commodity prices. But we don’t believe a washout will signal the end of the commodity rally, instead we think it will be setting the stage for an even bigger rally down the road.

While the resurgence of the Irish and EU debt crises are not something to discount out of hand, we think that a large portion of the Euro zone is in much better condition than it was when the Greek debt crisis surfaced. We also think that the Spanish and Irish economies will be more resilient that the Greek economy was. And we think that overall, global financial market anxieties are lower and that therefore the markets might not be as prone to whip the crisis back up into a full blown problem.

We are also not of the opinion that China is destined to kill their economy for the sake of restraining inflationary pressures, as many economists and traders seem to fear. Given the pace and quantity of Chinese physical commodity buying over the last two months, it would appear that China still sits upon a very sustainable pattern of growth. While some traders think that China’s buying pattern in 2010 was merely stockpiling or pulling demand forward, we think that the aggressive buying of grains and oilseeds might also have been part of the government’s attempt to quell inflationary pressures. According to recent press reports, the Chinese have been purchasing grain and food products that will be released this winter to head off rising price threats and/or regional food shortages.

With both Russia and China thought to be negotiating to buy as much as 4 million metric tonnes of corn from Argentina (Argentina’s total annual corn exports usually amount to only 17 to 18 million) and Mexico actually securing 120,000, it is clear that countries that haven’t typically imported grains are starting to do so. The 2011 crop year is shaping up to be battle for acres, but if the weather in South America becomes truly threatening, grain prices aren’t going to wait to see what shakes out in North America.

From a bigger picture perspective, energy prices managed two impressive rally attempts in the month of November, with the second one taking place directly in the face of a sharp rally in the Dollar. To us that suggests a very high probability of energy-inspired inflationary pressures ahead. In the meantime, it is possible that a rising Dollar will upend energy prices, even though a low refinery operating rate is already serving to tighten the product markets (see chart).

While the sharp rally in energy prices last week might have been the result of other developments, to us it seemed like a minor refinery glitch in California and news that Venezuelan refineries were operating at only 76% of capacity due to electrical issue were the main catalysts for the move. Perhaps the energy markets also found support off of talk of removing ethanol subsidies for budgetary purposes, as that in turn could threaten up to 6% of the US gasoline supply chain. Crude oil prices in the vicinity of $90.00 a barrel in the face of a sluggish global economy clearly suggests that some type of energy shortage remains in place, but the question will be whether or not Congress wants to make the shortage worse in 2011. RBOB trading above $2.20 might be a little expensive, but if the choppy pre-holiday period does bring about a break in energy prices, it should be viewed as a buying opportunity.

A number of unrelated physical commodity markets appear to have the capacity to extend their upward track, but it is our opinion that a temporary correction is needed before another wave begins in earnest. And while the markets might see a noted holiday break, traders and investors should be on the lookout for opportunities to get long some markets that are facing fundamentally tight supply situations.

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Like a number of other commodity markets, copper saw a rather aggressive correction in November when it fell 46 cents per pound or roughly 11% in just four trading sessions. Certainly copper bulls deserved to fret over the prospect that China might over-tighten in their effort to control inflation, but many traders still think that copper will be one of the last commodities to be impacted by the tweaking of their economy. Certainly the rise in the Dollar was considered to be a source of the decline in copper prices, but in reality the copper market is less affected by Dollar movements because such a large amount of supply flows from Mexico, Chile and Peru. It appears that those countries all saw declines in monthly copper production in the latest figures, which indicates that the copper market is still tightening, even under less than stellar economic conditions.

While Shanghai copper stocks did show a significant, 4,124 ton weekly decline for the week ending November 26th, the previous week showed a build of 11,313 tons, which was probably at least partly responsible to the weakness in copper into November 23rd. Still, LME copper stocks have shown a very consistent pattern of daily declines for most of 2010, and if the world outside of China manages to regain any margin of economic strength, it could give copper prices a surprising lift. Daily LME copper stocks so far this year saw 172 daily warehouse stock declines out of a total 230 market days.

Almost forgotten in the copper demand story is the fact that a whole host of countries beyond the US and China implemented infrastructure programs to combat the recession, and with the beginning of the sub-prime having occurred three years ago, some of the more difficult-to-start programs are just starting to gather momentum. This factor could provide copper prices with a tailwind into 2011.

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The platinum market continues to be a relatively small commodity market in what is becoming an even bigger world. In addition to being a precious metal market that sometimes garners financial/flight to quality investment buying, platinum is also an industrial commodity that is starting to see physical demand rise sharply. While a recent, widely regarded industry paper from Johnson Matthey predicted that the platinum market might remain in a minor supply/demand “surplus” condition into 2011, it should be noted that their projection for 2010 called for a surplus of 290,000 ounces. Apparently industry sources expected global platinum demand to remain flat and that increased demand needs would be largely met by increased recycling efforts. Supposedly South African platinum production is expected to decline, but that expected to be offset by increased output from Russia. Furthermore, reduced US platinum production is expected to be offset by rising production from Zimbabwe. In other words, total world production of platinum from mining doesn’t seem to be poised to rise, despite the fact that platinum prices at times during 2010 were $200 or $300 an ounce above the levels seen in 2009. While some industry sources expect jewelry and investment demand to sag next year, we seriously doubt that interest in the precious metals has peaked. On the other hand, Johnson/Matthey also predicted an increase in global auto sector demand of just under 37% for next year, with a large portion of that demand growth coming out of China.

In the wake of the November high to low correction (which as of this writing consisted of a break of roughly $83 per ounce) and given that nearby platinum prices still sit roughly $670 an ounce below their all time highs, we have to think that platinum offers a unique play into what could be a continued precious metals rally or perhaps even a rally off classic physical commodity market fundamentals.

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The gold market looks to enter 2011 with a very long list of bullish themes. Not surprisingly, historic price levels are being accompanied by truly historic conditions. However, after a decade-long run-up in prices, we think that the market is poised to make a rather fantastic top. With nearby gold prices almost six times as high as they were when they made low in 1999, clearly the market has made a dramatic return from being on the ash heap of the investment world to what might be called the world’s most favored asset. When it put in its low, the market made what we consider a classic, “textbook” bottom. In looking ahead for signs of an eventual top, we suggest traders consider the inverse of the 1999 “textbook” as a model.

However, while we see the gold top drawing nearer, being able to predict the actual price high could prove difficult, as the gold market is currently drawing capital from almost every corner of the earth. For a couple of years now we have suggested that the final rally in gold would probably not come as a result of flight to quality issues, but instead because the flight to quality issues had been appeased and inflation was on the march. We think gold will forge a major historical top in 2011, but that top could be $1,400, $1,500 or even higher. When the time comes to determine whether the gold market has topped, we will look to the key factors that caused the 1999 bottom. When those indicators reach extreme levels, we will consider gold to be into its end-game.

By the late 1990’s low gold prices were under heavy pressure, with prices falling to the cost of production at some mines. As gold approached the $250 per ounce level, high-cost mines were trimming production, and capital for new ventures was dwindling. The downtrend in gold prices was so entrenched that banks that owned gold were loaning it out in hopes of being able to buy it back at cheaper levels. The futures trade was so convinced that gold was headed lower that the speculator net short position repeatedly made new records. Gold producers were even selling their future production.

Not surprisingly, this pervasively bearish environment prompted central banks to make the now infamous suggestion that gold was no longer an investment class instrument.” To add insult to injury, the Dollar was in the midst of a sharp appreciation that led many to conclude that the Greenback, and not gold, was the ultimate safe-haven instrument. Lastly, the sharp run up in equities that started in 1994 and was burning hot by 1999 created the impression that gold investors were missing out on the huge rates of return that were being offered by mutual funds and other equity vehicles.

In short, by 1999 almost everyone that would or could participate in the short side of gold was doing so, including central banks, producers, banks and futures and options traders. Furthermore, the investment environment was such that gold was simply being viewed as part of a washed up asset class known as “commodities.” The final piece of the puzzle was the economy, which was getting ready to burst the tech bubble.

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The corn market faces a key USDA report this week. The last report showed an aggressive downward revision in US yield and a sharp drop in production, and March corn consolidated just under the $6.00 level in the month since. While we have seen a slight setback in export interest for US corn since the surge in prices, we have NOT seen a surge in breeding stock liquidation in the livestock sector. Nor have we seen ethanol plant closures, weakening energy prices or economic reasons to suspect less demand for feed grains on the world market. Instead, we have seen an expanding world economy with the potential for increasing demand for feed grains from China, which opens the door for an increase in US exports. Cumulative export sales for corn are on pace to reach the current USDA projection; weekly ethanol production hit record highs for the past few updates; and ethanol stocks are on a decline. Poultry production is expanding, not contracting, and live cattle futures prices on the deferred contracts have move to high enough levels to encourage cattle feeders to place more animals on feedlots. Hog futures were already in a decline going into the October report, and the steep downtrend seems to be a function of seasonal increase in supply and not liquidation of breeding stock. All of this suggests that the corn rally to date may not have been enough to slow down demand. The market still faces the second tightest stocks/usage level in history for US corn and the second tightest stocks/usage level since 1973 for world coarse grains.

At 902 million bushels, 2010/11 US corn ending stocks will be high enough to avoid severe price rationing, but the market will need to be confident that 1) the profitability outlook is high enough to encourage an additional 5 million acres for the 2011/12 season, 2) weather will be sufficient for a near record yield for next year and 3) there are no further revisions lower in production or higher in demand for the coming season. But going into the November 9th USDA Crop Production and Supply/Demand reports, traders were looking for a drop of 1-2 bushels per acre in yield. If demand numbers are left unchanged and the USDA drops yield by 2 bushels/acre, then ending stocks for the 2010/11 season would come in near 742 million bushels, down from 1.708 billion bushels last year. This would be the lowest ending stock level for US corn since 1995/96. This would result in a stocks/usage ratio of 5.5%, close to the record low of 5.0% set in 1995-96. Last year the ratio was 13.1%.

If we plug in a lower beginning stocks number for the 2011/12 season and assume a jump of 5 million acres planted and a record yield of 165 bushels per acre for next year, ending stocks would reach just 1.3 billion bushels, and the stocks/usage ratio would be 9.7%. Since 1973, there have only been a few times when the ratio fell under 10%. This illustrates how the current tight supply situation for corn could require two years of strong pricing to rebuild stocks to a more comfortable level.

If we assume a yield of 161 bu/acre next year, still the second highest on record and we still see a 5 million acre increase in plantings, ending stocks slip to just 970 million bushels with a stocks/usage of 7.1%. Clearly, the potential for extremely tightness this year and the outlook for a continued very tight situation next year is great if we do not see conditions favorable for an increase of 5 million acres or more for the coming season, which means high corn prices.

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