Vale SA (ADR) (VALE), United States Oil Fund LP (ETF) (USO) – Commodities: Long/Short

The outlook: Oil prices remain remarkably resilient given the bearish consensus and a highly uncertain world. As a matter of fact, I do not see a strong enough shift in the fundamentals to knock prices out of their their quarterly average range. Nevertheless, rising risks to emerging market economies (China and Brazil are growing at slower rates), which are the engines driving oil demand growth, mean that oil consumption shouldn’t rise by more than 1% in the second half of the year. That said, price support keeps coming from the supply side. Production outside the US is still underperforming, while flows from sovereign producers remain well below expectations.

The suggested trade: When prices remain flat the correct strategy is selling out of the money call options. Hence, I would suggest selling October 2013 United States Oil Fund LP (ETF) (NYSEMKT:USO) call options. Since the ETF that reflects the price movements of light-sweet crude oil trades at around $33 (1x NAV), I would sell calls with a strike of $35 since they offer a great 3.5% premium (+$1.10 per contract).

Not only do I expect the US natural gas supply to remain abundant, I also expect production of US dry-gas to keep on growing. Nevertheless, I think price momentum is building, essentially since an unusually long winter created a deep inventory deficit compared to the 5-year norms.

I would expect second half 2013 prices to average $4.20 per million thermal units (MMBtu) against today’s $3.67 per MMBtu. This 14% upside potential could be realized on the basis that lower storage levels will require higher gas prices relative to coal to adequately loosen the summer supply/demand balances.

That said, I would also expect prices to go down to $4 per MMBtu in 2014, as supply grows thanks to new processing plants. Besides, the second wave of the Marcellus pipeline at the end of 2013 should also put some pressure on prices.

The suggested trade: Go long United States Natural Gas Fund, LP (NYSEMKT:UNG) ETF, which is designed to follow the movements of the price of natural gas as delivered at the Henry Hub, Louisiana. The ETF, which trades at a 5.5% discount to NAV and has a 0.60% expense ratio, is a good way to go long on short- and medium-term natural gas prices. I would buy it now having in mind a price target of $22.5.

Reasons to go short: As expected by everyone in the market, a huge supply of iron ore is coming to the market in 2014. All miners – Rio Tinto plc (ADR) (NYSE:RIO), Fortescue Metals Group Limited (ASX:FMG), BHP Billiton Limited (ADR) (NYSE:BHP) and Vale SA (ADR) (NYSE:VALE) – are poised to deliver significant volume growth over the next year and a half. On top of this, China’s steel production is likely to slow in the second half of the year as credit, construction and infrastructure cycles all appear to be turning down.

Reasons to go long: Everyone is expecting supply to go up and demand to go down so a lot of those dynamics are already embedded into current prices. From the second quarter of next year, iron ore should head back towards $95 to $100 per tonne and stabilize around those levels.

The commodity market is adjusting to a new world: higher interest rates, somewhat higher growth in developed markets (the US and Japan) and lower growth in emerging economies. That said, every commodity should be treated differently and, as I depicted above, the market always offers opportunities. You just need to keep your eyes wide open!