Overview
In 2006 the futures market experienced what should be viewed as one of the greatest volatility expansions and contractions in recorded history.  While there have been several instances of years in which the markets have shown extreme volatility (2005 as a perfect example), and even years in which we have witnessed relatively dead markets, there has rarely been a year in which so many individual markets exhibited both tendencies in the same year.  Energies retraced about 25% in 2 months and then channeled for the last 3 1/2 months of the year.  Silver rallied over 50% in under 2 months and then had the largest one day down move since the Hunt Brothers nearly three decades ago, only to develop a pennant for the last six months of the year.  The U.S. dollar plummeted over 7% in under a month and then entered into one of the tightest and longest channels in its history by staying in a 4% range for six months.  Sugar doubled in 2005, plunged over 50% thru September (70% of that move in three months) and then flat lined into a tight trading range to end the year.  So what do all of these shifts in volatility mean for the markets in 2007?  Simply put, more of the same. 

Commodities are, for all intensive purposes, in a long term bull market.  Typically we see these markets function on a cyclical basis which, depending on the sector, could be a 2 year cycle or as long as a 20 year cycle.  However, the current market action suggests we are in a period of shorter term cycles.  This means large moves in short time frames followed by stretches of price consolidation as the market adapts to the recent volatility and price shifts.  Moreover, this also indicates the potential for increased average daily trading ranges, gap moves and large swings in option premiums. 

The driving force for price action in 2007 will be the STRENGTH of the US DOLLAR.  You read that correctly - the U.S. dollar will rally in 2007 and force a surprise shift in commodity prices.  Remember, this is a cyclical market structure, and currency cycles in the US dollar have ranged from about 2 years to 7 years over the last two decades.  This market is approaching key support and is likely to find, albeit a contrarian outlook, support in 2007.  As most commodities are priced in U.S. dollars for international trade, you can expect adjustments in pricing and import/export relationships in many futures markets. 

Secondary forces to shift prices in 2007 include economic policy with a new Democratic Congress, weather pattern shifts from a post El Nino year, U.S. pullout from Iraq, Middles East tensions, China infrastructure and demand, and of course the unknown.  Market recaps and forecasts below - best wishes for profits and progress in the New Year!

Energies
What goes up must come down, right?  The energy complex is stuck in a debate over whether this is the end of outrageous oil prices or simply a major retracement in a long term rally that is just getting started.  I am, for the most part, a believer that market price extremes are temporary.  In fact, you could count on your fingers how many times markets have experienced permanent fundamental changes that force a new price zone beyond a decade time frame.  The 1 to 10 year moves, that I like to call 'price fads', are the cyclical patterns that I discussed in the overview section of this report.  Crude oil triples in less than four years and natural gas follows a similar path.  Is this an epic shift in the supply and demand structure of this sector?  Let's take a closer look.

Over the past half decade we have seen four significant events affect oil prices - war in Iraq, war in Lebanon, Hurricane Katrina & political tension in Iran.  Granted, a slew of other issues such as the Alaskan pipeline, Venezuela, Nigeria, etc. have had their toll on supplies.  When a long term price shift occurs in a commodity it is normally due to a permanent change in either supply or demand.  For example, when the diet craze of low carb Atkins and South Beach hit the U.S. consumer, we saw a gradual shift in the demand structure for beef products.  Normally this would be viewed as a price fad, but when a fad forces the USDA to change an over 20 year old RDA program then we may well be looking at a long term permanent price shift due to demand.  When 50% of the world's population starts consuming coffee that never consumed it before, we might be looking at a demand shift there too.  When the President of the United States pays farmers to produce corn for ethanol production to remove the stigma of being energy dependant, then corn farmers might see a shift in the supply and demand of their industry (only time will tell if that is fad or not).  But when supply is cut off by a localized disaster, inflated by a geopolitical flight to quality and supported by market hysteria, therein lies the flaw in the market's perception of the future of crude oil prices. 

Let me take a step back for moment.  There is one theory out there that needs to be addressed, as it is the main counterargument to this line of thought.  I like to call it the Jim Rogers/Boone Pickens straight jacket theory.  I call it that because if you subscribe to it, much like the dollar going to zero or the gold bugs shouting $5,000 gold, you are one more insane thought away from a straight jacket.  So the theory goes something like this: Oil is a limited supply market that has reached its apex and has begun a downtrend in supply that will ultimately cause the largest price boom in history.  Now, in all fairness the first part is irrefutable, which is the part that makes the theory so attractive to the average speculator.  Moreover, it is hard to argue against the world's addiction to oil.  But there are some flaws in the logic. 

While oil is a natural resource that will eventually run out, there is absolutely no definitive proof that we are anywhere near the apex of its supply.  You probably want to finish this report before 2008 so I will spare you the fine points here, but needless to say the longer oil sustains a high price the more money will be thrown at finding new and alternative supply.  Deep water drilling, Alaska, Russia and the unknown all make this such a question mark that for anyone to say we can't supply more oil with a straight face is a step away from a straight jacket. 

The natural order of markets says that if the price of oil is unsustainable then alternatives will be created.  If no one can afford it then demand will dissipate and remove the price expansion.  Whether it comes from hydroelectric power, solar, natural gas, ethanol, etc. the market will find substitutive commodities for supply or alternative methods to filter demand.  The question isn't if but rather when and at what price?  It is interesting to note that the U.S. has the least expensive cost factor to a gallon of gas of any major 1st world country - even in countries like the U.K., where gas prices are more than double the U.S. in some areas, the consumer can handle it.  Granted, the euro and pound are providing a nice buffer to the cost of gasoline, but overall the market is showing it's willingness to absorb these price extremes.  This suggests that we have not yet pushed the envelope completely and that testing a higher price is plausible, albeit unlikely.

So, if it isn't clear enough, the energy rally is in all likelihood caput, done, finito, adios ga-bye-bye.  It is important to note that this is a cyclical observation and not a short term one.  2007 could easily provide us with a bounce back in the market.  After all, we did rally 25% and sell off 25% in less than one year.  However, long term this market has nothing fundamentally to sustain a permanent price shift and, in turn, it will fall back on the 'what goes up must come down' theory.  Sell out of the money call premium 12-15% away from the market (4-8 weeks out in time) on market spikes and avoid puts as the market isn't paying you enough to take the exposure.  If the market plunges in the beginning of the year, below $50 a barrel, then look to be a call buyer from mid-June to mid- August as the threat of hurricane exposure is still enough to rally this market. 

Financials
The stock market offered a shocker of a year to us bears.  Now we can excuse it anyway we want, but the reality is that the economy is better than the market expected, stocks are reporting solid growth, the real estate market is in decline but not freefalling and the threat of terrorism and geopolitical concerns are less than a year ago.  Many bulls, and for some reason bears too, leave out the obvious reason for financial strength in the S&P 500 and DJIA - a weak U.S. dollar.  The export demand for U.S. goods is at multi-decade highs and the spike in agricultural demand and benign inflation have led to a successful bounce back year for many U.S. companies.  The 16-20 bull/bear stock cycle theory has more historical relevance than any one year performance or any argument of differences in current structure versus historic structure.  We are in a long term bear cycle which, oddly enough, has historically had more up years then down ones but has netted substantial draw downs on a percentage basis over the lifespan of the bear cycle.  This is an excellent time to develop bear plays over different time frames to expose you to gains on a bear move in 2007.  I recommend an equal division of risk capital to 3, 6, 9 and 12 month time frame bear put spreads in the S&P.

Bond prices have historically been a step ahead of U.S. economic policy, but 2006 offered us an extreme look at this phenomenon as the bond market literally led the Fed to halt its rate hikes and begin 2007 in neutral.  The market is backing off of a recent move higher, indicating they went too far too fast.  The anticipation of rate cuts is purely conjecture at this point.  The Fed is coming off of 17 consecutive rate hikes that was like watching the paint dry with 1/4 point hike after 1/4 point hike.  The market looks at the historical relevance of the quantity of consecutive hikes and says we can't possibly do more, but they fail to recognize that we have never hiked 17 times in such small increments.  The Fed is being slow and methodical and will revert back to a rate hike if they see inflationary news hit the wires.  This is a great premium collection market in 2007, despite historically low volatility premium in options.  It doesn't matter if you are not getting paid well to sell premium if the market isn't going to move.  Expect 114 to hold on the upside and a possible selloff to 108 or lower over the course of the year.  Sell calls on bounces and maybe even be a synthetic short trader (short calls and long puts).

The dollar will be the story in '07, as the likelihood of a continued failure below 80 on the index is minimal and bullish momentum should carry this market to 90 before year's end.  Key resistance is at 87.  The cyclical nature of currency trends places this market in a low volatility support mode for much of the year to come.  This means bear plays in the euro, pound, and Canadian dollar and premium collection on volatility spikes.  The Japanese Yen has declined about 10% since May and while this is important to help in its critical export industry, the market will likely find support above 80 and possibly as nearby as 83.  The Canadian dollar is perhaps the most attractive short as its recent break below key 87 support suggests that this may be the first severe correction in this market since 1998.  Key support lies at 85, 83.50 and 78.50 respectively.  The introduction in 2007 of U.S. dollar versus the Columbian Peso and Brazilian Real currency swaps will not draw much attention but is worth watching as it is intended to allow coffee hedgers and producers to offset currency risk and will be the first gauge of this important dollar/commodity relationship the coffee market has ever had.

Grains
Grains experienced severe volatility shifts throughout 2006, spurred by crop issues, fund buying, positive P.R. from Bush and the ethanol subsidies and by pundits like Jim Rogers.  Corn has already experienced one of its largest one-year percentage rallies in history and is overdue for a market correction in 2007.  Ratio credit spreads and straight put buying is highly recommended.  The aftereffects of El Nino will likely lead to a benign summer and, without wishing to be a much maligned weather forecaster, will likely experience a booming crop year.  Soybeans have remained relatively contained, mainly due to a substantial crop and a lack of spikes in demand from China and other countries.  Wheat suffered one itââ,¬â"¢s worst global crops in history, as measured by its percentage drawdown in supply from the previous year, and is on thin ice heading into 2007.  As a long term spread trade, I recommend 1 long soybean and 2 long wheat versus 6 short corn (July contracts).  Combine some options with futures - look to play long 1 bean and long 2 wheat against 10 long July 3.20 corn puts.  As a bear corn play, sell a July 4.00 corn put and buy 1 July corn 3.60 put and buy 4 July corn 3.20 puts for a combined spread credit of $350.  To learn more about option spreading techniques, sign up for our FREE 8 week option education program.

Rough Rice continues to be a standout bull breakout buy and has the potential to extend its current run by as much as 50% in 2007.  Calls remain relatively inexpensive and are an excellent way to play this illiquid market.

Meats
Cattle offered some significant trending and price volatility in 2006.  With over a 20% decline followed by a 20% rally and 10% decline it is clearly one of the most choppy and volatile markets in 2006 when compared to historical norms.  We head into ââ,¬â"¢07 with fears of 1,000s of cattle dying from starvation in Colorado and the surrounding areas as extreme winter conditions have made it nearly impossible to get feed to the herds.  This is a short term supply issue that will likely be offset by a flood of cattle being brought to market in January and February.  Cattle traders witnessed the largest inventory supply report in cattle on feed report history, and saw erratic cash price swings throughout the year.  The overall outlook is bearish as the market is approaching a critical resistance band between 92 and 98 cents.

Hogs enter the year in a downtrend and overdue for some price support, but this market has a tendency to stretch to price extremes.  I would be a buyer in the 50-52 range and a seller if we approach 75.  Essentially we are in the mid-range of a trading opportunity.

Metals
A year of sporadic volatility in metals bore witness to the largest one day price decline in almost 3 decades in silver, an all-time high in copper and an epic 30% two month rally in gold.  A critical pennant in gold sets up an explosive beginning to 2007, with all indications pointing to increased volatility and the potential for a serious market collapse if we break through $550.  The dollar is bullish but has not been the main driver in the metals for some time, as the intermediate and long term gold moves have run independent of U.S. dollar prices.  This is historically not an inverse correlation that disappears for very long and I suspect the dollar rally in 2007 forces the gold bugs to bail on the market in the intermediate term.  Moreover, the decline of crude oil is relieving a geopolitical flight to quality in gold and the neutral stance by the Fed in regards to interest rates will likely deflate the metals even further.

Silver plummeted earlier in the year on a one day decline of over $2.  The decline has left many traders minds, but it is important to note that the reasons for the plunge should be used as a lesson in trading.  For months prior to the plunge silver had rallied on what many considered a no sellers market, which means any high volume buying did not have a seller to meet the other side and surged the market which forced buy stops to be triggered.  This constant momentum to the upside increased the odds of a one day meltdown, and just prior to the collapse the market surged to levels of volatility not seen in many, many years.  The day before the decline the exchange increased the margin requirement substantially, which forced traders to move up their futures stops to prevent a margin call on a decline.  The market sold off the following day and started a triggering of sell stop orders that forced a lock limit move.  The market resumed trading after a brief halt and ultimately destroyed the price by the close of trading. 

To end the year the silver market experienced a $1 single day decline, suggesting increased volatility ahead.  Silver ratio call credit spreads on price spikes and put plays are recommended. 

I wouldnââ,¬â"¢t be surprised if we see a similar move in the copper market as the longs have been bailing out ever since setting an all-time high at $4.  This market is coming off of a straight vertical multi-year price incline and could retrace to $1 before it is all said and done.  Platinum is also likely to follow in its footsteps.  Palladium could be the lone bright spot in the metals in 2007, but most hold above $280 to maintain proper price support.

Softs
Softs came out of the doldrums in 2006 and are showing significant signs of expanding volatility in 2007.  OJ continued its incredible run as it cleared $2 before trading sideways to end the year.  With supply problems in Florida and Brazil and long term cyclical planting issues, this market is likely to have sustained price strength.  However, my gut says this market will retrace heavily in the first few months of ââ,¬â"¢07 with a possible move to $1.50 area.  I recommend long ratio strangles with 2 long July 160 puts for every 1 long July 220 call for a spread cost of approx. $600.

Sugarââ,¬â"¢s plunge from its extreme recent historic highs has left us channeled for the last quarter of ââ,¬â"¢06, but I suspect we will not have to wait long into ââ,¬â"¢07 to see this market move outside of this range.  I recommend long strangles here as well, but also see the downside as more likely than the upside. 

Cocoa is seeing, after a long period of dead trade, a breakout move to the upside.  Readers of the Weekend Commodities Review will recall that the spark of this rally was not necessarily fundamental but rather, in my opinion, the effects of a well known recommendation service recommending long call plays.  It helps to have unrest in the Ivory Coast, postponed disarmament efforts and elections and a bad disease destroying crops.  This market is a bull market to watch in 2007.

Cotton remained relatively quiet in 2006 as it continued to form a massive long term pennant.  While analyst sentiment is overwhelmingly bullish and the market is historically low, I forecast lower prices in 2007 due to a lack of fundamental support and long term technicals suggesting lower lows before a cyclical turn will occur.

Coffee trended higher through much of 2006 as Brazilian supply issues and global demand increases helped to form a solid support above $1.  The potential for a multi-country supply squeeze and major supply issue in 2007 suggests that a January pullback is an ideal entry point as this market makes its way to $2.  Bull call spreads for July are highly recommended.

Lumber remains a straightforward long term technical market.  Buy it at 250 and sell it at 400.  The current uptrend has life and long calls are recommended.  The market oversold the housing bubble burst and a rebound in new home construction this year should boost prices.

James Mound is the head analyst for www.MoundReport.com, and author of the commodity book 7 Secrets. For a free email subscription to James Mound's Weekend Commodities Review and Trade of the Month, click here.