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Commodities - the Ultimate Hedge

Published in Automated Trader Magazine Issue 17 Q2 2010

Given the roller coaster ride of financial markets and the growing volatility of exchange rates, investors have been searching for an ultimate store of value. In recent years many have looked to commodities, and there has even been a proposal to create a global currency, known as the Terra, tied to a basket of physical commodities1. This search for long-term value has led to its own dynamics. Studies have shown for example that commodity futures are negatively correlated with equity and bond returns, while having a similar risk premium to equities. At the same time they are positively correlated with inflation and even sudden, unexpected price shifts2. So how then have the commodity markets fared in the crisis? Bob Giffords investigates.

Bob Giffords

Bob Giffords

From around 2003 there was a lot of focus on the influence of new factors such as Chinese demand and bio fuel demand," says Dr. Paul Netherwood, co-founder and partner at Beach Horizon. "Activity in grains and metals picked up considerably after languishing for a decade." Netherwood describes how, when the credit crisis first broke in 2007 and the US dropped interest rates, everyone looked to Asia to drive demand. The dollar weakened and prices for commodities soared. "When the banking crisis hit in 2008, positions flipped from long to short and commodity traders continued to profit," he adds. "Since then 2009 has seen a slow but good recovery in many markets."

Those markets are, however, hugely varied. "Prices in agricultural products have tended to be steady of late, with corn prices coming down while soybeans have remained strong," says David Lehman, head of commodity research and product development at CME Group. "China is the largest consumer and an aggressive buyer, but crops have been good to offset demand. Volatility overall is now back to historical levels."

Yet every market is different. "We saw New York sugar futures swing from 200,000 contracts in the 1990s, to 1.1 million in 2007-8 but that has now fallen back to 650,000," observes Shaun Downey, technical analyst at quote vendor CQG. "Copper is still near its all time highs."

"Livestock prices had been trending up," continues Lehman at CME. "Then a couple of years ago we saw some volatility followed by weak prices and negative margins, which led to declining investment in the herds. Feed costs were also high." Commodity prices tend to be cyclical due to their seasonal production cycles, however, biofuels have added a new source of demand for some agricultural commodities.

"Natural gas markets in the US are still affected by a huge overhang in supply, along with reduced economic activity and some significant discoveries last year," says Michael Cosgrove, head of energy and commodities in North America for GFI Group. "Prices are so low that some producers have examined the economics of shutting down their fields, but shutting in a natural gas well can cause structural damage to the well." This means that some producers may have an economic incentive to continue to produce gas even if it is sold for less than the cost of production. "A couple of years ago natural gas prices in the U.K. went negative as traders paid you to take their gas when storage facilities were full," adds Cosgrove. "Prices have of course since recovered."

"Spot intraday electricity products are highly customized depending on market conditions," explains Paul Newman, managing director of ICAP Energy. "Therefore, we use a hybrid of electronic and voice broking. From the point of view of security of execution, highly liquid, short dated electricity or gas products are better traded purely electronically, but anything on the curve is hybrid: screens tell you about prices, brokers then tell you about the markets. Prices differ based on location, time of day, demand, which power stations are on line, their fuel mix and other factors."


New investment products attract new participants that also change market behaviour. "Many more types of traders and especially the explosion of commodity ETFs have changed the markets," says Downey at CQG. "As more money flows in or out, the ETFs have to buy the underlying with huge swings in open interest. Physical commodities are volatile anyway with seasonal flows, so they reinforce each other."

"Big pension funds have found it attractive to get very limited exposure to commodities via the index funds referencing the GSCI or the Dow Jones UBS index," says Netherwood at Beach Horizon. "But these types of investments are long only and only perform when prices rise in the majority of the commodities in the index. CTAs like ourselves can take advantage of going long or short in each individual market that can give much more diversified options to outperform the indexes."

Competition Grows

How has electronic trading impacted the markets? "Algorithmic and proprietary trading is now 43% of our overall flow of 12 million futures and options contracts per day, which includes financials and commodities," says Lehman at CME. "We don't break down the portion of algorithmic trading in our agricultural markets, which trade about 800,000 contracts a day. In less than four years agricultural futures are now nearly 90% electronic, while agricultural options are barely 10% fully automated." Traders access the markets from eighty-six countries directly, although physical delivery is predominantly in the US and less than 5% of their products that are physically settled actually go to delivery. "We've now announced skim milk powder contracts with overseas delivery," says Lehman. "However, 98% of contracts will likely be sold or rolled forward prior to delivery. The only requirement is to have a US based clearer, but many firms also have offices in Europe or Asia, so our products are truly global benchmarks. OTC prices in Asia or Latin America are typically priced relative to CBOT."

Each market, however, is different. "We have seen a dramatic increase in electronic trading at LME, especially in the Asian time zone," says Glen Chalkley, head of electronic market development at the London Metal Exchange. "It's doubled in five years to 40% of our flow, with many more algorithmic black box and day traders adding depth. Volatility depends more on the economy." Chalkley explains how they list futures up to a term of ten years with physical, not cash, delivery world wide through their approved network of warehouses and delivery points. "That makes us unique and a global reference for non-ferrous metal trading and worldwide delivery prices."

Chalkley illustrates how physical delivery can also be relevant to speculators. "Some people will speculate on long forward dates and simply store the metals in the interim," he says. "Others will use the market simply to speculate and will close out their positions prior to delivery.

"Exchanges went electronic to cut costs and attract global participants," says Netherwood at Beach Horizon. "Algo trading with DMA using the FIX protocol and now direct exchange memberships are a big story. If you don't have to run a floor operation it's much cheaper. Liquidity has improved or stayed about the same but average lot size has decreased as algos pump in smaller orders to disguise position size."

"Soft commodities are still seen as a largely futures-based product area," says Newman at ICAP. "They have taken a long time to take off in OTC, while metals are dominated by the London Metal Exchange. Energy, on the other hand, has seen some rapid development with new products and trading venues to provide serious hedging tools for long term investors."

Yet there are many historical legacies that traders also need to understand. "Spot oils and oils products are frequently based on prices published by Platts, a division of McGraw Hill, using data from the brokers for global delivery," says Newman. "Most commonly in non-listed areas, this quote is used as the index basis for the swap price."

Electricity, gas, coal and emissions products are currently traded on Trayport. "Now ICAP is launching oil swaps using ICE technology, which already carries oil futures, so on a single screen customers will see both," says Newman. "Other brokers will be welcome to join later on if they, too, feel there is an opportunity for them to improve their service through a voice-hybrid offering." Critically, ICAP will ensure that customers continue to have a choice of which clearing-house they want to use. "Liquidity does not just arrive by itself," says Newman. "Whether through voice, through screen or through hybrid 'screen supported voice solutions', the broker's agency plays an important role in coalescing price formation."


Another option is EnergyMatch, operated by GFI, an open, multi-broker, web-based platform with a FIX 4.4 two-way trade API and full Microsoft Excel connectivity for easy interconnection to other applications. "EnergyMatch does not require dedicated connections," explains Cosgrove. "Customers are able choose where to route their trades for clearing either by setting their default preferences in EnergyMatch's 'SmartRoute' module or by making clearing selections on the fly." EnergyMatch customers may select from all available clearinghouses including CME, LCH, NODAL, NECC, VMAC or ICE. "Our smart routing algorithm will take the highest common clearing choice for both the initiator and the aggressor with the initiator's preference taking precedence," notes Cosgrove.

"For OTC trading two things are key," insists Newman at ICAP, "how sticky is your screen and who holds the open interest. To hold traders on your screen you need lots of relevant content, but equally you need to clear where customers can have one margin pool. This became clear when LCH lost the emissions clearing to ICE back in 2008. We'd like to see open interoperability for clearing, but that's not the way it works."

"Recently exchanges have tried to poach volume from each other rather then generating new contracts," says Netherwood. "This tends to increase costs since the markets are highly correlated. Having all the volume in one place gives us informational advantages and reduces margin. Most copy-cat contracts launched by exchanges tend to be unsuccessful. In futures it seems that each contract has a natural home. Some exchanges did launch all day markets for electricity futures or weather contracts but without success. It takes time to build liquidity and would have been better to start with a single daily fixing, like platinum in Zurich."

"The dealers are keen to increase fragmentation to arbitrage the spreads, but liquidity is incredibly sticky," notes Downey. "Clearly we'll see emerging market exchanges opening up. If the Chinese Dalian grain market ever opens to foreign participants it will be huge. Flow will shift. "

So clearly there is a lot to learn and many niche opportunities.

Gavin Lavelle

Gavin Lavelle


We talk about trading in commodities and we talk about using them to hedge. One of the quirks* of the commodities markets is that there are participants who really do want to take delivery of physical hogs, cereal crops, raw materials. So much we know. But there's an angle to the physical, tangible, stick-it-in-a-vault quality of some commodities that can get overlooked - and we're not just talking about gold. Gavin Lavelle, CEO of Brady, has been in China recently.

"China is starting to use copper as a reserve currency. When the commodities markets crashed last year, they were big buyers across the board of all physical metals, both base and precious, and they are starting to look at copper and iron ore, but particularly copper, as a reserve currency. That makes a lot of sense if you think about the amount of industrial growth that is happening in Asia right now, and their undoubtled demand for raw materials. They're building up stacks of metal as an alternative to buying US T-bills. China wants to diversify away from straight investment in US dollars."

Once opon a time, paper currency used to represent physical value. Then it floated free, and we were all exchanging paper promises. Then the global banking system collapsed, that first volcano erupted, and the world changed.

Perhaps if China was to put all that copper in a vault, and then devise some kind of a barter system involving paper certificates of ownership? We could call those certificates 'money' for short.

Brady PLC is one of the leading CTRM vendors in the metals agricultural commodities.

*Or perfectly normal characteristics, depending on your point of view

Algo Trading: Challenges and Strategies

What are the different ways to trade commodities? Cash or forward physical trades, futures and options, index tracking ETFs, or OTC swaps all interact, and that needs to be clearly understood.

For example, Colin O'Shea, head of commodities at Hermes Fund Managers focuses on swaps. "Our long only commodity funds are benchmarked to the S&P Goldman Sachs Light Energy Index," says O'Shea. "We have a passive tracker fund and a fund that aims to outperform the benchmark by 3% per annum." They trade exclusively cash settled OTC swaps referencing underlying futures contracts via dealer voice trade execution. Some are highly customized and negotiated with a single counterparty; for more standard index trades they seek best execution.

"We gain alpha primarily through relative value calendar spread positions," explains O'Shea. "These positions involve buying and selling different maturities or calendar dates of the same commodity. Traders really need to understand how the shape of those curves is likely to change based on different market conditions or shocks. Other additional sources of alpha include inter commodity spreads where the Fund trades one commodity against another within the same sector." O'Shea sees their counterparties hedging the price risk of their positions with producers and consumers through their investor business clients via OTC swaps."

"Up to 1990 there were only short term futures products," explains Newman at ICAP. "Trading in longer term price swaps in oils (and later, in electricity), came into its own after the first Gulf war. Commodity forward prices often start from a spot price plus storage costs, but electricity can't be stored. This means you can have a very active short date market based on the "now" of what's available, but that forward price discovery tends to orientate itself to basis spreads against other part-substitute energy commodities over the spot price at delivery." Understanding these cross asset relationships is clearly important to automated trading.

Managed futures traders take a very different approach. "We've had many years experience systematic trading of commodity futures," says Netherwood. "The main advantage of trading futures is it's equally easy to take long or short positions and does not involve any form of borrowing from your prime broker." While financial futures are highly correlated with each other because they react to similar economic fundamentals in well understood ways, Netherwood has found commodity futures to be uncorrelated with each other and with financial futures because each market's price can move independently reflecting its own supply and demand fundamentals.

"We currently access over 100 markets to diversify our portfolio of which 40 are commodity markets," he confirms. "Although there are fewer commodity markets than financial we place over 60% of our risk into the commodity markets due of their diversification benefits. There are some smaller markets we can trade but we have to consider liquidity, and correlations and other factors such as currency risk." Netherwood gives the example of Kuala Lumpur palm oil, which is highly correlated with Chicago soybean oil because they have similar uses in food manufacturing. However, he sees the historical currency risk of the Malaysian ringgit as a factor in choosing soybean over palm oil.

"High frequency electronic traders add liquidity but they tend to be concentrated in the more liquid financial contracts," concludes Netherwood. "Most commodity markets are not really liquid enough to be effectively traded using high frequency."

Nevertheless, all the usual electronic tricks of the trade apply. "Virtually all of the flow for futures is electronic," says Downey, "with iceberg orders or variable icebergs to disguise what's happening and all very fast and uncorrelated with equities or bonds. However, there's a lot more cross asset trading now: soya meal to bean oil spreads, for example."

"Since the GSCI index rolls their contracts at specific times, notes Netherwood, "the market has advanced knowledge which sometimes gives you an advantage in terms of being able to act before the indices."

Downey argues that trading software has to look at volumes and open interest, commitments of traders, who is long or short based on the weekly CFTC reports, even 6 month cropping cycles. There are a lot of web sites with data as well. "With new participants and globalisation the rules are being rewritten," he concludes, "so relying on past history can get you into trouble, even FX trading is changing. Food is still incredibly cheap compared to the 1970s on an inflation basis, for example."

Then there can be unexpected climate impacts. "Take the Icelandic volcano, will that mean cooler summers?", asks Downey, "Traders may have to take a view. It's all sentiment." Finally there is the issue of quality. "With some physical warrants you never quite know the quality of what you are getting," warns Downey. "A dealer might corner the market in a high grade category and then sell at a premium price. Polish zinc has a purity of 97.5, Canadian has 99.8. So prices can be very specific to traders and liquidity."

"Some managers correlate the volume of news stories with market activity and volatility in their algos," notes Netherwood, "but it's difficult to get clear alpha signals from news because there are so many factors at play."

Signals can be difficult to tie down, as Downey illustrates with biofuels: "You'd have thought they would increase demand and prices for corn, but then the government gave out subsidies, acreage expanded and prices fell."

Many counter-intuitive impacts can affect behaviours of the brokers as well. "In most of our markets we are paid by volume not notional value," says Cosgrove at GFI. This means that in times of extreme high prices and / or extreme volatility we can experience a counter intuitive decline in revenue as a result of the high prices consuming our customers' credit facilities while the extreme volatility consumes their VaR limits."

Long arm of the law

Since the financial crisis regulators have taken a particular interest in all derivative markets. Commodities, the historical home of derivatives trading, are also in the firing line. Indeed, commodity futures trading goes back over 150 years in the US, although federal regulation applied only since the 1920s. Therefore, a key player in the global debate has been the US Commodity Futures Trading Commission (CFTC). How might their initiatives change the markets?

"The CFTC, like the exchange, actively regulates the futures markets," says Lehman at CME, "and it publishes weekly reports of open interest by types of trader. To ensure market confidence there are clear limits for grain futures that a trader can hold. Commercial hedgers typically represent around half the open interest."


"Futures trading is inherently leveraged," says Netherwood, "because you're only putting down margin with the clearer. Consequently there are many regulatory rules about position limits and hedging. Financial hedging is now categorized separately from commercial producers or consumers and thus more restricted in terms of position limits."

"The CFTC has been very active over the past year," observes Cosgrove at GFI, "declaring a broad range of products as serving the role of significant price discovery and therefore subject to CFTC regulation.

While I generally agree with the excellent work that the CFTC has done, and continues to do, I fear that their insistence on setting position limits in cash settled swaps will damage the markets that they seek to protect."

Regulators are also pressing all OTC markets to set up a shared central repository. "ISDA has now chosen TriOptima as their interest rate swaps repository," notes Newman at ICAP. "We'll have to wait and see what happens to commodities."

"The proposed central clearing of OTC swaps will certainly increase transaction costs," adds O'Shea, "however, it still could be required."

Regulators are also cracking down on so-called speculation. "Index investors have sometimes been blamed for volatility and higher prices in agricultural markets," says Lehman, "but no case has really been made. These funds normally have a fixed dollar amount to invest. When prices are high, they sell so their overall effect is probably neutral. The CFTC has now started to report their aggregate positions."

"Currently, the open interest represented by commodity managed funds is only about 15% of the total," adds O'Shea. "So, aside perhaps from the very short term, investors in the commodity markets do not impact the underlying commodity price. This is dictated by the fundamental supply and demand dynamics of each individual commodity market."

So there are many challenges for the would-be commodity algo trader from market complexity and acts of God, to the usual forces of supply and demand, globalization and regulatory scrutiny. What is also clear, however, is that the era of electronic trading of commodities is only just beginning.

1. Bernard Lietaer, "The Future of Money: Creating New Wealth, Work and a Wiser World", January 2001

2. "Facts and Fantasies about Commodity Futures", Gary Gorton and K. Geert Rouwenhorst, Yale ICF working Paper 04-20, February 2005

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