Yet those studying, trading and regulating these markets know that such deceptively simple descriptions cannot explain the subtle dynamics that drive supply and demand. To be sure, China’s growth, industrialisation and consumerism have led to soaring demand for everyday commodities: China now accounts for over 40% of the demand of the world’s iron ore, copper, and other metals. But commodity markets are now part of the integrated global financial system - buffeted by demand from growing emerging-market economies as much as by cash-rich funds eyeing commodities as an asset class. Contributors include: Michael Haigh Société Générale, Kamal Naqvi Credit Suisse, Mark Hooker State Street Global Advisors, Carlos Blanco NQuantX, LLC and Wang Xueqin Zhengzhou Commodity Exchange. Commodity markets are an indelible element of financial markets and of society. For thousands of years they have shown themselves to be the most efficient way to assign the elemental resources necessary to advance. This fundamental quality has not changed. What has changed is the breadth, depth and complexity of markets. Chapters focus on the fundamentals of major, key markets: • oil and petroleum • metals • natural gas • power • weather • grains and oilseeds • coal. Edited by Stinson Gibner Editor Stinson Gibner brings two decades of experience to Commodity Investing and Trading, having cut his teeth at Enron, Citadel, and Citigroup. He has assembled a team of industry experts whose contributions give the reader a unique view of the commodity markets. Subsequent chapters detailing risk management, trading, and market insights including: • structural alpha strategies • energy index tracking • enterprise risk management • CVA for commodity derivatives • the future of markets in China. Commodity Investing and Trading For some, the trends - and volatility - in commodity markets in the 21st century can be summed up in one word: China. Commodity Investing and Trading EDITED BY STINSON GIBNER PEFC Certified This book has been produced entirely from sustainable papers that are accredited as PEFC compliant. www.pefc.org Commodity Investing and Trading.indd 1 01/10/2013 15:36 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page i Commodity Investing and Trading 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page ii 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page iii Commodity Investing and Trading Stinson Gibner 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page iv Published by Risk Books, a Division of Incisive Media Investments Ltd Incisive Media 32–34 Broadwick Street London W1A 2HG Tel: +44(0) 20 7316 9000 E-mail: books@incisivemedia.com Sites: www.riskbooks.com www.incisivemedia.com © 2013 Incisive Media ISBN 978 1 906348 84 7 British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Publisher: Nick Carver Associate Editor: Alice Levick Managing Editor: Lewis O’Sullivan Designer: Lisa Ling Copy-edited by Laurie Donaldson Typeset by Mark Heslington Ltd, Scarborough, North Yorkshire Printed and bound in the UK by Berforts Group Ltd Conditions of sale All rights reserved. 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While best efforts have been intended for the preparation of this book, neither the publisher, the editor nor any of the potentially implicitly affiliated organisations accept responsibility for any errors, mistakes and or omissions it may provide or for any losses howsoever arising from or in reliance upon its information, meanings and interpretations by any parties. 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page v Contents About the Editors About the Authors Introduction ix xi xvii PART I: COMMODITY MARKET FUNDAMENTALS 1 The Impact of Non-fundamental Information on Commodity Markets Michael S. Haigh Société Générale Corporate and Investment Bank 3 2 The North American Natural Gas Market Stinson Gibner Whiteside Energy 25 3 A Day in the Life of Commodity Weather Jose Marquez Whiteside Energy 65 4 Oil and Petroleum Products: History and Fundamentals Todd J. Gross QERI LLC 75 5 Wholesale Power Markets William Webster RWE Supply and Trading 113 6 The Metals Markets Kamal Naqvi Credit Suisse 133 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page vi COMMODITY INVESTING AND TRADING 7 Grains and Oilseeds David Stack Agrimax 165 8 Coal Jay Gottlieb 207 PART II: TRADING AND INVESTMENT STRATEGIES 9 Farmland as an Investment Greyson S. Colvin and T. Marc Schober Colvin & Co. LLP 10 Agriculture Trading Patrick O’Hern Sugar Creek Investment Management 11 Quantitative Approaches to Capturing Commodity Risk Premiums Mark Hooker and Paul Lucek State Street Global Advisors and SSARIS Advisors 229 249 295 12 Structural Alpha Strategies Francisco Blanch; Gustavo Soares and Paul D. Kaplan Bank of America Merrill Lynch; Macquarie Funding Holding Inc. and Morningstar, Inc. 307 13 Energy Index Tracking Kostas Andriosopoulos ESCP Europe Business School 337 PART III: MARKET DEVELOPMENTS AND RISK MANAGEMENT 14 Enterprise Risk Management for Energy and Commodity Physical and Financial Portfolios Carlos Blanco NQuantX LLC and MTG Capital Management vi 371 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page vii CONTENTS 15 Credit Valuation Adjustment (CVA) for Energy and Commodity Derivatives Carlos Blanco; and Michael Pierce NQuantX LLC and MTG Capital Management; NQuantX LLC 16 The Past, Present and Future of China’s Futures Market: Trading Volume Analysis Wang Xueqin Zhengzhou Commodity Exchange Index 389 409 439 vii 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page viii 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page ix About the Editor Stinson Gibner is an analyst at Whiteside Energy, having worked in energy risk management and trading since the early 1990s. He previously headed the quantitative analytics team as a managing director for Citigroup Global Commodities, supporting offices in Houston, London and Singapore. Before joining Citigroup in 2005, Stinson served as a director at Citadel Investment Group LLC, where he was responsible for developing models and systems used for energy trading and risk management. Between 1992 and 2001, he worked in the quantitative modelling group at Enron Corp. Stinson received his BA in physics from Rice University and a PhD from Caltech. ix 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page x 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page xi About the Authors Kostas Andriosopoulos is executive director of the Research Centre for Energy Management at ESCP Europe Business School. His research interests include price modelling, financial engineering and the application of risk management techniques and innovative investment strategies in energy, shipping and agricultural commodities markets, and international trade. Kostas is the associate editor for the International Journal of Financial Engineering and Risk Management and has organised numerous international conferences. He holds a PhD in finance from Cass Business School, London, an MBA and MSc in finance from Northeastern University, Boston, and a bachelor’s degree in production engineering and management from the Technical University of Crete, Greece. Francisco G. Blanch is managing director and head of global commodities and derivatives research at Bank of America Merrill Lynch, where he is also a member of the research investment and executive management committees. Prior to joining Merrill Lynch, he was an energy economist at Goldman Sachs and consulted for the European Commission. Francisco holds a doctorate in economics from Complutense University of Madrid and a masters in public administration from Harvard University, where he was also a teaching fellow in financial markets. Carlos Blanco is managing director of NQuantX LLC, and director of risk management at MTG Capital. He is also a faculty member at The Oxford Princeton Programme, where he heads the Certificate Programme on Derivatives Pricing, Hedging and Risk Management. Greyson S. Colvin is founder and managing partner of Colvin & Co, an agriculture-focused investment manager. Previously, he was a research analyst at Credit Suisse in the Portfolio Management Group and at UBS Investment Research. Greyson has been featured in xi 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page xii COMMODITY INVESTING AND TRADING numerous publications and is co-author of the Investors’ Guide to Farmland. He received a BA in financial management from the University of St. Thomas and an MBA in finance and investment banking from the University of Wisconsin, Madison. Rita D’Ecclesia is a professor at Sapienza University of Rome and visiting professor at Birkbeck College, University of London. She is also a director of the PhD programme in Economics and Finance at Sapienza, as well as the director of the International Summer School on Risk Measurement and Control, chair of the Euro Working Group for Commodities and Financial Modeling and associate editor of several scientific journals. Rita teaches courses at graduate and PhD levels on quantitative models, finance and asset pricing. Rita's research activity focuses on optimisation techniques and modelling financial and energy commodity markets. She is active within the Research Centre for Energy Management at ESCP Europe. Jay Gottlieb led development of the first coal derivatives instrument, the NYMEX CAPP coal futures contract, while a director in the Exchange's Research Department. Jay was also instrumental in the launch of instruments and over the counter clearing for the electricity and emissions markets, and exchange traded funds for gold and oil markets. He has served as a member of the board of directors of the New York State Energy Research and Development Authority and the Coal Trade Association. He holds an MBA from Stanford, a BS from Huxley College of the Environment, and a BA from St. John's College, Annapolis. Todd Gross is chief investment officer, managing member and founder of QERI LLC, a New York commodity trading firm which invests client assets in liquid, fundamentally-based strategies. Throughout a 25-year career Todd has been dedicated to understanding the nuances and inefficiencies of the commodity space with particular emphasis in Energy. He began his career at Cooper Neff & Associates, moved on to manage derivatives in Morgan Stanley's Global Commodity Group, and founded and ran Hudson Capital Group LLC, before launching QERI LLC in 2012. Todd received a BS in economics from Wharton and a bachelor of applied science in systems engineering from the Moore School of Engineering. xii 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page xiii ABOUT THE AUTHORS Michael Haigh is managing director and global head of commodities research for Société Générale, based in New York City, managing a team of commodity analysts in Singapore, Paris, London and New York City. Prior to joining Société Générale, he was global head of commodities research at Standard Chartered Bank in Singapore. Michael has also held the position of managing director at K2 Advisors, and spent several years as the associate chief economist at the US Commodity Futures Trading Commission and as a tenured associate professor of economics at the University of Maryland. He holds a PhD in economics with a minor in statistics from North Carolina State University. Mark Hooker was most recently senior managing director of State Street Global Advisors and head of its Advanced Research Center, where he was responsible for the worldwide development and enhancement of SSgA’s quantitative investment models. Prior to joining SSgA in 2000, Mark was a financial economist with the Federal Reserve Board in Washington, and before that an assistant professor of economics at Dartmouth College. He earned a PhD in economics from Stanford University and a bachelor’s degree with a dual concentration in economics and mathematics from the University of California at Santa Barbara. Paul D. Kaplan is director of research for Morningstar Canada and a senior member of Morningstar’s global research team, as well as a qualified CFA. He is responsible for many of the quantitative methodologies behind Morningstar’s fund analysis, indexes, advisor tools and other services. Paul’s research has appeared in many professional publications, including his book, Frontiers of Modern Asset Allocation. He received his bachelor’s degree from New York University and his masters and doctorate in economics from Northwestern University. Paul R. Lucek is the chief investment officer, Hedge Fund Group, and a member of the Hedge Fund Investment Committee at SSARIS Advisors. Prior to joining SSARIS, he developed quantitative algorithms for trading stock index futures, and in 1996 he co-founded SITE Capital Management. He made the transition to money management from the MD/PhD programme at Columbia xiii 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page xiv COMMODITY INVESTING AND TRADING University, College of Physicians and Surgeons, where as a researcher he pioneered the use of neural networks in the analysis of complex genetic inheritance in humans. Paul earned his bachelor’s and master’s degrees in biology from Harvard University, and a master’s degree in genetics from Columbia University. Jose Marquez is a meteorologist for Whiteside Energy. Since 2000, his meteorology experience has been focused on the energy industry, where he has held positions as senior meteorologist at Total Gas & Power, Citigroup, Citadel Investment Group and Enron North America. After graduating from the Navy’s Meteorological and Oceanographic training school, he served in the US Navy, and he was also director of meteorology for the Latin America Weather Channel. He has a BS in environmental sciences from the University of Puerto Rico and an MS in atmospheric sciences from the Georgia Institute of Technology. Kamal Naqvi is a managing director, global head of metals and head of commodity sales across Europe, the Middle East and Africa in the investment banking division of Credit Suisse, based in London. He has been working in the resources industry since the early 1990s, having also worked in commodity sales and commodity research positions at Barclays Capital, Macquarie Bank and the Tasmanian State Government. Kamal holds degrees in law and in economics (hons) from the University of Tasmania. Patrick E. O'Hern is the managing partner and co-founder of Sugar Creek Investment Management, an actively managed commodity trading and alternative investments advisor in Chicago. Patrick is also head of portfolio management for the Meech Lake Investment Group, a commodity trading asset manager. Previously, Patrick held the position of senior analyst in the funds group at FourWinds Capital Management in Boston. Prior to joining FourWinds Patrick spent his early career in trading and brokerage on the floor of the Chicago Mercantile Exchange, where he traded in the livestock and dairy pits. Patrick has a bachelor's degree in agriculture business from Western Illinois University. xiv 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page xv INTRODUCTION Michael Pierce is co-founder and director of Financial Engineering at NQuantX LLC a financial engineering firm which develops software for portfolio valuation and risk management. He also worked with Platts as the lead financial engineer and analytics software developer. He is a former senior financial engineer at Financial Engineering Associates (a MSCI/Barra company), where he was responsible for front-line development of numerous software products over an eight-year period. Michael has a master's degree in mathematics from the University of California at Berkeley. T. Marc Schober is a director at Colvin & Co and managing editor of “Farmland Forecast”. He has been featured in numerous publications and is co-author of the Investors’ Guide to Farmland. Growing up on a Wisconsin farm, the Schober family has owned and managed farmland in Wisconsin for over 40 years. He received a BS in business management from the University of Wisconsin, Eau Claire, and is also involved in a number of cancer fundraisers, including the Oconomowoc LakeWalk. Gustavo Soares is part of the Commodity Investor Products Group at Macquarie Bank, where he is responsible for designing investable strategies and indexes in commodities. He joined Macquarie in 2012, having spent several years at Bank of America Merrill Lynch working as a commodity strategist. Gustavo holds a BA/MA in economics from Universidade de São Paulo, Brazil and a PhD in economics from Yale University. David G. Stack is managing director of Agrimax, a commodity market consulting firm. He has worked in the commodities industry since the late 1980s on all aspects of the energy and agricultural markets. David is experienced in all parts of the physical and financial space, and specialises in derivatives, with clients ranging from the smallest producer to the largest consumer, including hedge funds and NGOs. Having previously worked at Barclays, Louis Dreyfus, Bunge, Enron and BP, he is also MD of the Commodity Trading Room at ESCP Europe, and develops trading and risk management software with riskGRID. xv 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page xvi COMMODITY INVESTING AND TRADING William Webster is head of EU power market design for RWE Supply and Trading. He began his career in the UK Government Economic Service, ending with a period at UK water regulator Ofwat, where he was a team leader. William joined the European Commission in 2000, working in both DG Energy and Competition, and introduced competition into electricity and gas markets. In 2007, he joined RWE and ran two major strategy projects for RWE power before starting his current role in 2010. William read economics at Cambridge University, has an MA from the College of Europe and is a member of the Chartered Institute for Securities and Investment. Wang Xueqin is a senior specialist of the Zhengzhou Commodity Exchange, where his major research areas are market development, new products and commodity options. He previously worked for the International Department of China Securities Regulatory Commission, as well as the working taskforce for China’s preparations for launching CIS 300 at CFFEX. Wang was the first from China’s futures industry to research options as a visiting scholar at CBOE and IIT, and he has worked for Zhengzhou Grain Wholesale Market, the precursor of the China Zhengzhou Commodity Exchange. xvi 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page xvii Introduction Stinson Gibner Whiteside Energy Strong gains in commodity prices since the early 2000s created a growing interest in the asset class. The financial industry responded with many products, including new hedge funds, index funds, commodity-linked fixed income products and exchange-traded funds (ETFs). With oil and natural gas making a prominent peak in 2008 and gold hitting a peak in 2011, many took this as a sign that the commodity bull had run its course and expected that we would return to the normal long-standing trend of commodity price deflation. The deflationist camp notes that growth in China must slow down, possibly to a dramatic degree, if imbalances in that economy are not handled carefully. Europe and the US continue their struggle to reignite sorely needed jobs growth in order to relieve high youth unemployment, while at the same time facing demographics that lead to a shrinking labour force. However the world’s economic situation is resolved, commodities and commodity flows will remain critical to the functioning of cities, states and economies. For this reason, a basic knowledge of the supply and demand issues relevant to each commodity sector provides financial insights even beyond the commodity markets. This book therefore discusses the fundamentals of many of the major traded commodities offering both an introduction and a reference for all those interested in understanding and analysing these markets. This book is divided into three sections. The first covers the fundamentals of the most important markets in energy, metals and xvii 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page xviii COMMODITY INVESTING AND TRADING agriculture. Michael S. Haigh starts us off with an investigation into the importance of non-fundamental information. He uses principle component analysis to discover how commodity market behaviour has changed over the years, and shows evidence that commodity market participants have adjusted their behaviour since the financial crisis of 2007–08. Within the energy complex, crude oil, European power, North American power, natural gas, liquefied natural gas (LNG), and coal are covered in separate chapters. Chapter 2 by Stinson Gibner provides an introduction to the fundamentals of the North American market for natural gas. Natural and economic forces impacting supply are illustrated along with the annual rollercoaster of demand. The critical role of storage in balancing short-term and seasonal swings is explained, and key issues for the supply–demand balance are discussed. Also within this chapter, Rita D'Ecclasia gives an overview of the expanding global LNG trade. Relevant to all commodities, Jose Marquez discusses weather and climate from the unique perspective of a working commodities meteorologist. His chapter walks through the daily analysis and information flow that must be monitored to keep abreast of weather impacts on commodity demand and supply, while a panel discusses climatology and its longer-term indicators of weather trends. In Chapter 4, Todd Gross tells the incredible story of how oil prices climbed from US$17/bbl in 2002 to an amazing US$147/bbl a mere six years later. Todd also examines, as he puts it, “why the globe always seems to be running out of oil, and yet, so far, that fate has yet to be realised.” Unafraid of digging into the details, the analysis of global refining capacity gives a great insight into the changing demand for – and flows of – various types of crude. The impact of transport bottlenecks within North America is also discussed. William Webster then explains the unique challenges of operating a market for power, and explores the solution adopted by the European power market. He explains the instruments traded and price formation, before offering a historical perspective of pricing for these markets. He concludes with thoughts about possible future market trends and regulatory changes. Kamal Naqvi takes us on a whirlwind tour through the precious, base and industrial metals in Chapter 6, in which he discusses the key drivers for metals and offers insights as to which may outperxviii 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page xix INTRODUCTION form going forward. In Chapter 7, David Stack provides a tour de force discussion of the global grains markets, giving an overview of the markets for food grains, feed grains and oilseeds. Farming area, yield and production trends are discussed for major producers. The chapter also reviews past import and export flows, as well as likely future trends for global grain flows and crop rotation flexibility. A discussion of the coal markets in Chapter 8 completes the energy commodities. Jay Gottlieb lays out the fundamentals of the coal markets and discusses which trends are likely to dominate going forward. Rounding out agricultural investments, Greyson Colvin and Marc Schober open the second section of the book by explaining the basics of agricultural land in Chapter 9, arguing that the fundamentals behind the rush to invest in farmland are likely to persist far into the future. Complementing the grains discussion, Chapter 10 by Patrick O’Hern explores the agricultural trading and hedging markets and gives an overview of the types of participants active. He provides several examples of trading strategies to illustrate intra-market and cross-market trade opportunities within the agriculture markets, and illustrates the diversification that may be provided across commodities. The remainder of the section on trading and investing strategies focuses on alpha strategies and index investing. In Chapter 11, Mark Hooker and Paul Lucek present an interesting case study of what they call convergent and divergent strategies, concluding that useful risk diversification can be achieved through intelligent choice of strategies within a commodity portfolio. An overview of alpha strategies that could be used by either traders or index funds is given by Francisco Blanch and Gustavo Soares in Chapter 12, which covers momentum, roll yield and volatility methods. The accompanying panel by Paul Kaplan gives a short case study of active index funds applying these alpha concepts. In Chapter 13, Kostas Andriosopoulos finishes out the commodity index investing discussion by bridging the gap between commodities and equities. It presents his proposal to track a spot commodity index by using a carefully selected portfolio of equities, and shows his tested selection methods and tracking results. The third section of the book opens with two chapters by Carlos Blanco. In Chapter 15, Blanco and Michael Pierce present the choices xix 00 Prelims CIT_Commodity Investing and Trading 26/09/2013 11:30 Page xx COMMODITY INVESTING AND TRADING for performing a proper analysis of credit risks embedded in your bilateral trade portfolio. The resulting credit value adjustment (CVA) provides a measure of expected future loss due to credit events. Taking a broader view of risk, Chapter 14, also written by Carlos Blanco, explains the structure for putting in place a system of enterprise risk management and some possible pitfalls. In principle, everyone wants to have proper risk systems and structures in place; however, operational weakness is difficult to avoid as daily choices must be made between risk levels and the potential profitability of the enterprise. Carlos explains the challenges of the risk manager and offers advice about properly structuring a risk management function. Wang Xueqin then reviews the rapid growth of commodities trading in China in Chapter 16, and shows that although still largely restricted to domestic participants, the size of China’s commodity futures markets now rivals commodity markets globally. xx 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 1 Part I Commodity Market Fundamentals 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 2 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 3 1 The Impact of Non-fundamental Information on Commodity Markets Michael S. Haigh Société Générale Corporate and Investment Bank Commodity markets can (and will) occasionally co-move with broader macro markets for reasons beyond the physical fundamentals. The purpose of this chapter is to illustrate how different commodities are affected by non-fundamental factors (macro shocks, liquidity events, currency moves and broader market sentiment swings) that are normally considered exogenous to commodity fundamentals (eg, mine or oil supply). At certain points in time, especially since the Lehman bankruptcy in September 2008, the non-fundamental influences on certain commodities have dwarfed the impact of actual commodity fundamentals. Accordingly, understanding this has brought obvious benefits for analysing how commodity market price moves can be applied to trading strategies. The chapter will examine this by focusing on energy (oil), base metals (copper) and precious metals (gold), and agriculture (soybeans). Until the late 1990s, commodity markets generally enjoyed excess capacity as innovations and new discoveries resulted in greater supply (think of how the US natural gas markets have evolved). Any supply side shock that was persistent would result in commodity price increases, higher inflation and a consequent decline in equity markets: hence the negative relationship with commodity price movements. However, by 2000, increased demand growth and underinvestment in the supply chain meant the excess capacity was slowly absorbed. By 2008, the underinvestment in activity became more evident as the credit crisis resulted in suspensions and cancella3 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 4 COMMODITY INVESTING AND TRADING tions of hundreds of commodity projects. As such, changes in global economic activity, Purchasing Manager’s Index (PMI) strength, dollar strength and changes in inflation expectations (resulting from quantitative easing) are playing a much larger role in commodities. Given the increased influence of “non-fundamental” information on commodity markets, it is worthwhile to quantify as accurately as possible the level of this influence, across commodities and across time. To thoroughly assess the role of non-fundamentals during episodes of quantitative easing, we employ the principal component analysis (PCA) technique. Simply stated, PCA is the analysis of the covariance matrix and can be used to analyse multi-assets: baskets made up of commodities, other financial indicators, volatilities, etc. From the historical data, the analysis determines the principal components of the covariance matrix – ie, the way in which the asset price movements correlate, by order of importance. To conduct PCA on commodity prices, we analyse price data for a variety of commodities against a diversified basket of 28 assets across markets, including: volatility indexes (EU and US), credit (EU and US and HY versus IG), FX (dollar, yen, euro, carry trade (G10 and EM)), bonds (spreads, 10Y GVT and inflation break-even), equities (BRIC, Euro, emerging, EU and US) and global indexes. Factors are estimated using the 28-member basket, which means each factor is a weighted average of the 28 assets with different weights for each factor. The model estimated three main explanatory factors: macro, dollar and liquidity. What is not explained by these factors (the residuals) is interpreted as the commodity fundamentals. Depending on the commodity, the relative importance of each factor varies considerably, as does the influence on commodities of all the factors combined. Moreover, extreme events (eg, Lehman Brother’s bankruptcy) have structurally altered the influence of the macro factor (in particular) and largely demoted the dollar factor to a secondary “outside” influence on the commodity markets. Energy Here we focus on Brent and note that, unsurprisingly, Brent’s fundamentals in terms of explanatory power began to deteriorate (consistently) in 2007 when the subprime crisis became a reality (see Figure 1.1). In the early 2000s, fundamentals prevailed with 80–90% explanatory power (eg, in March 2002, dollar and liquidity explained 4 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 5 THE IMPACT OF NON-FUNDAMENTAL INFORMATION ON COMMODITY MARKETS roughly 10% each of Brent’s price movements). The Lehman bankruptcy changed this, with fundamentals’ explanatory power dropping to the 30–40% range, on average. Since 2013, we have seen Brent’s fundamentals progressively giving up explanatory power to the macro influences as inventories increase, alleviating concerns of a shortage (see Figure 1.2). The dollar’s influence has latterly been practically irrelevant in determining the price path for Brent. Figure 1.1 Non-fundamentals influence on Brent experienced a structural break in 2008, jumping from 20–30% to over 80% Macro Dollar Liquidity 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 Jan-13 Jul-12 Jan-12 Jul-11 Jan-11 Jul-10 Jan-10 Jul-09 Jan-09 Jan-08 Jul-08 0.00 Source: SG Cross Asset Research Figure 1.2 In late 2012 and early 2013 the macro influences had taken away from Brent’s fundamentals Mar-13 Sep-12 Mar-10 Sep-10 Mar-09 Sep-09 Mar-08 Sep-08 Mar-07 Sep-07 Mar-06 Sep-06 Mar-05 Sep-05 Mar-04 Sep-04 Mar-03 Sep-03 Mar-02 Sep-02 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 Sep-11 Liquidity Mar-12 Dollar Mar-11 Macro Source: SG Cross Asset Research 5 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 6 COMMODITY INVESTING AND TRADING Base Prior to the Lehman crisis, the bulk of the explanatory power relating to base metals price movement was explained by fundamentals (for both copper and aluminium (not shown)), followed by movements in the dollar. The role of fundamentals diminished post-Lehman with more explanatory power coming from the macro factors and much less from the dollar (see Figure 1.3). Copper is the one base metal that is very exposed to the macro outlook, especially as price levels have become significantly higher than the marginal cost of production. Not surprisingly, prices can be significantly influenced by other factors. In late 2012, the role of macro dropped in its explanatory power (Figure 1.4). Precious The gold market remains an outlier among commodities (not surprisingly), with the influence from non-fundamentals still coming from the dollar, and liquidity and macro factors jostling for second place in terms of explanatory. Since Lehman (Figure 1.5), liquidity has improved in terms of extra explanatory power of gold price movements. Since late 2012, the “outside influences” have diminished (see Figure 1.6), coinciding with gold prices plummeting in early April 2013. Figure 1.3 Copper – the dollar has taken a back seat to macro since Lehman Macro Dollar Liquidity 0.8 0.7 0.6 0.5 0.4 0.3 0.2 6 Mar-13 Mar-12 Sep-12 Mar-11 Sep-11 Mar-10 Sep-10 Mar-09 Sep-09 Mar-08 Sep-08 Mar-07 Sep-07 Mar-06 Sep-06 Mar-05 Source: SG Cross Asset Research Sep-05 Mar-04 Sep-04 Mar-03 Sep-03 Mar-02 0 Sep-02 0.1 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 7 THE IMPACT OF NON-FUNDAMENTAL INFORMATION ON COMMODITY MARKETS Figure 1.4 The role of macro has deteriorated since late 2012 Macro Dollar Liquidity 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 Jan-13 Jul-12 Jan-12 Jul-11 Jan-11 Jul-10 Jan-10 Jul-09 Jan-09 Jan-08 Jul-08 0 Source: SG Cross Asset Research Figure 1.5 Gold: the dollar is usually the greatest influence Mar-13 Mar-12 Sep-12 Mar-11 Sep-11 Mar-10 Sep-10 Mar-09 Sep-09 Mar-08 Liquidity Sep-08 Mar-07 Sep-07 Mar-06 Dollar Sep-06 Mar-05 Sep-05 Mar-04 Sep-04 Mar-03 Sep-03 Mar-02 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 Sep-02 Macro Source: SG Cross Asset Research Agriculture The market’s fundamentals (here represented by soybeans) accounted for approximately 70–95% of price volatility prior to Lehman (see Figure 1.7). The remainder of the price movement was captured mainly by the dollar (after the early 2000 recession). Nevertheless, soybeans could not avoid the influence of the Lehman 7 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 8 COMMODITY INVESTING AND TRADING Figure 1.6 “Outside influences” on gold have become irrelevant since late 2012 Macro Dollar Liquidity 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 Jan -13 Jan -12 Jan -11 Jan -10 Jan -09 Jan -08 0.0 Source: SG Cross Asset Research Figure 1.7 Percentage explanation: fundamentals versus non-fundamentals; soybean fundamentals have been resilient over the years Mar-13 Mar-12 Sep-12 Mar-11 Sep-11 Mar-10 Sep-10 Mar-09 Sep-09 Mar-08 Liquidity Sep-08 Mar-07 Sep-07 Mar-06 Dollar Sep-06 Mar-05 Sep-05 Mar-04 Sep-04 Mar-03 Sep-03 Mar-02 0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 Sep-02 Macro Source: SG Cross Asset Research crisis, as the percentage explanation coming from the macro factors increased immediately following that event. Since late 2012, soybean fundamentals have returned, explaining almost 100% of the price move (Figure 1.8). In summary, the more supply constraints, the lower the inventories, the closer the price to the marginal cost of production and the 8 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 9 THE IMPACT OF NON-FUNDAMENTAL INFORMATION ON COMMODITY MARKETS Figure 1.8 The drought of 2012 brings more explanatory power from soybean fundamentals on price movement Macro Dollar Liquidity 3 -1 2 2 -1 Ja n Ju l -1 Ja n Ju l-1 1 0 n11 Ja 0 -1 l-1 Ju 9 Ja n 9 -0 l-0 Ju 8 Ja n l-0 Ju Ja n -0 8 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 Source: SG Cross Asset Research lesser the impact of “outside” factors on commodity markets. Agriculture continues to be the most independent of the markets (alongside natural gas), relying mainly on its own fundamentals. Structurally, we have seen a shift in all markets (except gold) whereby the role of the US dollar in terms of explanatory power has dropped dramatically, to be replaced by the role of macro factors. THE SG SENTIMENT INDICATOR VERSUS COMMODITIES The job of assessing commodity price movements becomes difficult when macro, dollar and liquidity dominate. It becomes even more difficult when prices are pulled around by market sentiment. Fortunately, we can assess the role of sentiment employing a sentiment indicator – a tool used to gauge an average level of risk experienced throughout the global markets. Although the methodology is intuitive and simple, each step must be analysed to provide a clear understanding. Our sentiment indicator is built in three steps. First, suitable financial market variables, expressing a clear connection with risk, are selected. The following variables have been selected as input risk factors: equity volatility (VIX index), FX volatility (average of G4 3M volatility), interest rate volatility (average of G4 1m1y and 1y5y swaptions), credit spreads (iTraxx index), swap spreads (2y, G4 average) and the ratio of gold to gold equity. Second, the scoring 9 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 10 COMMODITY INVESTING AND TRADING technique is developed. Of the six variables selected, a score is assigned depending on the current value of the variable over the time horizon. Each day, the variables are sorted based on the last 30 days of data, and are assigned a score of one if they have the highest value in the past 30 days (extreme “risk off”) or two if they have the second highest value, all the way to 30 for the lowest value. Last, a simple weight of 1/6 is assigned to each of the variables. The average of the six scores is linearly projected in the interval 0–1, with low/high values representing risk aversion (“off”) if the sentiment indicator falls below 0.35, risk-seeking (“on”) sentiment (above 0.7) and risk neutral (between 0.35 and 0.7). These bands can be seen in Figure 1.9 and illustrate the strong connection between the Dow Jones-UBS (DJUBS) commodity index and the sentiment indicator. In addition to the 30-day sentiment indicator, here we develop a 100-day and a 252-day sentiment indicator for a commercial application. The methodology/scoring method is identical, but the look-back period is 100 days and 252 days, not 30. The reason for a longer look-up is intuitive. Imagine a scenario where commodity prices are trending down, say, for 60 days. The 30-day sentiment indicator has to turn upwards within those 60 days because the scoring is based on the last 30 days, and so even in a declining market the sentiment may rise. In this sense, the 30-day sentiment indicator is a short-term indicator, and we develop the 100-day and 252-day indicator to assess medium- and longer-term trends. Obviously, with the 100-day indicator the sentiment is less volatile and would enable Figure 1.9 SG sentiment indicator and the DJUBS (5d ma) returns: a strong link 1.0 Sentiment Indicator 0.015 DJUBS (5d ma) Risk seeking 0.8 0.01 0.6 0.005 0.4 0 0.2 -0.005 Risk averse 0.0 Feb-12 -0.01 Mar-12 Apr-12 Source: SG Cross Asset Research 10 May-12 Jun-12 Jul-12 Aug-12 Sep-12 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 11 THE IMPACT OF NON-FUNDAMENTAL INFORMATION ON COMMODITY MARKETS an investor to hold positions for longer (as the investment is based on sentiment) and incur lower trading costs from rebalancing. Overlaying with an even longer timeframe (252 days) would add a further layer of security, ensuring that in periods of extended risk aversion one does not see a return to risk seeking prematurely, which may be signaled by a 30-day indicator. Regardless of the lookback period, the methodology is simple and its relationship to commodity prices extremely strong. Indeed, it is difficult to find a daily indicator with such a strong short-term relationship to almost every commodity within the DJUBS (see below). SENTIMENT CAUSES COMMODITY PRICES AND NOT THE OTHER WAY AROUND Of interest is the question of causality and the speed of response of the DJUBS to changing sentiment. To this end, we estimated a reduced-form five lag VAR (vector-auto-regression) using daily (stationary) data from early 2007 to mid-2012 (technical details excluded to conserve space). Resulting causality tests confirm at very high levels of confidence (5%) that sentiment “causes” DJUBS price movements, and not the other way around. Here we can take the causality analysis one step further with the assistance of impulse response functions. We shock our VAR model by one standard deviation (down) and trace out the influences of sentiment on the DJUBS price path, and vice versa. Focusing on Figure 1.10, we see that a one Figure 1.10 Impulse response: a one standard deviation drop in sentiment drags down the DJUBS to its lowest level after five days Std. Dev 0.2 Reaction of DJUBS to a drop in sentiment over 10 days 0 -0.2 1 2 3 4 5 6 7 8 9 10 -0.4 -0.6 -0.8 -1 -1.2 Source: SG Cross Asset Research 11 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 12 COMMODITY INVESTING AND TRADING Figure 1.11 But a one standard deviation drop in the DJUBS does not influence sentiment Std. Dev 0.1 0.08 0.06 Reaction of sentiment to a drop in DJUBS over 10 days 0.04 0.02 0 1 2 3 4 5 6 7 8 9 10 Source: SG Cross Asset Research standard deviation decline in sentiment results in a negative price path for DJUBS – ie, it also declines. What is interesting, however, is the speed of that response and the time it takes for DJUBS to fully incorporate the negative sentiment. The first day after the shock (day 1) DJUBS prices react, but by day five, DJUBS has declined by the same amount, in percentage terms, as the negative sentiment. Beyond day five, DJUBS returns to its preshock level. The equivalent decline in DJUBS prices (one standard deviation) does not have a significant influence on sentiment (but raises it modestly) – see Figure 1.11. FOR ALMOST EVERY COMMODITY, 2008 RESULTED IN A STRUCTURAL SHIFT IN ITS RELATIONSHIP WITH SENTIMENT Measuring the relationship between variables at various points in time, rather than using a single correlation coefficient over the entire sample period, provides information on the evolution of the relationship dynamically. For this purpose, simple correlation measures such as rolling historical correlations and exponential smoothing are widely used. The rolling historical correlation estimator provides equal weights to newer and older observations, and raises issues surrounding window-length determination. The exponentialsmoothing estimator requires the user to adopt an ad hoc approach to choosing the smoothing parameter. The dynamic conditional correla12 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 13 THE IMPACT OF NON-FUNDAMENTAL INFORMATION ON COMMODITY MARKETS tion (DCC) methodology developed by Engle (2002) helps to remedy both of these issues.1 In the first step, time-varying variances are estimated using a general autoregressive conditional heteroscedasticity (Garch) model. In the second step, a time-varying correlation matrix is estimated using the standardised residuals from the first-stage estimation. Here, we use the DCC method because it has been shown to outperform other widely used correlation structures in helping with portfolio investing decisions.2 To assess the relationship between commodities and sentiment, we correlate the rolling nearby futures contract prices (using log returns) for each component of the DJUBS with the 30-day sentiment indicator with daily data beginning in September 2006. Importantly, the results are qualitatively very similar when we correlate the DJUBS component prices with the 100-day indicator (results excluded to conserve space). Figures 1.12 and 1.13 plot the time-varying correlation of the log returns of aluminium (LHS) and copper prices (RHS). September 15, 2008 (Lehman bankruptcy) was a game changer – there is a noticeable shift in the relationship between the base metals markets and sentiment. For aluminium, the average correlation tripled (from 0.13 to 0.38) with the maximum correlation post-Lehman reaching 0.59. The minimum correlation post-Lehman was 0.15, still higher than the average pre Lehman. In the case of copper, the correlation increases from an average of 0.11 to 0.42, almost four times higher post-2008. Interestingly, the volatility of the correlation of copper Figure 1.12 DCC between aluminium prices and sentiment 0.6 0.5 0.4 0.3 0.2 0.1 2 12 -Ju l-1 1 12 -O ct -1 11 Ja n12 - -1 0 12 - Ap r 9 12 -Ju l-0 8 ct -0 12 -O 08 nJa 12 - pr -0 7 6 -0 Ju l 12 -A 12 - -0.1 12 - O ct -0 5 0 Source: SG Cross Asset Research 13 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 14 COMMODITY INVESTING AND TRADING Figure 1.13 DCC between copper prices and sentiment 0.6 0.5 0.4 0.3 0.2 0.1 2 l-1 12 -J u 12 -O ct -1 1 11 -Ja n12 12 -A pr -1 0 9 12 -Ju l-0 8 12 -O ct -0 08 12 -Ja n- 7 -A pr -0 l-0 -Ju 12 12 -0.1 12 -O ct -0 5 6 0 Source: SG Cross Asset Research Figure 1.14 DCC between Brent and sentiment 0.7 0.6 0.5 0.4 0.3 0.2 0.1 2 1 12 -Ju l-1 -1 -O ct 12 n11 -Ja 12 -A pr -1 0 l-0 -Ju 12 12 9 8 ct -O 12 12 -Ja n- -0 08 7 -0 pr -A -Ju l-0 12 12 -0.1 12 -O ct -0 6 5 0 Source: SG Cross Asset Research and sentiment is half that of aluminium, post-Lehman. Turning now to the energy markets, here represented by Brent and heating oil, the results also illustrate a structural break. Pre-Lehman, the Brent correlation was a mere 0.08, post-Lehman it was 0.39 (see Figure 1.14). For heating oil (Figure 1.15), we see the correlation rise from an insignificant 0.04 to 0.38. At first glance, the results of gold and sentiment may appear counterintuitive, as their average correlation pre-Lehman was 0.06 (see Figure 1.16). While low, their post-Lehman correlation (relative to 14 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 15 THE IMPACT OF NON-FUNDAMENTAL INFORMATION ON COMMODITY MARKETS Figure 1.15 DCC between heating oil and sentiment 0.7 0.6 0.5 0.4 0.3 0.2 0.1 12 -Ju l-1 2 1 ct -1 Ja n11 12 -O 12 12 - -A p r-1 0 9 12 -Ju l-0 ct -0 8 12 -O 12 -Ja n08 r-0 7 12 -A p 12 -Ju -0.1 l-0 6 0 -0.2 Source: SG Cross Asset Research Figure 1.16 DCC between gold and sentiment 0.6 0.5 0.4 0.3 0.2 0.1 0 -0.1 -0.2 -Ju l-1 2 12 1 ct -1 -O 12 -A p 12 12 -Ja n11 0 r-1 9 12 -Ju l-0 -0 8 -O ct 12 n08 12 -Ja r-0 7 12 -A p 6 l-0 12 -Ju 12 -O ct -0 5 -0.3 Source: SG Cross Asset Research other markets) is not much higher at 0.18, on average. Interestingly, for both gold and silver, the Lehman event did increase the correlation, but it was not a structural change, in the way it was for the energy and base metals markets. However, gold is a unique commodity, driven as much by sentiment, macro and the dollar as by its own fundamentals (eg, central bank involvement, exchange-traded fund 15 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 16 COMMODITY INVESTING AND TRADING (ETF) volumes, jewellery and coin demand, mining and scrap supply), so a decrease (increase) in sentiment may result in an increase (decrease) in gold demand, hence dragging their correlation lower. Gold is often negatively related in periods of extreme crisis, hence fulfilling its role as a flight to safety. Post-Lehman, and after the August 2011 euro crisis, there has been a negative correlation with sentiment. This is less evident in silver (Figure 1.17), the more industrial of the two precious metals. Its correlation rose from an average of 0.16 pre-Lehman to 0.30 post-Lehman. Not surprisingly, the role of sentiment is not as important to the agricultural markets despite their reacting to the Lehman crisis in the same way as the base metals and energy markets (albeit at a much lower level). The scale of the axis hides the subtle nature of the change: it was very low in the case of corn (Figure 1.18). From a preLehman correlation of 0.13, we only see a rise to 0.16. Hardly significant, for coffee we see a rise from 0.10 to 0.22, a doubling of the correlation (Figure 1.19). Not shown (to conserve space) is the change in the relationship for wheat. The correlation before Lehman was actually negative, on average; post-Lehman, it averages 0.19. Therefore, agriculture – which was less influenced, certainly in the short run, by the euro crisis, or by a slowdown in Chinese demand which would influence the more cyclical commodities – as with base metals and energy, is not going to be as affected by things outside of its own fundamentals. As we have illustrated, agriculture markets are still positively related Figure 1.17 DCC between silver and sentiment 0.7 0.6 0.5 0.4 0.3 0.2 0.1 -0.2 Source: SG Cross Asset Research 16 2 12 -Ju l-1 -1 1 12 -O ct n11 12 -Ja pr -1 0 12 -A l-0 9 12 -Ju ct -0 8 -O 12 -Ja n08 12 7 r-0 -Ju -A p 12 12 -O -0.1 12 ct -0 5 l-0 6 0 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 17 THE IMPACT OF NON-FUNDAMENTAL INFORMATION ON COMMODITY MARKETS Figure 1.18 DCC between corn and sentiment 0.6 0.5 0.4 0.3 0.2 0.1 12-Jul-12 12-Oct-11 12-Jan-11 12-Apr-10 12-Jul-09 12-Oct-08 12-Jan-08 12-Apr-07 12-Jul-06 12-Oct-05 0 Source: SG Cross Asset Research Figure 1.19 DCC between coffee and sentiment 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 12 -Ju l-1 2 1 1 ct -1 12 -O n1 0 pr -1 12 -A 12 -Ja 9 -Ju l-0 12 ct -O 12 12 -Ja n- -0 08 7 12 -A pr -0 l-0 6 12 -Ju 5 ct -0 -O 12 8 -0.05 Source: SG Cross Asset Research 17 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 18 COMMODITY INVESTING AND TRADING to sentiment and are still part of global benchmark indexes, but sentiment’s influence on them is certainly lower. Last, we present a couple of examples of markets that did not change after Lehman. US natural gas (a domestic rather than global market) is the distinct outlier in that its correlation pattern did not change at all with the structural change in 2008 (see Figure 1.20). Its average correlation remained at 0.06, precisely the same value it had before the crisis in 2008. Lean hogs is also independent of sentiment, having a very similar correlation value pre- and post-Lehman (0.06 and 0.05). Its correlation can occasionally go negative (Figure 1.21). Figure 1.20 DCC between US natural gas and sentiment 0.6 0.5 0.4 0.3 0.2 0.1 2 l-1 -Ju 12 12 -O ct -1 1 1 12 -Ja n1 -1 0 pr 12 -A -Ju l-0 9 8 12 - -Ja 12 12 r-0 Ap 12 - O ct -0 n08 7 6 l-0 -Ju 12 -O -0.1 12 ct -0 5 0 -0.2 Source: SG Cross Asset Research Figure 1.21 DCC between lean hogs and sentiment 0.6 0.5 0.4 0.3 0.2 0.1 -0.3 Source: SG Cross Asset Research 18 2 l-1 12 -Ju ct -1 1 12 -O 11 12 - Ja n- 0 12 - Ap r -1 9 Ju l-0 12 - ct -0 8 O n-Ja 12 -0.2 12 - 08 7 -0 6 l-0 12 -A pr 12 -O -0.1 12 -Ju ct -0 5 0 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 19 THE IMPACT OF NON-FUNDAMENTAL INFORMATION ON COMMODITY MARKETS DO SOME COMMODITIES REACT MORE TO SENTIMENT IN “RISK-OFF” VERSUS “RISK-ON” ENVIRONMENTS? We conclude our analysis of the relationship between commodities and sentiment by digging deeper into the relationships during periods of “risk off”, “risk neutral” and “risk on” before the Lehman crisis (see Table 1.1, left-hand side) and post-Lehman (right-hand side). First, we present the rankings from the 30-day sentiment indicator in Table 1.1. Prior to the Lehman bankruptcy (left-hand side), the top 10 commodities most correlated with sentiment in “risk off” Table 1.1 Ranking of correlations (20 = least, 1 = most) between components of the DJUBS and 30-day sentiment (pre-Lehman, January 2006–September 2008, post-Lehman, September 2008–September 2012) Pre-Lehman Post-Lehman Risk off Risk neutral Risk on Risk off Risk neutral Risk on Zinc 1 1 2 Silver 2 4 4 Aluminium 1 4 4 Copper 2 1 1 Cotton 3 1 1 Brent 3 2 2 Copper 4 Nickel 5 8 8 Heating oil 4 3 3 3 3 WTI 5 6 6 Aluminium 6 5 5 RBOB 6 8 8 Gold 7 14 18 Zinc 7 5 5 Corn 8 6 7 Nickel 8 7 7 WTI 9 10 10 Silver 9 9 10 RBOB 10 7 6 Soybean oil 10 10 9 Brent 11 12 11 Soybeans 11 11 11 Coffee 12 9 9 Coffee 12 12 12 Soybean oil 13 18 15 Cotton 13 13 13 Soybeans 14 16 16 Wheat 14 14 14 Sugar 15 17 12 Corn 15 16 16 Natural gas 16 13 14 Gold 16 15 15 Heating oil 17 15 17 Live cattle 17 17 17 Lean hogs 18 11 13 Sugar 18 18 18 Live cattle 19 20 20 Natural gas 19 19 19 Wheat 20 19 19 Lean hogs 20 20 20 Source: SG Cross Asset Research 19 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 20 COMMODITY INVESTING AND TRADING were represented by all commodity types: base metals, precious metals, agriculture and energy. In fact, energy only just makes the top 10, with West Texas Intermediate (WTI) ranked ninth in terms of its correlation with sentiment in “risk-off” environments. When we focus on the post-Lehman period, the patterns change considerably. The top 10 most-correlated commodities with sentiment are base metals and energy and silver (which one could argue is somewhat of an industrial metal). There are no more agricultural commodities at the top (with “risk off”) until we get to number 10: soybean oil (which moves into number nine (just) in “risk-on” environments). Moreover, regardless of the environment, “risk on”, “risk neutral” or “risk off”, the rankings of commodities hardly change post-Lehman. The most “significant” change is aluminium, which moves from being the most correlated with sentiment in “risk off” to being the fourth most correlated in “risk off”: a relatively minor change. Compare this to gold, for example, pre-Lehman. Its ranking changes from the seventh most correlated with sentiment in “riskoff” to 18th in “risk-on” environments. The bottom line is, with changes in sentiment, base metals and energy are much more influenced by sentiment than other types of commodities post-Lehman. BRINGING IT TOGETHER: A SIMPLE OVERLAY EXAMPLE TO THE DJUBS In this section, we will illustrate how to incorporate the main results from our research into a simple product for investors wishing to benchmark against the basic DJUBS (excess return) long-only exposure. There are obviously numerous applications, but for clarity and simplicity we focus on a simple overlay. We simply try to incorporate a medium-run sentiment indicator (100-day) to help with re-weighting overlaid with a longer-term indicator (252-day) to provide a further layer of insurance in periods where prices fall for a long period of time. Critically, this is just an example and many other applications can be made. Here is the procedure. ❏ First, we develop two sentiment indicators based on the principles outlined in the previous section. One is the sentiment indicator based on the 100-day look-up period to signal reweighting decisions (to reduce trading costs that occurs to shorter-run indicators). The second sentiment indicator has a 20 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 21 THE IMPACT OF NON-FUNDAMENTAL INFORMATION ON COMMODITY MARKETS 252-day look-back period. The 252-day sentiment indicator is going to behave differently than the 100-day indicator as it incorporates a much longer-term risk appetite. Therefore, the 252–day indicator provides insurance for periods of extended declines/risk aversion that even the 100-day indicator might not pick up on. Second, using the 100-day indicator, we focus on weight tilting ave already identig natural gas) – the nt nine) – have the -off” and “risk-on” entiment indicator ff” is where sentiween 35% and 70% e start in the “riskinvested fully into on the close of the o fully account for Then, on a day that vironment, we remodities” and into e preserve the relaJUBS but distribute ther commodities ties” weights equal nts, we reduce the zero and re-weight ning their relative a longer-term view h a risk switch that 52-day sentiment is or falls below 20% e set to zero (again, roducts (alpha), for his is an arbitrary nvestor’s risk tolers is that, if there is ue to a crisis (for 21 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 22 COMMODITY INVESTING AND TRADING example), the investor sits on the sidelines until long-term sentiment improves (ie, passes through 20% to the upside), at which point the risk-tilting mechanism kicks in once more. Importantly, while we have isolated the commodities most affected by sentiment as the ones to remove in “risk off” versus capture in “risk on”, even the less-sensitive commodities are positively correlated with sentiment. Therefore, one could argue to completely remove all commodity exposure in “risk off”, but here we choose to remain invested instead of having extended periods of time sitting on the sidelines. Performance is clearly better overlaying the sentiment (see Figure 1.22), a function of re-weighting and overlaying with an extra layer of insurance (the 252-day window). Focusing purely on the September 2008 onwards (47 months), the number of positive months increases from 27 to 32 and average annualised return rises from –13.34% investing in the DJUBS (about –3.52% annualised) to 74.08% (about 15% average annualised) investing in the DJUBS, weight-tilted 100-day sentiment indicator with the 252day overlay. Ignoring the 252-day overlay (from sentiment) results in a return of 32%. Therefore, most reward from using the sentiment indicator comes from the performance attributed from shifting weights based on the 100-day indicator (about 45% over the DJUBS), although the overlay (insurance) adds almost the same amount. The number of times the portfolio is re-weighted because of a change in sentiment is approximately 25 times per annum. With the 30-day sentiment indicator applied (instead of the 100-day), the number of times is 46 – hence higher trading costs. SUMMARY It is clear that outside influences on commodities have picked up since 2008. The role of macro, dollar and liquidity vary across commodities and across time. Sentiment has made a substantial impact on the commodities markets since 2008. Here, we have documented the causal relationship (from sentiment to commodities) and reported that some commodities are more affected by sentiment than others. A ranking was established. We applied our research results by overlaying the DJUBS with the sentiment indicator signals, utilising the rankings of the sensitive commodities by re-weighting in “risk-off” and “risk-on” environments. The re-weighting alone 22 200 Incremental return since 2008: overlaying with 252 day Sentiment Indicator: 42% 180 140 120 100 80 60 Overlaying with sentiment was actually detrimental before 2008 Incremental return since 2008: applying weight tilts to DJUBS: 45% 40 DJUBS 20 0 Sep -06 Sep -07 Source: SG Cross Asset Research DJUBS + weight tilt Sep -08 Sep -09 DJUBS + weight tilt + 252 day overlay Sep -10 Sep -11 Sep -12 23 THE IMPACT OF NON-FUNDAMENTAL INFORMATION ON COMMODITY MARKETS 160 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 23 Figure 1.22 DJUBS versus DJUBS-with-weight-tilt (based on 100-day sentiment) and 252-day sentiment indicator overlay 01 Chapter CIT_Commodity Investing and Trading 25/09/2013 15:43 Page 24 COMMODITY INVESTING AND TRADING significantly outperforms the long-only DJUBS exposure since 2008 – we achieve an extra 45% higher return over the period. However, overlaying with an extra layer of protection (a signal from a 252-day sentiment indicator) significantly protects returns from large declines in commodity prices – this adds an additional 42% on top of the 45%. Total returns using weight tilts and 252-day overlay equals 74.08% since 2008, compared to –13.34% by investing the DJUBS. The purpose of this chapter is not to suggest fundamentals do not matter – they do, but what is clear is that an analysis of commodity markets requires something more than counting barrels or bushels. Even basic applications of sentiment onto commodity markets add outperformance and significant protection. 1 Engle, R., 2002, “Dynamic Conditional Correlation – A Simple Class of Multivariate GARCH Models”, Journal of Business and Economic Statistics, 20(3), pp 339–50. 2 Huang, J. Z and Z. Zhong, 2010, “Time Variation in Diversification Benefits of Commodity, REITs, and TIPS”, working paper, Department of Finance, Pennsylvania State University. 24 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 25 2 The North American Natural Gas Market Stinson Gibner Whiteside Energy This chapter will provide an overview of the most important supply and demand developments for natural gas, beginning with a brief discussion on natural gas and how it is traded. The analysis of gas demand fundamentals and gas production leads to an understanding of the dynamics of the storage market for natural gas. The geographic distribution of sources and demand for gas will also be examined, before we move on to price dynamics, aided by examples of how many of these factors influence market prices for gas. In conclusion, key factors that will determine the future evolution of prices are identified. OVERVIEW What makes the North American natural gas market unique? The most important factor is that it is a self-contained system within the confines of North America, apart from limited liquefied natural gas (LNG) import and export capability. Consequently, the market can by analysed by understanding supply, demand and storage stocks within the US and Canada. LNG imports can be relevant, but having been at less than 2% of the annual supply for many years, they have little market influence. Highly seasonal demand driven by winter heating and a lesser peak from summer cooling loads combines with relatively constant production flows to require massive storage facilities that can inject gas during times when supply outpaces demand and withdraw 25 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 26 COMMODITY INVESTING AND TRADING when gas burn rises. Injections and withdrawals from storage facilities are surveyed and reported by the Energy Information Administration (EIA), part of the US Department of Energy (DOE), providing a closely watched weekly monitor of supply/demand balance. The natural gas transported through long-haul pipelines is primarily methane with a mixture of some ethane and smaller amounts of heavier hydrocarbon gases, and may contain a small percentage mixture of nitrogen and carbon dioxide. The average heating value of gas consumed in the US is now about 1,025 Btu per cubic foot or 1.025 million Btu (MMBtu) per thousand cubic feet (Mcf). This leads to an often-used rule of thumb conversion factor that 1 Mcf approximately equals 1 MMBtu. Pipelines have specifications for the range of gas quality acceptable for receipt. The heating value of the gas accepted must typically lie within a range of, for example, ~970–1,100 Btu per cubic foot. Some of the most common natural gas units of measure and conversions are given in Table 2.1. GAS MARKETS Before the 1990s, natural gas purchases and sales were predominantly handled by long-term contracts for physical natural gas. Natural gas can still be traded by the purchase or sale of physical gas where the seller delivers and the buyer receives the molecules, and there is also a liquid market where gas can be traded purely finanTable 2.1 Common units of measure and conversions Common units of measure MMBtu Mcf Bcf Tcf Bcm MMT MMBOE Million Btu Thousand cubic feet Billion cubic feet (1,000 Mcf) Trillion cubic feet (1,000 Bcf) Billion cubic meters Million tonnes Million barrels of oil equivalent Conversions 1 1 1 1 26 Bcm = 35.3 Bcf MMT of LNG = 48.7 Bcf methane MMT of LNG = 1.38 Bcm MMBOE ~ 5.6 Bcf (conversion varies) 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 27 THE NORTH AMERICAN NATURAL GAS MARKET cially. Most financial market instruments derive from the traded structures in the physical gas market. The physical gas market traditionally trades gas for both monthly and next day delivery. Purchases of monthly gas are for gas to be delivered in approximately equal daily quantities over an entire calendar month. The majority of these physical gas purchases and sales are made during “bid week”, the last week of each month. Gas also trades in the daily market, with purchases and sales of gas typically occurring during the morning hours prior to the gas flow date in order to allow time for proper nominations for gas flows on the required delivery pipelines. Gas for the weekend and Monday are traded on the preceding Friday. The Nymex natural gas futures contract was introduced in 1990, and it rapidly grew in traded volumes. The contract can be physically settled at the Henry Hub in southern Louisiana, which allows for the interchange of gas between 13 pipelines, or at an alternate delivery point based on mutual agreement between the buyer and seller. Monthly futures contracts are listed, each contract unit representing 10,000 MMBtu, with the contract price quoted in US$/ MMBtu and having a tick size of US$0.001 (0.1 cent) per MMBtu. Although many months of futures are listed, liquidity concentrates at the front of the futures curve. In addition to trading on the Chicago Mercantile Exchange (CME), Henry Hub futures are listed on the IntercontinentalExchange (ICE). Of course, gas trades, both physical and financial, for many delivery locations throughout North America other than Henry Hub. In order to facilitate these transactions, a large number of gas price indexes have been created. The primary publishers of these indexes are Platts and Natural Gas Intelligence. Each of these publishers conduct daily and monthly polls of market participants in order to estimate a representative market price transacted for natural gas at a variety of geographical delivery areas. The published gas indexes allow for managing a financial exposure to the gas index price without transacting any physical natural gas. For example, July gas at Chicago Citygate may be trading in the forward market for US$5.00/MMBtu, and a financial buyer may enter a contract to pay US$5.00 and receive the Chicago Citigate index price after it is published at the beginning of July. 27 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 28 COMMODITY INVESTING AND TRADING DEMAND SIDE DYNAMICS FOR NATURAL GAS Most consumption of natural gas falls into four of the categories used by the EIA: residential, commercial, industrial and electric generation. Residential and commercial use is primarily for heating, and both sectors are characterised by a strong winter demand peak and very flat demand in the summer. Industrial use has much less seasonality, but about 10% does go toward heating demand in winter. Electric generation burn peaks in the summer, when air conditioning loads are the highest. In 2011, residential plus commercial users consumed 32%, power generation 31% and industrial users 28% of all gas consumed in the US. Industrial use Industrials use gas for space heating, process heat and also as a feedstock. As can be seen in Figure 2.1, industrial demand in the US decreased dramatically from 1997, dropping by a total of almost 5.5 Bcf/day before bottoming in 2006. Since then, industrial use has rallied by more than a Bcf per day, interrupted by the Great Recession year of 2009. Figure 2.2 deconstructs industry demand by sector; we find that, Figure 2.1 Average annual industrial gas use (Bcf/day) 24 US$40.00 Industrial use (Bcf/day) 23 US$36.00 US$4.00 14 US$0.00 Source: EIA 28 20 0 20 12 15 20 11 US$8.00 20 10 16 20 09 US$12.00 20 08 17 20 07 US$16.00 20 06 18 20 05 US$20.00 20 04 19 20 03 US$24.00 1 20 20 02 US$28.00 20 00 21 19 99 US$32.00 19 98 22 19 97 Industrial demand (Bcf/day) Henry hub annual avg. spot price (right axis) 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 29 THE NORTH AMERICAN NATURAL GAS MARKET from 1998 to 2006, there was declining use in every significant sector except food and non-metallic minerals. The largest losses in use were in chemicals manufacturing (down 2.59 Bcf/day), primary metals (down 0.82 Bcf/day) and refining (down 0.43 Bcf/day). Within the chemical sector, nitrogenous fertilisers alone accounted for almost 0.75 Bcf/day loss of demand over this time period due to production moving offshore. Imports of anhydrous ammonia grew by 4.4 million short tons, equating to 0.45 Bcf/day of domestic gas demand loss. Since 2006, industrial use of gas has begun to grow again. Of course, the deep recession between late 2008 and early 2010 created a loss of demand of around 1.5 Bcf/day in 2009. However, growth of industrial demand has started to accelerate due to low natural gas prices, which looks to continue into the future, driven by a resurgence in the chemical and refining sectors. Domestic ammonia Figure 2.2 Largest industrial consumers of natural gas (Bcf/day) 8.0 1998 2002 2006 2010 7.0 6.0 Bcf/day 5.0 4.0 3.0 2.0 1.0 s al s m et er al in ed m Fa br ic at c al li et m th Pa pe r N on or ie er ca te g m et a ar y im s ls d g in re fin Fo o Pr O Pe tro le um Ch em ic al s 0.0 Source: EIA 29 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 30 COMMODITY INVESTING AND TRADING production has been stepped up again, and a number of corporations have announced plans to build new chemical plants to take advantage of the low energy prices in the US. There have even been announcements of new metal-processing plants to be built, expanded, or reopened. It appears likely that 2013 industrial consumption will be at least 2 Bcf/day above the levels of 2006, and growth should continue to be robust for a number of years as new use facilities come online. Power generation Because power generation is a large and growing source of demand for natural gas, an understanding of the power markets is critical in anticipating future levels of gas demand. Increasing use of gas for power generation has provided the largest increase of any sector. Figure 2.3 shows monthly average gas burn for power generation and the upward trend in demand since the early 2000s. Figure 2.4 shows that this steady growth in gas burn for generation continued even through years of little or no growth in total power demand. This trend is poised to continue as the phasing in of air pollution standards for coal plants leads to continued coal plant retirements. Figure 2.3 shows that monthly gas burn also comprises strong seasonality of gas generation burn with the distinct summer “air conditioning” demand peak and the much smaller winter heating demand peak that has emerged. Most of the growth in gas burn for power since the early 2000s has come at the expense of decreasing coal-fired generation. Figure 2.5 shows the annual mix of generation sources for the 11-year period ending in 2012. During this time, the percentage of generation from nuclear plants and from sources other than coal, gas and nuclear (which leaves hydroelectric, other renewables and liquid fuels) has held roughly constant, so there has been an almost one-to-one tradeoff in loss of coal generation with gain in gas generation. Gas generation has grown from 17.9% in 2002 to 30.4% of total US generation in 2012, while coal has fallen from 50.1% to 37.4% over that time. We should note that 2012 was an exceptionally high year for gas burn due to conditions that may not recur in the near future. In fact, power generation provides one of the few demand sectors that can significantly change the fuel mix based on short-term fuel price levels and economics. During the period of cheap oil in the 30 00 -2 0 00 3 Ju 04 l-2 00 4 Ja n20 05 Ju l-2 00 5 Ja n20 06 Ju l-2 00 6 Ja n20 07 Ju l-2 00 7 Ja n20 08 Ju l-2 00 8 Ja n20 09 Ju l-2 00 9 Ja n20 10 Ju l-2 01 0 Ja n20 11 Ju l-2 01 1 Ja n20 12 Ja n 2 00 3 l-2 Ju Ja n2 -2 00 02 n20 Ju l Ja 5 0 31 THE NORTH AMERICAN NATURAL GAS MARKET Source: EIA 1 20 01 Ju l-2 Ja n- 35 30 25 20 15 10 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 31 Figure 2.3 Monthly average gas use for electric generation (Bcf/day) 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 32 COMMODITY INVESTING AND TRADING Figure 2.4 US annual power generation (million GW hours) 4.20 Million gigawatthours 4.15 4.10 4.05 4.00 3.95 3.90 3.85 3.80 3.75 3.70 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: EIA Figure 2.5 Percentage of annual power generation by energy source 60.0% Coal 50.0% 40.0% Natural gas 30.0% Nuclear 20.0% All other 10.0% 0.0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: EIA 1990s and early 2000s, fuel oil was sometimes economically competitive with natural gas, so during times of high gas prices there could be an economic incentive to turn on oil-fired generation – which, in turn, liberated gas for higher value heating use. With the advent of oil prices near US$100+/bbl, natural gas has remained much less expensive and oil use for generation has fallen from the already low level of 2% of total generation in 2002 to 0.3% in 2012. 32 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 33 THE NORTH AMERICAN NATURAL GAS MARKET Latterly, coal-to-gas substitution has become a key factor to watch for understanding demand trends for natural gas. The relative costs of generating power from coal and gas drive substitution economics. To calculate the cost of generation, we must know how much coal or gas it takes to generate a megawatt (MW) of power. The amount of fuel required per unit of power generated is called the heat rate. For actual generation plants, the heat rate will depend on a number of factors – including type of equipment, generation level (% of maximum capacity) and ambient air temperature. After estimating the heat rate, fuel cost and variable operating and maintenance cost, the marginal cost of power production can be calculated for a plant. Many analysts construct “stack models”, in which plants are stacked in order of their production costs, then the market’s marginal cost of production can be found for a given level of net power demand, and the amount of expected gas burn and coal burn can be calculated. Of course, there are many additional details involved in this process, including estimation of load served by nuclear and renewable sources, forecast of power imports and exports to connected regions, plant maintenance and forced outage rates, and the influence of operational optimisations to minimise start costs. In practice, stack models are difficult to calibrate for accurately forecasting future market prices, but they can be quite useful in more qualitative analysis of market trends and behaviour. Figure 2.6 tells of an interesting chapter in the natural gas demand growth story. US power load growth accelerated in the mid-1990s at the same time that uncertainties about market deregulation and about future coal plant environmental regulations led to a reluctance to build additional coal-fired generation. The market reacted by beginning an unprecedented build of new gas-fired generation, which can be seen by the huge increases in gas capacity as new plants came online in 2002 and 2003. The build rate slowed but has continued through the last decade. In addition to making more gasfired generation capacity available, the new and more efficient plants have lowered the average heat rate of the available gas-fired generation fleet. The average heat rate of gas generation has dropped from just over 10 MMBtu/MWh in 2001 to 8.15 MMBtu/MWh in 2011, and the US continues to build new combined cycle gas turbines with heat rates near 7 MMBtu/MWh. The shift away from coal toward gas generation is set to continue, 33 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 34 COMMODITY INVESTING AND TRADING Figure 2.6 Natural gas and coal generation capacity and gas average heat rate 450 Capacity (gigawatts) 400 11.5 11.0 10.5 350 10.0 9.5 300 9.0 8.5 250 8.0 7.5 200 Gas average heat rate (mmbtu/MWh) 12.0 NG summer capacity (GW) Coal summer capacity (GW) Average heat rate 7.0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: EIA with over 30 gigawatts (GW) of additional coal plant retirements planned between 2013 and 2018. In that time period, combined cycle gas generation capacity may grow by almost 60 MW if all planned units are permitted and built. Residential and commercial demand While the residential and commercial (rescom) use of gas has not displayed the growth seen in the generation sector, there are substantial year-to-year variations in total use. The largest driver of demand variability in rescom use are winter temperatures, which influence the amount of gas needed for home and commercial heating during the cold months of the year. As can be seen in Figure 2.7, there has been considerable variability in the weather-sensitive heating demand months, but no obvious trend or much change in summer demand levels since the early 2000s. This suggests that growth in the number of consumers has been offset by conservation and heating efficiency gains, resulting in very little (if any) net demand growth. Exports The US plans to begin exporting LNG from the Gulf Coast. Sabine Pass LNG facilities target around early 2016 for beginning LNG exports. With US gas prices likely to remain in the range of US$4.00–6.00 MMBtu, landed prices to Europe would likely be in the range of US$8.00–11.00 MMBtu. Export volumes are expected to 34 20 0 n10 0 Source: EIA 35 THE NORTH AMERICAN NATURAL GAS MARKET Ju l 1 -2 00 1 Ja n20 02 Ju l-2 00 2 Ja n20 03 Ju l-2 00 3 Ja n20 04 Ju l-2 00 4 Ja n20 05 Ju l-2 00 5 Ja n20 06 Ju l-2 00 6 Ja n20 07 Ju l-2 00 7 Ja n20 08 Ju l-2 00 8 Ja n20 09 Ju l-2 00 9 Ja n20 10 Ju l-2 01 0 Ja n20 11 Ju l-2 01 1 Ja n20 12 Ja Bcf / Day 60 50 40 30 20 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 35 Figure 2.7 Residential and commercial gas demand (monthly average in Bcf/day) 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 36 COMMODITY INVESTING AND TRADING reach over 1 Bcf/day in 2016 and planned projects would grow exports to over 3 Bcf/day by 2018, suggesting that the EIA’s projected 2013–20 total production growth of about 5 Bcf/d (shown in Figure 2.11) may be low compared to the likely demand growth. SUPPLY SIDE CONSIDERATIONS The US meets its gas needs primarily with domestic production and imported gas from Canada. LNG imported by tanker from overseas locations provides a third source of supply. Figure 2.8 shows historical monthly production since 1993. Production grew slowly in the 1990s and peaked in March of 2001. Production then began a series of annual declines that led many to believe that domestic US gas supply might be permanently headed in that direction. LNG imports were seen as the solution to securing additional gas supply. In 2000, the US had two operating LNG import facilities: Everett and Lake Charles. Two additional existing facilities, Elba Island and Cove Point, mothballed in the early 1980s, were re-commissioned and began receiving deliveries in 2001 and 2003, respectively. In addition, the Federal Energy Regulatory Commission (FERC) granted authorisations for several additional import terminals that were completed and commissioned in 2008–11. However, most of these new facilities have not yet seen heavy use due to the strong resurgence in domestic production that began in 2007. Shale gas The driver of this reversal in fortune for natural gas production was a combination of new technologies and higher natural gas prices, which allowed shale gas to be produced economically in high quantities. Conventional gas production came largely from gas trapped in sandstone formations with high porosity and permeability, allowing the gas to flow through the formation to the wellbore. It had long been recognised that natural gas was also trapped in many shale formations, but shale is characterised by much lower porosity and permeability that limits the movement of the trapped gas. Mitchell Energy began to experiment with a combination of horizontal drilling and hydraulic fracturing to produce gas from the north Texas Barnett Shale. After Devon acquired Mitchell in 2002, the Barnett drilling programme accelerated and, by 2007, the Barnett Shale produced 1.1 Tcf of gas equivalents – making it the second36 55 50 Gustav & Ike 45 Katrina & Rita 37 THE NORTH AMERICAN NATURAL GAS MARKET Source: EIA 19 94 Ja n19 95 Ja n19 96 Ja n19 97 Ja n19 98 Ja n19 99 Ja n20 00 Ja n20 01 Ja n20 02 Ja n20 03 Ja n20 04 Ja n20 05 Ja n20 06 Ja n20 07 Ja n20 08 Ja n20 09 Ja n20 10 Ja n20 11 Ja n20 12 Ja n20 13 3 19 9 n- Ja n- Ja (Bcf / day) 75 70 65 60 TX Cold 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 37 Figure 2.8 US domestic production (Bcf/day) 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 38 COMMODITY INVESTING AND TRADING largest producing field in the US (see Joel Parshall, 2008, “Barnett Shale Showcases Tight-Gas Development”, JPT, September). After this success in the Barnett, many shale fields began to contribute significantly to US production, and Fayetteville, Haynesville, Marcellus, Bakken and Eagle Ford all became well-known names in the oil and gas E&P sector. Shale gas grew from less than 3% of US gas production in 2003 to more than 40% at the beginning of 2013. Figure 2.9 shows this growth in production from shale gas fields. Figure 2.10 shows that the number of drilling rigs directed towards natural gas production more than doubled from ~700 in 2003 to a peak of almost 1,600 near the beginning of the financial crisis and recession of 2008–09. Then, in spite of the gas-directed rig count plunging back to the 700–1,000 levels, natural gas production continued to grow as shale gas production growth accelerated in 2010 and 2011. The continued growth in production even with lower gas directed rig counts can be attributed to a combination of factors, including the shift of drilling towards horizontal shale wells, improvements in drilling efficiency and growth in associated natural gas production. From September 2008 to September 2010, the number of gas-directed rigs fell from roughly 1,600 to 1,000; however, the number of hori- Figure 2.9 US shale gas production (Bcf/day) 30 Other US shale gas 25 Bakken (ND) Eagle Ford (TX) Bcf/day 20 Marcellus (PA and WV) Haynesville (LA and TX) 15 Woodford (OK) Fayetteville (AR) 10 Barnett (TX) Antrim (MI, IN, and OH) 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: EIA 38 16 1600 Natural gas price 14 Oil directed rigs Natural gas directed rigs 12 1200 Rigs US$/mmbtu 10 8 800 6 400 2 Source: EIA n13 Ja -1 2 Ja n n11 Ja 10 nJa 8 09 nJa -0 Ja n n07 Ja n06 Ja Ja n05 04 nJa n03 Ja n02 Ja 00 n01 Ja 99 Ja n- nJa 98 nJa n97 Ja n96 Ja n- 95 0 Ja Ja n- 94 0 39 THE NORTH AMERICAN NATURAL GAS MARKET 4 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 39 Figure 2.10 Count of rigs drilling for oil and gas in the US Figure 2.11 Annual US gas production by source 90 Shale gas 80 Forecast Tight gas Non-associated offshore 60 Coalbed methane Associated with oil Gas production (Bcf/day) Non-associated onshore 50 40 30 20 10 0 1990 1995 2000 2005 2010 2015 2020 2025 2030 Source: EIA, “Annual Energy Outlook 2013”, early release 40 COMMODITY INVESTING AND TRADING 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 40 70 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 41 THE NORTH AMERICAN NATURAL GAS MARKET zontal drilling rigs directed towards gas actually increased from ~500 to about 650 over the same period. In other words, horizontal drilling grew from one-third of gas rigs to almost two-thirds by late 2010. The much higher average initial production rates from horizontal wells allowed continued production growth with lower rig counts. At the same time, drillers were learning and improving the efficiency of their shale-drilling operations, leading to shorter drilling time and more wells drilled by each active rig, a trend which continues. The rapid deployment of oil-directed drilling rigs beginning in July 2009 can be clearly seen in Figure 2.10. According to the EIA, natural gas associated with oil was about one Bcf/day higher in 2012 than in 2010, thus adding to natural gas production growth. It should also be noted that the distinction between drilling categorised as oildirected as compared to gas-directed is somewhat imprecise. Additionally, new natural gas production lags drilling activity, especially in the new shale production fields, because wells often must wait for infrastructure to catch up with drilling – whereas oil production can, if necessary, be moved by truck or rail. The only economically feasible way to move natural gas production from the wellhead is by pipeline. Therefore, new fields must wait for the requisite gathering pipeline systems to be constructed to deliver gas to users and to the long-haul pipeline system. In addition, wet or sour gas production may need to wait for processing facilities that remove liquids and impurities before the gas can be delivered to a major pipeline. Robust production growth plus the warm winter of 2011/2012 led to a supply surplus, driving prices down to below US$2.00 for the first time in years. Gas-directed rig counts plummeted to near 400 rigs, the lowest level in a decade, as many shale gas fields became uneconomic at the low price levels. In the long run (but hopefully before we are all dead), one would expect that natural gas prices should gravitate towards a price level that makes marginal production economic. However, limited transparency of drilling costs and uncertainties in well production profiles and estimated ultimate recoveries (EUR) make estimating production costs difficult. Also, costs and efficiencies change continually, making drilling economics a moving target. In addition, the proportion of associated liquid hydrocarbons influences the overall 41 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 42 COMMODITY INVESTING AND TRADING economics as the liquids sell at a premium to natural gas. Conventional wisdom recognises the Marcellus shale as the lowest cost of the gas shales, with production costs below US$3.00/MMBtu in the prime locations. With strong crude oil prices, gas-drilling returns may have to compete with oil-drilling economics when exploration and production budgets are decided. Weather impacts on supply Certain types of weather events can influence production as well as demand. The clearly noticeable production drops in August and September 2005 and September 2008 were caused by hurricanes in the Gulf of Mexico, where there is substantial offshore gas production. Hurricanes Katrina and Rita were both Category 5 storms as they crossed the production area in 2005, and hurricanes Gustav and Ike were both Category 4 storms. Smaller hurricanes, and even tropical storms, may cause some disruption to supply as personnel are evacuated from the storm path and some production platforms may be shut-in as a precautionary measure. Rita and Katrina shut-in almost 520 Bcf of production, and the 2008 storms caused a loss of about 340 Bcf of production. Offshore gas production has been in decline but remains above 4 Bcf per day. Because hurricanes need very warm water temperatures to power them, the Gulf hurricane season runs June–November, with August, September and October being the most active months. The production decline seen for February 2011 in Figure 2.11 resulted from very cold temperatures in Texas and nearby states. Gas production declined from wells freezing off and from conditions that hampered the ability of pumpers to maintain production. Severely cold temperatures happen rarely enough in these production areas that many wells do not have protection against cold temperatures, allowing water vapour in the natural gas stream to freeze and constrict flow from the wells. Thus, when unusually cold weather invades southern and southwestern production areas, freeze-offs are a danger to production. Ethane rejection NGLs, which are comprised of ethane, propane, butane and heavier hydrocarbons, enhance production value when stripped from the natural gas stream and sold separately. The stripping of wet gas, 42 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 43 THE NORTH AMERICAN NATURAL GAS MARKET carried out by fractionation facilities, may also be necessary to bring the liquid content of the gas down to standards required by pipelines. For example, 1.25 MMBtu/Mcf gas may yield around 0.12 bbl of liquids per Mcf. At an average liquids price of US$25.00/bbl, the liquids alone are worth US$3.00/Mcf and may comprise nearly half of the value of production. The lowest value liquid in this stream, ethane, may fall below the value received by leaving it in the delivered gas stream. In these cases, the ethane can be rejected during the fractionation process and effectively increases the net amount of delivered natural gas. That is, when we say that ethane is rejected, we mean that it is left in the gas stream with the methane. Ideally, economics will dictate the ethane rejection decision; however, with the rapid growth of new gas production in some regions, the infrastructure is sometimes not sufficient to process all of the produced gas. The total amount of ethane being extracted from the US gas stream had a heating equivalent value of about 3 Bcf/day of gas in late 2012, and the historical levels of ethane extraction suggest that varying ethane rejection could impact net gas deliverability by up to 0.5–1 Bcf/day. STORAGE There is a mismatch between highly seasonal demand as compared to production which, in the absence of disruptions, trends more slowly over the years. The large seasonal variability of demand requires gas to be stored in the low-demand months and withdrawn in times of high demand. There are over 400 natural gas storage facilities in the US to support this balancing need. Most use depleted gas reservoirs as the storage space, but leached out underground salt domes provide almost 8% of the storage capacity and another 8% is provided by aquifer storage. Reservoirs take many months to fill and so can be cycled only once a year, although there is usually some flexibility in scheduling the injections and more flexibility in the timing of withdrawals. Salt domes require much less time to fill, perhaps one month or less, and so can be cycled many times per year if there is an economic opportunity to do so. During the 2010/2011 heating season, a net amount of about 2,200 Bcf was withdrawn from US storage and then about the same net amount injected during the summer; however, gross injections plus withdrawals for the year ran well above the annual net injections plus net withdrawals, showing 43 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 44 COMMODITY INVESTING AND TRADING that many short-term storage injections and withdrawals are made to support the daily physical market balancing, as well as the annual seasonal cycle of demand. Gas storage nomenclature denotes working gas capacity as the amount of storage gas that can be cycled in and out of storage facilities as part of normal operations. An amount of base gas must be maintained in the storage facility at all times to maintain the integrity of the facility. Base gas plus working gas added give the total storage capacity. Most analysts of supply and demand are mainly interested in watching the level of working gas in storage, as this represents the gas available to withdraw for market needs. As of early 2013, the EIA estimated that US facilities have the ability to store 4,558 Bcf of working gas. However, the most working gas actually in storage at any one time was 3,929 Bcf, in autumn 2012. The EIA also calculates the “demonstrated peak working gas capacity” by adding the non-coincident maximums for each facility to get 4.24 Tcf, 94% of the design capacity. Latterly, additional storage has been added at a rate of around 75 Bcf of working gas each year. The maximum working gas capacity becomes quite relevant to the market in years such as 2012, when the market was oversupplied and excess production needed to find a home. In spring and early summer 2012, prices collapsed on fears that storage might fill completely, but low prices solved the problem as power producers turned off coal plants and turned on combined cycle gas turbine (CCGT) plants to burn the inexpensive gas. Analysts speculate on what minimum amount of working gas the market “requires” at the end of the injection season. As can be seen in Figure 2.12, end-of-season fills since the early 2000s have ranged from just under 3.2 Tcf to just over 3.9 Tcf. Because of the growth in use, many believe that the market will now want to be near the high end of this range to ensure winter reliability of supply. Each Thursday, the EIA releases a weekly report giving their estimate of the amount working gas in US storage as of the previous week. This widely anticipated publication gives the single most important short-term data point about the current supply and demand balance, and often incites a strong price response from the natural gas markets. Because of the high importance of the reported number, fundamental analysts labour daily to forecast it. The EIA’s number itself is based on a statistical model that they use to extrapo44 4,500 4,000 3,500 3,000 Bcf 2,500 2,000 Range 2004-2010 1,000 2011 2012 500 Apr Source: EIA May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar 45 THE NORTH AMERICAN NATURAL GAS MARKET 1,500 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 45 Figure 2.12 Working gas in storage (Bcf) 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 46 COMMODITY INVESTING AND TRADING Table 2.2 US production and estimated net exports, demand and imports State or region Texas Louisiana Oklahoma Gulf of Mexico, Federal Offshore Arkansas Rockies (NM, CO, UT, WY) Marcellus (Northeast States) Midwestern States California Florida Southeast Production (Bcf/d) Exports 20 8 6 4 3 15 7 1 1 11 5 4 4 2 13 1 Demand Imports 12 12 6 3 7 4 11 5 3 6 late from their population of storage survey respondents to a total US storage amount, and so has some level of uncertainty itself. This number represents the net injection or withdrawal summed over all US storage facilities. Net injections typically begin in late March or early April, making March the last month of net injections and April the first month of the year with net withdrawals, except in extreme conditions such as the warm March of 2012, which left that month with net injections. During autumn, November is usually the first month to see weekly withdrawals, although there have been net withdrawals as early as the last week of October or as late as the first week of December. In 2006, summer gas demand for power generation was sufficiently strong and production low enough that there were net withdrawal weeks in late July and early August. Because of this seasonality of injections and withdrawals, the natural gas year is divided into the summer (injection) months of April–October, and the winter (withdrawal) months of November– March. This seasonality of storage manifests itself in the gas markets as well. The volatility of the price spread between the October and November contracts, and the volatility of the price spread between the March and April futures, are often the highest of all the sequential month spreads. Also, the term structure of options volatility typically has local maxima for options on the October and March contracts. 46 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 47 THE NORTH AMERICAN NATURAL GAS MARKET GEOGRAPHY OF PRODUCTION AND DEMAND A large portion of the US gas supply has come from the Gulf Coast and mid-continent. Texas has the largest gas production at about 20 Bcf/day. Neighbouring Louisiana produces ~8 Bcf/day, and gas from the Gulf of Mexico Federal Offshore areas comes ashore to pipelines in Texas, Louisiana and Alabama, and adds another ~4 Bcf/day of supply, although this is less than half of the offshore supply levels seen in the early 1990s. Additional supply comes from Oklahoma (~6 Bcf/day) and Arkansas (~3 Bcf/day). There are two other large supply areas outside of the Gulf coast/mid-continent. The Rocky Mountain states of New Mexico, Colorado, Utah and Wyoming combine to produce about 15 Bcf/day of gas, and Marcellus Shale and other production in Pennsylvania and nearby states adds about 12 Bcf/day. Texas, Louisiana and Oklahoma also consume large amounts of gas for industrial use and power generation. Other demand centres are the highly populated states of the northeastern US, the midwestern states and California; Florida and the southeastern states use significant gas generation to serve summer cooling load. Table 2.11 shows production and estimated net exports for the main supply areas and demand and estimated net imports for the top demand areas. An extensive pipeline network provides for the movement of gas from the supply to the demand areas. Many pipelines have been built from the traditional Gulf Coast and mid-continent supply areas. Multiple pipelines, including Texas Eastern Transmission Company (TETCO), Transcontinental (Transco) and Tennessee Gas Pipeline Company were built to transport gas from the Gulf states to demand areas in the northeast. Some of these pipes are now backhauling gas from the shale fields of the northeast back towards the Gulf. Florida Gas Transmission and Sonat carry gas to Florida. Northern Natural Gas, Panhandle Eastern Pipeline Company, ANR and Natural Gas Pipeline Company of America (NGPL) deliver gas to the midwest. El Paso Natural Gas and Transwestern Pipeline take gas west to the California market. The Kern River pipeline to California and the more recently built Rockies Express Pipeline, which can move gas east to Ohio, provide two primary outlets for gas produced in the Northern Rockies, while Transwestern Pipeline can take San Juan Basin gas from Northern New Mexico and southern Colorado to Arizona and California. 47 Figure 2.13 NG price (average of front 12 months) and storage levels relative to five-year trailing average (right axis) Production declining Production growing US$14 2,000 Recession + mild summer Katrina & Rita US$12 1,600 Cold Jan-Mar Coal to gas switching 1,200 Mild winter '11-'12 US$8 800 US$6 400 Bcf US$/mmbtu US$4 Mild Jan US$2 (400) Mild summer '03 Cold winter '02-'03 US$0 12 month strip price Storage Delta to 5yr avg Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 (800) Source: EIA for reported storage 48 COMMODITY INVESTING AND TRADING 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 48 US$10 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 49 THE NORTH AMERICAN NATURAL GAS MARKET PRICE DYNAMICS OF GAS FUTURES Figure 2.13 presents historical natural gas prices since 2002, and relates how fundamental drivers of supply and demand have translated into changes of price regime. The figure shows the average price of the front 12 futures months in order to remove seasonality from the prices. We have reviewed earlier the most important factors influencing the supply/demand balance which, in turn, creates pressure on natural gas prices. Let us look at some of the fundamental drivers of price levels. On the demand side, there is: weather (winter heating, summer cooling loads); al price competition; and 49 50 -5 Jan-13 Jul-12 Jan-12 Jul-11 Jan-11 Jul-10 Jan-10 Jul-09 Jan-09 Jul-08 Jan-08 Jul-07 Jan-07 Jul-06 Jan-06 Jul-05 Jan-05 Jul-04 Jan-04 Jul-03 Jan-03 Jul-02 Jan-02 COMMODITY INVESTING AND TRADING US$/mmbtu 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 50 Figure 2.14 Prompt month price and front-year contango 20 Prompt Futures 15 1 Year Contango 10 5 0 0 8 6 4 2009 2010 2 2011 2012 2013 51 THE NORTH AMERICAN NATURAL GAS MARKET Mar-02 Jul-02 Nov-02 Mar-03 Jul-03 Nov-03 Mar-04 Jul-04 Nov-04 Mar-05 Jul-05 Nov-05 Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07 Mar-08 Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11 Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Jul-15 Nov-15 Mar-16 Jul-16 Nov-16 Mar-17 Jul-17 Nov-17 Mar-18 US$/mmbtu 12 10 2002 2003 2004 2005 2006 2007 2008 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 51 Figure 2.15 The annual evolution of the natural gas futures curve 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 52 COMMODITY INVESTING AND TRADING influencing weather events are noted on the figure. A cold 2002/03 winter pushed gas storage down to very low levels and prices up above US$6.00, before a mild summer in 2003 helped storage levels recover, and gas sold back down to below US$5.00. Similarly, an extremely cold January in 2008 started gas on its run towards prices well over US$10.00. The recession of 2008 destroyed industrial demand and sent gas prices back down, and this trend was exacerbated by mild summer weather in 2008 that further decreased gas burn for power generation. Some time periods, however, show gas prices trending generally upward while storage also builds, such as March 2004–December 2004. For most of 2006 and 2007, storage levels trended, on average, lower, but prices gradually moved lower as well. The same happened mid-2009 to end-2010. Referring back to Figures 2.8 and 2.11, we see that production was on a downwards trend from 2001 to 2005, so prices moved higher to drive out demand. Perhaps the storage builds in 2004 were not taken as a sign of structural surplus but a temporary respite from the tightening supply balances. In contrast, production began its spectacular rebound in 2006, and the market took several years to understand and digest the implications of the shale gas revolution. Market prices were adjusting downward even during times when the storage surplus was reverting to near historical levels. Figure 2.14 shows historical prices for the prompt (ie, front) natural gas contract. The figure also shows a measure of the contango (slope) of the futures curve, calculated here as the price of the 14th contract less the price of the second contract – in other words, the one-year contango of the futures curve starting at the second to expire contract. Clearly, the level of curve contango has a strong inverse relationship to the front month price level for most of the 11 years of price history shown. Because the contango of the price curve is quite volatile, traders are attracted to trades sensitive to changes in the slope of the price curve. Many trading strategies attempt to profit from changes in calendar spreads by taking spread positions, shorting one month and going long a different month. Because of the seasonal nature of gas use and storage, certain calendar spreads tend to have more trading interest and thus higher liquidity. Many of the favourite spreads involve the key storage season months of October, March and April. The March/April spread, sometimes referred to as the “widow maker”, 52 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 53 THE NORTH AMERICAN NATURAL GAS MARKET trades actively, as do the April/October and October/January spreads. Two other favourites are the January/March and January/ April spreads, which have high sensitivity to winter price seasonality. In addition to these seasonal spread favourites, the prompt/ prompt+1 month spread is active, as is the second/third futures month spread, as index fund managers and other market participants are active in rolling forward their nearby month positions. Figure 2.15 shows the evolution of the front 60 months of the natural gas futures curve. Historical curves for each year, 2002–2013, are shown as of late March of each year, when the April contract is prompt. A number of interesting features can be seen from this evolution. The front of the curve tends to lead in most price movements. Therefore, the curve will often go into backwardation when prices move sharply higher, and contango steepens when prices move rapidly lower. The winter to summer month spreads clearly went higher during the high gas price environment of 2005–2008, but collapsed to very low levels in 2012 and 2013. CONCLUSION: KEY ISSUES FOR THE COMING DECADE Since the early 2000s, the natural gas market has moved from a period of declining production and use into a new period of production growth so rapid that it managed to push prices back below US$3.00, a price level that few in 2006 or 2007 ever expected to see again. These lower prices have encouraged drillers to concentrate more on crude oil production and less on dry gas, and at the same time engendered a renaissance of gas-intensive industrial demand. Increases in gas demand for industrial use and power generation should require additional gas production, and potential exports of LNG will accelerate demand from around 2016. At what point in time will growth in associated gas production fail to keep up with demand growth, requiring prices to rise to a level that will encourage more drilling directed towards dry gas? How long will drilling efficiency gains continue to push down production costs, and will production costs begin to rise dramatically when the best shale prospects have been produced? Even with renewed gas-directed drilling, will production growth manage to keep up with the large price-induced demand growth that we are witnessing? All of these interesting questions will require constant reevaluation over the coming years. 53 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 54 COMMODITY INVESTING AND TRADING GLOBAL LNG Rita D'Ecclesia Sapienza University of Rome Global LNG flows reached over 200 MMT in 2012, the equivalent of almost 10 Tcf of gas or about 8% of world gas production. This panel will discuss major exporters and importers and possible trends going forward. Exports By 2012, LNG exports represented about 30% of international gas flows. Global LNG exports grew from 117 MMT in 2005 to 203 MMT by 2012, an average annual increase of 10%. Table 2.3 shows the LNG exports for the 10 largest exporters since 2005 including Canada scheduled to be a major player by 2020. The biggest LNG exporters in 2005 were Indonesia (17%), Malaysia (15%), Algeria (14%) and Qatar (14%), accounting for 60% of world exports. By 2012, the balance had shifted and four countries – Qatar (39%), Malaysia (13%), Australia (11%) and Indonesia (10%) – accounted for 73% of the total exports, with Algeria having heavily reduced its share. During this period LNG exports grew by 56 MMT. In terms of geographic distribution the Middle East was the fastest growing exporter, growing from 38 MMT (28% of total) in 2005 to 85 MMT (43% of total) in 2012, while the Atlantic Basin reduced its exports from 44 MMT in 2005 to 37 MMT in 2012. Exports are tied to the liquefaction capacity of each country, therefore we need to look at the existing plants and those planned for the next decade. In Table 2.4, the evolution of liquefaction capacity between 2000 and 2012, and an estimate for 2020, is provided. The list of exporters with more than 10 million metric tonne per annum (MMTPA) of liquefaction capacity is short and rapidly changing. There are 20 countries exporting LNG and five major re-exporters (Belgium, Brazil, Mexico, Spain and the US). Liquefaction capacity utilisation around the world averages 90%, and so its growth is critical to expanding volumes, whereas global utilisation of regasification is only 35%. In 2001, the US was expected to become a major importer of LNG, but by 2012 a resurgence in US gas production lead to the prospect of the US becoming a major exporter once liquefaction trains become operational, expected to begin around 2016. Because of the high infrastructure costs of creating and delivering LNG, most projects require long-term contracts that lock in the destination of LNG produced. An estimated 25% of these flows are now short-term contracts (less than four years in duration), and an increasing amount of LNG flows are in the hands of international oil and gas companies (IOCs – see Table 2.4) with more destination flexibility. From 2008 to 2012, IOCs increased their share of export capacity by 45 54 Algeria Egypt Nigeria Oman Qatar Australia USA Indonesia Malaysia Russia Canada World total 2005 2008 2009 2010 2011 2012 D(2012–2005) 2015 15.9 4.3 8.0 5.7 16.8 9.2 1.1 19.5 17.6 15.9 10.6 16.7 8.6 30.0 15.0 0.8 20.1 22.1 15.7 10.2 11.6 8.1 36.9 17.9 0.6 19.3 22.3 5.0 14.3 7.1 17.9 8.6 56.2 18.8 0.6 23.5 23.2 9.9 12.5 6.3 18.9 8.1 75.4 19.5 0.3 21.9 24.9 10.6 11.2 4.7 19.6 8.2 76.4 20.9 0.2 19.0 24.9 10.9 –4.7 0.5 11.6 2.4 59.6 11.7 –1.0 –0.5 7.3 10.9 19.3 4.9 14.2 8.3 75.3 21.7 9.9 13.6 25.9 9.6 8.1 0.1 –5.4 0.2 –1.1 0.8 9.7 –5.4 1.0 –1.3 19.3 4.9 14.2 8.3 75.3 77.3 80.8 15.1 25.9 9.6 16.9 0.0 0.0 0.0 0.0 0.0 55.6 70.9 1.5 0.0 0.0 0 147.5 180.0 173.5 195.9 56.0 202.6 22.6 347.5 144.9 117.0 139.8 D(2012–2005) D(2015–2012)* D(2020–2015)* Maj Pac Basin % of total 57.2 41% 64.5 44% 75.3 42% 76.9 44% 75.6 39% 18.4 70.7 35% –4.6 144.8 42% Middle East % of total 38.6 28% 45.0 31% 64.8 36% 83.5 48% 84.5 43% 45.9 83.7 41% 18.9 83.7 24% Maj Atl Basin % of total 44.0 31% 38.0 26% 39.9 22% 38.0 22% 35.7 18% –8.3 48 24% 8 119 34% * Estimates by GIIGNL. 74.0 70.9 55 THE NORTH AMERICAN NATURAL GAS MARKET Major exporters D(2015–2012)* 2020 D(2020–2015)* 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 55 Table 2.3 10 largest exporters of LNG 2005–2015 (MMT) 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 56 COMMODITY INVESTING AND TRADING billion cubic meters per annum (bcm/a) from 85 to 130 bcm/a, led by Shell, Exxon Mobil, Total, ConocoPhillips, Woodside and Chevron. National oil and gas companies (NOCs) increased by 74 bcm/a, from 137 to 211 bcm/a. Trading houses, LNG importers, financial institutions and local companies represent the balance, 33 bcm/a in 2008 and 48 bcm/a by 2012. NOCs have an obligation to satisfy domestic demand, therefore Russia, Nigeria and Indonesia are increasingly focused on the price gap between their domestic market and export prices. In general, IOCs are more responsive to market conditions, and bring advantages in terms of integrated project development. European utilities with considerable LNG strategies include GDF-Suez, EdF, E.ON and RWE. In 2012, Qatar dominated global export capacity with a 39% market share and 84 MMTPA of liquefaction (see Table 2.5). The other Middle East exporters, including Abu Dhabi, Oman and Yemen, have no reported plans to expand their liquefaction capacities. Qatar is a true swing exporter and, in the period 2008–12, sent on average 35% to Europe, 5% to the Americas and the rest to Asia (of which 33% was to Japan, 25% to each of India and South Korea, 10% to Taiwan and 7% to China). Asian demand growth is impressive (see Table 2.6). China has grown from nothing in 2005 to 5 MMT in 2012, India from 6 to 10 MMT, Japan from 8 to 16 MMT and Taiwan from 1 to 6 MMT. South Korea is the only stagnant Asian importer, with 9 MMT in 2005 and 11 MMT in 2012. Most of the LNG from Abu Dhabi, Oman and Yemen flows to Asia. The Pacific Basin liquefaction capacity stands at 92 MMTPA, representing 38% of the world total. It is expected to increase by 2020 as many large Australian and Canadian projects come online, and Australia is expected to tie with Qatar’s liquefaction capacity. Indonesia has been experiencing domestic production outages, and is therefore planning to expand its liquefaction capacity to send out 40% of production to the domestic market. In addition, adding new liquefaction capacity in 2014, Indonesia is converting two ageing liquefaction plants to regasification. Malaysia has had a series of outages on liquefaction maintenance and has minor plans for floating liquefaction in the future. Australia and Canada are positioned to be key exporters in this basin. In the period 2005–12, Australia added 24 of the 26 MMTPA Pacific Basin liquefaction increase. According to planned new liquefaction plants, Australia will increase its capacity by 60 MMTPA, and Canada is expected to build 17 MMTPA of liquefaction capacity by 2020, estimated as 50% of the 34 MMT of filed projects. The major Atlantic Basin exporters hold 23% of liquefaction capacity. From 2005, Algerian capacity has remained unchanged at 19 MMTPA, still recovering from the 2004 explosion at Skikda that kept capacity offline in the 2008–12 period. New capacity additions for Algeria have been quoted at US$1,000/MT capital costs. Egypt started as an exporter in 2004 and has 12 MMTPA of capacity. Its economic growth has created more domestic demand, and it is planning to build regas capacity. By 56 Country Basin 2000 2005 2008 2009 2010 2011 Algeria Egypt Nigeria Oman Qatar Australia 1 USA2 Indonesia Malaysis Russia Canada3 Atlantic Atlantic Atlantic Middle East Middle East Pacific Atlantic Pacific Pacific Pacific Pacific 19.4 0 9.6 7.1 16.1 0 1.4 26.5 15.9 19.4 12.2 9.6 7.1 25.5 12.1 1.4 26.5 22.7 19.4 12.2 21.8 10.7 36.9 19.8 1.4 26.5 22.7 19.4 12.2 21.8 10.7 60.3 19.8 1.4 34.1 22.7 9.55 19.4 12.2 21.8 10.7 75.9 19.8 1.4 34.1 24.2 9.55 19.4 12.2 21.8 10.7 83.7 19.8 1.4 34.1 24.2 9.55 2012 19.4 12.2 21.8 10.7 83.7 24.1 1.4 34.1 24.2 9.55 2015 8% 5% 9% 4% 35% 10% 1% 14% 10% 4% 24.1 12.2 21.8 10.7 83.7 24.1 10.4 33.95 26.07 9.55 100% TOTAL 96.0 136.5 Capacity change 212.0 229.1 236.9 241.2 2008–05 2009–08 2010–09 2011–10 2012–11 40.5 34.9 and percentage share 40.55 17.1 7.8 4.3 9% 5% 8% 4% 33% 9% 4% 13% 10% 4% 24.1 12.2 21.8 10.7 83.7 85.9 85 37.75 26.07 9.55 16.9 100% 256.6 413.7 2015–12 2020–15 15.42 157.1 6% 3% 5% 3% 20% 21% 21% 9% 6% 2% 4% 100% Capacity by area 2000 2005 2008 2009 2010 2011 2012 2012–2005 2015* 2015–2010 2020* 2020–2015 Maj Pac Bas % of total capacity 44% Middle East % of total capacity 24% Maj Alt Bas % of total capacity 32% 42.4 45% 23.2 24% 30.4 31% 61.3 40% 32.6 28% 42.6 32% 69 41% 47.6 33% 54.8 26% 86.15 38% 71 38% 54.8 24% 87.65 37% 86.6 40% 54.8 23% 87.65 38% 94.4 39% 54.8 23% 91.95 37% 94.4 37% 54.8 27% 26.35 93.67 43% 94.4 23% 68.5 35% 1.72 176.17 82.5 0 94.4 0 13.7 143.1 74.6 1 2 57 3 Adds 10 MMTPA capacity, or more. 134.2 Mmtpa fled with FERC. Canada is expected to build in 2015, the 50% of 34Mmtpa in liquefaction capacity (estimates by the author). 54 12.2 THE NORTH AMERICAN NATURAL GAS MARKET 2005–00 171.4 2020 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 57 Table 2.4 Liquefaction capacity (MMTPA) (estimates by the author). 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 58 COMMODITY INVESTING AND TRADING many estimates, Egypt will not be an exporter by 2020. Its utilisation of liquefaction has dropped from almost 90% in 2008 to 40% in 2012 (see Table 2.11). Nigeria holds 22 MMTPA of liquefaction, more than doubling since 2000, but suffers considerably from political unrest and infrastructure construction delays. Despite having the greatest gas capacity in the Atlantic Basin, it continues to struggle to perform. The US is expected to operate 85 MMT of liquefaction capacity by 2020 out of the 135 MMT of filed projects, according to the author’s estimates. Importers and import growth Import demand is relatively simple to analyse in the LNG market, given the different regional demand drivers. Asia depends heavily on oil, and LNG increasingly flows to the industrial complexes on the southern coast of China. China’s natural gas assets are in the Northwest, and while the trans-China gas pipelines will inevitably be built, LNG is at least the short- Table 2.5 Regasification capacity by country, 2000–20 (MMT) Country Belgium France Italy Netherlands Spain Turkey UK Big 7 total 2000 2005 2008 2009 2010 4 7 2 4 7 2 4 7 2 4 11 5 4 11 5 19 3 34 22 3 9 47 27 6 11 57 27 6 24 77 Europe 34 47 59 USA 3 8 Americas 3 China India Japan South Korea Taiwan Asia 2011 2012 * Estimates by GIIGNL. 58 2020* 27 6 24 77 4 11 5 5 27 6 24 82 4 11 5 5 27 6 24 82 9 20 16 15 27 6 24 117 10 22 27 20 27 10 27 143 77 77 84 88 125 150 46 53 78 83 83 8 50 60 100 110 112 104 44 4 5 108 55 4 8 5 115 55 4 10 6 115 55 7 10 8 116 55 7 12 8 117 55 7 14 8 118 55 7 152 168 175 177 178 179 207 Middle East Total 2015* 4 189 223 284 314 355 373 411 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 59 THE NORTH AMERICAN NATURAL GAS MARKET term supply choice. Coastal India is another big importer, where GDP is crimped by a lack of energy, and rolling brown-outs are common. Asia more than doubled imports in the period 2005–12, with Indonesia and Taiwan starting to import in 2005, with Japan, China and South Korea also increasing their volumes. Europe and the Americas reduced their LNG imports in 2010–12, despite increasing between 2005 and 2010 (Table 2.6), due to factors such as price, the economic downturn and increasing US domestic production. Asia is the largest importing region, with almost 65% of total world imports. In 2008–12, Asia imported an average of 136 MMT (63% of world total imports). Of these, 55% was delivered to Japan, 22% to South Korea, 6% to China and the remaining 17% to India, Taiwan and Indonesia. Imports in Asia have staged a recovery after a contraction in 2009 (–7%, see Table 2.7). European imports increased by 70% during 2005–12. In 2012, they accounted for 21% of global imports. The largest importer is Spain (31% in 2012), followed by France (15%), the UK (21%), Turkey (11%), Italy Table 2.6 LNG imports by country (MMT) 2005 2008 2009 2010 2011 2012 D(2012–2005) 3 7 5 1 15 5 10 47 1 –1 4 1 2 2 10 19 Belgium France Italy Netherlands Spain Turkey UK Big 7 Total 2 8 2 2 9 1 5 10 2 5 10 7 14 3 0 28 22 4 1 40 20 4 7 48 21 6 14 62 5 11 6 1 17 5 19 63 Europe 30 42 52 65 65 49 20 USA 11 7 10 9 6 4 –8 Americas 12 11 16 21 19 18 6 China India Japan South Korea Taiwan 3.7 47.2 18.8 5.9 3 8 69 29 9 6 9 66 21 9 10 12 72 28 11 13 12 78 35 12 15 13 87 37 13 15 9 40 18 7 Asia 75.7 118 113 132 153 166 90 0 0 1 2 4 3 3 117.7 195 181 220 241 236 119 Middle East TOTAL 59 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 60 COMMODITY INVESTING AND TRADING Table 2.7 LNG imports by country (growth rate %) 2008/2005 2009/2008 2010/2009 2011/2010 2012/2011 Big 7 Europe 40% 22% 29% 0% –25% Europe 43% 23% 25% 0% –24% Americas –2% 37% 33% –8% –5% 119% 45% 53% 54% 56% 68% 13% –4% –27% –3% –4% 70% 35% 9% 32% 21% 17% 37% –1% 9% 26% 9% 16% 13% 5% 12% 4% 8% 9% 67% –7% 21% 9% –2% China India Japan South Korea Taiwan Asia Total (10%), Belgium (6%) and the Netherlands (1%). These six countries account for the lion’s share of demand (96%). Imports by the Americas accounted for an average 17 MMT over 2005– 12, and in 2012 were a mere 7% of world LNG imports. The US accounted for 44% of the volume followed by Mexico (19%), Argentina and Chile (9% each), and 6% for Brazil and Canada. Two countries in the Middle East (Kuwait and Dubai) started to import LNG in 2009 and in 2012 were an insignificant 1% of global imports. Imports of LNG are linked to the regasification capacity of the various importing countries (see Table 2.8). In 2012, there were 93 LNG regasification terminals operating in the world including 11 floating facilities. There are two possibilities for significant regasification capacity growth around the world. Both China and India have considerable plans to expand LNG imports. The GIIGNL 2012 Annual Report lists eight projects under development in China that are expected to add some 15 MMT of regas capacity. This would double Chinese import capacity. By 2020, China could be importing as much as South Korea. India similarly lists 12.5 MMT of capacity under construction, likely to continue to be hampered by logistical issues, and also lists a variety of terminal and distribution projects. This would more than double Indian import capacity into the early 2020s. Regasification in Europe is mainly concentrated in the seven largest European importers which have 82 of the total 88 MMTPA of regasification capacity. The utilisation rates swing depending on the LNG price. For example, Spain imported 22 MMT in 2008 and only 15 MMT in 2012. The flexibility of imports in Europe is a reflection of its market maturity and efficiency. The LNG demand in Europe has been growing at a fast pace over 2005–10, with an annual average growth of 19% to 2011, and declined 60 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 61 THE NORTH AMERICAN NATURAL GAS MARKET Table 2.8 LNG regasification capacity by country (percentage of utilisation) 2008 2009 2010 2011 2012 2015* 2020* Belgium France Italy Netherlands Spain Turkey UK 56 132 72 121 89 42 112 96 130 95 96 93 75 73 30 76 100 60 73 68 98 10 56 98 44 95 96 93 81 70 7 115 97 122 13 62 85 79 70 85 44 70 85 44 Big 7 total Europe 70 71 63 68 81 76 57 56 69 69 USA 16 18 11 7 4 11 11 107 164 74 66 186 82 157 64 54 171 82 157 64 54 171 Asia 80 85 90 Middle East 72 75 80 Total 35 40 40 Americas China India Japan South Korea Taiwan 16 41 154 60 52 211 56 155 57 38 130 95 157 62 50 158 110 156 67 64 172 Source: Author’s estimate heavily in 2012 (–25%, partly due to relative price and partly economy shrinkage). The large reduction of LNG demand is in line with the heavy reduction of natural gas demand in 2011–12 in Europe. In the period 2005–08, virtually every European country, from Lithuania to Ireland, added regas capacity. In the US during 2005–08, a lot of regas capacity was built, but subsequently was not needed, so US utilisation rates are abysmal. Regasification global usage is only 35%, but capacity utilisation varies widely by region. Regas capacity can provide flexibility and security of supply. Utilisation rates change as capacity is added and as other energy flows dictate. For example, between Spain and France energy may flow as gas or be wheeled as electricity. Table 2.9 lists regasification capacity utilisation rates. Italy’s data is difficult to follow, with listed additions apparently running earlier than official openings. India suffers from the same problem. Russia and China do run at excess of nameplate capacity. Taiwan’s import data is suspect. All figures come from GIIGNL. 61 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 62 COMMODITY INVESTING AND TRADING Table 2.9 European natural gas supply and demand in the European Union (bcm) Production 2000 2005 2008 2009 2010 23193 21198 19328 17426 17779 15793 14965 average (2008–12) 49613 49729 46512 average (2008–12) Russian pipeline imports 19390 15128 18099 16429 average (2008–12) 18634 17856 18590 1792 1447 13288 12302 12657 average (2008–12) Excess demand in LNG equivalent (MmT) 50289 45305 44388 4724 average (2008–12) Excess demand (BCM) 2012 1706 44029 Consumption 2011 13876 11656 10833 1226 1070 9833 9103 9366 10269 8626 8016 908 LNG supply chain The cost of gas is critical to the analysis of future export availabilities, especially for US shale gas. The cost of building liquefaction has risen dramatically: ❏ the variable costs of liquefaction in the US are approximately US$2/MMBtu; ❏ transatlantic freight is approximately US$1/MMBtu; and ❏ regas costs are US$0.50/MMBtu. This means a built-in supply cost which must be added to the natural gas price (Henry Hub) of US$3.50/MMBtu for gas landed into Europe. This natural gas chapter estimates the price at which we will continue to expand US shale gas at US$4.00–5.00/MMBtu leaving us with a landed Europe price of US$7.50–8.50/MMBtu. Notwithstanding this high price, we expect to see a continued healthy European demand, especially if GDP growth can recover. Assuming Japan has an incremental freight cost of US$2/MMBtu the natural gas price for Asia may reach US$10.50/MMBtu. The liquefaction cost in Canada, after the building of the planned liquefaction plants, is expected to be close to US$1.70/MMBtu, and these volumes are directed to Japan. Terminal expansion is lowering costs along with expanding fleet and vessel size. The global fleet is 378 vessels and 54,000,000 m3, including floating storage and regasification units (FSRUs). Only two vessels were added to the fleet in 2012, compared to 16 in 2011, three ships were scrapped and one was converted to an FSRU. More than 40 vessels in the fleet have been used for over 30 years and more than 250 vessels are under 10 years old. 62 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 63 THE NORTH AMERICAN NATURAL GAS MARKET The order book was 78 vessels at the end of 2012 and 27 new orders were added in the year, of which 23 were LNG carriers ranging from 150,000–172,000 m3, two FSRUs, one regasification vessel (RV) and one floating liquefied natural gas (FLNG) carrier (210,000 m3). ICIS Heren has forecasted that additional expansion is needed for the fleet in order to retire older ships in 2015–20. What may be more important for estimating future shipping flows is the ever-increasing share of flows to the Pacific basin, rather than the Atlantic basin, lengthening tonne miles. The future growth of European demand, on the other hand, depends mostly on building storage and distribution assets, where environmental and other compliance issues will be considerably more expensive than in emerging or frontier markets. Concerns over emissions seem to be curtailing European demand for LNG and compressed natural gas (CNG) as a truck fuel. Future LNG flow considerations Liquefaction plant build costs in the early 2000s (such as Egypt’s US$250– 350/MMTPA and Oman’s US$200/MMTPA) were comparatively low. Qatar RasGas II and III build costs were around US$350/MMTPA, while Qatargas IV was close to US$750. Australian Pluto was estimated at US$800 and the Russian Sakhalin capacity got deferred on an estimated US$1,000. Geography, climate and political risks drive construction costs. An ever-increasing amount of gas trying to come to market from emerging countries (Equatorial Guinea, Yemen, Peru, Angola, PNG, Libya and Iran) will not help lower costs of future liquefaction capacity addition. This will make it increasingly easier for an IOC to get involved, compared to an NOC. More generally, domestic gas demand is growing in many producing countries – for generating power and water, fuels and petrochemical production, as well as reinjection to oilfields. In terms of major exporters, we note that Qatar, who have paused liquefaction at current levels, actually have approvals in place to expand liquefaction up to 105 MMT. This represents an opportunity. Nigeria still has considerable waste between gas field and liquefaction, and an uncertain future for further developing gas pipelines within Africa. The US has a major opportunity to capture export market share, but energy exports have no great historical precedent within the world’s largest energy consumer. Russia will inevitably add more LNG capacity for Asia. Europe has experienced a reduction in natural gas production since 2000, from 232 bcm in 2000 to 150 bcm in 2012 (see Table 2.9). The demand for natural gas reached a high of over 500 bcm in 2010, but by 2012 was back near the 2000 level of 440 bcm. Russian natural gas pipeline exports to Europe have declined since 2000 bringing an increase in other import demand from 14.5 bcm in 2000 to 108 bcm by 2012. This equates to a European LNG demand of 80 MMT in 2012. 63 02 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:37 Page 64 COMMODITY INVESTING AND TRADING Table 2.10 Total LNG capacity holders (bcm/year) 2008 2012 D(2012–2008) D% IOC’s Shell BP BG ExxonMobil Total ENI Repsol/Gas Natural ConocoPhillips Marathon Woodside Chevron 19.3 15.3 9.7 9.3 7.9 6.3 4.7 4.0 3.4 2.7 2.7 27.4 17.3 9.7 20.8 14.6 7.3 5.9 7.2 3.4 9.6 6.3 8.1 2.0 0.0 11.5 6.7 1.0 1.2 3.2 0.0 6.9 3.6 42 13 0 124 85 16 26 80 0 256 133 TOTAL 85.3 129.5 44.2 52 NOC’s Pertamina (Indonesia) Qatar Petroleum Sonatrach (Algeria) Petronas (Malaysia) NNPC (Nigeria) StatoilHydro (Norway) Gazprom 39.6 27.8 27.8 25.4 14.8 1.9 0.0 39.6 84.0 33.9 26.5 14.8 1.9 10.0 0.0 56.2 6.1 1.1 0.0 0.0 10.0 0 202 22 4 0 0 10+ TOTAL 137.3 210.7 73.4 53 Table 2.11 Percentage plant utilisation Algeria Egypt Nigeria Oman Qatar Australia USA Indonesia Malaysia Russia Canada 2008 2009 2010 2011 2012 2015 2020 82% 87% 77% 81% 81% 76% 56% 76% 97% 0% 81% 83% 53% 76% 61% 90% 43% 57% 98% 53% 74% 58% 82% 81% 74% 95% 44% 69% 96% 103% 64% 52% 87% 76% 90% 98% 21% 64% 103% 111% 58% 39% 90% 76% 91% 87% 12% 56% 103% 114% 80% 40% 65% 78% 90% 90% 95% 40% 99% 100% 100% 80% 40% 65% 78% 90% 90% 95% 40% 99% 100% 100% 100% 100% Total Source: Author’s estimate 64 03 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:44 Page 65 3 A Day in the Life of Commodity Weather Jose Marquez Whiteside Energy This chapter will offer insight into the role of a commodity meteorologist and how they aid our understanding of risk within commodity markets. Primary sources of information, methods of interpretation and strategy considerations are given from the perspective of an energy trading firm. Weather linkages in other commodity markets are also briefly discussed. Weather drives daily volatility demand for natural gas. Weather influences residential, commercial and electrical power end users, natural gas is burned in the winter for heating and electrical generation requirements in summer. Regional demand differences and seasonality ultimately affects natural gas futures pricing and regional basis hubs. In natural gas markets, cold weather can force peak day demand events where price-induced curtailments may occur to non-temperature sensitive clients (ie, reduction of industrial load) in order to ensure that needed gas is available to residential and commercial consumers. Residential and commercial sectors requirements peak during the heating season, and gas must be stored to meet the winter demand. Weather is a constant source of short term volatility in natural gas demand and price expectations. Therefore, a solid understanding of the relationship between weather and natural-gas fundamentals is imperative. 65 03 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:44 Page 66 COMMODITY INVESTING AND TRADING WEATHER DATA BASICS Meteorologists working for commodity trading firms have long been utilised in agriculture markets, where extreme weather conditions affect diverse crops throughout the year. The US National Weather Service (NWS) and several weather consulting firms provided weather information and forecasts for 1–5 and 6–10 day periods. Meteorologists then enhanced this information through further interpretation and acted as a quality control for the weather forecasts provided by these external sources. In the early 1990s with the deregulation of natural gas, Enron was the first energy merchant to utilise meteorologists on staff to expedite and maximise the accuracy of weather forecasts. The company understood the significant correlation between temperature and natural gas demand, and that being ahead of the pack at incorporating incoming temperature changes would help maximise profits on their large natural gas portfolio. For example, buying or selling natural gas molecules ahead of others gave the ability to profit from expected increase or decrease in demand, which then moves price on a regional or national basis. Of course, such methods to create a trading edge do not last forever. Soon, many other energy trading firms maintained their own staffs of in-house meteorologists. At one point, Enron had a team of six people providing weather information to the trading desks. The main daily source of weather information for everyone across the globe comes from global weather models. Some models provide forecasts up to 10 days, others up to 16 days. In a nutshell, a global weather model is a sophisticated mathematical model that uses a set of equations with diverse parameterisations that represent the Earth and atmosphere. Horizontally and vertically, the Earth’s surface and the atmosphere is divided into grids or pixels that interact with each neighbouring point, ultimately allowing calculation of a forecast for the future state of the atmosphere. The resulting forecast may step through time, starting with three-hour increments increasing to 12hour time steps after 192 hours. The size of the geographic and temporal grids are tuned in order to optimise the balance between the number of required computations and the grid resolution, since more calculations are required using the higher resolution grid compared to the lower resolution grid. As an example, the grid size or pixel may vary from 35-kilometre spacing up to 70-kilometre spacing for forecast periods after 192 hours (8 days). 66 03 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:44 Page 67 A DAY IN THE LIFE OF COMMODITY WEATHER Meteorological and oceanographic data to initialise the models come from across the globe: from air and land weather recording stations, weather satellites and commercial and military pilot reports. This immense dataset is gathered, assimilated and fed into various global weather models. An initial condition or initialisation defines the beginning state of the earth–atmosphere system, before forecasts with a defined time stamp are calculated by the models. As you can imagine, the amount of data and the computational power required to run these models are immense, and to truly obtain an adequate global initial condition requires full access to global data (some data could be considered confidential). Consequently, specialised government agencies or research centres with special international agreements for data sharing are the only entities capable of producing a meaningful and skillful global forecast. Therefore, meteorologists across the world obtain their daily temperature and weather changes from global weather models produced by various institutions. In the energy industry, the main models observed and analysed are the American Model (GFS), the European Model (ECMWF) and the Canadian Model (GEM). In addition, and to a lesser extent, there is the NOGAPS (US Navy) and short-range models such as the NAM (up to 84-hour forecasts). The American model is run by the US National Weather Service's National Center for Environmental Prediction, in Washington DC, the European model is run by the European Centre for MediumRange Weather Forecasts, located at Reading, UK, and the Canadian Model is run by Environment Canada (Canada’s National Weather Service). The US National Weather Service provides daily forecasts for the 1– 5, 6–10 and 8–14 day periods. The information comes in data output or graphical format. A DAY IN THE LIFE Early in the morning, multiple weather sources release information which could be utilised by the markets. The changes on weather information and data are compared to the previous trading day determining upcoming changes in natural gas demand and setting the tone for traders early in the morning. Traders know that colder than normal conditions in the highest population areas of the US, mainly East of the Rockies in the winter means higher demand 67 03 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:44 Page 68 COMMODITY INVESTING AND TRADING for the US as a whole. In summer months, warmer than normal temperatures in the East, especially Texas and Southeastern US, means more demand for air conditioning, of which a large percentage is generated by natural gas-fired power plants. Meteorologists on staff do not influence the market with their information or have an influence on Nymex pricing. Their information is kept in-house. On the other hand, weather information and forecasts come from multiple sources, including global weather models which have a broad dissemination across markets. Thus, large changes to the forecasts can create a tangible reaction in the energy markets. Meteorologists have their own language to forecast or explain weather patterns and/or phenomena. They talk in terms of geopotential heights, vorticity and jet streams to mention a few. Energy traders talk in terms of Heating/Cooling Degree Days (HDDs/ CDDs), increase/decrease demand, confidence level and risks. Therefore, the most important job of the in-house meteorologist is to "translate" the meteorology language into an energy trader's language. They link the language of science to trading. The meteorologist on staff will gather all relevant information available from multiple sources and streamline it in a way that is easily accessible and understood by the trading desks. The meteorologist could come with the following checklist: How is the weather pattern evolving for the 6–10 and 11–15 day periods? What is my confidence level in the weather pattern? What is the risk of the forecasts to change directionally and temporally? The in-house meteorologist gives a sense of confidence level for the existing forecast. If the staff meteorologist feels that the current forecast may change then forecasting how that change is likely to occur, in timing and direction, becomes critical. First, the meteorologist on staff has their own view of the weather pattern for the 6–10 and 11–15 day periods. When all the moving parts are in agreement, for example when diverse global weather models forecasts are aligned, the job for the in-house meteorologist is usually uneventful. However, when the in-house meteorologist is in disagreement with the diverse global model’s output, the situation can be quite challenging. Most of the time, the divergence in forecasts starts when global weather models are differing in their output. For example, the European model may be showing a cold wave in the Midwest while 68 03 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:44 Page 69 A DAY IN THE LIFE OF COMMODITY WEATHER the American model does not show it for the same time period. So, there is no middle ground here and a forecast must be made. Does the Midwest have a cold event or not? Therefore, the in-house meteorologist has to react with a highly accurate, timely response and be prepared to accommodate many information requests from traders. An important process after having a forecast view of the incoming weather pattern is anticipating how or when the forecasts from various sources may change. This task is called "forecast the forecast". Overall, agreement or disagreement with the forecast's output from various sources serves as a confidence level barometer for traders. Situations arise when the Nymex price moves strongly due to forecasts of impending cold or warm events, and traders can put immense pressure onto the in-house meteorologist to either change the internal forecast or to precisely time when the forecasts will change. Therefore, it is the meteorologist’s job to make such information both accessible and easy to understand, and to be clear and concise about the risks from a challenging forecast. Following Keynes’ advice that “Wordly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally”, the easiest way out is to agree with the general weather view of the markets, and when the pattern “surprisingly” changes, then point to the fact that global weather models were wrong. To provide true value to the firm, however, the meteorologist must make the best possible assessment of forecasting the forecast revision and communicate that opinion along with the relevant risks to the trading desks. The meteorologist should not get overly bogged down in details but focus on the importance of getting the weather pattern right first, and then worry about the details. Simpler is better. After the early morning weather operations are finalised, several weather updates will arrive during regular trading hours. As the numerical models update, any significant change in the weather pattern compared to early morning weather information could cause price volatility. The NAM is the first one to update, although this weather model only provides forecasts up to 3.5 days ahead. The GFS is the first global weather model to update the 16-day forecasts. The GFS is immediately followed by its ensembles, a package of forecasts that show the level of stability or instability of the current solution. Then, the ECMWF updates after the American models are 69 03 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:44 Page 70 COMMODITY INVESTING AND TRADING done. The whole updating process of new weather information consumes the last three hours of the regular Nymex trading day. TROPICAL WEATHER There is a seasonal weather system that creates quite volatile price action during the summer months: hurricanes. The hurricane season runs from June 1 until November 30 in the Atlantic Basin. The main threat area is the Gulf of Mexico, specifically from Mobile to just north of Corpus Christi. Historically, close to 10% of total gas production in the US could be impacted. The National Hurricane Center (NHC), is the official entity responsible for issuing tropical forecasts, watches and warnings. NHC establishes a tropical cyclone as an organized system of clouds and thunderstorms with a low level circulation rotating anticlockwise in the Northern Hemisphere. Tropical cyclones develop over tropical or subtropical waters. They are classified as follows: ❏ Tropical Depression: Maximum sustained winds of 33 knots or less; ❏ Tropical Storm: Maximum sustained winds between 34 to 63 knots. At this level, tropical cyclones are named; and ❏ Hurricane: Maximum sustained winds greater than 64 knots. A hurricane’s exact centre location can easily be identifiable via satellite imagery because of the development of an eye. In addition, a hurricane wind scale called the Saffir–Simpson is used to classify hurricanes into five categories depending on their wind intensity. Category 1 hurricanes are dangerous and create some damage, while category 5 hurricanes are monster storms that create catastrophic damage. A storm is classified as a major hurricane when it reaches category 3 or higher. In terms of the energy markets, the biggest concern is when the hurricane becomes a major hurricane. At this level, structural damage to energy infrastructure may occur both offshore and onshore. Rigs and platforms can be destroyed and severe damage may be inflicted on onshore refineries. Underwater pipelines can also sustain damage due to heavy wave activity. The NHC naturally has human safety as its primary objective, and has been designated at the one official source of forecasts in order to reduce possible confusion during hurricane events. History has 70 03 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:44 Page 71 A DAY IN THE LIFE OF COMMODITY WEATHER shown that conflicting forecasts and "hype" from different media outlets creates public confusion as well as potentially causing confusion in the energy markets. Imagine if there were several scientific and media venues with different forecasts and weather/hurricane model solutions showing landfall of specific hurricane ranging from North Carolina to Tampico, Mexico. NHC is the liaison for all the data gathering, scientific streamlining, government safety planning and coordination, and dissemination of information to keep the public alert and informed. When a tropical cyclone develops, they send standard advisories every six hours, at 0300, 0900, 1500 and 2100 UTC, that include up to five days of forecast information. When the tropical cyclone reaches a level of tropical storm or hurricane and may be impacting land in the next 48 hours, watches and warnings may begin to be issued, and intermediate advisories are released every three hours between the main advisories after a watch and/or warning has been issued. Imagine such a large system being modelled mathematically, trying to represent the entire structure and energy of the tropical system. That is what global weather and hurricane models try to do. As would be expected due to limited numerical capacity and inherent model limitations, different models will show somewhat different forecasts and, even worse, may show quite different forecast tracks for the storm. Global models may start by showing a tropical system developing on day 16 off of the West Coast of Africa, and Nymex price action may start to be influenced by the forecast. In this scenario, three basic questions should be asked: Is the tropical system going to develop into a hurricane? Will it be a threat to the Gulf of Mexico? Most importantly, is it likely to grow into a major hurricane that can damage infrastructure? Therefore, from the NHC advisories and the constant flow of updated hurricane output solutions from the models, the markets become quite jittery, reacting to the diverse information as it is revealed. If all models show the hurricane moving to the open waters of the North Atlantic, the market will see that as a 0% chance of impacting production. However, if one of the global or hurricane models shows the hurricane moving into the Gulf, there is a chance of a market-moving event which will be reflected in the price action. The in-house met has to constantly monitor all the information, 71 03 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:44 Page 72 COMMODITY INVESTING AND TRADING analyse all the forecasts available and, of course, forecast the forecast of the official tropical NHC advisory. The time between a tropical cyclone developing off the coast of Africa and reaching the Gulf of Mexico can take nearly ten days. High volatility of energy prices comes packaged with these systems and persists over the lifetime of these tropical cyclones. OTHER WEATHER IMPACTS Weather updates during regular trading hours provide energy traders with significant demand change expectations for North America down to a regional and individual city level. In the summer, power traders are the most sensitive to small changes in temperature, cloud cover, precipitation and wind. Sea breezes or thunderstorms over downtown cities create rapid and significant changes in electricity demand. Therefore, meteorologists providing information to power traders have to be in tune with radar and satellite images on a constant basis during the trading day. Agriculture Reuters, May 2013: “After a cold and wet spring in most of the US crop belt, farmers have seeded 28% of their intended corn acres, up from 12% a week earlier but far behind the five-year average of 65%, … Chicago Board of Trade corn and soybean futures were trading higher on Tuesday, due in part to the slow planting pace that threatened to trim 2013 production prospects.” October 9, 2012, the Financial Times reported that hopes for bountiful crops in South America fell after forecasts reduced the likelihood of El Niño conditions developing, reducing the probability of abovenormal rains during the growing season. Bloomberg reported on May 2, 2013, “Oklahoma wheat production, already expected to decline 45% from a year earlier, may fall further as freezing weather tonight threatens crops.” September 12, 2012, The New York Times story, “US Lowers Forecast of Crop Yields for a 3rd Time as Record Heat Lingers,” reported that the USDA lowered forecast corn and soybean yields as record heat added to drought damage. The normal daily meteorological operations used in the energy business can be extrapolated to other commodity markets for which weather changes/influences the supply or demand for a commodity. The most obvious are the agriculture markets. The planting season 72 03 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:44 Page 73 A DAY IN THE LIFE OF COMMODITY WEATHER for corn or soybeans could be delayed or run ahead of time depending on spring temperatures and rainfall. Too much rainfall does not allow planting processes to take place on muddy fields. In addition, corn needs a minimum of 50°F and adequate moisture for germination. If soil temperatures remain below 50°F after planting, damage to the corn seed can be severe. Therefore, the germination process could be curtailed. A cold spring, such as the spring of 2013, will delay the planting season and make the corn more susceptible to summer heat during pollination. In the summer, drought conditions and temperatures above 95°F with low humidity can cause damage to the exposed silks, potentially damaging pollen. During this period, weather forecasts of potential heatwave across the US Corn Belt can create a quite volatile price action in the corn market. Transport On January 4, 2013, Time reported that drought conditions could disrupt barge traffic on the Mississippi river, disrupting corn, soybean and grain transport. Drought conditions in the Midwest and Ohio Valley can affect the river levels at the Mississippi and Ohio rivers. Coal and agricultural barges might be restricted from travelling across the low levels of these rivers. Supply of coal and agricultural goods could be affected on a regional basis due to transportation restrictions. Even nuclear power plants can be affected by drought conditions: nuclear facilities need large amounts of water for cooling purposes. After the water has been utilised in the plant, it is discharged back to a nearby body of water at a higher temperature. State and federal regulations prohibit nuclear plants from continuing operations once the water temperature reaches a certain threshold. There is a two-fold issue here: it compromises the reactor safety and affects aquatic life. Livestock January 2013, Bloomberg reported, “Hogs futures climb as US cold may hinder supply”, noting that Northern temperatures of –10–15°F might disrupt the movement of animals to market. May 2, 2013, Farmers Weekly reported that UK livestock deaths exceeded 100,000 because of March blizzards and extreme freezing weather. 73 03 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:44 Page 74 COMMODITY INVESTING AND TRADING A cold wave creates stress in cattle, despite the bovine being extremely tolerant to low temperatures. An adequate winter coat and body condition in addition to availability of food and water help them to withstand the cold. However, the bovine will lose body fat during a cold event and in many severe cold temperature events, hypothermia and death can occur. Newborn calves are also at high risk of death during cold weather events. The cattle markets typically react in quite a volatile way when these weather events occur in the Texas/Oklahoma Panhandle and lee side of the Rocky Mountains. Softs May 29, 1997, The New York Times reported that “Fears of Freeze in Brazil Push Coffee Prices to 20-Year High.” July 3, 2009, Bloomberg reported that cocoa crops in Indonesia and Ecuador could be damaged by El Niño conditions, bringing lower rainfalls. Coffee futures can become quite volatile if strong cold events affect Southern Brazil. Brazil is the largest coffee producer and the only one threatened by frosts. The coffee plant cannot tolerate frost. Depending on frost intensity, the flowers get killed or the entire tree can die. If the plant dies, then new plants need to be planted – and it can take around three years for them to bear coffee cherries. Vietnam is another large producer of coffee but the main weather threat to coffee production is the landfall of typhoons into that country. Cocoa futures have their main weather risk in droughts. Western Africa, especially Ivory Coast and Ghana, are the largest producers of cocoa in the world. Lack of sufficient moisture causes the budding pods to wither. CONCLUSION The basic tools of operational weather forecasting for the commodity markets are essential as an invaluable source of information for traders. All these operations can be reduced to one goal: the best weather fundamentals for forecasting supply and demand changes. 74 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 75 4 Oil and Petroleum Products: History and Fundamentals Todd J. Gross QERI LLC In this chapter, the conversation on crude oil will be broken into two main parts. The first section will cover the basics and mechanics of the current global market, while the second will address historical price perspective and why the state of the price exists as it does. In the first section, the basic fundamental and seasonal price drivers of the new global marketplace for crude oil will be examined. Subsequently, the chapter identifies the tendencies of crude oil pricing based upon supply and demand processes that effectuate seasonal price movements. Some details on the characteristics of crude oil that can drive price, including quality, grade, location and transportation, will be next. Finally, the section will conclude with a discussion of pricing and trading. The second part will discuss price perspective. It will address how a US$17/bbl commodity in 2002 could become a US$147/bbl commodity by only 2008. It will question why the globe always seems to be running out of oil, while, so far, that fate has yet to be realised. WHY OIL? Critical fuel and elasticity What can you use crude oil for? This question has a strange, somewhat counterintuitive, answer: not much! However, when crude oil is delivered to and processed through a refinery, this answer becomes very different. 75 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 76 COMMODITY INVESTING AND TRADING Crude oil and its products are critical fuels to the world economy and have huge effects on our daily life. Whether you are using a plastic cup, filling up your car, heating your home during a cold winter, or fuelling farm equipment to plant, harvest and bring crops to market, petroleum plays an important role. The uses of petroleum products are generally linked to essential modern human needs, and the demand for crude oil is generally inelastic. Examples can be too real for those who were waiting in queues in the aftermath of Hurricane Sandy on the East Coast of the US in October 2012. Having unfortunately been affected first hand, the return of 2+ hour queues to fill your car or electric generator, rationing and police presence at stations resoundingly begs the inevitable question … why don’t we just use something else? Certainly those in New Jersey and New York City would have instantly shed their place in the queue for a readily available and cost-beating alternative, but they could not. There are many reasons for this, most of which point to the factors of inexpensive cost and infrastructure. Crude oil and its products have been the least-expensive source of energy across many areas of the economy for decades. This fact has led to an explosion of petroleum-related infrastructure that services most daily needs without a reliable inexpensive alternative. Tankers, refineries, pipelines, trucks, stations and home furnaces point to a petroleum infrastructure that makes our society reliant on them while offering no credible alternative. These issues – infrastructure, price and convenience – have caused a generally limited elasticity of downside demand, which is supported by the data. As Figure 4.1 shows, the drop-off in Organisation for Economic Co-operation and Development (OECD) demand in 2008–09 was large in absolute terms, but less impressive in percentage terms: only a 6% decline during the worst recession since the 1930s. Furthermore, the West Texas Intermediate (WTI) oil price could barely get back to 2004 levels of approximately US$50/bbl on a quarterly average basis. This was a level that had actually not been seen prior to 2004. Such an effect points to a generally increasing price trajectory since the early 2000s. The elasticity of demand is roughly a 0.3 ratio to the change in GDP in OECD countries. Essentially, if the OECD GDP increases by 1%, the demand for crude should increase by approximately 0.3%. 76 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 77 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS Figure 4.1 OECD liquid fuels consumption and WTI crude oil price Percent change (year-on-year) 6 Price per barrel (real 2010 dollars) 150 4 100 2 50 0 0 -2 -4 -6 2001 2002 2003 2004 2005 2006 2007 2008 OECD liquid fuels consumption 2009 2010 2011 2012 2013 2014 WTI crude oil price Source: US Energy Information Administration, Thomson Reuters This phenomenon is a stark contrast to non-OECD growth and elasticity. It is partially due to the fact that total US demand peaked in the 2004–05 time-frame. In Figure 4.2, a much higher elasticity of demand is indicated for these non-OECD countries. This ratio is closer to 0.7. With the OECD and non-OECD countries accounting for about equal amounts of demand, the average elasticity is approximately 0.5. However, Figure 4.2 shows another important point. Observe the size and scale of the downturn in the non-OECD during the period Figure 4.2 Non-OECD liquid fuels consumption and GDP Percent change (year-on-year) 12 10 8 6 4 2 0 -2 -4 2001 2002 2003 2004 2005 2006 2007 2008 Non-OECD liquid fuels consumption 2009 2010 2011 2012 2013 2014 Non-OECD GDP Source: US Energy Information Administration, IHS Global Insight 77 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 78 COMMODITY INVESTING AND TRADING we focused on in Figure 4.1: the 2008–09 period. The demand profile is skewed higher in the non-OECD countries. Growth rates are higher and the recession area of 2009 is shallower. Does this come as such a surprise considering Chinese growth rates of nearly 8%, along with the many emerging economies growing their manufacturing base? Certainly not; all of these factors lead to limited elasticity of downward demand for crude oil. Seasonality Crude oil and its petroleum products also exhibit significant seasonality. In Figure 4.3, the monthly demand from 2008–12 along with the US Energy Information Administration (EIA) projection for 2013 shows that, even although each year exhibits a different slope (largely due to macroeconomic developments such as the economic downturn at the end of 2008), the shape of the demand curves are nearly the same each year. Basic forces driving oil demand are approximately the same from year to year. January is plagued by Figure 4.3 World consumption patterns (2008–13) (in millions of barrels per day) 92.00 91.00 90.00 89.00 88.00 87.00 86.00 85.00 84.00 83.00 82.00 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec World consumption 2008 World consumption 2012 World consumption 2009 World consumption 2013 World consumption 2010 World consumption average World consumption 2011 Source: US Energy Information Agency 78 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 79 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS some refinery turnarounds and holidays, such as the western New Year and Chinese New Year. Also, it seems like a low level but, as demand increases on average year on year, the January “low” demand is actually on the upswing from the previous November’s trough. By February, some refineries return to service around the globe to meet heating demand in the northern hemisphere. Then, there is the major second quarter fall off. As spring approaches, the global refinery complex goes into major turnaround mode. With major refining regions such as the US taking much of the refining infrastructure down for maintenance ahead of the burgeoning summer seasonal usage, along with the moderation of winter temperatures across the northern tier, demand for petroleum tends to sag, culminating in the lowest demand period coming in May. In the second half of the yearly cycle, demand escalates. US demand for driving and transportation fuel picks up as many take to the highways for summer vacation. The transportation fuel demand increase is not only seen in the world’s largest oil consumer but generally around the globe, culminating in September. The strength of demand in September is noticeable compared to many other months. Driving demand is still strong, early pre-winter seasonal restocking of distillate and heating fuels in Western Europe is afoot and the global refining industry has yet to go into its autumn maintenance mode. Finally, the waypoint of August and the third quarter has exhibited stronger demand as air conditioning usage from developing nations such as Saudi Arabia have kept demand strong while many are on holiday. Finally, as can be seen in Figure 4.4, the cycle is complete with the second refining maintenance season in full swing across the globe as we enter the fourth quarter. More vacuum distillation units (VDUs) and atmospheric distillation units (ADUs) are down for maintenance this time around as opposed to fluid cat cracking units (FCCUs), which tend to monopolise the spring maintenance season. Crude grades and locations Crude oil, when it is taken out of the ground, either offshore, onshore, using traditional methods or with hydraulic fracturing (which has precipitated tremendous gains in onshore drilling, especially in the US), can come with many different chemical make-ups. Based on the main use for crude oil of refining, each crude grade has 79 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 80 COMMODITY INVESTING AND TRADING Figure 4.4 Seasonal world crude oil consumption 1.00 0.80 0.60 0.40 0.20 0.00 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec World crude oil consumptional seasonal 2008–2012 Source: US Energy Information Agency been tagged with two defining characteristics: light/heavy (based on the number of carbon atoms) and sweet/sour (depending on the sulphur content). Grades are then given a name corresponding to their respective production field name and/or geography, such as WTI, Brent Blend, Venezuelan Orinoco, Indonesian Minas, Malaysian Tapis, Saudi Arab Heavy, Oman, Ecuadorian Oriente, Nigerian Bonny Light and Dubai blends. The EIA defines light as crudes with an API gravity above 38, heavy as crudes with an API gravity of 22 or below, medium as those that fall between 22 and 38 degrees, with 31.1 API as the dividing line between light and heavy. According to “Platts Energy Glossary”: API gravity = (141.5/specific gravity at 60 degrees F) – 131.5. As for sulphur content, the dividing line is approximately 0.5% sulphur, where a reading greater than 1.1% sulphur is considered sour and a reading <0.5% is considered sweet. Figure 4.5 gives the relationship between most benchmark crudes and where they fall on the light/heavy, sweet/sour spectrum. Generally, the process of refining is a chemical process that enables the breaking and recombining of chemical structures through heating (as in a VDU or an ADU) or by catalyst (such as an FCCU), in order to produce petroleum products for commercial use. Heavy crudes have a higher proportion of large molecules that are harder to break down, while light crudes have a higher proportion of smaller molecules. This leads to the lighter crudes that can produce 80 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 81 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS Figure 4.5 Density and sulphur content of selected crude oils Sulphur content (percent) Sour 3.5 Mexico – Maya Saudi Arabia – Arab Heavy 3.0 Kuwait – Kuwait 2.5 UAE – Dubai United States – Mars 2.0 Iran – Iran Heavy Saudi Arabia – Arab Light 1.5 Iran – Iran Light FSU – Urals Oman – Oman 1.0 Ecuador – Oriente North Sea – Brent Libya – Es Sider United States – WTI 0.5 Sweet Nigeria – Bonny Light 0.0 20 25 United States – LLS 30 35 40 API gravity (a measure of crude oil density) Algeria – Sahara Blend Malaysia – Tapis 45 50 Heavy Light Source: US Energy Information Agency around 40% gasoline versus closer to 20% in the heavier crudes. These heavier crudes will, in turn, produce heavier distillates to the tune of around 60% of the barrel. These types of distillates can go to make heavier materials such as asphalt. In refining, when burning crudes in a refinery with heavy sulphur content, the output can emit sulphur dioxide (SO2) or hydrogen sulphide (H2S), a poison gas. Thus, to meet certain continually stringent sulphur specifications for petroleum product production, a desulphurisation process has become increasingly necessary in refineries. These processes help to refine more sour grades to meet specifications of products such as diesel, low sulphur diesel or ultra-low sulphur diesel that have specifications of >500 ppm, <500ppm but >10 ppm and <10 ppm, respectively (ppm = parts per million). The crude mix has been moving globally over time towards a heavier (higher) sulphur mix, which is why the long-term refinery strategy has been to upgrade their refineries to be able to handle such lower-quality crudes. Upgraded refineries have been caught between more sweet crudes and condensates taken out of the ground, and the many global disruptions in locales such as Libya, which have been throttling supply. 81 Date Company Commodity Entry port State of entry Origin August 2012 August 2012 August 2012 August 2012 August 2012 August 2012 Chevron USA Chevron USA Chevron USA Chevron USA Chevron USA Chevron USA Crude oil Crude oil Crude oil Crude oil Crude oil Crude oil El Segundo, CA El Segundo, CA El Segundo, CA El Segundo, CA El Segundo, CA El Segundo, CA California California California California California California Ecuador Ecuador Ecuador Ecuador Ecuador Ecuador BBLS SULPHUR (000s) 324 326 328 353 371 374 1 1 1 2.01 1 1 API 23.7 23.4 23.5 19.4 23.9 24 Source: US Energy Information Agency 82 COMMODITY INVESTING AND TRADING 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 82 Table 4.1 Monthly Imports from Ecuador to El Segundo, California 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 83 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS Furthermore, locations of crudes and their availability have a huge impact on the type of refinery operations at a specific refinery. Although most refinery operations are very secretive about their incoming crude oil slate, some refineries match very well with their import crude oil. Let us take Chevron and its assets in the western part of the US, along with the corresponding crude oil inputs. Here is a good example. Table 4.1 comes from the EIA website that tracks company-wide imports on a monthly basis. Why would Chevron import medium-heavy oil (19–24 API degrees) that is medium-to-high sulphur (1–2.01% sulphur) from Ecuador to El Segundo, California? In Figure 4.5, the specs fit Ecuadorian Oriente Blend well and, considering Chevron has E&P operations in Ecuador, this would seem to make sense. Ecuador, being on the western side of South America, has relatively easy transport access to California, as opposed to the US Atlantic Coast or to many other places. This crude is a natural fit for California, but why El Segundo? The answer makes the picture even clearer. Chevron owns and operates the El Segundo refinery. The reason that the crude is a natural fit for this refinery is no accident. Chevron intelligently spent quite a bit of money to upgrade this refinery to the specifications that would enable it to run such a complex refinery in the state of California (the most difficult place to refine in the US) and, at the same time, have the capability to take the medium-heavy, medium-higher sulphur crude oil of Ecuadorian Oriente. Locations of major oil supply to demand and limitations of the transport grid The world’s oil supply has specific areas of concentration, with many players moving in and out of prominance over decades. Their relevance is predicated upon their ability to cultivate reserves according to current economics (as in Venezuela and Iran, Brazil and Angola), on technology and each country’s willingness to adapt it (as in the US, with hydraulic fracking) and on their ability to install an infrastructure that will enable production to grow and hasten its delivery to market. On the other side of the coin is the ability for the crude oil being produced to match the corresponding refining capacity. This match up enables the easy refining of demanded and legally permitted petroleum products. 83 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 84 COMMODITY INVESTING AND TRADING As we can see in Figures 4.6 and 4.7, production from the Middle East has historically been sent to the refining areas of the Gulf Coast of the US, as well as many other refining regions across the world. However, in response to refining capacity additions and subtractions by region, oil trade flows have changed. The ability of western nations to continue to compete globally on refining has become suspect. The US and Western Europe found their great refining centres under tremendous duress in 2011. Atlantic Basin crude oil prices, generally indexed to Brent and imported, were being used as feedstock to produce higher and higher quality (lower sulphur content) products. These product specifications were mandated by the EU and US governments. In addition, these refiners faced evermore stringent quality standards on petroleum products while having to combat a reduction in petroleum product demand since 2008. Furthermore, higher fuel efficiency and the greater acceptance of clean technologies have also cut into demand. The business case for continuing to produce petroleum products in these two jurisdictions if a refinery was lower on the Nelson Complexity scale and its refining power was generally simple was becoming increasingly unprofitable. Examples of victims of these two simultaneously negative phenomena were PetroPlus, the largest independent refinery in Western Europe, Sunoco, the biggest refining presence on the US East Coast, and ConocoPhillips, who divested its downstream business and spun it off into Phillips 66 Figure 4.6 World oil production by region (millions of barrels per day) Asia Pacific, 8.1 North America 14.3 Africa, 8.8 South & Central America, 7.4 Middle East, 27.7 Source: BP Statistical Review, 2012 84 Europe & Eurasia 17.3 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 85 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS (with this last case probably augmenting efficiencies in management). The replacements for these refineries were generally Indian, Chinese and Middle Eastern refining capacity additions. With fewer regulations for start-up, cheaper labour (none or fewer union labour constraints) and closer proximity to the source of crude oil, the trends depicted in Figure 4.7 are not only set to continue, but to be accentuated in the coming years. After all, no major refineries have been built in the US since 1976. Capacity grew solely through upgrades and increases in complexity. Meanwhile, Asian refiners, less hindered by regulation and clean air rules, have been building brand new, more efficient refineries that can actually fill the gaps left by those archaic, decommissioned refineries of the west. However, as this all seemed to be speeding out of control in the US and Western Europe, a new technological breakthrough came along just in time to give at least a temporary reprieve for many US East Coast refineries. Domestic crude oil, produced through techniques of hydraulic fracturing from the interior of the US, has made its way across the country to the refining centres in a cost-efficient way. This trend has given some of these refineries hope. We will talk more about the phenomenon later in this chapter but, with the Carlyle Group purchasing part of the Girard Point refinery from Sunoco and Delta Airlines purchasing the Conoco Phillips Trainer, PA refinery, the progression of this global change in regional refinery economics Figure 4.7 Refining capacity market share evolution 2001 global capacity: 83.4mb/d 26.22% 2011 global capacity: 93.0mb/d 24.21% 3.80% 31.33% 22.99% 7.09% 7.49% 3.57% 8.09% 30.19% 8.61% North America Middle East South & Central America Africa Europe & Eurasia Asia Pacifc 26.42% Source: BP Statistical Review, 2012 85 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 86 COMMODITY INVESTING AND TRADING seems to have been stayed. Additionally, the US Gulf Coast has been importing less and less crude to run its refineries, and within 2–3 years the region should not need to import crude oil at all.1 The future trajectories of production, refining and storage are beginning to change the market and may slowly change how crude oil and petroleum are priced. Despite the extraordinary growth in US production, there is little risk to the status of the Middle East and former Soviet Union (FSU) as major producers. The inclusion of Iraq’s huge reserves under a market-oriented and ambitious regime provides optimism for the continued strength of Middle Eastern crude oil production. With Brazil and Russia having gained in economic prominence, these countries will also have the ability to marshal larger resources toward oil exploration and production (E&P) for increasing contributions in the global crude oil supply mix. Also, new technology and high prices have encouraged a renaissance in US oil production. The real issues that have arisen from this sea change are logistical. How does the crude get from production areas to the refiners, and what are the risks along these routes? The flow of crude oil from Middle Eastern countries to jurisdictions East of Suez has been growing for decades. However, with more and more of global oil production heading in this direction, the world oil transit choke- Figure 4.8 Refinery additions (2010–35) Millions of barrels/day 5 4 2030–2035 2025–2030 2020–2025 2015–2020 2011–2015 3 2 1 0 US & Canada Latin America Africa Source: OPEC World Oil Outlook, 2011 86 Europe FSU Middle East China Other Asia 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 87 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS points should be examined, especially in light of the risks concerning the Strait of Hormuz. Crude transport and chokepoints2 There are seven major world transport and chokepoints for crude oil tanker movements (see Figure 4.9): ❏ ❏ ❏ ❏ ❏ The Strait of Hormuz; The Strait of Malacca; Bab el Mandeb; Turkish Straits; Danish Straits; The Suez Canal/SUMED Pipeline; and per day in transit is shown in Table 4.2. IA, about half of the world’s oil production routes, the rest mainly transits through he Strait of Hormuz and the Strait of Malacca d Pacific Oceans are by far the most strategic. Figure 4.9 Potential chokepoints to global crude transport Source: US Energy Information Agency 87 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 88 COMMODITY INVESTING AND TRADING Table 4.2 Volume of crude oil and petroleum products transported through world chokepoints (2007–11) Location 2007 2008 2009 2010 2011 Bab el Mandeb Turkish Straits Danish Straits Strait of Hormuz Panama Canal Crude oil Petroleum products Suez Canal and SUMED Pipeline Suez Crude Oil Suez Petroleum Products SUMED Crude Oil 4.6 2.7 3.2 16.7 0.7 0.1 0.6 4.7 1.3 1.1 2.4 4.5 2.7 2.8 17.5 0.7 0.2 0.6 4.6 1.2 1.3 2.1 2.9 2.8 3.0 15.7 0.8 0.2 0.6 3.0 0.6 1.3 1.2 2.7 2.9 3.0 15.9 0.7 0.1 0.6 3.1 0.7 1.3 1.1 3.4 N/A N/A 17.0 0.8 0.1 0.6 3.8 0.8 1.4 1.7 Notes: All estimates are in million barrels per day. “N/A” is not available. The table does not include a breakout of crude oil and petroleum products for most chokepoints because only the Panama Canal and Suez Canal have official data to confirm breakout numbers. Adding crude oil and petroleum products may be different than the total because of rounding. Data for Panama Canal is by fiscal year. Source: EIA estimates based on APEX Tanker Data (Lloyd’s Maritime Intelligence Unit); Panama Canal Authority and Suez Canal Authority, converted with EIA conversion factors Let us talk about the granddaddy of them all at first, the Strait of Hormuz, which is located between Oman and Iran and connects the Persian Gulf with the Arabian Sea. Here, roughly 35% of all seaborne traded oil and 20% of all oil traded worldwide passes through on a daily basis. More than 85% of these crude oil exports go to Asian markets such as Japan, India, South Korea and China. At the narrowest point, the Strait is 21 miles wide and the width of the shipping lane in either direction is only two miles, separated by a two-mile buffer zone. The alternatives are woefully inadequate. Pipeline replacement capacity currently only offers 4–5 million barrels a day of unused capacity, and trucking would add only a maximum of a few hundred thousand barrels per day. Most tankers going through the Strait of Hormuz run greater than 150,000 deadweight tonnage (DWT) – these are very large tankers. A block of the Strait of Hormuz would result in a shortfall of undelivered crude oil of perhaps up to 12 million barrels a day. The Strait of Malacca is the other main strategic point. It is located between Indonesia, Malaysia and Singapore (where the big Pulau Bukom 500,000 barrel-a-day Shell refinery operates), and links the Indian Ocean with the South China Sea and Pacific Ocean. 88 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 89 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS This is the key chokepoint in Asia. With 13.8 million barrels per day (mbpd) flowing in 2007, the Strait had ratcheted flows up to an estimated 15.2 mbpd in 2011. At the narrowest point, in the Phillips Channel of the Singapore Strait, Malacca is only 1.7 miles wide. If the Strait was blocked, nearly half of the world’s fleet would have to reroute around Indonesia. With so much crude flowing through this waterway, it would not go undelivered as in the case of a blockage of the Strait of Hormuz; it would just have to be rerouted at greater costs and time to market. The rest have their strategic interests too. The Turkish Straits are important for western pricing because it is a main thoroughfare that transports Russian crude exports, as well as exports from Azerbaijan and Kazakhstan, to Western European refineries. Weather often impacts transit in winter, forcing additional transit time of up to weeks in some cases. Finally, a Bab el Mandeb closure could keep Persian Gulf tankers from reaching the Suez Canal as it is located between Yemen, Djibouti and Eritrea, and connects the Red Sea with the Gulf of Aden and the Arabian Sea. Most transit goes north to destinations in Europe, US and Asia. If impassible, it would redirect 3.4 mbpd around the southern tip of Africa, a significant addition of transit time. Crude pricing and trading Not all crude oil that is produced and delivered goes directly into the refinery for processing. The crude that awaits refining in any timeframe is held in storage. Storage is the most significant statistic of over- or under-supply in the crude oil market. Most notable has been the effects of storage levels and capacity in Cushing, OK, the delivery point of the CME/Nymex WTI crude oil futures contract. Being a landlocked area with limited capacity and limited transit to and from the storage tanks, the Cushing phenomenon played a major role in the term structure of the Nymex futures contract through 2010. As one can see from Figure 4.10, a significant amount of storage capacity has been added to Cushing inventories since the third quarter of 2010. This fact has alleviated some of the risks of storage congestion and stock-out phenomenon that has plagued this storage area, and therefore the Nymex pricing of prompt/term spread relationships. When storage levels approached high percentages of capacity, the 89 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 90 COMMODITY INVESTING AND TRADING Figure 4.10 Cushing storage 80 Shell capacity Million barrels 70 60 50 40 Working storage capacity Inventories 30 20 10 0 Sep 30, 2010 Mar 31, 2011 Sep 30, 2011 Mar 31, 2012 Source: US Energy Information Agency WTI market would go into a strong contango. Known as storage congestion, this has not been overly studied in the “theory of storage” and academic circles. The volatility in the markets is usually greatest when the market is near stock-out capacity, and when there is not a credible alternative to satisfy demand (Kaldor, 1939; Working, 1948, 1949). The opposite is also true. For certain commodities, where storage is not universal and is limited, and there is little outlet for continued production, the price will pick up significant volatility as full storage is approached. Spot prices will tend to become more volatile when storage operators are not seasonally involved in the market or their facilities are near capacity (in a similar fashion to how front-month futures price volatility tends to increase as expiration draws near (Samuelson, 1965)). As prices plummet and the market becomes more volatile, the percentage movement in underlying pricing and spreads can rival even the most extreme stock-out scenarios. Research from the likes of Carlson, Khokher, and Titman (2007) and Evans and Guthrie (2009) has suggested that there is more of a U-shaped relationship between spot price volatility and the slope of the term structure of forward prices. Strangely, both phenomena are less likely with greater storage capacity! We can see in Figure 4.11 the takeaway points for Cushing crude oil and many additions to alleviate the so-called bottlenecks that inhibit the transit of crude oil to the Gulf of Mexico’s major refining area have been, and continue to be, implemented. However, generally, there are inflows from local production and the incoming crudes off of the 90 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 91 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS Enbridge pipeline into the Cushing area. Outflows had been going to the only consumers on the block, the local refineries. Other pipeline capacity is in full swing, such as the Seaway pipeline reversal (it used to bring crude up from the US Gulf Coast to the PADD II refineries until domestic Bakken and Southern Canadian production exploded), alleviating most bottlenecks. The consuming pipelines name the destination. BP is flowing towards Chicago (or, more specifically, Whiting, Indiana) to its 410,000 bbl/day Whiting refinery. Likewise, the Ponca line heads to the Phillips 66, Ponca City refinery (at 195,000 barrels/day) and the Ozark pipeline takes off to St Louis area to supply the Phillips 66 (formerly Conoco Phillips) Wood River Refinery at (300,000+ barrels/day). Also worth noting is CVR Energy’s 115,000 barrels/day Coffeyville, KS refinery, which has its own line coming from the Oil Hub. Then there are other inputs, such as the Enbridge Spearhead pipeline that delivers more Canadian crude to Cushing. Furthermore, Figure 4.11 shows existing and proposed pipeline expansions, which continue to address transport issues of crude oil Figure 4.11 North American oil pipelines Sources: Map from Canadian Association of Petroleum Producers. TransCanada overlay from TransCanada Corp. Assembled for Watershed Sentinel by Arthur Caldicott. 91 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 92 COMMODITY INVESTING AND TRADING from production areas in the north to the refining centres in the Gulf Coast. Finally, Figure 4.12 points out the more important figures for pricing the WTI near term structure. Two very different states of the world existed for prompt second-month WTI spreads in September 2008, and then quite the exact opposite in January 2009. On September 13, 2008, the 110 mph Hurricane Ike crashed into the Houston Gulf Coast, delaying crude oil imports and disrupting infrastructure up the Houston Ship Channel and the Loop, to the point that Cushing inventories plummeted and the spike in prompt/second WTI spread blew out to US$29/bbl on expiration (See Figure 4.14). Then, only four months later, the opposite was true. Crude oil inventories were approaching a limit at 80% of then storage capacity at Cushing, Oklahoma, and global inventories were dramatically swelling. With capacity at just under 40 million barrels in early 2009, the inventories ballooned to just under 35 million Figure 4.12 Continuous prompt/second nearby spread WTI Daily CL CL spread 3/13/2007–4/23/2012 (NYC) Price Line, CL CL spread, trade price (last) 12/13/2012, -0.52, +0.02, (+3.70%) A M J J A S O N D J F MA M J J A S O N D J F MA M J J A S O N D J F MA M J J A S O N D J F MA M J J A S O N D J F MA M J J A S O N D J F MA Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08 Q1 09 Q2 09 Q3 09 Q4 09 Q1 10 Q2 10 Q3 10 Q4 10 Q1 11 Q2 11 Q3 11 Q4 11 Q1 12 Q2 12 Q3 12 Q4 12 Q1 13 Source: Thomson Reuters 92 USD Bbl 10.5 10 9.5 9 8.5 8 7.5 7 6.5 6 5.5 5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 -0.5 -1 -1.5 -2 -2.5 -3 -3.5 -4 -4.5 -5 -5.5 -6 -6.5 -7 -7.5 -8 .12 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 93 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS Figure 4.13 Crude oil stocks: Cushing, OK 40000 35000 30000 25000 20000 15000 10000 5000 Ja n 04 Fe , 20 b 0 4 08 ,2 M 00 ar 8 04 ,2 Ap 00 r0 8 4, M 20 ay 08 04 ,2 Ju 0 n 08 04 ,2 Ju 00 l0 8 4, 20 Au 08 g 04 Se , 20 08 p 04 ,2 O 0 ct 04 08 , N ov 200 8 04 ,2 D 00 ec 8 04 ,2 Ja 00 n 9 04 Fe , 20 b 09 04 ,2 M 0 ar 04 09 ,2 00 9 0 Source: US Energy Information Agency barrels (Figure 4.13). The ensuing change in prompt second-month spread was dramatic. In the 2000s, the small glimmer of technological advancement in hydraulic fracturing almost entirely captured headlines in the natural gas arena as a production game changer. The realistic impact on global crude supplies was initally discounted because, although technology made additional US production theoretically possible, the barrels could not be moved from these interior locations due to the lack of midstream infrastructure. Pipeline assets usually take onshore crude oil from E&P areas to refinery gates for easy loading into the facility to make product. The completion of many new assets to fulfill additional takeaway-capacity needs seemed several years away. There was a trend towards the bankruptcy of East Coast refineries that had similar issues to that of their cousins in Europe, and the stranded nature of this new crude production’s location. The only outlet seemed to be to get the oil to Cushing, OK. However, events have begun to change this state of affairs, although a lot more needs to be done to rectify the two main dislocations in the oil and products markets that are inexorably intertwined: the Brent/WTI pricing mechanism and the East Coast refinery market. The Brent/WTI spread market flourished because of two very important attributes, that were both financial and physical in nature. 93 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 94 COMMODITY INVESTING AND TRADING Figure 4.14 WTI – Brent price spread (January 2013 contract) Daily WTCL-LCOF3 7/13/2007–12/18/2012 (LON) Price USD Bbl 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10 -11 -12 -13 -14 -15 -16 -17 -18 -19 -20 -21 -22 -23 -24 -25 -26 -27 .12 Line, WTCL-LCOF3, trade price (last) 12/13/2012, -22.32, +0.41, (+1.80%) Q4 2007 Q1 Q2 Q3 Q4 Q1 2007 Q2 Q3 2009 Q4 Q1 Q2 Q3 2010 Q4 Q1 Q2 Q3 2011 Q4 Q1 Q2 Q3 Q4 2012 Source: Thomson Reuters The flagship contract on the Nymex was WTI, which fostered an active, entrepreneurial place for hundreds of traders to provide liquidity for the crude oil futures contract. There was always a transparent price that could be transacted. Likewise, the counterpart in the UK was the Brent Blend contract, which started on the IPE before being owned by the ICE. The Brent contract had a little different make-up. Although not as liquid as a futures contract, it had the unique characteristic of being directly tied to Dated Brent, a more commonly used benchmark for the spot price of crude oil. Furthermore, the the two contracts were easily linked as there was a direct route to get Brent to the same place as WTI. Take a loading on a tanker in the North Sea and drop it off at the Loop, the Louisiana Offshore Oil platform, or in the Houston Ship Channel. The crude could then be piped onshore and up yet another pipeline, sending it north up to the Midcontinent and Cushing, OK (one of these pipelines being Seaway). Brent typically traded at a discount to WTI, because most incremental refining barrels were absorbed by the US refining machine and therefore Brent traded at a discount to Light 94 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 95 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS Louisiana Sweet (LLS), generally by the cost of transportation to the US Gulf Coast (USGC). LLS and WTI were generally linked by inexpensive pipeline economics that would bring crude from the Gulf via the pipeline. There existed a very liquid market in buying and selling Brent cargoes, hedging with more liquid WTI futures and trading the spread back and forth actively. The spread (and its economics) were severely disjointed by the unexpected explosion in Midcontinent supply coming from Bakken shale in the US and production from Southern Canada. This increase came at the same time that production in the North Sea was declining to a point that there was a noticable drop in production out of the Brent, Forties, Oseberg and Ekofisk (BFOE) cocktail. Specifically, Nexen’s Buzzard field of 200,000 barrels per day, approximately 10% of the North Sea production, has had major, continuing maintenance problems. The BFOE cocktail that cargoes were priced off of had compounding issues when Buzzard was down. Buzzard Forties production, one of the lowest-quality crudes in the cocktail, had a knock-on effect on price. As production went down, supply would shrink drastically. In addition, the cheapest element of the cocktail was diminished, leaving even more expensive crudes to make up the price. The cocktail had been priced on the cheapest-to-deliver crude. This phenomenon adds extra elasticity to the Brent/WTI movement that had come to plague the market. Meanwhile, many remedies were being sought to alleviate this price differential on Brent/WTI. While the East Coast and Gulf Coast refineries were having their crude feedstock priced off of Brent, the Midcontinent PADD II refineries enjoyed the economics of landlocked Cushing pricing. There was financial incentive to redistribute the crude and try to alleviate bottlenecks. The sale of the Seaway pipeline and the reversal of flow has begun to help, but much more needed to be done. The Brent/WTI price differential (still at Brent US$20 over) did not look like it would relent soon. The reversal of Seaway, which has removed 150,000 bbls/day along with another 250,000 bbls of throughput to be added in 2013, should help. The political football of the Keystone XL pipeline, as well as many lesserknown avenues, had been put to work to alleviate the glut and to take advantage of the US$20+ price differential. However, unforeseen issues such as the limited storage tank capacity at Jones Creek, Texas, had diminished the Seaway pipeline’s effectiveness. This final 95 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 96 COMMODITY INVESTING AND TRADING outlet for the Seaway pipeline only boasts 2.6 million barrels of storage and has limited the ability of Seaway to move all of its 400,000 bbls/day capacity to the Gulf. These constraints had prevented a resolution of the spread relationships. With many alternatives for crude transport unavailable, the markets turned to an old school form of crude oil transportation: railroads. Rail loadings of oil have been soaring and the economics make sense. With many new terminals being built to handle much of the throughput, the transport of crude via rail has been able to alleviate some of the issues. This solution has changed the equation enough to rationalise the economics of two East Coast refineries. With the hope of getting Midwest crude oil, the business case has changed from an unprofitable venture such as those in Europe to big opportunities for those including Monroe Refining (a division of Delta Airlines) and the Carlyle Group. Both investors have bought two main East Coast refineries previously set for closure because of poor economics. The ability to receive shale crude oil as feedstock has helped to make the business case to keep these refineries open. Furthermore, in Monroe Energy’s case, their supply chain of jet fuel in the New York market and ability to supply competitors makes it a sound investment, with some personnel who used to work at the refinery already being part of the Monroe team. 2009 2010 Source: AAR Weekly Railroad Traffic 96 2011 36,544 26,247 16,789 11,389 11,324 10,843 8,583 6,784 3,395 2,650 2,832 2,498 2,860 51,482 64,663 Figure 4.15 Oil on rail transport 2012 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 97 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS Figure 4.16 North Dakota railroad map Source: www.Trainsmag.com (May 2012) As Figure 4.15 shows, there has been a jump in railcar loadings with petroleum. With growth near 45% for 2012, rail movement of crude oil is showing itself as the stopgap measure of choice between the production and demand today and the time when lower transmission cost pipelines are built. Economics are showing the railing of crude from Bakken to the Gulf Coast as an approximate mid teens per barrel cost. These economics have enabled such railing. Risks to this method have been highlighted with the crude oil rail tanker accident July 6, 2013 in Lac-Megantic, Quebec. Crude markets and trading Oil is traded physically in many corners of the globe. With benchmarks such as Dated Brent off the BFOE pricing, the Japanese Crude Cocktail (JCC) pricing many far eastern contracts, Oman/Dubai pricing a lot of the Middle East sour crudes and FSU Urals pricing much of Eastern Europe and distillate products, these crude oil 97 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 98 COMMODITY INVESTING AND TRADING benchmarks are all interrelated. Global pricing is influenced by what refining capacity is operating or down for maintenance, and generally if there are problems in loading (for example, in Nigeria when there are militant attacks). Maintenance in fields such as the Buzzard field in the North Sea can also have an outsized influence on these benchmarks. Grades are crucial and which refineries take those grades can make the difference between a wide or tight sweet/sour spread differential. Crude oil is mainly moved on Dirty tankers with >150,000 DWT, or very large crude carriers (VLCC). Specifically for crude oil, Dated Brent is the most widely accepted global crude oil benchmark, and always faces intense scrutiny from producers, end-users and regulators. Dated Brent is generally used as a sweet crude benchmark and prices crude in the North Sea, West Africa, the Mediterranean, South and Latin America, Canada, Central Asia and Russia. More than 60% of the world’s internationally traded crude oil is priced against Dated Brent.3 Dated Brent is the price assessment of physical cargoes of North Sea light sweet crude oil. The term “Dated” refers to the physical cargo price for North Sea Brent light crude which has been allocated a specific forward loading date (10–25 days ahead). The North Sea light sweet crude oil grades – Forties, Oseberg and Ekofisk – are also deliverable against the Dated Brent contract known as “alternative delivery”, as the combination of all four crudes is known as BFOE. This combination gives Dated Brent a supply of approximately 1.4 mbpd and provides enough liquidity to sustain it as a benchmark. The window for pricing Brent occurs at 4:30 pm, London time. When prices of Dated Brent are high, the North Sea attracts crudes from West African and the Mediterranean, while when the benchmark price is low, North Sea pushes crudes to other places, such as the US Gulf Coast. Historically, Malaysian Tapis and Indonesian Minas had been the benchmarks for sweet crude in the Far East and Asia. However, with production becoming smaller and smaller and fewer barrels being available for export, the region has turned to Dated Brent for much of its pricing, with even Indonesia pricing its barrels off this global benchmark. The Asian version of Dated Brent is priced off a Singapore pricing window at close of business 4:30 pm, Singapore time. As for sour crude oil, Dubai had historically been an Eastern benchmark. However, as physical export supplies became scarce in 98 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 99 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS the Asian/Pacific regions and import demand climbed to levels greater than 17 million barrels per day, these benchmarks needed a little help. Therefore, the Dubai benchmark has added Oman and the Dubai Mercantile Exchange has touted its Oman futures contract that has a delivery point east of Suez and 860,000 barrels/day of export volume. As for the pricing of many grades of crude for export, these benchmarks enable pricing schemes, but vary based upon destination. For example, Saudi Arabia may price exports to Europe based upon the Brent Weighted Average (BWAVE) price, its exports to Asia based upon Oman and Dubai and its exports to the USGC based upon Argus Sour Crude Index (ASCI), an index of delivered sour crude to the USGC. Product points have just as much relevance. With product trade and transport becoming more of the global petroleum trading market through the 2010s (International Energy Agency, IEA, 2012), one has to be cognisant of those that produce and those that will receive. The ports of interest are mainly the USAC, USGC, Sullom Voe terminal in the UK, Amsterdam, Rotterdam, Antwerp (ARA), Ras Tanura in Saudi Arabia, Singapore, Chiba in Japan, Shanghai and the MED terminals in Fos Lavera near Marseille, France. Most product pricing hubs are aligned with an important maritime port, usually one or many large refineries and, of course, most importantly, storage facilities for petroleum products. Most petroleum products are moved on barges or clean tankers of around 60,000 DWT. The terms FOB (free on board) and CIF (cost, insurance and freight) denote whether the pricing is based on the buyer providing transport and the seller delivering the barrels “on board”, or the seller covering transportation and insurance costs to deliver the cargo to the buyer’s destination port. On a global basis, the trend is for less refining activity out of Western Europe and for those losses to be supplanted by gains in India and China. The growth of the giant Jamnagar complex in India, along with the upgrade of the Essar Oils refining complex from 300,000 to 600,000 barrels per day, has shown India’s high-profile strength in the refining sector. China has added a multitude of refineries since the late 2000s. These refineries have been located in many different areas of China, and although not aggregated into a single massive refining complex, they represent huge additions in refining capacity. 99 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 100 COMMODITY INVESTING AND TRADING As this was taking place, the bankrupcy proceedings of PetroPlus’ mainland European holdings was happening. These older, less complex refineries, which originate crude oil from long distances, and which are forced to deal with organised labour issues, have become less competitive on the global landscape. The final straw was the recent Libyan revolution that took away the much-needed sweet crudes that some southern European refineries had used for feedstock, not easily replaced by the sour FSU Urals blend that was the most readily available swing supply at the time. As refining moves East, pricing and benchmarks for the world’s refineries will change. Figure 4.17 shows many of the benchmarks for crude oil and the pricing points. As the North Sea faces continuing decline in output capacity, the US production pushes Nigerian and Angolan crudes to the East, and refining interests procure more marginal barrels from Middle East sources, some of the refining benchmarks may move towards the Oman contracts on the Dubai Mercantile Exchange. The US is a different matter. With its strong refining base in the USGC, its excess capacity has been mobilised to export products to certain markets, many located in South America. As South American demand for products has continued to climb, along with the closure of the Hovensa refinery on St Croix, the Valero Aruba refinery and the chronic maintenance needed at the giant Paraguana refining Figure 4.17 Pricing benchmarks for global crude oil North Sea - Brent FSU - Urals Algeria - Sahara Blend United States - WTI United States - LLS United States - Mars Libya - Es Sider Mexico - Maya Ecuador - Oriente Nigeria Bonny Light Malaysia - Tapis - Iran Heavy Kuwait - Kuwait IranIran - Iran Light Saudi Aradia - Arab UAE - Dubai Heavy Oman - Oman Saudi Aradia - Arab Light Source: US Energy Information Administration 100 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 101 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS complex in Venezuela, US Gulf Coast refineries have been recruited to export products to meet demand in the south. Several commodity exchanges offer futures contracts, some which may be settled by physical delivery of the underlying crude or product, and some that may be settled financially. These futures are widely used by producers, refiners and large consumers of crude and products for price risk management, and are also traded by speculators and investors who desire exposure to energy prices. The main futures and options markets are traded on the CME and the Intercontinental Exchange. The products listed are WTI, Brent, UltraLow Sulfur Distillate (which was previously known as Heating Oil), Gasoil, RBOB and many other locational contracts (such as flatpriced delivery points of USGC, ARA or Singapore) that are listed on ICE or cleared on CME Clearport. Although Heating Oil and Gasoil have been the mainstay for pricing of global distillate demand since the early 1980s, these contracts are slowly being replaced by their lower sulphur counterparts that are becoming a larger segment of distillate demand, with the ICE and CME adding Low Sulphur Gasoil contracts since 2012. A HISTORICAL PRICE PERSPECTIVE Figure 4.18 illustrates a historical perspective of oil prices and some of the major effects since the early 1970s. The first commercially drilled oil well was drilled near Titusville, Pennsylvania, in 1859 by Edwin Drake. Even although kerosene production from crude oil goes back to the Babylonians’ uses of petroleum, the implementation of the combustion engine and later uses in transportation were the main drivers of the pursuit of crude oil production. Early on in petroleum history, 90% of the world’s crude oil was in Baku, Russia, and after a century and a half Russia has once again become the largest producer of crude oil, but, according to the IEA report of October 2012, by 2017 the US will resume its place as the world’s largest oil producer. However, the history of modern oil pricing really started in 1960 with the birth of Organization of Petroleum Exporting Countries (OPEC). During that era, Western demand for oil was mostly met by international oil companies (IOC) and production was mandated by quotas set by the Texas Railroad Commission. What followed was a series of events that turned the price and availability of oil upside 101 Figure 4.18 Oil disruptions, OPEC spare capacity and crude prices 25% Threatened oil supply Disrupted oil supply Spare capacity (EIA) Crude oil price (RHS) US$120 Share of world oil demand Iran 15% US$80 US$60 10% US$40 Iran–Iraq war 5% Iran revolution US$20 Arab oil embargo Gulf war I Gulf war II US$0 0% 19 70 19 72 19 74 19 76 19 78 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06 20 08 20 10 20 12 VZ ‘02–’03, Iraq ‘03, Nigeria ’03–>, Libya ‘10–>, and others Source: The Rapidan Group Prices: ‘72–’73 Arab Light, ‘74–present US refiner average imported crude cost. 102 COMMODITY INVESTING AND TRADING US$100 Current US$ per barrel 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 102 20% Market fears of an Iran-related Hormuz disruption faded after April 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 103 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS down. Back in 1956, M. King Hubbert’s presentation to the American Petroleum Institute suggested a peak in US production that actually took place (albeit for the time being) in 1970. Then, in March 1972, the Texas Railroad Commission declared that having quota restrictions on production was not necessary because demand had outstripped supply and that producers could produce at their capacities. This event ushered in the shift of power over global pricing of crude oil from the West to OPEC. Shortly thereafter, there was the Yom Kippur War, and, with the West’s support of Israel, the ensuing Arab oil embargo that lasted from October 1973 to March of 1974. Prices skyrocketed. Once again, Hubbert’s ideas of a global production peak had permeated into the market, now pointing to global production peaking around 1995. With the growth in production coming from the Middle East, and the economic changes and expansions on the horizon set for what would become the nations of the G7 and eventually the G20, the secular movement of Western economic powers taking from the Eastern producers became the emerging status quo. In 1979, the Iranian revolution added another jolt to the spot crude oil price. In late 1978, a strike by foreign workers who later fled the country during the 1979 revolution, helped Iranian production decline from more than six million barrels a day – from which the production has yet to recover. The 1979 revolution led into the 1980 Iran/Iraq war, signalling a second oil price spike in a decade. However, with the resurgence of Soviet Era assertion for energy dominance and new technologies for exploration and production, first the USSR and then Saudi Arabia in the 1990s stepped in to fill the gap to become the number one and number two global oil producers. With the emergence of a general global peace, excess supply and better technology, Hubbert’s predictions looked implausible. In fact, in the late 1980s there were several events that helped to vault prices lower. In 1986, with Mexico becoming a strong regional player in the West, the Mexican government offered to price crude delivered on a netback basis. This meant that they would price crude oil based upon the price at which products could be sold. As refiners were basically guaranteed profits, they produced until there was major oversupply, which pushed WTI prices on Nymex to US$9.75/bbl (meaning that prices were down by 80% in a few short years). The lower price regime continued generally through the late 103 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 104 COMMODITY INVESTING AND TRADING Figure 4.19 Crude oil production trends (since 1960) 14 Former USSR Million barrels per day 12 United States 10 Saudi Arabia 8 6 Russia 4 Iran 2 0 1960 1970 1980 1990 2000 Source: US Energy Information Administration 1980s. A perfect example was a pre-OPEC meeting headline in The New York Times Business Section in November 1988, which read: “Three Cheers for US$5 Oil”. At the time, Kuwait was a chronic overproducer and kept the prices down. The Saudis suggested that they could just flood the market with oil and be the last one standing...at US$5/bbl. This particular dynamic seemed to replay over the next few years as a recurring theme, even although OPEC was able to come out with an agreement in November 1988. Kuwait’s overproduction was not such a black and white case. During this era, OPEC quotas were actually important. They were hard to enforce, but markets did enforce them, as otherwise the price would plummet, and OPEC ministers were forced to act. Kuwait was coming into its own at that time in oil production. The country was able to invest in production and grow its production capability, but they wanted to sell this new capacity. These aspirations eventually caught the ire of Saddam Hussein and Iraq. The Iraqis believed that Kuwait was originally (and still was) the 18th province of Iraq, and, due to its chronic overproduction, Kuwait was blamed for keeping oil prices low. Much to the disbelief of the West (even although Iraq had amassed hundreds of thousands of troops on the border days before), Iraq 104 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 105 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS invaded Kuwait on August 2, 1990 – and away went the price of crude oil. The price peaked in October of 1990 and, when the US lead a coalition to free Kuwait in January 1991, it ushered in an era of a stronger Western military presence in the Gulf region, relatively unchecked after the break up of the Soviet Union in 1989. The result was a stable environment for oil prices throughout the 1990s. Excess OPEC capacity trended higher throughout the decade as OPEC nations added capacity faster than demand, and this excess capacity reached a level not seen since the Iran/Iraq war. In 1998, with the price of WTI trading near US$10/barrel, there was once again trouble in OPEC. The supply situation had placed Sunni-lead Saudi Arabia at loggerheads with Shi’ite Iran based on pumping. By default, Saudi Arabia had become the swing oil producer in times of market shortfalls, tightening their new alliances with the consuming nations in the West – they had become the de facto central bank of oil. With overproduction coming from Iran and Venezuela, the balances were once again hard to maintain. The market found a bottom, but not until a real resolution on production and quotas were reached by these countries. This market downdraft was not without casualties. With Hubbert’s predictions about 1995 all but forgotten, perhaps the best “trade” of the decade happened with oil near US$10/bbl. Exxon bought its largest rival, Mobil, in 1999 at the bottom of the market. Hubbert’s global production assessments were not off, but somewhat delayed by the one thing that has also reemerged in the previous decade: technology. The ability to leverage existing oil fields by pumping large amounts of water into a field and thus expanding its production capacity, enabled big oil fields, such as the Ghawar oil field in Saudi Arabia, to increase or sustain its production capability when it should have begun to decline. Saudi Aramco, boasting the best technology of any oil “company” in the world, was defying production constraints with new technology. Finally, around the new millenium, some old predictions began to take hold. After the economic downdraft in 2002 precipitated by September 11th and the South American debt crisis, the growth of emerging economies became noticeable. The Brazil, Russia, India and China (BRIC) economies began to grow to a point where the consumption of crude oil and refined products were overwhelmingly dependent on the ability to find oil. 105 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 106 COMMODITY INVESTING AND TRADING The era of finding onshore super-giant oil fields was gone. The new cost of finding fields and extracting was increasingly being focused on deep-water offshore finds that were expensive and risky to excavate. With very large fields such as Mexico’s Cantarell in decline, and the West feeling the pinch of the fall-off in production from the Hugo Chavez regime in Venezuela, there was great concern in the race for the marginal barrel. Areas such as the North Sea had begun a decline that continues to the present day. The one major bright spot that Figure 4.19 does not point out is the upswing in US production that now boasts greater than 7 mbpd, reversing the downward trend which was intact since 1970. Let us now look at Figure 4.20, which illustrates the growth in consumption of the largest driver of the decade, China. Amazingly, since China became a net importer of crude oil, its shortfall has grown substantially to make it the second largest consumer of crude oil after the US. This rapid growth and migration of the populace to a middle class that is a global consumer of crude oil products has had a profound effect on price and excess capacity (as shown in Table 3). According to EIA projections, this trend will continue going forward through to 2035. With much of the future growth in liquids consumption coming from China, India, other non-OECD Asia and the Middle East, much of the supply growth will have to come from somewhere. Interestingly, OPEC is showing a growth in market share from about 40% to 42%. Therefore, the promise of Iraqi growth may have some lasting effects on keeping OPEC share growing. Meanwhile, as shown in Table 4.4, with the production declines in the OECD countries, the lone shining star is the US thanks to the shale production boom that may even supercede the estimates which may crowd out some OPEC production growth. The IEA claims that the US will be the world’s largest oil producer by 2017. This implies a staggering growth rate, which may be difficult to achieve given the typically high decline rates for most new wells in the Bakken and Eagle Ford shales. There are a few things to note based upon the overall trends. Looking once again at Figure 4.18, the tightness of the supply– demand balance that ushered in this new era of prices largely took effect when the excess OPEC capacity shrank back below 3% of global production (about 2.7 mbpd). At the same time, there was a second stage ramp-up in Chinese demand (as shown in Figure 4.20) 106 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 107 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS Figure 4.20 Chinese net oil consumption Thousand barrels per day Forecast 12,000 10,000 Consumption 8,000 Net imports 6,000 4,000 Production 2,000 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 0 Source: US Energy Information Administration at the acceleration point around 2003. Thus, the new price regime entered the markets. With similar shortages during the first Gulf war, the nominal price reached US$41 in late 1990. Contrast that time with early 2009, in an oversupplied environment of having 6%+ excess capacity the price was only able to fall to US$32/bbl. This price action speaks to a new price regime. Note the price assumptions listed by the EIA in Table 4.4. These price assumptions show a steady growth. The answer is sensible. As excess capacity continues to be very low, price needs to ration the market’s demand. To get 109.50 million barrels of oil out of the ground in 2035, many new fields, unprofitable at today’s prices, would require the ability to contribute to the global liquids production mix. Before the great recession that collapsed the markets in 2008, price raced towards US$147/bbl, an incredible feat for a commodity that hit a low of around US$17/bbl in 2002. There was the push of Chinese demand, the faster decline in Mexican, North Sea and US production, and a dwindling of excess capacity to a point where only 800,000 bbls/day was projected to stand between easily functioning markets and an aggregate stock-out. 107 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 108 COMMODITY INVESTING AND TRADING Table 4.3 International liquids supply and disposition summary (million barrels per day) 2009 2010 2015 2020 2025 2030 2035 Annual growth (%) 2010–35 OECD US 50 states US territories Canada Mexico and Chile OECD Europe Japan South Korea Australia and NZ 18.81 19.17 0.27 0.28 2.16 2.21 2.35 2.34 14.66 14.58 4.39 4.45 2.15 2.24 1.16 1.13 19.1 0.31 2.15 2.39 14.14 4.51 2.25 1.11 19.02 0.32 2.21 2.43 14.43 4.6 2.35 1.14 19.2 19.47 0.34 0.36 2.25 2.29 2.5 2.6 14.65 14.76 4.62 4.51 2.46 2.53 1.17 1.21 19.9 0.36 2.35 2.68 14.74 4.42 2.56 1.23 0.10 1.00 0.20 0.50 0.00 0.00 0.50 0.20 TOTAL OECD 45.94 46.4 45.95 46.5 47.19 47.72 48.24 0.20 2.94 2.97 0.10 2.45 2.55 16.03 17.65 5.4 5.79 8.85 9.4 8.16 8.98 3.57 3.8 3.15 3.47 2.63 18.5 5.8 9.89 9.49 4.09 3.8 0.90 2.80 2.40 1.50 1.00 0.80 1.50 4.05 4.09 1.70 54.32 58.62 61.26 1.70 Liquids consumption NON-OECD Russia Other Europe and Eurasia China India Other non-OECD Asia Middle East Africa Brazil Other Central and South America 2.73 2.93 3.02 2.94 2.15 8.33 3.11 6.43 6.84 3.23 2.52 2.08 9.19 3.18 6.73 7.35 3.34 2.65 2.3 12.1 3.7 7.28 7.78 3.3 2.84 2.35 14.36 4.58 7.95 7.69 3.37 2.94 3.07 3.19 3.49 3.66 Total non-OECD consumption 38.41 40.65 45.82 49.83 Total liquids consumption 84.35 87.05 91.76 96.33 101.51106.35 109.5 0.90 33.34 34.58 51.01 52.47 10.25 10.53 37.3 54.46 11.11 39.23 57.1 12.6 41.91 44.05 59.6 62.3 13.94 14.85 45.89 63.61 15.54 1.10 0.80 1.60 39.5 40.7 40.7 41.3 41.9 OPEC Production Non-OPEC production New Eurasia exports OPEC market share (percent) 39.7 2.91 3.81 41.4 Source: EIA, “Annual Energy Outlook 2012”, Table A21 The demand destruction that ensued from the recession temporarily changed the equation; however, does this risk still exist? Just as Hubbert predicted, in early 2008 an almost universal feeling of peak oil and high prices were beginning to be the norm. Then 108 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 109 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS Table 4.4 Production 2009 2010 2015 2020 2025 2030 2035 Growth (%) Crude prices (2010 US$/BBL) Low sulphur light Imported Crude oil prices (NOM) Low sulphur light Imported 62.37 59.72 79.39 116.91 126.68 132.56 138.49 75.87 113.97 115.74 121.21 126.51 144.98 132.95 2.40 2.30 61.65 59.04 79.39 125.97 148.87 170.09 197.1 75.87 122.81 136.02 155.52 180.06 229.55 210.51 4.30 4.20 Petroleum liquids production OPEC Middle East North Africa West Africa South America 22.3 3.92 4.16 2.43 23.43 3.89 4.45 2.29 25.46 3.62 5.09 2.13 27.16 3.42 5.35 1.97 29.77 3.37 5.4 1.92 32.07 3.31 5.31 1.79 33.94 1.50 3.27 –0.70 5.26 0.70 1.72 –1.10 Total OPEC prod 32.8 34.05 36.3 37.91 40.46 42.48 44.19 1.00 8.79 1.91 2.98 4.36 0.13 0.62 18.8 9.82 1.79 2.65 3.7 0.14 0.55 18.65 10.73 1.82 1.97 3.33 0.15 0.54 18.54 10.53 1.82 1.58 3.15 0.15 0.54 17.78 10.57 1.81 1.65 3 0.15 0.53 17.72 10.15 1.78 1.68 2.83 0.16 0.53 17.14 0.60 –0.30 –2.30 –1.70 0.70 –0.60 –0.40 10.14 3.22 4.27 3.77 1.58 2.41 2.19 2.01 10.04 3.67 4.29 3.79 1.43 2.4 2.72 2.29 10.54 4.01 4.46 3.55 1.31 2.54 3.34 2.32 11.06 4.37 4.79 3.38 1.18 2.68 3.87 2.47 11.62 4.52 4.93 3.17 1.06 2.7 4.21 2.67 12.16 0.70 4.54 1.40 4.7 0.40 3 –0.90 0.97 –1.90 2.68 0.40 4.45 2.90 2.65 1.10 Non-OPEC OECD US 8.27 Canada 1.96 Mexico and Chile 3 OECD EUROPE 4.7 Japan 0.13 Aust and NZ 0.65 TOT OECD PROD 18.71 Non-OECD Russia 9.93 Other EUR AND EURASIA 3.12 China 3.99 Other Asia 3.67 Middle East 1.56 Africa 2.44 Brazil 2.08 Other Central and South American 1.9 Total non-OECD prod 28.69 29.59 30.63 32.07 33.8 34.88 35.15 0.70 Total liquids prod 80.21 82.44 85.58 88.52 92.04 95.08 96.47 0.60 Other liquids prod US Other North American OECD EUROPE Middle East Africa Central and South American Other 0.75 1.69 0.22 0.01 0.21 1.14 0.12 0.9 1.93 0.22 0.01 0.21 1.2 0.13 1.05 2.51 0.23 0.17 0.28 1.78 0.16 1.34 3.08 0.24 0.21 0.37 2.31 0.28 1.62 3.75 0.26 0.24 0.38 2.61 0.61 2.08 4.46 0.27 0.24 0.39 2.9 0.92 Total other liquids prod 4.14 4.61 6.18 7.82 9.47 11.27 84.35 87.05 91.76 Total production 96.33 101.51 106.34 2.59 4.30 5.16 4.00 0.28 1.00 0.24 14.50 0.4 2.60 3.17 3.90 1.18 9.10 13.02 109.5 4.20 0.90 Source: EIA, “Annual Energy Outlook 2012”, Table A20 109 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 110 COMMODITY INVESTING AND TRADING came the recession, and one can see in the consumption numbers in Table 4.3 that very little (if any) growth is expected between 2008 and 2015. The shale revolution coming from the US and southern Canada then appeared. At US$50/bbl, these technologies are not financially viable, but, at US$70–80/bbl, they are profitable. Once again, the peak oil whispers have faded because of technology and may stay quiet for a while if this technology becomes a universally accepted means of production. However, our new pricing regime is in place. The price assumptions made by the EIA exist so that the market stays balanced. This theme is an important one. As we move from one price regime to another, the effects of the market pricing is to ration demand (as it has already done in many OECD countries since 2008) and to price in new technologies for production that become financially viable at higher price points. CONCLUSION In summary, the global landscape of the market for crude oil has many intricate influences, stemming from grade, location, politics and its reception from its downstream counterparts at the refinery level. The growth in emerging economies have shaken the stability of the existing supply/demand balances, but have also ushered in a new era boasting new methods of combating the continuous struggle for the globe to be well supplied with crude oil. However, even as Hubbert had predicted back in 1956, the decline of crude oil as our main source of energy has been wildly overestimated. The cost and the technological breakthroughs continue to preserve this commodity as a large part of our daily lives. 1 International Energy Agency, 2012, “Oil Market Report, November. 2 US Energy Information Administration, 2012, “World Oil Transit Chokepoints”, August 22. 3 Platts, 2011, “Dated Brent: The Pricing Benchmark for Asia–Pacific Sweet Crude Oil”, May. REFERENCES Carlson, M., Z. Khokher and S. Titman, 2007, “Equilibrium Exhaustible Resource Price Dynamics”, Journal of Finance, American Finance Association. Evans, L. and G. Guthrie, 2009, “How Options Provided by Storage Affect Electricity Prices”, Southern Economic Journal, 75(3), January, pp 681–702. 110 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 111 OIL AND PETROLEUM PRODUCTS: HISTORY AND FUNDAMENTALS Hubbert, M. King, 1956, “Nuclear Energy and the Fossil Fuels”, Shell Development Company, Publication Number 95, presented before the Spring Meeting of the Southern District, American Petroleum Institute, San Antonio, Texas, March. Kaldor, N., 1939, “Speculation and Economic Stability”, The Review of Economic Studies. Oliver, M., C. Mason and D. Finnoff, 2012, “Pipeline Congestion and Natural Gas Basis Differentials: Theory and Evidence”, University of Wyoming. Samuelson, P., 1965, “Proof that Properly Anticipated Prices Fluctuate Randomly” Industrial Management Review, 6. Working, H., 1948, “Theory of the Inverse Carrying Charge in Futures Markets”, Journal of Farm Economics, 30, pp 1–28. Working, H. 1949, “The Theory of Price of Storage”, American Economic Review, 39, pp 1,254–62. 111 04 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:46 Page 112 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 113 5 Wholesale Power Markets William Webster RWE Supply and Trading The objective of this chapter is to provide an understanding of how the wholesale electricity market functions, and to explain its special features compared to other commodity markets. Despite the liberalised electricity markets having their first beginnings as far back as the 1990s, there probably remain few people outside of the industry who conceive of electricity as a traded commodity. This can be easily discerned from political discussions where there is regular pressure on government and regulators to intervene in the setting of electricity prices. However, an unhindered liquid wholesale market that sets prices is an essential component of a competitive market for electricity. Otherwise new suppliers and new generators cannot enter the market independently. This means all the usual components of commodity markets need to apply: the free interaction of supply and demand, development of forward markets, the participation of a diverse range of traders with different motivations and strategies, and the provision of platforms offering a range of matching, clearing and settlement services. This chapter will describe how these basic building blocks of traded commodity markets are applied in the electricity sector, and examine some of the outcomes. The following section will explore some of the special features of electricity and how they have influenced the development of wholesale markets, before we look at how electricity is traded in practice and introduce some of the products and markets that are typically found. We will then examine the behaviour of different market participants and explore some trading strategies, as well as review 113 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 114 COMMODITY INVESTING AND TRADING the development of market prices over time in some important European markets. The chapter will also seek to identify some key issues that might affect electricity trading over the next decade, and end by considering some of the main sources of information on electricity wholesale markets. ELECTRICITY AS A COMMODITY The unique characteristics of electricity The scientific laws of electricity The power market has particular characteristics that distinguish it from other commodity markets. These characteristics are mainly a consequence of the scientific laws of electricity production, transmission and consumption. These laws mean that, for example, it is not straightforward to trace the production and use of individual electrons across the transmission and distribution networks. Likewise, these laws mean that the whole system has to be maintained at a constant frequency for power plants and appliances to continue to function. There is therefore an interdependency between market participants that is not seen in other sectors. However, as with the peculiarities of other commodities, it is possible to develop a traded market by introducing some approximation around the consequences of these physical laws. Just as the market for crude oil is able to deal with, for example, different quality grades and delivery locations, so it is also possible to get around the specificities about electricity as a product. So, although the electricity system as a whole has to balance on a second-bysecond basis, traded markets usually allow for market participants to balance over a 15- or 30-minute period. These issues will be discussed in more detail in the remainder of this section. Dispatch arrangements First, compared to other commodities, delivery of electricity is strongly time dependent. It must be produced and delivered exactly as it is used. This contrasts with other commodities that can be stored to a greater or lesser extent. Electricity is also unlike most other commodities in that it has a dedicated delivery network: the transmission system. For electricity provision as a whole to continue to function, there must be equilibrium between the network, production and consumption in real time. 114 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 115 WHOLESALE POWER MARKETS Second, if there is a failure in the overall system, it will affect a broad range of users, and not necessarily those that caused the failure. There is therefore a strong public-good element in electricity supply. In particular, the electricity network can be characterised as “non-exclusive”. If the system as a whole works, it is there for everybody and nobody can be excluded from using it. However, electricity supply is not a pure public good, in that it is not “non-rival” (in the same way as, for example, street lighting). It is therefore competitive with respect to supply and consumption in that the same MWh cannot be used twice. This means that a market structure can function in the sense that the use of electricity can be rationed through the price mechanism. The main issue raised by these two points is, therefore, more about the extent to which producers and consumers can interact directly, as in other commodity markets, or whether there needs to be a specified regulated intermediary. In some jurisdictions, regulators impose a strong role for the transmission system operator (TSO) in overseeing the market process, and even in operational decisions. Under such arrangements, generators feed in all their technical and pricing information to the TSO, who then calculates prices using this information and assumptions about demand. Such market arrangements are characterised as “central-dispatch” because the system operator decides how all generation plant is dispatched on the basis of the prices and technical information that is submitted. In effect, the TSO buys electricity on behalf of retail suppliers and their consumers. Meanwhile, market arrangements where producers and consumers (or usually their retail suppliers) interact independently are termed “self-dispatch”. In these cases, generators negotiate individually with retail suppliers via traditional traded wholesale markets structures – ie, a variety of traded platforms and exchanges as well as voice-broking services. The system operator then takes a residual role in that they may adjust generation output via balancing actions and “re-dispatch” if this is necessary to ensure the overall security of the system. A simplified summary of these terms is provided below. ❏ Central dispatch Generators provide price and technical information (eg, ramping parameters, start costs) to the system operator. The system 115 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 116 COMMODITY INVESTING AND TRADING operator compiles an efficient dispatch schedule on the basis of this information and expected demand. Generators run to that schedule. The TSO calculates a price for each (eg, hour) and all trading is based around that price (eg, Ireland, England & Wales Pool). ❏ Self-dispatch Retailers contract in the market with producers to meet the needs of their portfolio of customers. Generators offer prices to the market based on their plant characteristics and conclude transactions on a bilateral basis or through an anonymous exchange. Trading is continuous and dispatch decisions can be continuously updated until a “gate closure” specified by the TSO. At gate closure, a final dispatch schedule is notified by the generator to the transmission system operator. ❏ Balancing actions and re-dispatch If, on the basis of the aggregate of final notifications, the system is out of balance or internal security limits are breached, the system operator will require some generators to change their actual output from the final notification amounts. This is usually based on priced offers by generators to increase/decrease production compared to notified amounts. Locational issues The production and consumption of electricity also has a locational element. However, it could be argued that this aspect is less important for electricity than for other commodities. Depending on the characteristics of the transmission network, it is not always necessary to deliver electricity exactly to the point of consumption. Provided the network is meshed enough, it is normal for most trading to be conducted around particular “hubs”, or on a zonal basis. ❏ With a zonal market, common in Europe, the assumption is that transmission capacity is always available to deliver the energy to the customer, wherever it is in that zone. This often requires “remedial actions” by system operators, such as re-dispatch (discussed above). But, as long as these do not become too frequent or costly, these actions can take place outside the market without upsetting trading. ❏ The main alternative, used in North America, is a nodal market where each node in the transmission network has a separate 116 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 117 WHOLESALE POWER MARKETS individual price. A hub price may then develop based around a set of nodes that usually end up with the same price, and which are then treated as a price zone by market participants. In this model, market participants carry the locational basis risk of possible price changes between nodes. However, system operators also sell transmission rights between these nodes to help the market manage these risks. Electricity “quality” Unlike many other products, electricity has the same “quality” for each unit of production. One megawatt hour (MWh) is exactly the same as another – unlike, for example, natural gas where a cubic metre of gas might have a different calorific content. However, this physical reality has latterly been changed by environmental considerations. Consumers and governments may now place a higher value on units that are renewable or low carbon. This is already starting to make the trading of electricity more complicated. For example, under so-called “green certificate” schemes, retail suppliers have to purchase such certificates alongside the electricity they need in order to serve final consumers. Likewise, under other support schemes, renewable energy might be sold in wholesale markets on a “must-run” basis, even if prices are zero or even negative. The fact that a section of the electricity market is asked to behave in a noncommercial manner makes it more difficult to form expectations about spot prices and discourages forward trading. Electricity “market design” Overall, electricity markets are probably more complicated than other commodity markets. This often raises the question about whether they are, in fact, too complicated to allow for a normal standardised and commoditised set of products to develop. Electricity markets are already not particularly liquid compared to other commodities. If the market becomes further fragmented into different time, location and quality characteristics, the future for standardised trading begins to look rather uncertain. In the meantime, these features normally mean that the wholesale market for electricity is, to an extent, something of an abstract regulatory construction. Academic and regulatory literature often speaks of “market design” for electricity, which is not a term commonly 117 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 118 COMMODITY INVESTING AND TRADING used for other commodity markets. Nobody ever talks about crude oil “market design” in a regulatory sense. Complications such as freight costs and quality standards are left up to the market participants to sort out for themselves. Part of the challenge in electricity market design is getting the balance right between the role of the market and that of government and regulators. Policymakers continue to struggle with this challenge, even in the most mature electricity markets. Indeed, there is an observable cycle backwards and forward between more regulated and more market-based policy frameworks. Where can functioning wholesale markets be found? At the time of writing, there are several functioning and reasonably liquid wholesale markets that perform the central tasks of price discovery, offer hedging opportunities and give signals to market participants for efficient operational and investment decisions. Liquid wholesale power markets exist to a greater or lesser extent in several areas of the European Union, in parts of North and South America, and in Australia and New Zealand. Traded electricity markets are also coming into existence in other countries. This chapter will concentrate on the development of wholesale power markets in Europe, particularly in Germany and Britain (GB). HOW POWER IS TRADED – THE CHARACTERISTICS OF EUROPEAN ENERGY MARKETS European market design principles: The importance of the balancing regime European market design is based on self-dispatch rather than centralised dispatch of power production – unlike, for example, most North American markets. It is therefore a bilateral two-sided market in that generators sell into, and retailers buy from, wholesale markets. As discussed, this means that the system operator’s role is restricted to dealing with residual imbalances in the system as a whole and resolving any locational constraints. This takes place after “gate closure”, which is normally one hour before real time operation. However, in reality, system operators sometimes have to begin to take some action before gate closure if plant expected to be used for balancing or re-dispatch needs to be ramped up or warmed in advance. 118 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 119 WHOLESALE POWER MARKETS Market participants on both the generation and the retail side have to balance at gate closure across a so-called “settlement period” of either 30 minutes or 15 minutes. Those market participants whose actual measured injections do not match their consumption are said to be “out of balance” and are subject to imbalance charges. They have to pay the system operator for the actions required to balance the system. This payment is governed by the national regulator in the country concerned. It is usually based on the costs to the TSO of resolving imbalances, although the formula used varies in each country. Balancing arrangements are increasingly market-based, with the settlement price based on bids and offers from those generators with spare capacity, or alternatively demand-side offers. An important consequence of this market design is that trading of electricity and also price formation is strongly driven by the desire of market participants to avoid the consequences of being out of balance. If a company goes into gate closure with a short position, they are potentially exposed to very high imbalance prices at particular times. Likewise, being long at gate closure is not without risks either, particularly if imbalance prices can go negative, which is a possible outcome. The balancing mechanism is therefore at the heart of European market design. Day ahead and intraday markets The other main reference price in European markets comes from the “day-ahead markets”. These are largely two-sided cleared auctions operated by dedicated market operators. For example, in Germany and France the auction is run by EPEX Spot (a joint venture between EEX and Powernext). Meanwhile, day-ahead auctions in GB and in Nordic markets are operated by Nord Pool Spot. The Dutch dayahead auction is operated by APX-ENDEX (now a subsidiary of ICE), who also operates a day-ahead market in GB. Day-ahead exchanges are not usually compulsory marketplaces. However, there is a strong regulatory push to ensure these markets are liquid. In the draft European network code on capacity allocation and congestion management (CACM), it is envisaged that these dayahead exchanges will play a central role in allocation of cross-border transmission capacity. This process is known as market coupling. The CACM network code was slated to become binding European legislation in 2014. 119 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 120 COMMODITY INVESTING AND TRADING As well as the day-ahead markets, there are various platforms for intraday trading. Unlike day-ahead, which is almost exclusively an exchange-based auction, trading in the intraday can either be exchange-based or a bilateral over-the-counter (OTC) market. This often depends on the historical development of markets and regulatory attitudes. For example, in the Nordic countries intraday trading is exclusively via the Elbas platform, which is provided by Nord Pool, whereas the system used in Germany is a platform that allows both exchange-based trading and bilateral exchanges. Forward markets Physical versus financial However, the day-ahead and intraday phases are only for finetuning positions. The vast majority of electricity is traded long before this point on a wide range of forward markets of different types. Forward products may be either physical or financial. Financial trading are contracts for difference that are based around a dayahead reference price. With financial trading, a strike price is agreed (eg, €40/MWh). If the day-ahead price is above this – for example, €45 – then the buy-side counterparty will buy their power in the dayahead market and the seller of the forward product will pay them the €5 difference. The buyer does not take on any obligations with respect to balancing and nomination, as discussed earlier. Physical contracts are used when both parties are already responsible for balance. Then the transaction is an obligation on the selling party to physically deliver the amount sold or else face the imbalance charges on behalf of the buyer. Brokers such as Trayport and Spectron offer a screen-based broker service based on physical delivery. Other products, such as those offered by EEX, APX-ENDEX or Nasdaq, are financial trades based on contracts based on the day-ahead prices. Voice-activated trading is also possible. Forward market products There is a range of possible products for forward trading. The most liquid market is for baseload power, meaning a flat amount of power over a 24-hr period. Baseload power can be traded weekly, monthly, quarterly, by seasons or annually. Trading may be either exchangebased and cleared, or through bilateral OTC transactions. Trading in 120 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 121 WHOLESALE POWER MARKETS seasonal and annual baseload products usually goes out to 2–3 years into the future for both financial and physical settlement. The other main product traded forward is peakload. This refers to the period of 0700–2300 each day. Again there is a range of forward peakload products available. However, the forward curve is not as liquid as for baseload. Products are usually only available for 1–2 years in advance of real time. Finally, it is also possible to trade four-hour blocks in some European markets, such as in the GB market. However, these are usually not available until some days/weeks before real time. Spark and dark spreads The final complication to mention is that trading in baseload products, in particular, is largely on the basis of “spreads”. For example, the “spark spread” is the difference between the electricity price and the cost of producing that electricity from a certain standard efficiency gas-fired power plant, based on the prevailing gas prices. The “dark spread” is the same concept for coal. With the advent of carbon trading, indexes for “clean spark spread” and “clean dark spread” were developed which are popular forward products, particularly in the GB market where both coal and gas have liquid reference prices. HEDGING STRATEGIES AND PRICE FORMATION Market participants will usually have some pre-specified procedures about how they interact with wholesale markets. This will partly be driven by the company’s risk controls. No company will wish to take or maintain a position that will leave it too exposed to a disadvantageous movement in prices. In particular, taking on large exposed positions requires the company to allocate risk capital to trading activity that is earmarked to cover possible adverse price movements. In addition, accounting rules, specifically the International Financial Reporting Standards (IFRS), may also discourage companies from taking large positions since these have to be “marked to market” in a company’s account. This can result in a potentially large impact on the company P&L, with undesirable knock-on effects on credit rating and market sentiment. In general, the expectation is that retailers hedge the bulk of their positions in advance through trading of baseload and peakload products. They will then use the short-term markets for fine-tuning 121 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 122 COMMODITY INVESTING AND TRADING their exposures. They may have some kind of target “hedge path” in terms of what proportion of their consumers’ needs should be covered by a certain date – eg, that X% should be bought by Y months before consumption. Likewise, generators will also sell the bulk of their generation capabilities in forward markets in order to allow for effective business management. For example, the generation business will need to know in advance how much revenue they are likely to collect in a particular year. They will then be able to decide on a maintenance timetable and other budgeting decisions. However, they will not necessarily sell all potential volumes into forward markets since this implies a risk in the event of a generation failure. In essence, price formation in forward markets, and therefore customers’ bills, is the consequence of how these decisions are taken about how, and when, to buy and sell. For example, the more that the supply–demand position is expected to be tight, the more that retailers will tend to try and manage their exposure to short-term markets and seek to hedge earlier, pushing up forward prices. Conversely, if there is expected to be large margins of spare generation capacity, retailers may be more content to delay buying volumes and wait for prices to fall. Similarly, generators may have to accept selling at lower spreads if they see a lot of spare generation capacity around and there is little prospect of prices increasing in spot markets. HISTORICAL PRICE PERSPECTIVE Germany Figures 5.1 and 5.2 show the main trends in electricity prices in Germany. The German electricity market is the most liquid in Europe, if not the world. Trading is based on a single Germany/ Austria day-ahead reference price. Initially, market opening between 2000 and 2005 led to significant reductions in wholesale market prices as more competition was introduced and trading became established. Prices gradually increased between 2005 and 2008, bringing considerable new investment in generation. Some 10GW of new conventional plant began operation in the period 2010–13. However, the financial crisis and reductions in industrial demand have bought about significant price reductions. This was only partly reversed by the enforced closure of all German nuclear plants in 2011 after the Fukushima disaster. 122 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 123 WHOLESALE POWER MARKETS Figure 5.1 Germany year-ahead forward prices (2005–13) 140 Baseload Peakload 120 EUR/MWh 100 80 60 40 20 0 03 05 20 / 1 /0 / 03 /2 01 6 00 2 1/ /0 3 0 7 00 03 8 00 /2 1 /0 / 03 /2 01 9 00 03 1/ /0 10 20 0 / 01 3/ 11 20 0 0 /2 01 3/ 12 / 03 /2 01 3 01 Source: RWE internal data Figure 5.2 Germany year-ahead baseload forward clean spreads (2005–13) 40 30 10 3 01 /0 1 /2 01 12 1/ 20 /0 01 01 /0 1/ 2 01 1 10 1/ 20 /0 01 01 /2 0 8 01 / 01 /0 1/ 20 0 07 1/ 20 6 01 /0 00 /2 /0 1 01 /2 00 01 /0 1 -10 09 0 5 EUR/MWh 20 -20 -30 Baseload clean dark spread Baseload clean spark spread Source: RWE internal data The other important feature in the German market is the combined impact of increased renewable production and energy efficiency initiatives. From 2010, renewable production started to have a profound impact on the market mainly due to the sheer scale 123 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 124 COMMODITY INVESTING AND TRADING of investment in this sector. Take-up of renewables has been rapid as producers benefit from a guaranteed feed-in-tariff. Compared to peak consumption of around 80GW, there is now some 30GW of wind production. Meanwhile, solar photovoltaics capacity increased from 10GW in 2010 to 30GW in 2012. In Germany, renewable producers do not themselves sell their own production. Neither do they have to balance their portfolios like other market participants. Instead, the TSOs have to accommodate all renewable production, which they themselves sell on day-ahead and intraday markets. This is known as “priority dispatch”. The high installed capacity of renewables means there are now frequent incidences where most, or all, of electricity consumption is served by renewable production. Understandably, this affects price formation on both spot and forward markets. Spark spreads have become particularly weak and have been negative since the start of 2012. The impact has been particularly strong on peakload prices, with the difference between baseload and peakload prices narrowing. This is because normal peak periods have been offset by high levels of solar production during the afternoon period in some parts of the year. In general, as renewable penetration continues to increase, the classic baseload and peakload products may begin to lose their relevance and alternative products may need to emerge in order for the market to fulfil its functions effectively. To an extent, periods with high renewable production can be offset by imports and exports of power to neighbouring countries. Since 2009, Germany has participated in the central–western Europe (CWE) Market Coupling project. This uses the day-ahead power exchanges to allocate cross-border capacity such that power automatically flows from low prices areas to higher priced areas. This may help the transition of markets to the high renewables world. Great Britain Figures 5.3 and 5.4 illustrate similar data for the GB market. As for Germany, there is a single price zone that covers all of the island of Great Britain. GB prices have followed a fairly similar pattern to those in Germany. The fall in demand in GB was, if anything, more pronounced than in Germany with an abrupt negative effect on clean spark spreads. Capacity margins are such that forward prices at the 124 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 125 WHOLESALE POWER MARKETS Figure 5.3 GB year-ahead forward power prices (2005–13) 120 Baseload Peakload 100 £/MWh 80 60 40 20 0 / 01 0 /2 01 05 01 6 00 /2 1 /0 0 00 /2 01 / 1 7 / 01 0 /2 01 08 01 1/ /0 09 20 0 0 /2 01 1/ 10 01 1/ /0 11 20 / 01 /2 01 2 01 0 / 01 1/ 1 20 3 Source: RWE internal data Figure 5.4 GB year-ahead forward clean spark spreads (2005–13) 35 Baseload Peakload 30 £/MWh 25 20 15 10 5 13 20 1/ /0 01 /0 1/ 2 01 2 11 01 20 1/ 01 /0 01 0 01 / 01 /2 09 08 20 1/ 01 /0 20 1/ 1/ 01 /0 01 /0 20 07 6 00 1/ 2 01 /0 01 /0 1/ 20 05 0 Source: RWE internal data 125 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 126 COMMODITY INVESTING AND TRADING time of writing do not show much sign of recovery despite the anticipated closure of some 10–15GW of generation capacity up to around 2017. Renewable production has not yet reached the same level of penetration as in Germany and its impact will continue to grow. However, a key difference in the GB market is that renewable producers are, and will continue to be, responsible for selling their own power and, other than the smallest facilities, are balanceresponsible. This may prevent the impact on prices being of the same magnitude. The subsidies for solar production and the extent of takeup, in particular, are markedly less generous. Compared to total peak demand of some 60GW, there is around 12GW of renewable production, a much lower percentage than in Germany. Only around 1GW of solar photovoltaics has so far been installed in the GB market. Wider relationships between European markets European markets are becoming increasingly correlated, especially as interconnection between EU countries increases and the existing infrastructure is managed more efficiently via market coupling. However, there are still major locational issues and associated basis risk that affects them. The main locational features of European power supply is that, due to hydroelectricity resources, the Nordic countries usually have a year-round surplus of generation (unless there is a very cold winter, preceded by very dry conditions). This often leads to comparatively low wholesale prices in the Nordic system. Both France and Belgium have high shares of nuclear power and these countries have traditionally had low wholesale prices. However, the high level of peak heating demand increasingly means that these countries now import in the winter. During 2009–12, the price differential between Germany and France closed and has reversed to an extent that in France, prices are higher than those in Germany. Both GB and the Netherlands electricity prices are typically driven by gas prices, and a locational spread with Germany will emerge if gas and coal prices deviate. Italy has typically had the highest wholesale electricity prices in the EU. Differences between these regions are maintained as a consequence of constraints in the overall European transmission network. 126 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 127 WHOLESALE POWER MARKETS Generally speaking, the construction of new transmission assets is very slow as a consequence of local resistance to new lines being built. The main problems are objections to the visible appearance of new transmission lines. Transmission assets are normally constructed on a regulated basis, although there have been a few sub-sea merchant interconnectors, such as Britned (between GB and the Netherlands). At the same time, the local supply–demand balance also tends to move rather slowly as new generation assets are added and others close. Overall, the extent of price differences between European regions has tended to reduce slightly over time. New developments Power prices are increasingly driven by regulatory interventions, in particular the objective of European Union countries to extend renewables and to decarbonise. As already noted, the significance of the traditional baseload and peakload divisions of wholesale products is beginning to be questioned. Locational issues are also becoming more complex as there will no longer be price areas that have low or high prices throughout the years or seasons. Instead, the variations will tend to be increasingly seen in short-term markets. Another regulatory development may come from possible changes to the price zones. At the time of writing, the EU is developing network codes that will embed the methods of market coupling that have already been in use for some time. Part of this discussion, however, is about whether the price zones as of 2013, mainly based on national borders, accurately reflect the real transmission constraints in the network. This raises the prospect of price zones being split, or indeed merged, in the future. This may affect how basis spreads between different zones develop. If the price zones more closely matched transmission constraints then the basis spreads between zones would probably be larger and more stable. A final important locational issue may arise from the introduction of flow-based market coupling. This model better takes into account the inter-relationships between use of capacity on different interconnectors in the meshed European networks. For example, suppose there are three price areas: A, B and C. In reality, the capacity available between area B–C is affected by how much electricity is flowing between A and B and between A and C. A 127 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 128 COMMODITY INVESTING AND TRADING flow-based approach explicitly takes these interactions into account. With a non-flow-based approach these relationships are not captured and the available transmission capacity between each area is set independently. The flow-based model will, in all likelihood, tend to make the envelope of interconnection capacity larger. On the other hand, it may be more difficult for market participants to understand the price formation process and make it more difficult to formulate a trading strategy. KEY ISSUES FOR THE COMING DECADE Evolving market design The main issues for the coming decade are mainly regulatory rather than purely economic. In particular, the increase in renewable production will be the main challenge for the market between 2013 and 2020. First, it creates long-term uncertainty, beyond the trading horizon, about what level of renewables penetration will occur. In addition, the way in which renewable production is activated and sold into the market also brings short-term issues. Under priority dispatch schemes, as in Germany, the renewable power tends to be sold into day-ahead and intraday markets by the system operator rather than being spread over forward markets. This creates unnecessary volatility and uncertainty. There are some moves towards removing priority dispatch rules and asking renewable producers to sell their own production into the wholesale market. This is expected to introduce more commercially oriented trading strategies that will be more predictable and stable. Meanwhile, in the GB market things are moving in the opposite direction. Under the proposed contract for difference (CFD) scheme, renewable producers will be compensated for the difference between the day-ahead price and a negotiated fixed “strike price”. So, although renewable producers will be required to sell their own power, the linkage of the CFD to the day-ahead price may again mean that plant is not being optimised in a predictable commercial way. Other regulatory developments include the intention, in many EU member states, to introduce capacity mechanisms. This is part of the policy response to the uncertainty created around the extent of renewables and other low-carbon penetration. However, these inter128 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 129 WHOLESALE POWER MARKETS ventions will inevitably have an impact on power prices. They will also introduce a further set of regulatory uncertainties that will make developing a trading strategy more challenging, and this is likely to reduce the liquidity of forward markets. Finally, as volatility moves from the forward markets to more short-term markets, different traded products may increase in significance. Option products are a market-driven way to reward capacity and flexibility. There may, therefore, be greater use of options to allow portfolios of intermittent generation to be managed effectively. Of course, this will only happen if renewable producers are responsible for their own portfolios and if a voluntary option market is not undermined by regulatory interventions. Some designs of capacity market such as the “reliability options” model used in North America are effectively a compulsory, centralised option market. Financial market regulation Financial regulation is also set to have an impact on the format of trading. The EU regulation on OTC derivatives, central counterparties and trade repositories (EMIR) came into force on August 16, 2012. It includes a requirement to centrally clear transactions once a company’s portfolio exceeds a certain threshold of €3 billion. Many large energy trading houses may be captured by this and, if so, there will be an increase in the amount of cleared transactions as a result. Discussions on the exact requirements were ongoing throughout 2012–13 via the “Draft Technical Standards”. These were produced by the European Securities and Markets Authority (ESMA) and, following the scrutiny of the European Parliament that concluded in February 2013, they were to be adopted by the Commission as binding requirements via the Comitology process and phased in over three years: 2013–16. In addition, discussions were ongoing during 2013 about new versions of the Markets in Financial Instruments Directive (MiFID). The old directive will be replaced by MiFID2 and a regulation (MiFIR). One possible outcome is that trading houses above a certain size will be regulated in the same way as banks, complete with strict capital requirements. However, there are possible exemptions that are being discussed, including the ring-fencing of some physical trades when determining whether companies exceed the threshold. 129 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 130 COMMODITY INVESTING AND TRADING MiFID is also expected to set requirements on companies regarding position limits and risk management techniques. Many of the proposals put forward in the EU context are already part of the legislation in the US, via the Dodd–Frank Act. Traders will have to get used to compliance with this type of regulation. However, all these tend to add transaction costs and potentially reduce the liquidity of wholesale markets. Other interventions have been regularly floated, such as the Financial Transaction Tax or sporadic restrictions on short-selling. These could have a similar negative impact on traded markets. Changing consumer requirements – more bespoke services? Other more consumer-driven factors are also relevant. The spread of small-scale renewable generation may tend to move the market away from more centralised solutions, and in the direction of more localised and bespoke solutions. New technologies such as electricity storage may also be more easily developed on a small scale. This will mean that the traditional relationships between producers and consumers will become blurred so that they become amalgamated into one role. So-called “prosumers” may become much more usual. Again this may make a centralised traded market less important. On the other hand, the development of alternative, innovative traded products may still preserve the role of the classic trading function. SOURCES OF MARKET INFORMATION There is a wide range of sources of information on European markets. In 2005, the European Commission established the Energy Market Observatory, which now produces regular reports on price developments, investment, etc. The transmission system operators (via the European Network of Transmission System Operators, ENTSO) also provide information on interconnector availability and regular assessment and projections of the supply–demand position. The Regulation on Energy Market Integrity and Transparency (REMIT) came into force in 2011, which requires all electricity and gas companies to publish any inside information that they hold. In effect, this means provision of data on all planned and unplanned outages, projected return to service dates and metered production volumes of all power plants above a certain size. It is expected that REMIT will be strengthened during 2013 with 130 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 131 WHOLESALE POWER MARKETS the introduction of more specific binding guidelines on transparency from the European Commission. This will apply to generators, transmission system operators and large consumers. The likelihood is that this will lead to a centralised platform for reporting information. At present, companies are largely reporting inside information on their own individual websites. CONCLUSIONS The main questions about power markets in Europe are well known. Where are prices and spreads going? What will the market look like in 2020 and beyond? Will there even be a market that we recognise? The first question is difficult to answer. Prices and spreads are low, and this is mostly due to an unexpected event: the financial crisis and its impact on the economy and electricity demand. So, although at the time of writing there does not seem much prospect of recovery, we do not yet know what other unexpected events might occur. However, we do know that prices for the traditional baseload product are likely to be continually eroded by more renewable penetration. Meanwhile, flexibility should become more valuable, so we might end up in a situation where one type of traded product continues to experience falling prices, while prices are rising in another segment of the market. The market in 2020 will clearly look somewhat different. More complex and bespoke products may develop, which may or may not have the same liquidity as the traditional ones. Trading might also continue to move towards the short term as it becomes more and more difficult to take a position on how things will look beyond one or two years. This may feed through into the relationships between the market and consumers. Supply contracts to end-users based on long-term contracts may also become prohibitively expensive in view of the additional risks and uncertainties. Will the traded market exist at all? There is clearly some risk that the panoply of regulatory interventions will drive liquidity out of wholesale markets entirely. Contractual structures may then become more bespoke and possibly also have a high degree of regulatory involvement. More integrated solutions may become more popular and this will move us away from traded outcomes. 131 05 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:47 Page 132 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 133 6 The Metals Markets Kamal Naqvi Credit Suisse In this chapter, we will examine the key determining factors for metal price analysis: physical demand, supply and inventory. We will then explore how these three factors combined lead to price formation, together with a short discussion of a range of other influences – such as currency, speculative and investor flows or positioning, and inflation. Across the metals complex, it should be apparent by the end of this chapter that the importance of these various factors varies significantly from metal to metal. We finally conclude with a short discussion regarding the major differences between the three metal segments, with a summary of the individual fundamentals and trends in these markets. For the purposes of this chapter, we shall define the metals markets, also known as basic materials or industrial minerals, as mined commodities that have a recognised and liquid global paper trading market that is widely used as the primary pricing mechanism for that commodity. The metals markets, under this definition, can be split into three areas: base metals, bulk commodities and precious metals. However, for much of this chapter we shall refer to the entire group as “metals”. The metal markets are, arguably, the most direct expression of applied macro and microeconomics. The core driver of demand for almost all metals is industrial production, on a country, regional and world basis. However, there are micro differences for individual metals demand and these can be very important for idiosyncratic pricing. The nature of global metal supply tends to be relatively 133 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 134 COMMODITY INVESTING AND TRADING stable with, typically, only modest seasonality compared to, say, agriculture. The meeting of demand and supply then is the stock and flow of inventory, which is the main underpinning for metal prices. The global metals markets are one of the longest serving commodity trading markets. Used as a currency at various points of history across the world, the metals markets are now best understood as, arguably, the purest form of global commodity market due to their homogeneity. Unlike most agriculture and energy markets, the metal markets tend to have largely standardised physical properties and are less specific to regions or countries. Hence, metal prices tend to reflect the interaction between global supply, demand and inventories. INVENTORY As they are relatively easily stored, inventories for metals tend to be more visible and therefore quantifiable compared to other commodities. The key to fundamentally driven commodity pricing is the relationship between inventories and price. For most of the metals (gold is perhaps an exception), this is a normal relationship – with declining inventories typically associated with upward price pressure. This is shown in Figure 6.1. The two key elements for pricing dynamics are: ❏ the level of inventories, measured best in terms of how many days, weeks, months or years of consumption; and ❏ the rate of change in inventory levels. These two factors combine to form the physical fundamental drivers for metal prices. A very low level of available inventories, such as copper or tin (as noted in Table 6.1), will typically see high and volatile prices as in this situation only modest changes in the supply/demand balance are needed to produce a large change in prices. In contrast, metals with very large levels of inventories, such as gold and silver in Table 6.1, require much larger changes in the supply/demand balance to justify a change to price. It should be noted that the “weeks of consumption” heading in isolation means little for relative pricing, but is shown for illustration of relative availability of metal inventories. The price for an individual metal depends more on the relative level of inventory compared to its own history. 134 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 135 THE METALS MARKETS Figure 6.1 Commodity prices and inventories Community price ($/t, $/oz, etc) 120 100 80 60 40 20 0 0 2 4 6 8 10 12 14 16 Weeks of consumption Source: Credit Suisse, Wood Mackenzie Table 6.1 Commodity inventories by weeks of consumption Commodity Copper Tin Lead Iron ore Thermal coal Zinc Nickel Aluminium Platinum Palladium Silver Gold Weeks’ of consumption (2012) 1.5 2.1 3.1 6.0 6.0 8.0 11.0 16.6 40.0 60.0 400.0 700.0 Inventory levels are not only the primary driver for price levels and change, but also for forward pricing, which will be discussed later in the chapter. DEMAND Metals demand is strongly linked to economic growth. However, while the level of global GDP is a reasonable proxy for living stan135 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 136 COMMODITY INVESTING AND TRADING dards and can be a useful broad macroeconomic variable for the energy and agricultural markets, it is not such a useful representation for industrial materials demand, as a large share of GDP is related to the services sector in most developed economies. Rather, the best macroeconomic drivers of industrial materials demand are industrial production (IP) and real fixed asset investment (FAI), as shown in Figure 6.2. There are, of course, micro differences between the metals markets in terms of sensitivity to these broad macro variables, depending on which sectors and countries dominate their use (see later in the chapter), but they are relatively modest compared to the primary trend. On a national level, for industrial materials one country has become dominant: China. As shown in the Figures 6.3 and 6.4, Chinese demand for almost all metals has become dominant in absolute terms and even more so as a proportion of global demand growth. For this reason, much of the traditional analysis of demand by country has been overwhelmed by the flows in Chinese demand, particularly as represented by Chinese trade data. SUPPLY Metals supply originates from mined ore that is then processed into standardised physical properties to allow for global sale. The various Figure 6.2 Global industrial production growth (month-on-month trend) 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% 2000 2002 2004 2006 Source: Credit Suisse, Thompson Reuters Datastream 136 2008 2010 2012 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 137 THE METALS MARKETS Figure 6.3 China is a key driver of growth in global metal demand 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0% 70s 80s 90s 00s 10s* Source: Credit Suisse, Wood Mackenzie * 2010s average of first four years, with Credit Suisse 8% forecast for 2012 and 2013 Figure 6.4 China dominating copper, aluminium, steel oil markets 50% Steel Copper Aluminium 12% Oil (rhs) 45% 11% 40% 10% 35% 9% 30% 25% 8% 20% 7% 15% 6% 10% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Credit Suisse BP World Statistical Yearbook, Wood Mackenzie, World Steel Association traded metal products, somewhat similar to the energy complex, are a variety of extracted and processed minerals. Iron ore and coal are concentrated ores and require only relatively modest processing to standardise quality. Copper, zinc, lead, tin and nickel are refined metals from concentrate, while aluminium and the precious metals require further elaborate processing to meet global standards. 137 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 138 COMMODITY INVESTING AND TRADING Figure 6.5 World copper mine production has grown very slowly since the 1990s, but this could change in 2013–14 Mine supply (without disruption), kt Mine supply, kt Increase, % (rhs) 22000 20000 10 8 2015 2013 2014 2011 2012 2010 2009 2008 2006 2007 2005 2003 -2 2004 10000 2001 0 2002 12000 2000 2 1999 14000 1998 4 1996 16000 1997 6 1995 18000 Source: Credit Suisse, Wood Mackenzie Scrap can also be a meaningful source of annual supply for some metals, such as lead and the precious metals. Long lead times for new mines tend to lead to longer price cycles for many metals. In Figure 6.5, copper mine production can be seen to have grown only modestly from 2004 to 2012, despite a massive increase in copper prices. This is due to the lagged response of mine supply to price. The cost of supply is the other supply-side factor that supports prices. Figure 6.6 depicts the industry cost curve for aluminium in 2012, and this can be used as an indication of sustainable prices in the medium term. However, this support level is not a stationary one as most elements of mine supply costs – such as labour, power, equipment and energy – are also cyclical. Using copper as an example, Figure 6.7 illustrates the drivers of mined supply costs and also highlights the sharp escalation in costs in copper mine supply since 2005. In money-of-the-day terms, mine site cash costs have doubled, largely due to steep increases in the unit costs of labour (direct wages), service provision (essentially a form of labour) and consumables. Energy costs have also risen, but for copper mines these are a smaller proportion of costs than, say, aluminium production. 138 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 139 THE METALS MARKETS PRICES As discussed earlier, the key to fundamentally driven commodity pricing is the relationship between inventories and price. The actual or estimated level of inventories, best measured in terms of consumption, and the expected change in inventories, known as the market balance, are the core drivers for the price level, the volatility of prices and the shape of the forward price curve. The metals markets tend to have long price cycles due to the long lead times in mined supply. Figure 6.8 depicts a long-term time Figure 6.6 Aluminium cost curve (2012) 3,500 Cash cost (C1) Cash cost (C1)($/t) 3,000 2,500 2,000 1,500 1,000 500 0 0 20,000 Production (kt/a) 40,000 Source: Credit Suisse, Wood Mackenzie Figure 6.7 Copper mine costs of production: sharp rises in consumable and labour costs 4000 3500 3000 Services & other 2500 Stores 2000 Fuel 1500 Electricity 1000 Labour 500 0 1990 1995 2000 2005 2010 2012 Source: Credit Suisse, Wood Mackenzie 139 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 140 COMMODITY INVESTING AND TRADING series for base metals showing how long the price cycle tends to be and also, interestingly, that current prices for base metals are not significantly high in real terms. This is despite the fact that since 2002, the prices of all metals have risen significantly, with gold and iron ore reaching all time highs in 2012, as shown in Figure 6.9. The rise of electronic access to commodity markets and growth in high-speed trading technology has, in our view, changed short-term commodity pricing dynamics – not necessarily for the better or worse, just changed. A standard technical analysis for copper, for instance, has become a new challenge for traditional commodity Figure 6.8 Average real base metal prices 8 Principal component 7.5 Equally-weighted metals index (logs, rhs) 6 7.0 4 20 years! 24 years! 12 6.5 years so far..! 6.0 17 years! 19 years! 2 0 23 years! 19 years! 5.5 -2 5.0 -4 4.5 -6 -8 1850 4.0 1870 1890 1910 1930 1950 1970 1990 2010 Source: Credit Suisse, IMF, Bloomberg Professional Service Figure 6.9 Gold, oil, iron ore and copper remain expensive relative to history 250% 200% 150% 100% 50% 0% -50% -100% Aluminium Wheat Corn Zinc T. Coal Nickel Tin Lead Source: Credit Suisse, IMF, Bloomberg Professional Service Note: Indexed to 2002 prices 140 Copper Iron Ore Brent Crude Gold 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 141 THE METALS MARKETS market participants, including (perhaps even especially) specialist commodity hedge funds. A paper on this topic (Filimonov, V., D. Bicchetti, N. Maystre and D. Sornette, 2013, “Quantification of the High Level of Endogeneity and of Structural Regime Shifts in Commodity Markets”, SSRN) concluded that there is evidence of greater price endogeneity rather than external news/factors. Other markets have gone through the same evolution, and the metals market is no different. It does not mean the physical commodity fundamentals have become irrelevant – indeed, return dispersion suggests the opposite – it simply means that there are a few more variables added to the market. Macro factors have latterly become a more important driver of, or rationalisation for, metal prices. The two factors that have endured the cycles as being an influence on metals prices, or being influenced by metal prices, are currencies and inflation. Figure 6.10 shows a long-run series of copper prices in a variety of currencies; it is notable that for key cycles the price experience can diverge significantly. This is relevant to metal price formation, as a weak domestic currency is a positive for producers and a negative for consumers, with the oppositive also being the case. The link between metal prices and inflation is more muted for most metals, with the clear exception for gold. For many reasons, gold is an exception to the price formation basis for the majority of the metals markets. It has often been seen as a long-term preserver of Figure 6.10 Currency appreciation significantly affected copper prices 700 USD AUD JPY 600 500 400 300 200 100 0 1971 1981 1991 2001 2011 Source: Credit Suisse, IMF, Bloomberg Professional Service 141 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 142 COMMODITY INVESTING AND TRADING wealth and, therefore, a hedge against inflation. Certainly it is true that, at times, gold prices can be highly correlated with inflation expectations (see Figures 6.11 and 6.12). The bulk of this chapter has discussed spot or front price formation, which is the prime focus for metals market analysis as it determines the demand for physical metal for immediate delivery – Figure 6.11 Gold versus five-year TIPS (since 2007) $2,000 $1,750 -3.0 Gold, $/oz (LHS) -2.0 US 5 year TIPS, % (scale inverted) $1,500 -1.0 $1,250 0.0 $1,000 1.0 $750 2.0 $500 3.0 % $250 Jan-07 4.0 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Source: Credit Suisse, IMF, Bloomberg Professional Service Figure 6.12 Gold versus five-year TIPS $2,000 -2.0 $1,750 -1.0 $1,500 0.0 $1,250 1.0 $1,000 2.0 $750 Gold, $/oz (LHS) 3.0 $500 US 5 year TIPS, % (scale inverted) $250 Jan-09 4.0 Jan-10 Jan-11 Jan-12 Source: Credit Suisse, IMF, Bloomberg Professional Service 142 Jan-13 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 143 THE METALS MARKETS from which all market price points are determined. However, when trading the metals markets, much discussion revolves around the point of the forward price curve that needs to be traded and to what degree that point does or does not reflect the expectations already “priced-in” to the market. For example, in Figure 6.13, the iron ore market curve changed significantly in both shape and level over several months reflecting how changes in market expectations, the demand from physical consumers for immediate delivery of metal and the flow of business across the various points of the curve can shift and reshape the forward prices. Commodities with relatively low levels of available inventory tend to be in backwardation, with nearer-dated futures contracts at higher prices than the futures contracts further out the curve, reflecting the premium that the consumer is willing to pay to secure metal. If the contrary is true, and the market is perceived to be in ample or over-supply, then the futures curve tends to be upward sloping, and the market is said to be in contango. Metals tend to have a somewhat more consistent contango compared to energy due to the relative ease of storing metals. Gold is the extreme example of this, with storage of gold being a tiny fraction of its cost and, therefore, gold tends to trade in perpetual contango Figure 6.13 Iron ore market curve Iron ore 62% China (TSI) swaps : NYM : last price : 6/4/2013 Iron ore 62% China (TSI) swaps : NYM : last price : 12/5/2012 Iron ore 62% China (TSI) swaps : NYM : last price : 5/3/2013 125 115 USD/metric tonne 120 110 Dec 2014 Oct 2014 Aug 2014 May 2014 Mar 2014 Dec 2013 Oct 2013 Jul 2013 May 2013 Feb 2013 Dec 2012 105 Source: Credit Suisse, Bloomberg 143 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 144 COMMODITY INVESTING AND TRADING with forward prices driven by the US interest rates minus the storage or leasing rate. For other metals, such as aluminium, there is also a tendency towards contango as inventory tends to be built and held for large consumers, such as car manufacturers. Operators with their own storage facilities and/or access to cheaper finance can sometimes buy and hold physical metal against an offsetting paper position for a (largely) risk-free return. BASE METALS The base metals, also known as industrial metals or non-ferrous metals, are aluminium, copper, zinc, lead, nickel and tin. The world’s benchmark contracts are listed on the London Metal Exchange (LME). However, other key contacts include the Comex Copper and Shanghai Futures Exchange (SHFE) copper contracts. The LME has an idiosyncratic trading system. The most active daily price is known as the “three months price”, literally a trading Figure 6.14 Structure of LME futures Daily prompt dates Weekly prompt dates Cash 3 months Monthly prompts to 12, 15, 27, 63 or 123 months 6 months LME Mini 12 Tin PP, LLDPE & Steel Source: London Metal Exchange 144 15 Aluminium (alloy) & NASAAC 27 63 Lead, nickel & zinc Aluminium (Primary copper) 123 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 145 THE METALS MARKETS date which is three months forward of the current day, subject to it being an official trading day (ie, not a UK holiday). Future points on the forward curve are then traded as a spread to the three months price. Figure 6.14 shows the structure of LME futures dates, daily out to three months, weekly to six months and monthly out to 10 years for some products. The LME also remains one of the few remaining open outcry trading markets where the official daily prices are set by the clearing price found across the floor, as it is known. Commercial players (mining companies, industrial users, physical merchants, endconsumers), banks, brokers, hedge funds, and institutional investors are all active participants. Most of the discussion in the chapter so far applies to the base metals markets in terms of market analysis and price formation. We shall now contrast the bulk commodities and precious metals markets. We provide a chart and table summary of the main features of the base metals markets in Figures 6.15–6.18 found at the end of this chapter. BULK COMMODITIES For the purpose of this chapter, we limit our definition of the bulk commodities to the mined materials of iron ore and thermal coal (note that others may include steel and freight within the definition). The bulk commodities are so-called due to the sheer physical volume of production. Both iron ore and coal production are more than the combined output of the six LME metals. However, unlike these metals, the majority of global production of both iron ore and thermal coal is used domestically, with the balance often being shipped long distances to consumers. Both materials have a dominant usage, with iron ore being the key ingredient for steel and thermal coal for energy. Historically, both iron ore and thermal coal were supplied on a contractual basis (typically, annually), based on periodic negotiations between producers and consumers. However, since the early 2000s, both markets have moved away from this structure towards a physical spot market supported by an over-the-counter (OTC) paper forward market. Latterly, clearing of OTC swaps and even futures exchange markets have emerged. The OTC markets are priced 145 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 146 COMMODITY INVESTING AND TRADING against industry benchmark indexes that are based upon spot physical deliveries. Due to the magnitude of the flow and the relative high costs of freight as a percentage of the final price, both iron ore and thermal coal can be quoted by including the cost of freight to the consumer port price (CFR). This is typical for iron ore, or from the port of the producing country before the freight on board (FOB) price, which tends to be more common for thermal coal. PRECIOUS METALS Precious metals, particularly gold, are among the most actively traded commodity markets, with gold having the widest number of trading participants of any commodity, including oil. The precious metals that are actively traded are gold, silver, platinum and palladium. All of these have liquid OTC and exchange-traded markets. Unlike other commodities, they also have a very large physically traded wholesale market, of which London is generally seen as the global centre, although there is a wide range of important local markets across the world. The term “precious” relates partly to their relative scarcity and partly as they are often used as a store of value rather than for direct consumption – although both gold and silver are commonly used as miniature decorations on top of Indian sweets, and hence are genuinely consumed! The precious metals markets are also distinctive in having traditional banking elements – that is, gold can be deposited, on an allocated or unallocated basis, and therefore also borrowed or leased, much like classic money. The precious metals, and particularly gold, have probably more trading centres than any other commodity, despite being globally homogenous. As mentioned, while the global central point for the precious metals market remains London, there are a wide range of very important physical gold markets, including Zurich, Mumbai and Dubai. However, increased market share and overall liquidity lies in the listed exchanges, in particular the New York Mercantile Exchange (Nymex), the Shanghai Futures Exchange (SHFE), the Multi Commodity Exchange (MCX), the Tokyo Commodity Exchange (TOCOM) and the Dubai Mercantile Exchange (DME). Unlike other commodities, a large fraction of all the precious metals mined in history still exist and can be considered, at least 146 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 147 THE METALS MARKETS theoretically, to be above-ground inventory. This is not so much the case in silver, and even less in platinum and palladium, which is why they are more similar to the base metals markets. Furthermore, precious metals, and particularly gold, used as a central bank asset in bar form means that there is also an active and liquid lease or borrowing market, which reduces the scope for physical scarcity to influence the price – although occasionally certain bars or coins may trade at a higher premium due to their individual scarcity. Instead, market sentiment tends to dominate precious metals prices and this can be influenced by many differing elements, of which physical supply and demand is just one; others include inflation, currencies, geopolitics and uncertainty or risk more generally. The jewellery sector is important for all the precious metals markets, while industrial usage is also important for silver, platinum and palladium. Physical investor demand is also a key factor, with increased accessibility through exchange-traded funds having become a major market influence and now also a major inventory. CONCLUSIONS The chapter was primarily designed to provide an initial guide to analysing the basic material of metal markets. It should hopefully have become clear that while there are overarching similarities to the group, specific analysis requires a quite idiosyncratic approach to not only each market’s supply, demand and inventory, but also to its relationship to other commodities, particularly other metals, as well as wider macro relationships. In reality, each individual market could have an entire book dedicated to its analysis. The global metals markets are at a pivotal time. Since the early 2000s, prices have often been gripped in the so-called “super-cycle”. Definitions vary on what “super-cycle” means, but for some it is higher than average real or nominal prices. Under such a definition, we think this will continue. However, for most it means synchronous rising metal prices, and this we do not think will occur. The true super-cycle, from 2002 to 2007, was buoyed by a range of synchronised, positive physical and financial factors that combined to drive prices to historical nominal highs. In summary, the physical factors driving the metals markets are shown below. 147 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 148 COMMODITY INVESTING AND TRADING ❏ Demand surge: ❍ Chinese; ❍ emerging markets; and ❍ moderate growth across the rest of the world. ❏ Supply constraints and costs explosion: ❍ falling ore grades; ❍ labour shortages and disruption; ❍ technical problems (mines and refineries); ❍ infrastructure bottlenecks, delays and disruptions; ❍ resource nationalisation; ❍ environmental and social legislation; ❍ reduced availability of scrap; and ❍ shift to underground mining. ❏ Inventory declines: ❍ falling visible exchange inventories; and ❍ off-exchange inventories either falling or not being made available. ❏ Investor buying: ❍ Investor buying: ❍ index inflows; ❍ structured product buying; and ❍ exchange-traded product demand (ETFs, etc). ❏ Hedge fund buying: ❍ commodity specialist fund buying on constructive S&D; ❍ macro hedge funds buying on a China play and/or US dollar weakness; and ❍ technical traders buying due to signals and momentum. ❏ Corporate flows: ❍ consumer forward buying due to concerns over price rises; and ❍ producer reductions of existing hedge books – ie, net buying. Looking forward, many of these factors are, or are likely to be, much less positive; indeed, they may become negative influences on price over the next few years. Generally, we still expect nominal and real prices to hold in a higher range compared to history, but we also expect to see greater variation in individual metals. The winners are likely to be those where we see little likelihood of sustained increases in supply – such as zinc, lead, platinum, palladium and copper. 148 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 149 THE METALS MARKETS Figure 6.15 Industrial metals: aluminium Demand by sector Other, 5% Machinery & equipment, 8% Construction, 19% Consumer goods, 9% Packaging, 13% Transport, 32% Electrical, 15% Demand by country 50% 2003 45% 2012 45% 40% 35% 30% 27% 24% 25% 20% 19% 18% 17% 15% 15% 14% 10% 3% 3% 5% 3% 2% 2% 2% 2% 1% 1% 1% Middle East Africa Oceania 0% China Europe Asia North America Latin America Russia Cost curve 3,000 90% minus premium: US$1,812 US$/t 2,500 90%: US$2,072 US$280/t premium added 2,000 92% 80% Current LME Cash: US$1,893 1,500 1,000 Source: Credit Suisse, Wood Mackenzie, International Aluminium Institute 149 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 150 COMMODITY INVESTING AND TRADING Figure 6.15 Industrial metals: aluminium (cont.) Costs breakdown Other, 10% Labour, 6% Alumina, 31% Energy, 39% Carbon & bath, 14% Supply by country 50% 46% 2003 2012 45% 40% 35% 30% 25% 20% 20% 20% 18% 14% 15% 10% 10% 10% 9% 8% 5% 5% 8% 8% 5% 4% 4% 4% 5% 3% 0% China North America Russia Europe Middle East Oceania Asia Latin America Integrated aluminium-making process flow chart Bauxite mining Stage 1 – refining Alumina refining Stage 2 – smelting Recycling Aluminium smelting Processing Extrusion Rolling Casting Source: Credit Suisse, Wood Mackenzie, International Aluminium Institute 150 Africa 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 151 THE METALS MARKETS Figure 6.16 Industrial metals: copper Demand by sector Consumer products, 9% Industrial machinery, 13% Electrical/electronics, 34% Transportation, 14% Construction, 30% Demand by country % of global copper demand 40 37.7 35 30 25 19.8 20 15 12.2 9.4 10 8.6 5 8.9 6.6 5.1 5.7 4.5 1.9 3.2 4.4 3.0 4.1 2.9 1.3 1.9 2.2 1.9 Taiwan Russia Brazil 0 China USA Germany Japan South Korea India Italy Cost curve 10000 9000 8000 Current price = US$7,370/t 7000 6000 90th percentile = US$5,335/t 5000 4000 3000 2000 1000 0 0 5,000 10,000 15,000 Source: Credit Suisse, Wood Mackenzie, Teck 151 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 152 COMMODITY INVESTING AND TRADING Figure 6.16 Industrial metals: copper (cont.) Costs breakdown Services/other, 23% Labour, 25% Electricity, 13% Stores, 32% Fuel, 8% Supply by country 50% 45% 2003 44% 43% 2012 40% 35% 30% 25% 20% 15% 13% 15% 9% 10% 4% 5% 9% 9% 7% 7% 9% 6% 6% 6% 4% 5% 1% 2% 0% Latin America North America China Africa Russia Oceania Europe Asia Middle East CESL copper process flowchart Evaporator Condensate Raffinate Oxygen Thickener Copper concentrate Pressure oxidation Wash water Atmospheric leach (optional) Pregnant leach solution (PLS) Limestone Neutralisation To pressure oxidation Residue washing (counter current decantation) Wash water Filtration Solvent extraction Filtration Electrowinning Leach residue (to gold plant) Source: Credit Suisse, Wood Mackenzie, Teck 152 Gypsum (to tailings) Copper cathode (to market) 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 153 THE METALS MARKETS Figure 6.17 Industrial metals: nickel Demand and industrial production 15% 16% IP – Mature economies (LHS) IP – Developing economies (LHS) Nickel consumption (RHS) 12% 10% 8% 5% 4% 0% 0% -5% -4% -10% -8% -12% 19 8 19 6 8 19 7 8 19 8 8 19 9 9 19 0 9 19 1 92 19 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 00 20 0 20 1 0 20 2 0 20 3 0 20 4 0 20 5 06 20 0 20 7 0 20 8 0 20 9 10 -15% Demand by country USA 10% Other 28% China 33% Germany 7% Taiwan 5% Korea 6% Japan 11% Cost curve 25,000 Ramp-ups, NPI and tocantins 92.7% LME cash 20,000 Price: US$18,917 US$/tonne 15,000 Median: US$10,136 10,000 5,000 0 -5,000 90%: US$15,945 -10,000 Source: Credit Suisse, Wood Mackenzie, Nickel Institute 153 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 154 COMMODITY INVESTING AND TRADING Figure 6.17 Industrial metals: nickel (cont.) Nickel production 1400 Sulphides Laterites 1200 1000 800 600 400 200 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 First use consumption Electroplating 11% Others (incl. chemicals) 6% Other steel alloys (incl. castings) 10% Non-ferrous alloys 12% Stainless steels 61% Demand by application Tubular products 10% Other 7% Building & construction 11% Engineering 24% Electro & electronic 15% Metal goods 16% Transportation 16% Source: Credit Suisse, Wood Mackenzie, Nickel Institute 154 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 155 THE METALS MARKETS Figure 6.18 Industrial metals: zinc Demand and industrial production 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% 1990 1992 1994 1996 1998 Global IP growth (YOY%) 2000 2002 2004 2006 2008 2010 Est. refined zinc consumption growth (YOY%) Demand by country Latin America 5% Oceania 2% Africa 1% Japan 4% Asia (excl Japan & China) 18% China 41% North America 10% Europe 19% Cost curve 90%: US$1,524 2,500 2,000 US$/tonne 1,500 US$120/tonne premium 99.1% LME cash price: US$1,847 1,000 95.9% Median: US$965 500 0 -500 -1,000 Source: Credit Suisse, Wood Mackenzie 155 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 156 COMMODITY INVESTING AND TRADING Figure 6.18 Industrial metals: zinc (cont.) Supply by country India 6% Russian Fed. 2% Europe 6% China 30% Other Asia 7% N. America 12% Australia 12% L. America 22% First use consumption Miscellaneous 4% Rolled & extruded products 7% Oxides & chemicals 8% Galvanising 57% Decasting alloys 11% Demand by application Industrial machinery 7% Consumer products 8% Infrastructure 13% Transport 23% Construction 49% Source: Credit Suisse, Wood Mackenzie 156 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 157 THE METALS MARKETS Figure 6.19 Bulk commodities: iron ore 210 Iron ore (62% Fe CFR Tianjin spot) Quarterly avg forecasts 190 170 US$/t 150 130 110 90 70 50 2009 2010 2011 2012 2013 2014 140 Spot Price US$ per dry metric tonne 120 100 Consensus CS price forecast 80 60 40 20 0 0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400 1500 1600 Million tonnes per annum BHP.AX CLF FMG.AX KIOJ.J RIO.AX VALE.N China Other Reported Cash Cost (FOB) All-In Cash Cost (FOB) All-In 62% IODEX equiv (CFR) Source: Credit Suisse, Wood Mackenzie, Company data 157 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 158 COMMODITY INVESTING AND TRADING Figure 6.20 Bulk commodities: coal Types of coal CARBON/ENERGY CONTENT OF COAL HIGH HIGH MOISTURE CONTENT OF COAL USES % OF WORLD RESERVES Low rank coals 47% Lignite 17% Hard coal 53% Sub-bituminous 30% Bituminous 52% Thermal Steam coal Largely power generation Power generation Cement manufacture Industrial uses Anthracite -1% Metallurgical Coking coal Power generation Manufacture Cement manufacture of iron Industrial uses and steel Domestic/ industrial including smokeless fuel Major contributors to seaborne demand India 50 RoW China 40 30 20 10 0 -10 2011 2012 2013 2014 2015 Major contributors to seaborne supply Australia 40 RoW Indonesia 35 30 25 20 15 10 5 0 2011 2012 2013 2014 Source: Credit Suisse, Wood Mackenzie, World Coal Institute 158 2015 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 159 THE METALS MARKETS Figure 6.21 Precious metals: gold Above ground stocks 60,000 Cumulative supply used as investment Cumulative supply used in jewelry Near to market 50,000 Cumulative supply used in industry/dental Tonnes 40,000 Annual mine supply 30,000 20,000 Far from market 10,000 0 2000 2002 2004 2006 2008 2010 2012 Demand by sector Bar coin retail investment 26% Dental 1% Jewellery 57% Industrial 11% Cost curve 1800 C3 costs (real) 1600 Average gold price (real) $/oz Au 1400 1200 1000 800 600 400 200 1980 1985 1990 1995 2000 2005 2010 Source: Credit Suisse, Wood Mackenzie, GFMS, Thomson Reuters, World Gold Council, Bloomberg Professional Service 159 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 160 COMMODITY INVESTING AND TRADING Figure 6.21 Precious metals: gold (cont.) Supply by sector Old gold scrap 39% Mine production 60% Official sector sales, 1% Mine supply by country 8, 1 9,000 34 Central bank reserves 8,000 7,000 160 06 3,7 80 3 Belgium Australia Canada Other 280 228 Austria 287 282 Spain Lebanon 445 310 UK Turkey 366 323 Venezuela Saudi Arabia 424 383 Taiwan Portugal 558 502 ECB Netherlands India 765 613 Russia IMF 2012A Mine Germany 0 United 1,000 Japan 1, 0 996 Switzerland 40 03 54 China 2, 3 2,000 1,0 2012A 52 35 2,4 2,4 Italy 3,000 France 14 2,8 17 4,000 2, 8 91 5,000 3, 3 Tonnes 6,000 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 161 THE METALS MARKETS Figure 6.22 Precious metals: silver Supply sources Scrap 20% Mine production 77% Government sales 3% Mine supply sources Gold 11% Others 1% Primary silver 28% Zinc & lead 37% Copper 23% Supply trends Mine production Producer hedging 1.0% growth rate Net official sector sales Implied net dis-investment 2.5% growth rate Silver scrap Zero growth 5.0% growth rate 1,200 1,200 1,000 1,000 800 800 600 600 400 400 200 200 0 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 0 Source: Credit Suisse, GFMS, Silver Institute 161 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 162 COMMODITY INVESTING AND TRADING Figure 6.22 Precious metals: silver (cont.) Demand trends Industrial applications 1,000 Photography Jewellery & silverware Coins & medals 900 800 700 600 500 400 300 200 100 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Demand by sector Coins & medals 8% Jewellery & silverware 26% Photography 13% Industrial applications 53% ETP demand 500 iShares ETF Securities ZKB physical silver Silver price (US$/oz) 30 450 Mln ounces 400 350 25 20 300 250 15 200 150 100 10 5 50 Ap r Ju -06 n Au -06 g O -06 c D t-0 ec 6 Fe -06 b Ap -07 r Ju -07 n Au -07 g O -07 c D t-0 ec 7 Fe -07 b Ap -08 r Ju -08 n Au -08 g O -08 c D t-0 ec 8 Fe -08 b Ap -09 r Ju -09 n Au -09 g O -09 c D t-0 ec 9 Fe -09 b Ap -10 r Ju -10 n Au -10 g O -10 c D t-1 ec 0 -1 0 0 Source: Credit Suisse, GFMS, Silver Institute 162 0 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 163 THE METALS MARKETS Figure 6.23 Precious metals: platinum Platinum mine supply 9,000 Others Zimbabwe North America Russia South Africa 8,000 '000 ounces 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Palladium mine supply 9,000 Others Zimbabwe North America Russia South Africa 8,000 '000 ounces 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Platinum demand by sector 10,000 9,000 Other Petroleum Medical & biomedical Glass Electrical Chemical Jewellery Autocatalyst Investment '000 ounces 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 -1,000 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Credit Suisse, Johnson Matthey 163 06 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:53 Page 164 COMMODITY INVESTING AND TRADING Figure 6.23 Precious metals: palladium Palladium demand by sector Other Electrical 10,000 Chemical Autocatalyst Jewellery Investment Dental 9,000 8,000 '000 ounces 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 -1,000 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Platinum ETF demand 2,250 2,000 $2,250 Plat. Ldn Bskt Ldn Plat. ZKB Pt other Plat. US Plat. Swiss ABSA Plat, spot $2,000 1,750 $1,750 Thousands oz 1,500 1,250 $1,500 1,000 $1,250 750 $1,000 500 $750 Apr-13 Jan-13 Oct-12 Jul-12 Apr-12 Jan-12 Oct-11 Jul-11 Apr-11 Jan-11 Oct-10 Jul-10 Apr-10 Jan-10 0 Oct-09 250 $500 Palladium ETF demand 2,500 Pall. Ldn Bskt Ldn Pall. ZKB Pall. US Pall. Swiss Pall, spot Pd Other $900 $800 2,000 Thousands oz $700 $600 1,500 $500 1,000 $400 $300 500 164 Apr-13 Jan-13 Oct-12 Jul-12 Apr-12 Jan-12 Oct-11 Jul-11 Apr-11 Jan-11 Oct-10 Jul-10 Apr-10 Jan-10 Oct-09 Jul-09 Jan-09 0 Apr-09 $200 $100 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 165 7 Grains and Oilseeds David Stack Agrimax Grains and oilseeds were the first commodities, the staple of our diet and the basic building blocks for meat and fish (through aquaculture). In developed economies, food represents some 10% of GDP, higher in developing economies. Around 20% of people around the world receive government-subsidised food. This chapter will examine these crops for each of the major producers and consumers around the world, analysing how the meat and fish protein markets impact grains, and the world’s ability to rotate and adjust crop plantings in the face of a changing demand profile. Likely trends are also noted. Once the domain of the big grain companies, these commodities have been a major asset class for investors since the early 2000s, and this chapter will take a bottom-up approach to analysing the most relevant information for the various investment themes and their critical drivers for the years ahead. The traditional power players in the agricultural markets, both originators and exporters, are the US, the EU, Brazil and Argentina, and this dominance has been dramatically affected by the increasing importance in price formation of nontraditional spheres of influence. Investment themes here have been greatly influenced by a number of factors, such as the emergence of China as the world’s largest grain economy – while US grain consumption as ethanol has made it a significantly less important player for global grains – biofuels in general, urbanisation and its attendant social changes, dramatic changes in food consumption and rapidly changing agricultural and environmental policy around the globe. Surprises that have led to a tightness in these markets include the 165 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 166 COMMODITY INVESTING AND TRADING disappointment of genetic modification (GM) to deliver on its promise of dramatically improving yields, the slow growth of supply versus the expected marginal supply curve and the high rate of expansion of China’s soya demand. There have been the usual droughts, food scares and a heightened sensitivity to food price inflation, as well as the global economic crisis and Arab Spring that affected all investors and markets. However, a number of important players have entered the agricultural markets. Land investment has become a mainstream activity, with some spectacular successes and many failures. The markets evolved from talking about speculation and land grabs to dividing the new investors into multiple investment styles (as many as 10, see Appendix 7.1). Some have embraced the traditional, fundamental style of the agricultural markets, while others introduced new methodologies. Finally, the Dalian Commodity Exchange became the second-largest futures market in the world, forever changing the role and dominance of the Chicago Board of Trade (CBOT). Uniquely, we will examine non-US grain and oilseed economies; the US is already data-rich and over-analysed, at a time when its importance in the global grains markets is declining. We look at the evolution of the Chinese oilseed industry to a staggering 125 million metric tonnes (MMT), far bigger than the US. This chapter will present an in-depth look at key developments around the world since the early 1990s, in particular: ❏ the soybean rally of 2003, a surprise for everyone; ❏ the wheat rally of 2007, from sizzling problems to market explosion; and ❏ the maize rally of the 2000s, and the US corn supply/demand net of ethanol (EtOH). Finally, we will draw from past market developments to define the main issues and opportunities for the forward-looking investor. FEEDGRAINS, FOODGRAINS AND VEGETABLE PROTEINS: THREE MARKETS, THEIR INDIVIDUAL ECONOMIES AND INTERDEPENDENCE The dynamic of these markets lies within the fundamentals, and this remains the key to understanding them. By first examining the trends for each of these three markets, and their major producers and consumers in terms of both the switchable and non-switchable 166 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 167 GRAINS AND OILSEEDS demand and economic drivers, we can then progress to the role of rotation in their convergence. The world harvests 2,525 MMT of major grains (corn, sorghum, barley, wheat, rice, soybeans, rapeseed and sunseed – See Table 7.1) on 800 million hectares (MHas) of land. Across the major producing countries, the land is devoted as follows: 79% grains (27% maize, 6% sorghum, 8% barley, 35% wheat and 25% rice) and 21% softseeds (64% soybeans, 21% rapeseed and 15% sunseed). The average yield is 3.20 MT, of which grains average 3.40 MT and softseeds average 2.20 MT. By crop, the global averages are maize 5.00, sorghum 1.50, barley 2.63, wheat 3.00, rice 2.88, soybeans 2.50, rapeseed 1.75 and sunseed 1.50. The gross production tonnages provide the base volume for each local grain economy, which subsequently consumes, exports or stores any excess to those two basic needs. We need to understand the local economy drivers and also the export availabilities. These exportable volumes, and the extent to which they are needed in other parts of the world, drive the price as we see it on the futures markets and through the various cash or physical prices the commercial world has access to. AYP is the common industry abbreviation for area in terms of MHa, yield in metric tonnes per hectare (Mt/HA) and production (the product of A and Y). In this section, we will discuss the current AYP for each major grain, where appropriate the whole grain economy for the major grains, the evolution of the major producer economies since the early 1990s and their changing role in price formation, as well as some thoughts on how this may evolve. The following is a summary of the total of 2,525 MMT of grain production: 850 MMT comes from the nine major maize producers (see Table (member states of ndependent States c of South Africa rs (see Table 7.3c) – s (see Table 7.3b) – or producers (see , EU-27, Morocco, and 167 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 168 COMMODITY INVESTING AND TRADING ❏ 460 MMT of rice comes from four major producers (see Table 7.7) – Brazil, Thailand, China and India. Of the soft oilseed total of 350 MMT: ❏ 250 MMTof soybeans are from four major producers (see Table 7.9a) – US, Argentina, Brazil and Paraguay; ❏ 60 MMT of rapeseed are from four major producers (see Table 7.9b) – Canada, EU-27, China and India; and ❏ 40 MMT of sunseed are from three major producers (see Table 7.9c) – Canada, EU-27 and CIS/FSU. Hard oils (palm oil production) are dominated by Malaysia and Indonesia at 38MMT (see Table 7.2). Each major producer has a substantial grain economy for each grain, and many interact since feedgrains are often combined with oilseed meals – for example, to make complete animal diets. Each of these economies is different and evolving. There are few clean lines, with many feedgrains also being foodgrains, and feedgrains being a major feedstock for biofuels (primarily ethanol, but also sugar cane), as is vegetable oil (primarily biodiesel). In Table 7.1 and subsequent tables we compare the last three-year average of 2010, 2011 and 2012 (2010–12) to the previous three-year averages of five years ago (2005–07), 10 years ago (2000–02), 15 years ago (1995–97) and 20 years ago (1990–92), to avoid blips in individual years. We see from this summary that, although the grains area appears remarkably stable over time (3% 20-year growth), the oilseeds area has expanded by more than 75%. For combined grains and oilseeds, the 20-year yield growth has been 24% on an overall hectare expansion of 13%, leading to a production increase of 40%. For total arable land, the last five-year’s production growth came evenly from area (5%) and yield (6%). Additionally, we must remember that in this period the US took around 160,000 km2 or 18.1 MHa (equal to 40 million acres, MAc) out of production through its Conservation Reserve Program (CRP). Also, in this period the EU ran its Cereal Set-aside programme. Setaside became compulsory in 1992, primarily as a means of reducing the “grain mountain” as part of the Common Agricultural Policy. It was originally set at 15%, before being reduced to 10% in 1996 and then abandoned in September 2007. 168 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 169 Table 7.1 Grain and oilseed 20-year AYP progression – comparing three-year averages of 2010–12 (absolute values) and percentage growth from 2005–07 (5-year growth), 2000–02 (10-year growth), 1995–97 (15-year growth) and 1990–92 (20-year growth); MHa, Mt/Ha and MMT Crop Last three-year average (2010–12) Area A Grains Oilseeds Total arable 635 164 799 Yield Y Prdn P 3.400 2.200 3.200 2170* 2% 355 15% 2525 5% 2005–07 2000–02 AYP % growth 8% 3% 6% 10% 18% 11% 1995–97 AYP % growth 6% 34% 11% 16% 8% 13% 23% 45% 26% 1990–92 AYP % growth 2% 52% 9% 23% 20% 20% 25% 82% 31% AYP % growth 3% 78% 13% 28% 31%** 27% 125% 24% 40% Source: Adapted from Informa; * 635/3.40/2,170 means grains area is 635 MHa, world average yield is 3.40 Mt/HA and world production is 2,150 MMT; ** 3%/28%/31% means grains area has grown 3% in 20 years, yield has grown 28% and production by 31% GRAINS AND OILSEEDS 169 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 170 COMMODITY INVESTING AND TRADING Table 7.2 Major exporters and major importers, by grain or vegetable protein Corn/Maize 100 MMT Top 10 Exporters 1 US 2 Argentina 3 Ukraine 4 Brazil 5 India 6 Russia 7 RSA 8 Paraguay 9 Canada 10 EU-27 Corn/Maize Wheat 130 MMT Soybeans/Meal/Oil 93/55/8 MMT Rapeseed 11MMT Palm Oil 38 MMT 70% of the 54 MMT of global veg oil US Australia Canada EU-27 Russia Argentina India Ukraine Kazakhstan Turkey US/Arg/Arg Brz/Brz/Brz Arg/US/US Paraguay/India– Canada/China/– Canada Australia Ukraine Indonesia (19.0) Malaysia (18.7) Wheat Soybeans/Meal/Oil Rapeseed Palm Oil China/EU/China EU27/Indonesia/ India Mexico/Vietnam/ Iran Taiwan/Thailand/ Bangladesh Japan/Japan/ Venezuela Thailand/Philipp/ Peru Indonesia/Iran/ Algeria Egypt/South Korea/ Egypt US/Mexico/South Korea South Korea/Canada & Colombia/ Morocco & RSA EU-27 India Japan China China EU27 Mexico Pakistan US Singapore Canada Egypt Top 10 Importers 1 US EtOH Egypt 2 Japan Brazil 3 EU-27 Indonesia 4 Mexico Japan 5 South Korea Algeria 6 Egypt South Korea 7 Iran Mexico 8 Taiwan Iraq 9 Colombia Morocco 10 Algeria Nigeria/Philipp. US Bangladesh CIS/FSU Iran, Vietnam & Japan FEEDGRAINS There are three major feedgrains in the world – corn, sorghum and barley – the production of which amounts to 1,045 MMT. However, we must add significant volumes of feed wheat consumed in China (10–12 MMT), the EU (49–57 MMT in 2007–12), Russia (13 MMT) and 170 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 171 GRAINS AND OILSEEDS India (3–4 MMT), a total of 80 MMT. It is important to remember that significant quantities of feed wheat produced globally is fed to animals – the broad consensus says this is about 17% of global wheat production, or 115 MMT. The world harvests 855 MMT of maize annually, whose major economies are the US (300), Argentina (25), Brazil (65), Mexico (20), France (15), EU-27 (60), CIS/FSU (30), RSA (10), Thailand (5) and China (195). Grain sorghum production of 60 MMT, widely distributed around the world, has major production in the US (7), Argentina (5) and Australia (2). For both of these crops, there is also significant non-grain production as feed, used as “silage” – best described as a whole, above-ground crop, whose stems, leaves and grain ear are pickled in vinegar (eg, formic acid) to preserve it, before it is stored and fed to livestock over the following winter. Barley totals 130 MMT, of which Canada (10), EU-27 (55) and CIS/FSU (25) are the major economies. Note that, at 130 MMT, barley production is greater than China’s wheat production (second only to EU wheat production) and twice that of Brazil’s corn production (the world’s third-largest corn producer). Both barley and sorghum are in decline in terms of devoted area and the world barley and feed-wheat markets are the same size. The major feedgrains are starch or carbohydrate producing and consumed by animals, hence the feed designation. They also have considerable industrial use. We can divide the animal kingdom into two stomach types: monogastric and ruminant. We humans are monogastric, having “one simple stomach”, as are pigs and chickens, while cattle are ruminants, having a “rumen”. The rumen can be thought of as a vat, capable of stewing and digesting highly fibrous food, such as grass and leaves, which contain carbohydrates bound by lignin, a complex fibre. Feeds such as potatoes require boiling to break down their complex carbohydrate structure to make them easily digestible for monogastrics. Grains are simply processed by grinding to break down the husk or outer covering, rendering them easily digestible to a ruminant, while full milling and husk removal makes them also easily digestible by monogastrics. As the reader will be well aware, there is an ongoing conflict between ease of digestibility and the many essential nutrients found in the husk – wholegrain bread being the classic compromise for humans. 171 Table 7.3a Maize 5-, 10-, 15- and 20-year AYP progression (comparing 2010–12 with 2005–07, 2000–02, 1995–97 and 1990–92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given Maize / Corn US Argentina Brazil Mexico France EU 27 CIS/FSU South Africa Thailand China World total 35% 21% 3% 2% 8% 10% 2% 5% 2% 1% 7% 3% 3% 2% 1% 3% 1% 1% 23% 16% 100% 100% 34.1 3.7 14.4 6.5 1.6 8.6 5.9 3.1 1.0 33.3 168.6 8.834 6.625 4.526 3.087 9.347 6.870 4.734 3.953 4.248 5.779 5.061 Prdn P 301 24 66 20 15 59 28 12 4 193 853 2005–2007 AYP % growth 9% 28% 4% –8% 6% –1% 58% 13% –1% 19% 11% –6% –1% 25% 1% 4% 11% 31% 20% 13% 10% 5% 2% 26% 30% –8% 10% 9% 110% 34% 12% 30% 16% 2000–2002 AYP % growth 20% 44% 15% –11% –13% –6% 120% –11% –13% 39% 23% 5% 12% 41% 18% 5% 14% 66% 48% 11% 22% 16% 26% 62% 62% 5% –8% 7% 269% 33% –3% 69% 43% 1995–1997 AYP % growth 20% 19% 11% –16% –7% 24% 130% –18% –11% 41% 22% 15% 35% 79% 34% 12% 0% 64% 61% 28% 19% 24% 38% 59% 100% 13% 3% 35% 271% 32% 15% 68% 52% 1990–1992 AYP % growth 22% 63% 9% –7% –8% 97% 108% –8% –22% 56% 29% 18% 59% 114% 38% 32% –3% 51% 82% 55% 27% 32% 43% 158% 133% 27% 21% 89% 216% 68% 20% 99% 69% % Of world yield 178% 133% 90% 63% 188% 138% 95% 80% 85% 115% 100% Table 7.3b Barley 5-, 10-, 15- and 20-Year AYP Progression (comparing 2010-12 with 2005-07, 2000-02, 1995-97 and 1990-92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given Last 3 year average 2010–2012 Area A Yield Y Barley Canada EU–27 CIS/FSU World total 5% 5% 25% 20% 27% 37% 100% 100% 2.5 12.5 13.5 49.5 3.125 4.250 2.000 2.625 Prdn P 8 53 27 129 2005–2007 AYP % growth –30% –11% –18% –12% 5% 6% 7% 8% –27% –5% –12% –5% 2000–2002 AYP % growth –37% –12% –17% –10% 20% 0% 2% 5% –25% –12% –16% –6% 1995–1997 AYP % growth –46% –17% –42% –26% 4% 3% 39% 16% –44% –15% –18% –14% 1990–1992 AYP % growth –40% –15% –50% –33% 9% 4% 10% 13% –35% –12% –45% –25% % Of world yield 119% 162% 76% 100% Table 7.3c Sorghum 5-, 10-, 15- and 20-Year AYP Progression (comparing 2010-12 with 2005-07, 2000-02, 1995-97 and 1990-92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given Last 3 year average 2010–2012 Area A Yield Y Sorghum US Argentina Australia World total 5% 10% 3% 2% 2% 1% 100% 100% 1.9 1.1 0.7 38.5 3.713 4.367 3.181 1.527 Prdn P 7 5 2 59 2005–2007 AYP % growth –21% 87% –12% –8% –10% –7% 11% 4% –30% 74% –7% –4% 2000–2002 AYP % growth –41% 4% 93% –12% –11% 36% –5% 3% –39% 70% 20% –3% 1995–1997 AYP % growth –53% 53% 20% –9% –8% 11% 33% 5% –57% 67% 59% –4% 1990–1992 AYP % growth –56% 52% 46% –3% –9% 18% 64% 5% –60% 78% 133% 2% % Of world yield 243% 286% 208% 100% 172 COMMODITY INVESTING AND TRADING 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 172 Last 3 year average 2010–2012 Area A Yield Y 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 173 GRAINS AND OILSEEDS For many animals, grains are a simple supplement for their diet (eg, beef cattle that consume mainly forage), while dairy cows, pigs and poultry require a considerable amount of protein to be added to their diet since they perform optimally with a 20–25% protein feed, almost twice that of any cereal grain. This implies a 75:25 grain:meal combination. Therefore, major feedgrain consumers must also produce or import their protein needs, making the EU a major importer of softseed proteins. Although it may seem very straightforward, the Pearson Square formulation works surprisingly well for estimating diets for forecasting animal or aquaculture needs, and is easily found with a web-search. Biosystems, of which one is the stomach, are complex and a series of associative effects can be observed. We do not digest equally meat and potatoes that are eaten separately, as compared to eating combinations in various proportions. The cooking method and previous meal also influence digestion. We do not similarly digest meat and rice in the same way as meat and potatoes. This leads to feed conversion efficiency (FCE), a metric which is the first step towards metabolisability, the rate at which we actually use the nutrients we have ingested. FCE is normally expressed as kilograms (kg) of dry matter output per Kg of DM feed. In principle, as we allocate raw materials, feedgrains should only go to those processes that efficiently transform them into human food. For example, this means that we would not feed grains to cattle other than what is required to optimise their ability to digest cellulosic feeds. If this were the case, and we were simply economic actors, we would have more than enough to feed the world – however, this would have the effect of large parts of the common diet disappearing around the world. We prefer to eat as we please, dependent on prevailing price and income. Associative effects include the reality of optimised nutrition, combining carbs, proteins and fats to get the optimal feed conversion. Diets have been balanced at the commercial level based on the least-cost formulation since the 1960s, and it remains a simple linear programming exercise. Animal nutrition has advanced much faster than human nutrition, not least because we can isolate genetics and enforce diets for animals, before butchering them to measure the output much more easily than with humans. Optimising nutrition is scientifically easy but socially complex, and we can imagine very 173 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 174 COMMODITY INVESTING AND TRADING different optimal strategies for an Olympic athlete and a couch potato, or a new born infant and an octogenarian. Calories are to modern nutrition what gasoline was to the Model T Ford: raw energy. We have come to think in terms of metabolisability (usefulness) of carbs, proteins and fat, and also the various micronutrients and salt balances that influence our bodies and lives. Wheat and barley belong to a category of grains (which includes oats) that the US Department of Agriculture (USDA) refers to as the “small grains”, and which are reported separately. A report issued annually in December and various updates provide detail on a stateby-state basis of the AYP of these three crops. The EU treats wheat in the same way that the US does maize, since it is the base of animal feed, and consequently describe everything else as “coarse grains”. The reader must be careful to compare coarse grains in different grain economies – they mean different things. There are over a dozen major feedgrain economies in the world, all growing grains and other food and feed in rotations – customised for the location, growing degree days (GDDs) and current economics. A major grain economy is defined by the author as one producing more than several million tonnes in excess of its local requirements through rotation. An example is Ukraine, which produces roughly 0.5 tonnes of wheat per capita. Its enormous simultaneous local production of potatoes leaves it with a huge exportable surplus of basic carbohydrate. The US produces one tonne of corn for every inhabitant. Once you get in the grain or oilseed producing business as a farmer, the quality of your output and its ultimate designation as food or feed will depend on the variety you chose to plant, how you cared for it, mother nature (weather), evolving global demand, the market where you choose to sell it and the degree to which it is carefully handled, processed, marketed and blended. In the early 1990s, the US dominated the maize market globally as a producer and exporter. Its exports were residual to its own animal feed and food, seed and industrial (FSI) needs, and it carried large stocks. In 1990/91, the US had almost 35 MMT in stock, producing 200 MMT and exporting 55 MMT. The US Maize crop year (CY) begins in September and ends before or at the start of harvest in August of the subsequent year. Optimal planting is between April 1st and May 30th while harvest runs from August 20th to November 174 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 175 Table 7.4 True US corn (maize) annual S&D (MMT), using 1990/91 crop year alcohol as base: a 20-year perspective (September– August crop) Crop year 1995/96 2000/01 2005/06 2010/11 2011/12 2012/13 27.1 7.44 26.4 7.12 29.3 8.59 30.4 9.29 33.0 9.59 34.0 9.24 35.5 7.67 34.2 34.2 201.5 201.5 0.1 235.8 235.8 39.6 38.8 188.0 186.8 0.4 228.0 226.8 43.6 42.8 251.9 244.8 0.2 295.7 288.6 53.7 51.9 282.3 250.5 0.2 336.2 304.4 43.4 37.0 316.2 197.6 0.7 360.2 241.6 28.6 21.7 313.9 195.5 0.7 343.3 224.9 25.1 18.1 272.4 164.5 3.2 300.7 192.8 Use Feed & Residual 117.1 % Adj Tot Supply 50% Food/Seed/Ind 36.2 Ethanol FSI 8.9 Fuel FSI 0.0 Non Fuel FSI 36.2 Total FSI as % total supply 15% Non fuel FSI as % total supply 15% Adj domestic use (ex fuel) 153.3 Exports 43.9 Exports as % adj total supply 19% Exports as % adj domestic use 29% Adj total use 197.1 Carryout 38.6 Adj Carryout (ex 20 days 'fuel as corn') 38.2 Adj C/O as % adj domestic use 25% 119.4 53% 41.4 10.1 1.2 40.2 18% 18% 159.6 56.4 25% 35% 215.9 10.8 10.3 6% 147.9 51% 50.2 16.0 7.1 43.1 17% 15% 191.0 49.3 17% 26% 240.3 48.2 47.4 25% 155.3 51% 76.7 40.7 31.8 44.9 23% 15% 200.2 54.2 18% 27% 254.4 50.0 47.7 24% 121.7 50% 163.3 127.5 118.6 44.7 45% 18% 166.4 46.6 19% 28% 213.0 28.6 21.7 13% 115.5 51% 163.5 127.3 118.4 45.1 48% 20% 160.6 39.2 17% 24% 199.8 25.1 18.1 11% 109.2 57% 153.0 116.8 107.9 45.1 51% 23% 154.4 25.4 13% 16% 179.8 13.0 6.6 4% 0.6 0.9 2.2 7.0 7.0 6.4 US (September/August) Harvested Area (MHa) Yield (MT/Ha) Carryin Carryin less 20 days 'fuel as corn' Production Production less EtOH Imports Total supply Adj total supply (ex fuel) 20 days of fuel as corn 0.5 175 Source: Agrimax Note: In each step the traditional USDA format is improved by deducting maize produced for fuel EtOH and the appropriate stocks deducted. GRAINS AND OILSEEDS 1990/91 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 176 COMMODITY INVESTING AND TRADING 30th. Both run progressively northwards. The current crop was planted two weeks late. The US plants 353.5 MHa, and has a threeyear average yield of 8.875 MT/Ha, which includes the disastrous harvest after the drought of 2012. Yields are normally expected to be over 9.0. Since the two major drivers of domestic maize consumption for all major producers are Feed and FSI, Table 7.4 takes the unusual approach of stripping out the “corn-for-ethanol” maize demand to allow accurate comparison with other countries. We can then proceed to examine the US and other maize-economies sequentially and draw some conclusions for the future. Table 7.4 follows usual USDA protocol so Area and Yield are directly comparable with USDA. Thereafter, line by line, it strips out the ethanol demand which is not a grain demand and allows us to get to non-fuel FSI by freezing fuel ethanol demand at 1990/91 CY-levels and shows in the Adjusted domestic use row that demand is in fact almost flat in the US from 1990 CY to 2013. The feed economy One way to quantify grain demand is to employ feed-use data and grain-consuming animal units (GCAUs), factors that allow comparisons of grain demand among different types of livestock. One GCAU is 2.15 tons (short tons have 2,000 pounds, while metric have 2,204.6). The USDA has developed a different factor for each type of livestock based on the average amount that one such animal consumes in a year. For example, a dairy cow has a GCAU factor of 1.0474, while a broiler has a factor of 0.002. Using these factors, we can see that one dairy cow will use the same amount of grain (1.0474 × 2.15 tons = 2.25 tons) in a year, as approximately 523 broilers (one broiler will consume 0.002 × 2.15 tons = 0.0043 tons, and 2.25 divided by 0.0043 equals 523 broilers). The major GCAU factors are feeder cattle: 0.0547, broilers: 0.002, layers: 0.0217, turkeys: 0.0155, dairy (cow + calf): 1.0474 and hogs: 0.2285. Informa Economics, Inc. offers the best analysis of GCAU’s and also protein-consuming animal units (PCAUs), allowing us to view the relative intensity by animal type of each major feed component side by side. Globally, we are eating an increasing amount of white meat, resulting in greater numbers of monogastrics and increased feed conversion efficiency (FCE). Two important issues arise here: there 176 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 177 GRAINS AND OILSEEDS has been a dramatic increase in industrial (large-scale) animal farming since the early 1990s, as well as further urbanisation, which are additive in effect. The effort to supply large quantities of meat requires significant supply chains and consumer packaged goods (CPGs) provided by companies such as Nestlé and Danone, meat companies and retail supermarkets. Animal feed demand is not hardwired in the same way as FSI for two reasons. The feed compounder can choose many feeds to make the ration, and the consumer has a lot more discretion, cut by cut, as to what meat they choose to eat. It is beyond the scope of this chapter to discuss global meat demand, but we do size the larger food protein economies – US, China, EU, Russia, Brazil and India (Table 7.5) – and look at the broad consumption figures. In addition, we note that, in much of the world, consumers will switch between different food proteins as their relative price changes. Price changes for proteins are frequently more volatile than for grains or oilseeds. Pork accounts for 60% of China’s meat protein consumption. In general, poultry is substituted as a meat protein when pork prices reach high levels. Conversely, when pork prices are affordable, China’s consumers prefer to purchase pork products. Before looking at animal feed, we should briefly review animal protein consumption. For some inexplicable reason, it is unusual to find this critical information in most discussions on grains and oilseeds. Table 7.5 shows that China leads on production and consumption, consuming twice as much meat as the US, while in 1990 they consumed roughly the same. In terms of quick numbers, this means the average Chinese person eats half as much meat protein as the average American, 40% more pork per capita, one quarter as much chicken and one ninth as much beef. From a tiny chicken industry in the early 1990s, China has come to consume more chicken than the US, at some 14 MMT. Not only does China consume 33% of the world’s meat, but also 33% of the world’s fish and aquaculture, and in 2010 it became the largest animal feedgrain user, including an estimated 12 MMT of wheat. In terms of total animal protein, China is twice as big a consumer than both the EU 27 and US. Outside of China, Brazil has become a major meat exporter. In addition, despite being widely thought of as a vegetarian country, India consumes almost 20 MMT of meat per annum. It is estimated to consume 5.5–6.0 kgs per capita of chicken with a retail value of 177 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 178 COMMODITY INVESTING AND TRADING US$9.0 billion, and it is widely touted to become more populous than China’s 1.35 billion people. Therefore, the forecasted 20% growth in chicken consumption in India will have an impact on the grain markets. Russia is seriously underserved in the animal protein category. In the not too distant future, the author would expect the Chinese and Brazilian poultry economies to surge past the US and EU markets. As a final caution against analysing enormous populations, remember the ag majors dig a lot deeper into this kind of data, and categorising 100 million people – never mind 1.35 billion – as behaving in a homogenous way is intuitively risky. The (FSI) industrial corn economy To compare FSI of the major producers we must use the adjusted true corn supply and demand (S&D) for the US. It has a 45 MMT FSI demand, roughly half the size of its feed consumption, growing 25% in 20 years and from 15% to 26% of the adjusted production which makes it globally comparable. Argentina consumes 2.2 MMT (up 90% in 20 years, yet declining from 14 to 8% of the crop); Brazil consumes 7.0 MMT (up 100% and down from 14% to 11% of the crop); Ukraine uses 1.5 MMT (up 33%, from 21 to 7%); Russia 1 MMT (down 40%, from 44 to 10%); the EU 15.5 MMT (up 45%, from 30 to 28%); RSA 4.5 MMT (up 15%, from 46 to 35%); China 64 MMT (up 100%, from 27 to 31%) and India 8.3 MMT (up 23%, from 78 to 42%). Non US major producers total 110 MMT in FSI, an important 2.4 times the US, growing 84% over 20 years and declining only slightly from 28 to 25% of local production. The industrial corn economy is aimed at high value-added processing, and a typical analysis is heavily clouded by the conventional reporting process of FSI, which includes fuel ethanol. FSI has no meaningful seasonality while feed demand does. There are two main types of corn processing: dry milling (EtOH) and wet milling (sweeteners). The products of each type are utilised in different ways. Over 80% of US ethanol is produced from corn by the dry milling process. The ethanol is dehydrated to about 200º proof using a molecular sieve system, and a denaturant such as gasoline may be added to render the product undrinkable. With this last addition, the process is complete and the product is ready to ship to gasoline retailers or terminals. The remaining stillage then undergoes a different process to produce a highly nutritious livestock feed 178 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 179 GRAINS AND OILSEEDS (DDGS). The carbon dioxide released from the process is also utilised to carbonate beverages and in the manufacturing of dry ice. Ethanol yield is constantly rising and water use efficiency improving. The initial assumption that biofuels were good for the environment because they had a smaller carbon footprint is debatable regarding the contention that the production of grain alcohol, and therefore E15, may actually have a greater environmental impact than fossil fuels. US non-fuel FSI averaged 15% of production across the 20-year period, amounting to some 42 MMT. In theory, this all comes from wet milling, a process which takes the corn grain and steeps it in a dilute combination of sulphuric acid and water for 24–48 hours in order to separate the grain into many components. The slurry mix then goes through a series of grinders to separate out the corn germ. This process is the backbone of industrial processing for the production of fructose, glucose, dextrose, starch, potable alcohol and industrial alcohols. These figures are typical of an industrial maize economy found all over the world – with the exception of highfructose corn syrup (HFCS) and fuel ethanol, which are US-specific. In 20 years, US production of HFCS increased by 33%, glucose and dextrose by 54%, starch by 14%, potable alcohol was unchanged and cereal consumption increased by 64%, largely driven by the USDA food pyramid. The growth is predictable since the plants are announced and take time to build. This industrial demand is largely non-switchable. For example, it was affected by a 2006 agreement (which became effective in 2008) to allow sweeteners to flow from the US to Mexico without tariffs. HFCS is produced by wet milling corn to produce corn starch, then processing that starch to yield corn syrup, which is almost entirely glucose, and then adding enzymes that change some of the glucose into fructose. The resulting syrup (after enzyme conversion) contains naturally 42% fructose, and is consequently called HFCS 42. Some of the 42% fructose is then purified to 90% fructose (HFCS 90). To make HFCS 55, the HFCS 90 is mixed with HFCS 42, and this increased fructose percentage gives it the same “sweetness” taste as sugar (which is why it is called “high” fructose corn syrup). A system of sugar tariffs and sugar quotas imposed in 1977 in the US significantly increased the cost of imported sugar, and US manufacturers therefore sought cheaper sources. HFCS, as it is derived 179 Beef and veal Pork 57.3 12.0 8.1 9.1 1.4 2.8 5.6 103.2 10.2 23.0 3.2 1.9 Top ten consumers by rank 1 US 2 Brazil 3 EU-27 4 China 5 India 6 Argentina 7 Australia 8 Mexico 9 Pakistan 10 Russia 51.1 China EU 27 US Brazil Russia Vietnam Canada Japan Philippines Mexico Poultry Meat 76.0 16.5 9.0 12.3 2.3 2.6 12.5 236.5 38.7 40.1 24.6 5.7 5.5 69.2 US China Brazil EU 27 Mexico India Russia Argentina Iran Thailand China India Peru Indonesia US Japan Chile Vietnam Thailand Russia Commercial catch of world & aquaculture Total meat %Meat protein %of world in diet fish 142.0 4.9 6.4 0.5 3.5 7.5 47.5 100% 16% 17% 10% 2% 2% 29% 615.0 82.3 86.6 49.7 14.8 18.4 185.8 38% 47% 46% 49% 38% 30% 37% 100% 3% 5% 0% 2% 5% 33% 180 World US EU-27 Brazil Russia India China COMMODITY INVESTING AND TRADING 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 180 Table 7.5 FAO estimates of world 2010 animal protein consumption by type – major economies (MMT) 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 181 GRAINS AND OILSEEDS from corn, is more economical because the domestic US prices of sugar was twice the global price while the price of corn was kept low through government subsidies to growers. HFCS became an attractive substitute, and was preferred over cane sugar by the vast majority of US food and beverage manufacturers. Soft drink makers such as Coca-Cola and Pepsi use sugar in other countries, but switched to HFCS in the US during the mid-1980s. In 2010, the Corn Refiners Association applied to allow HFCS to be renamed “corn sugar”, but this was rejected by the US Food and Drug Administration in 2012. Barley (Hordeum vulgare L.) is a member of the grass family and therefore closely related to wheat, and is a major cereal grain. Important uses for barley are as animal feed, as a source of fermentable material for beer and certain distilled beverages, and as a component of various healthfoods. It is used in soups and stews, and in barley bread. Malting barleys are normally separate and distinct varieties from feed barley. In a ranking of cereal crops in the world, barley is fourth, both in terms of quantity produced and area of cultivation. For our purposes we include it in feedgrains although, as with most of these crops, the lines are blurred. Canada, the EU and CIS/FSU are the major barley producers (see Table 7.3b), accounting for 70% of global production, and their yields are quite different at 3.125, 4.25 and 2.00 MT/Ha, respectively, giving very different competing crop economics. As one can imagine, the decline in area has been greatest in the low yielding producers, and in 20 years Russia fell from almost 50 MMT to almost 25, and global production decreased from 170 to 130 MMT, down some 33%, of which the big three declined by 40, 15 and 50%. Barley has been closely associated with small farms and on-farm feeding, which means the decline will continue. Sorghum is in a genus of numerous species of grasses and a relative of other C4 plants like maize and sugarcane. With lower yields than maize the US (the world's largest producer, see Table 7.3c) has more than halved its sorghum crop to 10% of global production, the remainder being scattered around the world where it may be locally important as food or feed. Many species are cultivated in warmer tropical climates worldwide. It is also biologically in the same tribe and subfamily as sugarcane and might have been grown widely in Brazil where local tastes prefer rice as food carbohydrate. Globally its 181 Table 7.6 Wheat five-, 10-, 15- and 20-year AYP progression (comparing 2010–12 with 2005–07, 2000–02, 1995–97 and 1990–92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given US Canada Argentina Brazil EU 27 Morocco CIS/FSU Turkey China India Australia World total Last three-year average (2010–12) 2005–07 Area A Yield Y Prdn P AYP % growth 9% 4% 2% 1% 12% 1% 22% 4% 11% 13% 6% 100% 11% 6% 2% 1% 8% 1% 21% 4% 14% 10% 4% 100% 19.0 9.0 4.0 2.0 25.5 3.0 49.0 8.0 24.0 29.0 13.5 220.5 3.000 2.875 3.625 2.500 5.250 1.625 1.875 2.125 4.875 3.000 2.000 3.000 59 –4% 25 –5% 15 –29% 5 6% 135 3% 5 4% 92 5% 17 –6% 118 4% 87 8% 26 11% 668 2% 13% 12% 29% 41% 4% 28% –2% 6% 8% 13% 45% 7% 9% 7% –8% 48% 7% 29% 3% 0% 12% 22% 60% 10% 2000–02 AYP % growth –3% –13% –37% 21% –2% 10% 9% –9% –3% 11% 14% 2% 16% 39% 59% 72% 7% 58% 0% 12% 29% 8% 24% 13% 12% 20% 0% 107% 4% 75% 9% 2% 24% 20% 40% 15% 1995–97 AYP % growth –24% –24% –29% 44% 10% 22% 4% –8% –18% 14% 31% –2% 22% –7% 27% –4% 60% 14% 60% 128% 12% 24% 38% 51% 29% 35% 17% 8% 28% 5% 16% 33% 3% 35% 19% 16% 1990–92 % of world AYP % growth yield –25% 21% –10% 100% –37% 29% –19% 96% –16% 70% 46% 121% –15% 100% 78% 83% 35% –2% 32% 175% 19% 21% 39% 54% 4% 0% 4% 63% –11% 20% 7% 71% –21% 51% 19% 163% 23% 32% 63% 100% 60% 19% 90% 67% –2% 21% 18% 100% 182 COMMODITY INVESTING AND TRADING 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 182 Wheat 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 183 GRAINS AND OILSEEDS stagnant 60 MMT production is neither important in world trade nor expected to be so. FOODGRAINS There are two major foodgrains: wheat and rice. The world harvests 670 MMT of wheat annually (see Table 7.6), of which the major wheat economies are the US (60), Canada (25), Argentina (15), Brazil (5), EU-27 (135), Morocco (5), CIS/FSU (90), Turkey (15), China (120), India (85) and Australia (25). World rice harvests is 460 MMT (see Table 7.7), of which Brazil (10), Thailand (20), China (140) and India (100) are the largest economies. There are thousands of wheat varieties being grown in the world, each selected, bred and adapted based on locality and consumer preference. Table 7.6 shows that US wheat production is flat (area declines and yield improves) and expected to decline as maize takes up more land for ethanol. Canada, Argentina, Australia and Brazil are stagnant, while the EU, China and India have grown quite dramatically. In addition, the FSU declined dramatically as it became more market-based, but has considerable potential to recover production through the use of modern farming methods. Yield growth around the world remains good, in many cases due to suboptimal wheat areas being taken out of production in China and the FSU. Throughout the world, there are various ways of categorising wheat, largely dependent on intended use. We can think of wheat globally and genetically as having 10% protein content, often referred to as its fair merchantable quality (FMQ). FMQ changes with variety, husbandry and weather. While the EU tends to specify wheat by specific weight (in the US, it is thousand grain weight, TGW) measured in kilograms per hectolitre (Kg/hl) and variety, feed wheat is generally assumed to have a 72 kg/hl FMQ (UK Liffe contract spec) and milling or baking wheat to have a 76 kg/hl FMQ (French Euronext contract spec). The most common simple laboratory test for protein quality (gluten) is the Hagberg falling number (HFN), which measures the rate of fall of a plunger through a column of water/flour mix, representing its stickiness or so-called “gluten extensibility” – the ability of the wheat to form a uniform rising dough. From the most simple feed/food designation in Europe, each major wheat exporter has its own preferred designations. A wheat chapter that does not discuss 183 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 184 COMMODITY INVESTING AND TRADING type by geography and consumption would be pointless, so we will take a deeper look at China and India. Wheat varieties can vary over 100 miles, and there are thousands around the world. In fact, there are several hundred varieties of wheat grown just in the US, all of which fall into one of six recognised classes. Wheat classes are determined not only by the time of year they are planted and harvested, but also by their hardness, colour and the shape of their kernels. Each class of wheat has its own family characteristics, as related to milling and baking or other food/feed use. Wheat production by type across the states and then subsequently for spring, winter and durum, and the intensity by county within each state can be seen at: http://www.thefreshloaf.com/node/4632/major-wheat-growing-regions-us-reference-maps. The largest volume of US wheat is of Chicago Board of Trade (CBOT) type and specification and is often referred to as simply W. CBOT-type wheat is both an animal feed and capable of making biscuit dough, or a simple unleavened dough, and has low protein content and poor “gluten extensibility”. Kansas City Board of Trade (KCBT) wheat (often referred to as KW) is true bread wheat destined for human consumption but capable of being fed in small quantities with other grains to animals. Its gluten extensibility is sufficient to capture a bubble of air and allow the dough to rise to produce a loaf of bread. Minneapolis Grain Exchange (MGE) wheat (often referred to as MW) is best thought of as a high-class or technical wheat capable of making fine pastries such as croissants. The gluten is extremely flexible and can produce a low-dough large bubble. W has no protein minimum per se, while KW has 11% and MW has 13.5%. All three futures contracts are based on #2 grade, which is a minimum TGW, #1 would be higher and sub-economic to deliver as we can simply blend it down. All of these markets carry a variety of scales that adjust for delivering #3 grain (lower specific weight), and KW and MW allow for penalties to be deducted for protein levels down to 10.5% and 13.0%, respectively. “Protein scales” refer to the per 0.5% or 1.0% value for protein quoted in the physical or cash markets, and represent the value of different grades that are blended by millers and shippers to make actual grists (the baker’s wheat “slate”) or shipping contract minimums. Protein levels do not blend linearly but are close enough for anything we need to discuss here. Baking is in fact a science, and there is a large body of work available 184 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 185 GRAINS AND OILSEEDS on wheat qualities, baking and the use of gluten-extenders, for example, a man-made additive intended originally for use in poor harvests but now used widely to create uniformity. Although many talk about declining wheat per capita consumption and the rise of corn and soybean production, this masks a much more complex picture. To talk of wheat and bread is a serious mistake, demographically. The grains and oilseeds industries of other countries are substantially different to the OECD; Mexico thinks about tortillas more than loaves of white bread, the Indian/Pakistan wheat economy is very large but flour production and sales direct to the consumer, rather than bread, remains a substantial industry, while Asian noodles are a major source of wheat consumption all over the globe, not just in Asia. Although much has been written on wheat and foodgrains, most focus on the easily researched OECD producers: US, Canada (three planting zones, 14 classes and three or four grades for export of each variety), Australia (five planting zones, six principal grades targeting 13 end uses, from Indian bread to Udon noodles and Asian instant noodles), Argentina (seven planting zones, three major categories, four flour grades) and France (17 planting zones or areas, four classes and four grades, all variety-specific). We will look at the two most populous countries, China and India, to provide a cross reference of their enormous wheat economies rarely found outside an ag major or the most serious investor. Without understanding these two rapidly evolving wheat economies there should be little expectation of understanding price evolution. Prior to the expansion of the EU to 27 countries, China was the world’s largest producer and consumer of wheat. Comparative advantage has led China to discourage low-quality wheat production, and it has reduced the amount of land devoted to wheat since the early 2000s. It imports as a way of balancing quality not quantity, and the US wheat class designations will not advance your understanding of Chinese wheat needs. Its planting zones can be divided broadly into three: hard wheats around the Greater Khingan Mountain range, hard wheats along the Yellow, Huai and Hai rivers and, finally, soft wheats along the lower Yangtze river. They include nine classes (the first is H or S for hard and soft, then W or R for white or red and W or S for winter or spring – the main ones are HWW, HWS, SWW, SWS, HRW, HRS, SRW, SRS and other), and five grades (79+, 77+, 75+, 73+ and 71+ Kg/Hl) by specific weight and a variety 185 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 186 COMMODITY INVESTING AND TRADING of other quality characteristics, including moisture and foreign matter. The nine Chinese grades are further divided into two classes of high-quality strong gluten wheat, two classes of high-quality weak gluten wheat and three other qualities for specific end-uses. Each grade class has a specific flour quality, including HFN and a range of other specific qualities. In addition, each of the classes and flour grades are identified by planting zone. Some 10% of the wheat is used for high-quality bread cookies and dumplings, some 50% for steamed bread, noodles and instant noodles, and the remaining 40% is used locally for home baking or small bakeries. Urbanisation and the industrialisation of its food industry is dramatically changing the patterns of consumption in China. Despite their large total animal protein consumption, the population effect means China (and indeed Asia) depends heavily on foodgrains for nutrition. Noodles represent some 40% of total flour consumption, and are a major staple in East and Southeast Asian countries. Apart from wheat flour, they can be made from rice flour, potato flour, buckwheat flour, corn flour, bean, yam and soybean flour. While pasta is made from tetrapolid durum wheat (Triticum durum), noodles are made from the hexaploid Triticum aestivum, which contains gluten, which reacts to the pressure during the sheeting process. Eggs are frequently added to provide a firmer texture. Given that wheat consumption in the form of Asian noodles exceeds the total US wheat production, we can understand its significance in the forecasting of demand for wheat round the world. Chinese noodles are typically made from hard wheat flours, Japanese noodles from soft wheat of medium protein. By colour, they are typically classified as white (containing salt) or yellow (containing alkaline salt). White salt noodles include Japanese noodles, Chinese raw and dry noodles. Yellow noodles include Chinese wet noodles, Hokkien noodles, Cantonese noodles, Chukkamen, Thai bamee and instant noodles. Over 50 billion meals are annually served around the world that contain ramen noodles alone. Asia imports US HRS, DNS, HRW, SRW and SWW, Australian standard white (SW), premium white (PW) and prime hard wheats (PH), as well as Canadian Western Red Spring (so called CWRS), Canadian Western Red Winter, Canadian Prairie Spring White and Canadian Prairie Spring Red wheats to blend with local wheats to make 186 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 187 GRAINS AND OILSEEDS noodles. China consumes 35% of global instant noodles, just twice as much as Indonesia, which is twice that of Japan. The US and South Korea consume one fifth as much as China. Steamed bread accounts for 60% of flour consumption in Northern China (where it is a staple) and 20–30% in the South (where it is a dessert). In Asia, it represents 5–15% of flour consumption depending on the country, and it is popular in the Philippines, for example. It is made predominantly from soft-to-medium hard wheats and, while it is prepared somewhat like a western pan bread, it is then steamed rather than baked. There are three principal types with varying protein and gluten qualities – Northern, Southern and Taiwanese. The Northern type is typically made from local wheat, and has 10–11% protein. The Southern type has added sugar and baking powder. The Taiwanese type has the highest protein, while all three types contain yeast. The steaming process produces a higher-quality food than baking as it destroys less of the amino acids (especially lysine) than the higher temperature baking. However, it is less conducive to large-scale production since much of its eating qualities are associated with being freshly steamed. It loses quality when re-steamed and its shelf life is short compared to baked bread due to the higher moisture content. This will inevitably lead to what the US and Europe call “in-store baking” as a means of bringing large-scale industrialisation to the cities. India’s second largest foodgrain crop is wheat, but strategically it has tremendous and growing importance with an ever-larger population, as it is a non-monsoon-based crop. It has six major growing areas: the Northern Hill Zone (NHZ, 1.2 MHa), the North West Plain Zone (NWPZ, 9.0 MHa), the North East Plain Zone (NEPZ, 9.0 MHa), Central Zone (CZ, 5.0 MHa), Peninsular Zone (PZ, 1.0 MHa) and the Southern Hill Zone (SHZ, 0.2 MHa). Some 90% of Indian wheat receives irrigation, although in the NHZ this does not occur at higher elevations but closer to rivers unless the crops are close to a river. The NWPZ is a large fertile part of the Gangetic Plain and is more than 90% irrigated, with crops maturing in 140 days and multiple days with lows of less than 5° C. Wheat plants tiller well and develop many spikes, so yields are high. However, disease can be a problem due to mono-cropping (poor rotation). Temperature spikes at grain fill can hurt yields in the same way as in the US Midwest. The NEPZ 187 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 188 COMMODITY INVESTING AND TRADING is humid with a large number of minor rivers for irrigation, and it also suffers from wheat diseases associated with a humid environment. Wheat matures here in 125 days and is susceptible to unneeded rain showers at harvest time. The CZ and PZ are highland deep soil areas but difficult to irrigate and may receive only two applications of water per season, and with high temperatures we see short growing seasons and poor yields. India has developed and distributed 200 of its own varieties of wheat since the 1980s which see several days with temperature lows of less than 5°C predominantly targeted for the higher yielding regions. Disease control is effected by using the SHZ for plant breeding. The many problems associated with Indian wheat production have been solved around the world and will be in India as well, although this will take time. These problems include but are not limited to poor acceptance of new varieties and the widespread planting of retained production from year to year, poor mechanisation, lack of modern harvesting methods and inexperienced machine operators, which results in low-quality grain samples and lots of admixture of foreign matter. A considerable amount of Indian wheat is consumed as chapati, a flat unleavened bread. The warm wheat areas have higher protein than the cool NHZ. Hill wheats are widely used for biscuits/cookies. PZ wheat is used for crackers and cookies due to its protein level and quality. The baking industry is largely based in the south, which has a deficit in wheat and the vast size of the country makes transport expensive. Significant quantities are exported for hard currency, but the industrialisation of baking and the introduction of whole grain branded flour will lead to improvements in revenues. Better prices for wheat will improve flour yields, and urbanisation will change farming practises and consumption patterns, making India a significant importer and producer of higher-quality breads for its increasing population. India will become an importer of higher-quality wheats over time, which will have a significant impact on world wheat flows. With only five classes (medium hard bread wheat, premium hard bread wheat, biscuit wheat, durum and Khapli wheat, a particular Indian wheat used for semolina) and no effective grading due to a largely flat price structure for wheat within classes under the Indian state run Public Supply Distribution (PSD) system, the Indian wheat 188 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 189 GRAINS AND OILSEEDS market will evolve as it becomes more market driven. Most ethnic breads (chapati, naan, tandori, rumati, roli, puri and bhatore) are made from medium-hard bread wheat. The Indian government has traditionally supported domestic wheat prices at a significant premium to world prices and they have carried significant stocks to allow it to intervene in the domestic food price. Given the overall excitement in the wheat market of 2007, we will review the run-up to this bull market, its causes and its effects. As with all great bull markets, its roots lay in the previous year’s crop, with widespread problems for the major exporters (US, EU-27, Canada, Australia, Argentina and Russia). Since the early 2000s, these countries have produced between 271 (2006–07) and 344 MMT (2008–09), carried stocks as low as 36 MMT (end-2007) and as high as 73 MMT. Exports have ranged between 88 and almost 125 MMT and stocks have responded dramatically, to build or draw-down, as price signals have changed. At the beginning of 2006–07, their stocks stood at 65 MMT and by the beginning of 2008–09 had fallen to 36 MMT, a 10-year low. Of these countries, all but Russia has highly visible stocks. Russia typically has a stock/use ratio of 10%. The EU has highly volatile wheat production, producing 133 MMT in CY2002/03 and 111/147/132 MMT in the subsequent years, respectively. In CY2005– 06, its crop decline year-on-year (yoy) of 14.5 MMT was absorbed by the other major producers. The following year, however, saw disappointing crops with the US down 8.0 MMT, the EU down 7.5 and Australia down a disastrous 14.5 MMT. This 30.0 MMT dip was not offset by the other major exporters and exports from the group dropped to 88 MMT. Australia has a volatile, rain-dependent wheat crop and, while production ranges between 10.0 and 30.0 MMT, it is in fact rather binary, producing less than 15.0 MMT in dry years and more than 25.0 MMT in wet years. In 2006–07, the world became increasingly concerned with wheat and the US drew stocks from 15 to 12 MMT, cutting domestic use and exports. Similarly, the EU drew stocks by almost 10 MMT and also cut domestic use and exports. Canada boosted exports and drew stocks, and Australia halved its stocks to export more than 16 MMT versus the previous year’s 23 MMT. Russia maintained big exports at 10 MMT, and Argentina almost emptied its stocks completely. At times like these, we turn to the minor exporters (Ukraine, Kazakhstan, India, 189 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 190 COMMODITY INVESTING AND TRADING China and Turkey) to see what they can contribute. The Ukraine crop dipped from 18.0 to 14.0 MMT, and they drew stocks to maintain exports at 3.5 MMT, down 3.0 on the previous year. Russia agitated for a Ukraine export ban. Kazakhstan exports surged from 4.0 to 8.0 MMT on a decent crop and a stock draw. India, however, who can be a 5.0 MMT exporter, was coming off two disappointing crops and had low stocks. So, not only were they absent from the export market in CY2006/07, but in fact imported almost 7.0 MMT. China’s production rose 11.0 MMT yoy, but they were already in stock-building mode and withdrawing from the export market strategically. China therefore barely exported 1.0 MMT more than the previous year. Turkey was down to bare minimum stocks and had a sufficiently reduced crop in CY2006/07 to be absent from the export market. In fact, across the minor exporters there was a significant increase in imports yoy, primarily lead by India and indicating the structural shift in the two most populous countries in the world; China is now a structural importer, and while India may come and go as both exporter and importer, it will inevitably follow China to the structural importer category. Among the major importers, Egypt built stocks by 1 MMT in 2006/07 and increased imports yoy, Brazil increased imports by 1 MMT, Japan maintained imports, Indonesia raised imports and Algeria cut theirs by an offsetting amount. South Korea, Nigeria, the Philippines and Morocco cut imports modestly, while Iraq imports took a big downturn and Mexico was unchanged. Overall, major importer demand dipped by only 2.0 MMT in the face of a 30.0 MMT dip in major exporter production, pinpointing the very staple nature of wheat demand and its insensitivity to price. It should be clear to the reader that every large market player has access to the shipping fixtures, or grain movements, by loadport and discharge port. We then entered the major bull run. Any problems in the 2007 growing season would cause a major disruption, and the hedging pressure and speculative pressure increased to intense levels. US production rebounded by 6.5 MMT in CY2007/08 and another 12.0 MMT in CY2008/09, but only after drawing stocks to a low 8.0 MMT. Disastrously, the EU had more problems in 2007/08 and production dipped another 5.0 MMT, and stocks hit a near record low. By CY2008/09, a world-saving rebound of 31 MMT would be 190 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 191 Table 7.7 Rice 5-,10-, 15- and 20-year AYP progression (comparing 2010–12 with 2005–07, 2000–02, 1995–97 and 1990–92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given Rice Brazil Thailand China India World total Last three-year average (2010–12) 2005–07 Area A Yield Y Prdn P AYP % growth 2% 7% 19% 27% 100% 3% 6% 22% 29% 100% 2.5 11.0 30.0 43.5 158.5 3.250 1.875 4.750 2.250 2.875 8 –12% 20 4% 141 4% 100 –1% 461 3% 18% 5% 6% 7% 6% 5% 9% 10% 6% 9% 2000–02 AYP % growth –18% 7% 5% 0% 6% 44% 10% 6% 20% 11% 1995–97 AYP % growth 18% 18% 12% 20% 18% –27% 15% –4% 1% 6% 77% 22% 8% 22% 15% 1990–92 % of world AYP % growth yield 30% –41% 106% 41% 21% 34% 4% –8% 17% 23% 2% 32% 21% 8% 21% 22% 113% 61% 65% 8% 165% 35% 78% 30% 100% Source: Adapted from Informa GRAINS AND OILSEEDS 191 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 192 COMMODITY INVESTING AND TRADING harvested, but not until the market had gyrated wildly. Adding to the woes in 2007, Canadian wheat production dipped 5.0 MMT, and they too drew stocks heavily to record a low of barely 4.0 MMT. Australian production recovered, by a mere 2.8 MMT, to a sub-14.0 MMT crop. Argentinian and Russian crop production increased slightly, and the major exporters saw their total production increase by 6 MMT and stocks draw another 7.0 MMT on top of the previous year’s 20.0 MMT decline. Collectively, their production would surge by more than 66.0 MMT in CY2008–09 to end the bull market. Minor exporters had a domestic production rebound of 8.0 MMT but reduced their exports yoy, and while they cut their imports in half they were also building stocks. Although there was some variance between major importers, stock were built modestly and imports rose modestly. Wheat exhibited the classic volatility of a market with inelastic demand and whose price-solving mechanism is to scale a steep marginal supply curve to increase production at the expense of competing crops. This occurred at the same time as crude oil price was increasing dramatically and maize demand for ethanol surged in the US. As in Table 7.6, the wheat supply from 2005–07 to 2010–12 would only increase in area by 2%, yield would rise 7% and production by 10%. Production increases were 20% in the EU, 18% in China, 14% in CIS/FSU, 13% in India and 9% in the US. As a foodgrain, rice provides the most widely consumed staple food of over half the world’s population (see Table 7.7), especially in Asia and the West Indies. It is the seed of the monocot plants Oryza sativa (Asian rice) or Oryza glaberrima (African rice). It is the predominant dietary energy source for 17 countries in Asia and the Pacific, nine countries in North and South America and eight countries in Africa. Rice provides 20% of the world’s dietary energy supply, while wheat supplies 19% and maize 5%. It is the grain with the secondhighest worldwide production after maize, but since a large portion of maize crops are grown for purposes other than human consumption, rice is the most important grain for human nutrition and caloric intake, providing more than one fifth of the calories consumed worldwide by the human species. There are many varieties of rice and culinary preferences vary regionally. In the Far East, there is a preference for softer and stickier varieties. 192 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 193 GRAINS AND OILSEEDS Rice yields continue to grow while area is largely stagnating, China’s dramatically better yields than India means it produces 40% more rice from two-thirds as much land. India’s yield growth at 33% in 20 years is, however, twice that of China, and Brazil’s yield has doubled in the same period. As previously mentioned, the Indian crop is monsoon-driven. World trade is small and most countries that consume rice grow their own. To close the foodgrain section, some basic numbers are provided for processed food sales. Worldwide, they are approximately US$3.5 trillion, and the industry is growing. The processors are giant companies that own huge brands, the CPGs such as Nestlé SA. These companies dwarf the ag majors who are their suppliers. The food industry is a complex, global collective of diverse businesses that supply much of the food energy consumed by the world’s population. Only subsistence farmers, those who survive on what they grow themselves, can be considered outside of the scope of the modern food industry. In developing country markets, the two reference points are the US and the UK. With populations of 313 million and 55 million, respectively, they can be used to estimate what the food economies of less-developed countries will likely look (more) like in the next few years. In the US, consumers spend approximately US$1.3 trillion annu- ood-expenditures. million people are consumer base of example, has the UK grocery market GDP, and employs uring sector in the K manufacturing. ufacturing in the . This is roughly a , for example, has 193 US Argentina Brazil Paraguay China India World Total Last three-year average (2010–12) 2005–07 Area A Yield Y Prdn P AYP % growth 29% 18% 24% 3% 8% 10% 100% 42% 9% 18% 2% 14% 5% 100% 30.5 18.5 25.5 3.0 8.0 10.0 105.0 2.750 2.625 2.875 2.125 1.750 1.125 2.500 85 49 74 6 14 11 258 8% 16% 18% 19% –15% 22% 13% –2% –7% 7% 8% 10% 10% 1% 5% 9% 27% 28% –6% 34% 15% 2000–02 AYP % growth 4% 62% 57% 105% –14% 73% 33% 8% –2% 6% –18% 4% 27% 5% 12% 60% 66% 68% –11% 120% 39% 1995–97 AYP % growth 17% 191% 114% 155% –1% 96% 63% 11% 20% 25% –6% 3% 18% 15% 30% 248% 166% 139% 2% 132% 87% 1990–92 % of world AYP % growth yield 31% 286% 154% 222% 8% 223% 89% 18% 12% 53% 39% 26% 21% 25% 54% 110% 333% 105% 288% 115% 348% 85% 36% 70% 294% 45% 135% 100% Table 7.8(b) Rapeseed 5-,10-, 15- and 20-year AYP progression (comparing 2010–12 with 2005–07, 2000–02, 1995–97 and 1990– 92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given. Rapeseed Canada China India EU 27 World total Last three-year average (2010–12) 2005–07 Area A Yield Y Prdn P AYP % growth 22% 20% 20% 19% 100% 15% 31% 31% 15% 100% 7.5 7.0 7.0 6.5 34.0 1.750 1.750 1.000 3.000 1.750 14 13 7 20 61 38% 15% 6% 17% 25% 5% –1% 5% –1% 2% 45% 14% 11% 17% 28% 2000–02 AYP % growth 88% 2% 44% 57% 47% 32% 16% 15% –1% 16% 143% 18% 65% 56% 70% 1995–97 AYP % growth 69% 10% 4% 58% 47% 1990–92 % of world AYP % growth yield 34% 127% 164% 32% 45% 23% 9% 14% 12% 94% 186% 117% 28% 87% 75% 37% 258% 100% 45% 78% 100% 13% 27% 57% 11% 145% 171% 31% 131% 100% 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 194 Soybeans COMMODITY INVESTING AND TRADING 194 Table 7.8(a) Soybean 5-,10-, 15- and 20-year AYP progression (comparing 2010–12 with 2005–07, 2000–02, 1995–97 and 1990– 92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given. 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 195 Table 7.8(c) Sunseed 5-,10-, 15- and 20-year AYP progression (comparing 2010–12 with 2005–07, 2000–02, 1995–97 and 1990– 92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given. Sunseed US Argentina EU 27 CIS/FSU World total Last three-year average (2010–12) 2005–07 Area A Yield Y Prdn P AYP % growth 2% 6% 16% 53% 100% 6% 15% 24% 26% 100% 0.5 1.5 4.0 13.0 24.5 1.625 2.125 1.875 1.375 1.500 1 –19% 4 –27% 7 12% 18 32% 37 9% 2% 25% 15% 15% 16% –19% –9% 28% 51% 26% 2000–02 AYP % growth –30% –16% 15% 84% 23% –5% 23% 26% 42% 28% –35% 3% 45% 160% 57% 1995–97 AYP % growth –40% –44% –31% 106% 23% 1990–92 % of world AYP % growth yield 8% –35% –22% 18% –34% –29% 96% 48% –3% 43% 195% 179% 23% 52% 44% 11% –14% 108% 38% –2% 142% 37% 66% 125% 7% 199% 92% 16% 68% 100% Source: Adapted from Informa GRAINS AND OILSEEDS 195 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 196 COMMODITY INVESTING AND TRADING OILSEEDS – VEGETABLE PROTEINS We harvest 355 MMT of the three major softseeds (soybeans, rapeseed and sunseed, (see Tables 7.8 a, b and c)), of which 260 are soybeans, 60 are rapeseed and 35 are sunseed. The major soybean economies are the US (85), Argentina (50), Brazil (75) and Paraguay (5). For rapeseed the big four economies are Canada (15), EU-27 (20), China (15) and India (5). For sunseed the big three economies are Canada (5), EU-27 (5) and CIS/FSU (20). The softseeds yield vegetable oil and high-protein meal in ratios of 19/35/33% of oil and 79/63/65% meal from soy/sun/rape crushing, the balance being the hulls or shells. This means a global soft oil output of roughly 50, 12 and 20 MMT, respectively. Much of the softseeds are crushed and their products consumed locally. Historically, we have described China, or Asia, as “oil deficit” and the EU as “meal or protein deficit”. Global exports of the three softseed oils are estimated by Agrimax at 8.0, 5.0 and 3.0 MMT respectively, compared to global palm oil flows of more than 38.0 MMT. In the early 1990s, the US dominated global soybean production. By a decade later, Brazil and Argentina combined produced as much as the US, and by the early 2010s Brazil alone threatened to match the US in production. World planted area has grown by almost 90%. World yields have grown by 25%, and production has surged by 135%. Brazil has the highest yields, followed by the US and Argentina, but it is important to note that yield advancements are in decline and largely occurred during the 1990s. In contrast, hard oils (their physical state at room temperature) are produced primarily from fruit (as compared biologically to seeds). The most commercial is palm oil, but the family also includes coconut oil and others. Butter and lard (animal fat) are also included in this category. Malaysia and Indonesia dominate palm oil production and annually export some 19.0 MMT each, amounting to more than 65% of global vegoil (the common industry abbreviation for vegetable oils) trade flows. Since they come from fruit, there is an associated pulp that remains from processing, normally returned to the soil as fertiliser. The four countries that dominate world rapeseed production, with 90% of production, are all major wheat producers, and rapeseed grows very nicely in a rotation with wheat. EU yields are more than 170% of the world average and planted area is now more or less 196 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 197 GRAINS AND OILSEEDS equal to each of the other producing countries, at 7 MHa each. EU area planted has driven the global yield growth, expansion being primarily for biodiesel production. Indian yields are abysmal, but domestic consumption is protected by the large costs of importing rapeseed from major producers and trucking to the interior. China dominates global rapeseed trade. Sunseed production is driven by three countries (CIS, EU and Argentina – 49%, 19% and 11%, respectively), with the US a poor fourth at 3%. While production has tripled in 20 years the low yields and expanding area in the CIS has slowed the market growth. Yields have expanded healthily in any case, although there was a lost decade when CIS yields regressed rather than grew. Sunflower oil is sold at a premium compared to other vegetable oils into to Mediterranean and North African markets, where it is preferred as a cooking oil. Global production at less than 40.0 MMT will grow to 50.0 or 60.0 MMT. Each major vegetable protein economy produces a variety of proteins locally as determined by their comparative advantage, and the balance is either exported or imported. Since China is a major importing vegetable protein economy, its S&D balance is summarised here. Its domestic production of almost 60.0 MMT of major oilseeds is dominated by soybeans (15), sunseeds (2.5) and rapeseeds (12.5), as well as cottonseeds (12.5) and groundnuts (15), the non-US name for peanuts. In addition, it imports a staggering 60.0 MMT of soybeans and 2.5 MMT of rapeseeds, crushing 100.0 MMT per annum. In the early 2000s, China imported only 20.0 MMT of soybeans and had a major softseed crush capacity of 55.0 MMT, of which 25.0 MMT was soybeans. At that time, the big four soybean exporters (US, Argentina, Brazil and Paraguay) had a total crush capacity of 100 MMT which has grown over the same 10-year period to roughly 125 MMT, (US 45, Argentina 38, Brazil 40 and Paraguay 3) while China’s grew from 25 to 100 MMT. Softseed crushing is the process by which seeds are pressed through a die. Heat, steam and solvents are used to extract the oil from residual meal to form the two principal by-products and leave the hulls and seed covering. One can imagine other softseeds that are produced and used in different ways, such as peanuts, sesame seeds and mustard seeds, which are consumed and processed or simply cooked. Oilworld.biz, an analyst specialising in the vegetable oils 197 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 198 COMMODITY INVESTING AND TRADING business, comprehensively analyses the crushing of 10 major oilseeds, 17 major oils and 12 major meals, including cottonseed oil, fish oil, corn oil, palm and palmkernel oil, butter and lard. Local tastes and GDDs drive the local markets, and deficits and surpluses are imported or exported. Rapeseed oil is preferred for its taste in Chinese cooking and it is by far the largest rapeseed market in the world. The complexity of the soybean business is perhaps best illustrated by the soybean product tree (see Bell, David E., and Mary L. Shelman, 2006, “Bunge: Poised for Growth”, Harvard Business School Case 506–036, July), which shows that the crushing plant complex is quite large and comparable to a petroleum refinery if all the various streams are included. In North America and the EU, the crushing plant will supply downstream processors such as Solae (a Bunge DuPont joint venture) for further processing. In Brazil, the industry is still evolving to develop the various processed product streams and many of these crushing plants are truly biomass operations – for instance, the plant being built on 10,000 Ha of which 20 Ha is the actual plant, bottling and bagging, trucking, warehousing and logistics, and the balance is producing eucalyptus trees which are harvested and used to power the plant and its various services. What we should note at this point is these plants do not suddenly appear, they are planned in advance and the crushing equipment is ordered in advance. The storage facilities for vegoil are quite technical, and meals are not without their complexities due to their physical characteristics. Fundamental analysis includes the forecasted change in crush and downstream capacity by location and type of operation. Compared to petroleum refineries, they are cheap. Impressive worldscale operations are built for US$0.2 billion rather than US$2.0 billion. Within the study mentioned above, at that time Bunge was the world’s biggest soybean crusher, and the expectation for soybean crush evolution by geography is given. They expected the 2010 crush of soybeans to look like US/Arg/Braz/EU/China as 52/25/30/17/25 (149 MT total), respectively, when in fact it looked more like 45/38/40/12/76 (211 MT total), respectively. The forecast missed both the size and geography of actual growth. The error was –7/13/10/–5/51 (62) or 87/152/133/71/304 (142)% of forecast. Although these would have been constantly revised by Bunge, it demonstrates the ease of making a substantial error and consequent difficulty of building for the future. In fact, the marketplace did 198 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 199 GRAINS AND OILSEEDS generally underestimate China’s appetite for soybean imports and the desire to crush them domestically, as it did the Chinese growth story for all commodities. We also have to remember that once capacity is built it is normally run, in any industry, at any contribution to the bottom line that exceeds variable cost. The different regional growth patterns imply different rates of port development to move the commodities, as well as different rates of growth in downstream and associated industries. A further unexpected agribusiness consequence, but one which the petroleum business is quite familiar with, was the building of strategic reserves of foreign currency held in commodities by China – look at their enormous stocks of soybeans and oilseed rape, 16 and 6 MMT, respectively. The Chinese domestic oilseed complex growth has been virtually stagnant since the early 2000s growing from 55 to more than 58 MMT, within which soybeans contracted by 2 MMT, while rapeseed, cottonseed and groundnuts increased. Soybean imports grew from 21 to almost 60 MMT, and rapeseed imports grew by more than 2.5 MMT, so that crush now stands at soy 61 MMT, rapeseed 15 MMT, sunflower 1 MMT, cottonseed 10 MMT and groundnuts 7 MMT, for a total crush of 96.0 MMT – the biggest in the world. Add to that the 24 MMT of oilseeds consumed other than through full crush (partial processing), of which 11 MMT is soybeans, 3 MMT is cottonseed and 8 MMT is groundnuts, and we see a better picture of the 120 MMT Chinese oilseed powerhouse, consuming far more than any of the big three producers. In the early 2000s, they carried oilseed stocks of almost 19 MMT in China, and in 2013 stocks stand at an estimated 24 MMT. The USDA estimates that if it costs US$100/MT to move soybeans from Iowa to Chinese ports, it costs US$175 from Mato Grosso in Brazil. This means the expansion of soybeans in Brazil is disadvantaged at the farmgate by that amount, and this inevitably leads to Brazil finding other uses for soybeans until transport efficiencies can be de-bottlenecked. On the soybean demand side, 10 years is also a long time and the rapidly changing face of Brazilian agribusiness is well illustrated by the emergence of JBS on the world stage. JBS is the largest Brazilian multinational food processing company, producing fresh, chilled and processed beef, chicken and pork, and also selling by-products from the processing of these meats. This has lead to a surge in Brazilian soybean consumption domestically. In a decade, its 199 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 200 COMMODITY INVESTING AND TRADING domestic meal consumption has grown by 5 MMT to 12.5 MMT. Argentine meal consumption in the same period grew from 0.25 MMT to almost 2.0 MMT. JBS has established itself as the largest global company in the beef sector with the acquisition of several retail chains and food companies in Brazil and around the world, especially the 2007 US$225 million acquisition of US firm Swift & Company, the third-largest US beef and pork processor, renamed as JBS USA. It leads the world in slaughter capacity, at more than 50,000 head per day, and continues to focus on production operations, processing and export plants, nationally and internationally. With the new acquisition, JBS entered the pork market, featuring an impressive performance in this segment, to end the year as the third largest producer and processor of this type of meat in the US. The acquisition expanded the company’s portfolio to include the rights for worldwide usage of the Swift brand. The following year, JBS acquired Smithfield Foods‘ beef business, which was renamed JBS Packerland. JBS’s production structure is embedded in consumer markets worldwide, with plants installed in the world’s four leading beef producing nations – Brazil, Argentina, US and Australia – serving 110 countries through exports. In September 2009, JBS announced that it had acquired the food operation of Grupo Bertin, one of three Brazilian market leaders, consolidating its position as the largest beef producer in the world. On the same day, it was announced that the company had acquired 64% of Pilgrim’s Pride for a bid of US$800 million, establishing JBS’s position in the chicken production industry. In August 2010, it was reported that JBS was trying to sell some of the eight slaughterhouses it owns in Argentina because of “scarce livestock and export restrictions.” By 2011 they were attempting to gain control of Sara Lee Corporation‘s meat business. Brazil has aquaculture production targets of 1.0 MMT by 2015 and 10.0 MMT by 2020 from a base of 0.5 MMT in 2011. While this may be too high to achieve by 2020, we can easily imagine them managing it by 2025, again reshaping soya and (non-vegetable) protein flows. It is worth looking back at Table 7.5 to understand the significance of this number. In 2003, the unthinkable happened in the soya world: there were terrible crop yields in the US, Argentina and Brazil, all in the same year. Forecasters expected a rising yield, but the US dipped from 2.56 200 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 201 GRAINS AND OILSEEDS to 2.28 MT/Ha, Argentina from 2.82 to 2.36 and Brazil from 2.82 to 2.37. In 2002, Argentina and Brazil out-yielded the US for the first time, and their combined production matched US. For the first time, not only did global soybean production not grow, it dipped by some 10 MMT. This sparked an unprecedented rally which had long-term effects on how the markets traded, who dominated them and how the Chinese thought about their soybean strategy. In the author’s opinion, this drop may be partly attributed to the illegal spread of GM seeds in Latin America at a time when the technology was new and certainly undeveloped for Latin American conditions. Critically, it demonstrated that yield advancements came with increasing yield variability and unexpectedly large sensitivity to weather variations. The US saw 0.5 standard deviation changes in GDD’s give far bigger swings in yield than history would have lead us to expect. For those who follow freight markets, part of China’s soybean importing strategy has been to add Chinese tonnage to the global dry bulk market, since they are structurally short, causing a sharp downward correction in freight prices. HOW ROTATION CONVERGES THE GRAINS As a major source of income for trading companies and hedge funds alike (see Appendix 7.1), and definable by excellent fundamental analysis, we can “arbitrage” maize, wheat and soybean prices. In the short run, one can reasonably expect these three commodities to change price relative to each other, to reallocate or switch hectares between crops and hemispheres. We can always bring more land into production, but in Brazil, for example, that involves a year of land clearance of indigenous plants before a year of growing rice and clearing the land, and then a serious commercial crop can be started in the third year. Table 7.9 shows an interesting view of the major crop economies in a side-by-side comparison of total arable land flexibility and individual crop flexibility. The major opportunities with existing resources, in terms of area, are all within Table 7.9. The serious student should understand this one table representation of flexibility in both percentages and individual crops as well as the yield gaps presented in the various tables for the major crops, by country. The US and the EU-27 are the most economically responsive areas or “rational actors” to relative price, by which we mean per-hectare 201 Table 7.9 Rotation flexibility by major grain economy in 20 years (total arable area and min/max percentages by major crop) “Swingable hectares” is total area times (max minus min); current percentage devoted to each crop is given by country and world Barley Min Max 90 60 30 45 105 90 85 32% 9% 9% 28% 22% 41% 17% 17% 46% 33% 2% 9% “Swingable hectares” US EU-27 Argentina Brazil China India CIS/FSU Theoretical total Min Max 21% 34% 16% Sorghum Rice Min Max Min Max 2% 6% 2% 5% 22% 40% 11% 3% 23% 31% 53% 34% 46% 38% 11% 31% 34% 64% 38% 7.9 4.8 2.2 8.3 12.4 0.0 5.3 41 Wheat 0.0 8.1 0.0 0.0 0.0 0.0 18.6 27 3.5 0.0 0.9 0.0 0.0 0.0 0.0 4 Soybeans Min 5% 29% 48% Max 15% 34% 57% 10.9 3.8 7.9 3.2 8.5 2.7 9.6 47 Min Max 28% 38% 31% 32% 7% 3% 68% 59% 10% 12% 0.0 0.0 0.0 4.5 4.7 8.7 0.0 18 Rapeseed Sunseed Min Max Min Max 6% 12% 6% 6% 15% 19% 6% 6% 8% 9% 5% 17% 8.8 0.0 11.3 12.4 3.6 7.6 0.0 44 0.0 3.8 0.0 0.0 2.7 2.7 0.0 9 0.0 5.2 4.0 0.0 0.0 0.0 9.6 19 Current % US EU-27 Argentina Brazil China India CIS/FSU Maize 40% 16% 12% 31% 33% 0% 9% Barley 0% 22% 0% 0% 0% 0% 17% Sorghum 2% 0% 4% 0% 0% 0% 0% Wheat 22% 44% 11% 4% 23% 33% 59% Rice 0% 0% 0% 5% 29% 48% 0% Soybeans 35% 0% 66% 59% 7% 12% 0% Rapeseed 0% 11% 0% 0% 7% 8% 0% Sunseed 1% 7% 6% 0% 0% 0% 15% Current % world 21% 6% 5% 28% 20% 13% 4% 3% Source: Agrimax. 202 Maize MHa US EU-27 Argentina Brazil China India CIS/FSU COMMODITY INVESTING AND TRADING 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 202 Area 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 203 GRAINS AND OILSEEDS income. Since the early 1990s the US has planted as little as 32% and as much as 41% of its 90.0 MHa of arable land to maize, 2–6% to sorghum, 22–34% to wheat and 28–38% to soybeans. At the last count, the US were at maximum on maize, 35% on soybeans and minimum on wheat. This trend will continue with more ethanol (maize) produced and less land available for wheat and soybeans. Wheat area is the most switchable, and surged 3.0 MHa in 2003. Soybean hectares surged almost 2.5 MHa in 1997 in response to the Freedom to Farm Act. Over the 20 years, total land area only increased by 6 MHa. With the threat (or reality) of E15, it is expected there will be more maize at the expense of wheat. By contrast, the EU-27 has 60.0 MHa in grains and oilseeds up by almost 20.0 MHa's in 20 years, with maize swinging between 9% and 17%, wheat between 40% and 46%, barley between 21% and 34%, rapeseed between 6% and 12% and sunseed between 6% and 14%. At the last count, the EU-27 was close to maximum on wheat and rapeseed, average on sunseed and close to bottom on barley. Argentina and Brazil till some 30 MHa and 46 MHa, respectively, with each having grown from 15.5 and 30.5 since the early 1990s. Argentina is more rotationally complex, with 10–17% maize, 2–5% sorghum, 11–38% wheat, 31–68% soybeans and 6–19% sunseed. Brazil is 28–46% maize, 3–11% wheat, 5–15% rice and 32–59% soybeans. Latterly, Argentina has been in the middle on maize, at the high end for sorghum, at the bottom end for wheat and all the way to max on soybeans and at minimum for sunseed. Brazil was close to minimum for maize, bottom end for wheat and rice and, like Argentina, at max for soybeans. China, with 103 MHa under tillage, is almost unchanged in area since the early 1990s (+5 MHa), and can swing 22–33% on maize, 23– 32% on wheat, 29–34% on rice, 7–11% on soybeans and 5–8% on rapeseed. At the last count, it was max on maize (to blend with imported soybeans), minimum on wheat, rice and soybeans and close to max on rapeseed. The main China growth story is meat production – pork and chicken – with high FCE. A high FCE requires a singular focus on “maize-plus-soymeal” diets, for physical flowability or product handling as well as nutrition. India, with more than 90 MHa in tillage, swings only 31–34% wheat, 48–57% rice, 4–12% soybeans and 6–9% rapeseed. Food security points to more wheat over time but much of this is going to go to 203 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 204 COMMODITY INVESTING AND TRADING more intensive large-scale farming. Indian productivity per hectare has only one way to go: up. The CIS/FSU has some 85 MHa under tillage and dismal yields. Maize farming should be declining and swings 2–9% (currently at max), wheat 53–64% (currently in the middle), 16–38% barley (currently at the low end) and 5–17% sunseed, which is now at the high end. We expect to minimise barley and maximise sunseed and wheat for the foreseeable future. It would be nice to make a big deal of Argentina and Australia, but this is not realistic. They do not have the land mass or yields and so, even if Canada is max on rapeseed at 1.0 MHa, it simply does not make a global difference. At this time, it is max on rapeseed and minimum on wheat. Australia is dryland farming with sporadic rain, so unreliable. The “call-like” planting of Australian wheat means they will continuously plant, from year to year, and hope for rain just as Texas does in the US. Area times yield equals production. The most populous countries have the land pretty much tapped and China has done tremendous work on yield. The baton falls to India to improve crop husbandry. Brazil has land in abundance but infrastructure is so tight and expensive that it is likely to continue its domestic trend toward more meat and aquaculture production. This would expand its export capacity by displacement, just as it now moves vast quantities of sugar by container to the export market. The major opportunities with existing resources in terms of A are all within Table 7.9 and the serious student should understand this one table representation of flexibility in both percentages and individual crops as well as the yield gaps presented in the various tables for the major crops, by country. SUMMARY OF MAJOR TRENDS AND SWING FACTORS FOR THE FUTURE If one thing alone has changed the grain markets completely since the early 1990s and is likely to continue to do so, it is undoubtedly the US corn-based ethanol programme. It remains phenomenally difficult to change commercial US law once it is in place other than by incremental amounts. If cellulosic ethanol arrives it will change the world forever and cause grain prices to collapse. However, it appears to be no closer in terms of substantial economic reality than we saw in the early 2000s. 204 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 205 GRAINS AND OILSEEDS If there is a second thing that has also changed the grain markets completely during this period, it is the manner and rate at which CPGs are growing to dominate our increasingly urbanised food consumption. At the time of writing, China’s Shuanghui International has just bought Smithfield Foods, the huge US-based but globally active pork and meat company, for US$4.7 billion. The need for modern food processing safety, branding and packaging, and all the required supply chain management skills, has rendered it more cost effective “to buy it rather than build it”. If there is a third thing that must happen over the next few years, it is the intensification of agriculture – for the cost of bringing more area into production has become much more expensive than most had anticipated. Since maize combined with soybean meal is the cornerstone of modern animal (and soymeal for aquaculture) nutrition, much more grain will be consumed in Brazil and exported as meat. China and the US have some 34 MHa under maize, and both will increase area. Also, Chinese yield will move towards the US (there is a 3 MT/Ha gap, see Table 7.3), just as China did with the EU in wheat (see Table 7.6). The maize market into the 2020s will remain fundamentally tight and expensive. E15 will take more corn to the fuel tank, although there are some real costs being discussed at the retail petrol station level where the retail supplier is pushing hard to stay at E10 or go to E15, but not carry both. This would require adding pumps, tanks, trucks and re-branding – all expensive items. Brazil will export more maize than the US consistently. The only two things that can cause maize demand to break to the downside are a dramatic u-turn in US energy policy (1:100) or a breakthrough in cellulosic ethanol (1:50). Even a dramatic fall in crude oil prices would only stimulate maize demand for the gasoline pool as it worsens the economics for cellulosic ethanol. Economics says Brazilian ethanol should continue to flow in ever-greater quantities to the US, but it may not become a political reality. It is ironic that the CIS/FSU has a higher barley than wheat yield, something almost impossible in terms of modern farming. The CIS/FSU has the greatest potential to increase yield through intensification and plant breeding, and has some 49 and 14 MHa under wheat and barley, respectively. Any area reductions will be offset by increased commercialism of these two markets inside Russia, from 205 07 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:57 Page 206 COMMODITY INVESTING AND TRADING farmgate to consumer. Wheat will continue to assume the role of primary determinant of grain prices globally as its volume is increasing while US maize volumes decline, net of ethanol. India will become a consistent importer of wheat and withdraw from the export market into the early 2020s. The Chinese (Asian) and Indian (sub-continent) appetites for soya will continue as meat and fish demand increase. The CPG intensification of their food systems will also increase, along with urbanisation and wealth. At 11 MMT of soybeans and 7 MMT of rapeseed, softseed production in India is growing rapidly, and significant imports will come in time. We have been waiting for palm oil production to reach a maximum in Malaysia and Indonesia, but it continues to increase. At some point this must happen and will create more pressure for global soybean area to increase. In terms of AYP, we will continue to see area expand slowly but yield to expand at more impressive rates (see Table 7.1). In fact, the author is optimistic it will be much higher. APPENDIX 7.1: AGRIBUSINESS INVESTORS The ag investing “funds” are listed below. ❏ Commodity-specialist funds: Ospraie, Ospraie Wingspan, Touradji, BlackRiver, Armajaro, etc; ❏ Global Macro funds: DE Shaw, Soros, etc; ❏ Pension funds: APG, Calpers, BT, Hermes, TIAA-CREF, etc; ❏ Sovereign Wealth funds (all EM-based and EM in focus): Kuwait Investment Authority, National Bank of Dubai, SinoLatin Capital, etc; ❏ Private Wealth aggregators: Barclays Global Investors (now BlackRock), GSAM, Adecoagro (Soros), etc; ❏ Index funds: the GSCI, DJ-AIG etc index funds and their hedgers, etc, as well as Schroders in ags; ❏ The Mega funds (ABC): Ashmore, Blackrock, Carlyle, etc; ❏ Managed Futures industry: self explanatory; ❏ Endowment funds: Harvard, etc; and ❏ Private Equity: BlackRiver (Cargill), The Mega Funds, Louis Dreyfus (Calyx Agro) and the L-D family, as well as PAI and an endless list stretching to CP (Charoen Pokphand) and Glencore. 206 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 207 8 Coal Jay Gottlieb This chapter will provide the risk management professional with an orientation to understand the oldest and oddest of energy markets: coal. It will explain the physical characteristics of coals, coal market structure and dynamics, and the coal price indexes and trading venues used for transacting financial derivatives. The chapter will also cover key developments in the fundamentals of coal along with an understanding of the broad range of instruments available to manage risk in that market, and will provide an overview of market drivers and their interaction, as well as offer an initial reference for the detailed data needed to analyse the coal market. OVERVIEW Coal seems to be the unwanted stepchild of the energy world: dirty, old-fashioned, not really popular anymore. Who cares? On the other hand, those who do care a lot often seem to echo the famous words of a White House adviser on energy and the environment: “A Harvard University geochemist who serves as a scientific adviser to President Obama is urging the administration to wage a ‘war on coal.’ ‘The one thing the president really needs to do now is to begin the process of shutting down the conventional coal plants,’ Daniel P. Schrag, a member of the President’s Council of Advisers on Science and Technology, told the New York Times. ‘Politically, the White House is hesitant to say they’re having a war on coal. On the other hand, a war on coal is exactly what’s needed.’”1 Trends in worldwide coal consumption indicate that Professor Schrag’s war is going badly: 207 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 208 COMMODITY INVESTING AND TRADING “Coal consumption grew by 2.5% in 2012, well below the 10-year average of 4.4% but still the fastest-growing fossil fuel...Coal reached the highest share of global primary energy consumption (29.9%) since 1970.”2 Coal has driven global development since the British industrial revolution, beginning in the 18th Century with the harnessing of increasing amounts of coal-fired steam power for transportation and steel production. The role of coal-fired steam in transportation and manufacturing along with the use of coking coals in the production of steel is familiar. While other fossils remain a big part of people’s daily lives – petrol for cars and natural gas for home heating and cooking – coal has largely receded from view. It works away quietly in the industrial background. While coal is no longer used locally for transportation or building heat, it is still consumed as a key component in steel and cement production and fuels around 40% of the world’s electric power generation. Coal is found abundantly around the world, is relatively easy to produce with existing mining technologies and can be transported through a wide variety of modes, such as conveyor belt directly from mine to power plant, or through combinations of truck, rail, barge and ocean-going freighter. As transportation infrastructure developed around the world since the 1960s, prices for bulk transportation declined and coal changed from a commodity with only a local regional reach and economics to one that is traded similarly to other higher-value energy commodities, flowing around the world from production areas to wherever it commands the highest value in consumption. Along with the explosion of transportation options, coal consumers have become much more sophisticated in managing their power plants to run on a greater variety of coals, adjusting for physical and chemical differences in coals from divergent sources. The major exporters of coal are Indonesia, Australia, South Africa, Colombia, US and Russia. China and Europe are the major importers. While the exact numbers will of course change from year to year, the major participants will not. CHARACTERISTICS OF COAL So, let us return to the question, “what is coal?” It is an energy-rich source of carbon that is relatively easy to find, mine and transport, but is also bulky and heavy relative to its energy value. Also, coal 208 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 209 COAL comes with many other non-carbon components that must be controlled to limit pollution and other unwanted emissions from power production and other consumption. Coal is a combustible sedimentary organic rock consisting of more than 50% carbon by weight. It is a fossil fuel derived from plants that grew in swamps that were later buried by sediments. Geological processes compressed and heated the plant remains over vast periods of time, producing various ranks (or categories) of coal. With increasing rank, coal becomes harder, brighter and the heat content is higher. The ranks from lowest to highest are: peat, brown coal, lignite, sub-bituminous, bituminous and anthracite (listed in Table 8.1). While coal is chiefly comprised of carbon, hydrogen and oxygen, it also contains varying amounts of sulphur, nitrogen and other elements. Coal quality varies a great deal and is priced based on these characteristics. The heat content is the key value of the commodity for electricity generators and cement producers, while other characteristics are important for steel producers. Disposing of the non-desirable components, particular sulphur and nitrogen, adds cost to the consumption of coal. Table 8.1 Coal rank description Peat Wet plant material that has been subject to bacterial and fungal action, very low energy level, moisture level ~60% calorific value ~2,600 kcal/kg Brown coal Peat that has had the water squeezed out, plant remains still visible moisture ~50%, calorific value 2,800 kcal/kg Lignite Coal is hard and massive, black looking, moisture content 40–50%, calorific value about 4,000 kcal/kg Sub-bituminous Coal is hard, brittle, black and shiny, moisture content is 20–40%, calorific value 4,000–5,800 kcal/kg Bituminous Coal is softer and shiny, moisture content is 8–20%, calorific value is 5,800–8,000 kcal/kg, crucible swelling number from 2–9+ possible for coking coals, volatile matter 16–40% Anthracite Coal is very shiny, repels moisture, calorific value 7,800–8,000 kcal/kg, no coking properties 209 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 210 COMMODITY INVESTING AND TRADING Heat content is measured as the heat produced by combustion of a specified quantity of the fuel when burned at a constant pressure under controlled conditions for water vapour. It is measured in terms of either British thermal unit (Btu) per pound in the US or kilocalorie per kilogram (kcal/kg) internationally. In all cases, higher heat content is preferable to lower. Thermal coal fires power generation plants, and metallurgical (or met) coal is used for steel production. We will now look at which coal qualities are of importance in thermal and metallurgical consumption. Thermal coal Most coal is used for the energy content within the volatile matter and the fixed carbon. These coals are generically termed “thermal” (or steam) coals and are mostly used for electricity generation. A typical Australian thermal coal contains 6,080 kcal/kg of usable energy (net as-received energy) or 25.46 megajoules/kilogram (MJ/kg) of coal. Electrical energy (power) is measured in watts which are joules per second, therefore one kilowatt hour of electricity (one unit) converted from coal at 35% efficiency requires 10.286 MJ of coal energy every hour, or 0.404 kg of coal. Other thermal coal uses are the calcination (breakdown by heat) of limestone to form cement for construction industries or lime for agricultural purposes. Hospitals and other institutions use coal for process heat, as do abattoirs, wool sours and timber-drying processes. Metallurgical coal For steel and other metallurgical production, certain bituminous coals are particularly suited to release gaseous components, called volatile matter, when heated to extremely high temperatures in the absence of oxygen. When these special bituminous coals swell on heating above 350 0C and release their volatile matter, they leave behind a hard porous carbon residue called coke. These coals are called coking coals and are limited in their occurrence around the world. Coking coals are primarily used to make coke that, under high temperatures, reduces metal oxides to metals. This process occurs when the coke is combined with the metal oxides at elevated temperatures. The carbon from the coke combines with the oxygen from the metal oxides to produce carbon dioxide, liquid metal and 210 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 211 COAL residual ash (slag). The coals most suitable for producing coke command the highest prices on the world market. Sulphur content is always undesirable. Creating air pollution when the coal is burned, sulphur emissions must be controlled with expensive technologies. Laboratory analysis of sulphur content as percentage of total weight of coal is typically adjusted for the heat content of a ton of the coal for pricing purposes, as regulatory standards are based on how much sulphur is emitted per ton of coal burned. High-rank coals are high in carbon and therefore heat value, but low in hydrogen and oxygen. Low-rank coals are low in carbon but high in hydrogen and oxygen content. Transportation More than any other energy commodity, transportation costs are a major component of the cost of fuel delivered to the end-user. This is a simple result of coal’s high bulk and weight relative to its value. The high cost of transportation and rigidities in the transport infrastructure impact the markets for coal. Coals are typically priced either free on board (FOB) at mine origin, or cost, insurance and freight (CIF) at the consumer’s destination, with either the consumer or producer responsible for arranging and paying for transportation from or to that point. There are no intermediate collection points and few wholesale marketing points. Train shipments are difficult, if not impossible, to re-schedule and re-direct, so there is very little trading of physical coal once it is en route to an ultimate destination, unlike the vast amount of trading of oil tankers. Seaborne coal markets are where the most active trading occurs, because of the greater flexibility and relative low cost of moving a bulky item across the water versus across land. Coal mines are either surface (open pit) or underground. Transportation from the mine can be done through a number of modes, but again the low value-to-weight ratio makes minimising the physical handling of coal the key to cost efficiency in transportation. Depending on distance and mode of transport, transport costs for delivered coal range from 20–70% of delivered price to the ultimate consumer, a major component of the total cost of coal procurement. Coal can be moved directly from source to end-user via truck for 211 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 212 COMMODITY INVESTING AND TRADING distances of less than 100 miles. For longer distances, rail or waterborne transport is typically used. Coal can also be trans-shipped from rail or truck into river barges or ocean-going vessels. For other than international export, no more than two trans-shipments would be used, as it is important that transportation mode changes add as little cost as possible. Therefore, coal goes from mine to end-user with few intermediate transactions. Historically, coal sold under long-term supply contracts with less trading than other commodities – due to high capital costs mirrored on both the production side (mine and transportation development) and the use side (power plant construction). Since many of the mines, transportation networks and generation plants have been put in place and their capital costs are amortised, the economics allows for shorter deals. In addition, consumers have learned to be much more flexible in sourcing, which enables coals to compete among each other and against other fuels. Consequently, markets have become more dynamic. Trading and risk management tools have also grown to match that flexibility. An increasing proportion of coal is sold on the spot market and priced off of indexes. This is what has stimulated the growth of derivatives trading. Cheaply mined and having relatively low heat content (and also low sulphur content), Powder River Basin coals are shipped by rail from Wyoming to west coast ports and then on to Asia. Eastern US coals can change modes several times, from mine by rail or truck to river barges and then out to Europe through loading on ocean-going vessels in the New Orleans area, or directly by rail to ports on the east coast. Once sea-borne, coals from Australia and South Africa compete with the US coals for markets in Europe and Asia. The consumer purchases the coal based on a limited number of heat content and quality variables against the price delivered to their power plant. Thermal coal has become for the first time a truly world commodity, a fact that is reflected in the growth of derivatives trading. Bituminous coal is typically much more expensive to mine, has up to 50% greater heat content and thus significantly lower transportation costs, and can be environmentally friendly, commanding higher price at the mine. As mentioned above, sub-bituminous coal, such as from US Powder River Basin, has lower heat content and transportation costs as much as 50% greater – with long, overland rail 212 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 213 COAL transportation to end-users or export terminals – but has low mining costs due to thick seams of easily accessible coal through surface mining, and often has lower sulphur content. This makes it extremely competitive, even in world markets, and significant export capacity on US west coast is under development. MARKET STRUCTURE Worldwide, most coals are priced on a per ton basis. In the US, however, many utilities prefer to buy on a price based on heat content rather than weight, in million Btu (MMBtu). Prices are measured by many indexes that are transparent and reliable, and have allowed the growth of derivatives trading based on them. In the past, published prices rarely changed and were totally unreliable for any contracting or trading. Little spot trading occurred and long-term contracts included negotiations of many factors, particularly free supply options for the buyer, which made price comparison across time or contracts meaningless. For these reasons, active physical and financial trading of coal was slow to develop, but has become fully integrated into the energy risk management environment. A joint venture between an energy market news organisation, Argus Coal Services, and a coal industry economic and management consulting firm, IHS McCloskey, produces the API indexes, which are the standard industry benchmarks. The main focus for activity in the coal derivatives market is the API 2 index, which consists of an average of the two firms’ price assessments for coal imported into Amsterdam, Rotterdam and Antwerp, and includes CIF. Another major index is API 4, which is the benchmark for coal exported from Richards Bay in South Africa and also incorporates CIF. Argus estimates that more than 90% of the world’s coal derivatives are priced against these indexes. The list below describes the key indexes used for international physical and derivatives coal business. ❏ API 2 index: the industry standard reference price used to trade coal imported into northwest Europe. The index is an average of the Argus CIF Rotterdam assessment and McCloskey’s northwest European steam coal marker. ❏ API 4 index: the price for all coal exported out of Richards Bay, South Africa. The index is calculated as an average of the Argus 213 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 214 COMMODITY INVESTING AND TRADING FOB Richards Bay assessment and McCloskey’s FOB Richards Bay marker. ❏ API 5 index: the price for exports of 5,500 kcal/kg net as received (NAR), high-ash coal from Australia. The index is calculated as an average of the Argus FOB Newcastle 5,500 kcal/kg assessment and the equivalent from IHS McCloskey. ❏ API 6 index: this index represents 6,000 kcal/kg NAR coal exported from Australia. It is calculated as an average of the Argus FOB Newcastle 6,000 kcal/kg assessment and the equivalent from IHS McCloskey. ❏ API 8 index: the price for 5,500 kcal/kg NAR coal delivered to south China. It is calculated as an average of the Argus 5,500 kcal/kg cost and freight (CFR) south China price assessment and the IHS McCloskey/Xinhua Infolink south China marker. The publishing schedule for these widely used indexes are as follows: ❏ Weekly average coal price: ❍ Northwest Europe (CIF ARA) API 2 index; ❍ South Africa (FOB Richards Bay) API 4 index; ❍ Australia (FOB Newcastle) API 5 index; ❍ Australia (FOB Newcastle) API 6 index; and ❍ CFR south China API 8 index. ❏ Monthly coal price: API 2, API 4, API 5, API 6, API 8 indexes; and ❏ Daily coal price: API 2, API 4 indexes. These prices are available exclusively through the Argus/ McCloskey’s Coal Price Index service. FINANCIAL MARKETS FOR COAL Virtually all markets are served by multiple over-the-counter (OTC)cleared standardised derivatives contracts. Multiple platforms offer products on the same indexes. OTC trades are cleared on two competing platforms: CME/Nymex and the Intercontinental Exchange (ICE). The types of coal futures for each exchange are listed below (as of June 2013). The exchanges also list options and strips for most of these futures. 214 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 215 COAL CME coal product slate Thermal coal products Global: MTF: Coal (API 2) CIF ARA (Argus/McCloskey); s Bay (Argus/McCloskey); 215 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 216 COMMODITY INVESTING AND TRADING ❏ Supply: mountaintop removal and water-course impacts for mining; construction of transportation facilities such as major rail improvements or development of export terminals. ❏ Consumption: emission of carbon, sulphur oxides and nitrous oxides on the consumption side; retrofitting of new control technologies and purchase of emission allowances and credits. Supply and trade Minerals mining companies focused primarily on coal extract the majority of the produced coal. Such companies range from national producers to international corporations, as well as many smaller companies. While it used to be very common, particularly in the Appalachian region of the US, for companies to be formed to own and operate just a single mine, much of the industry has taken advantage of economies of scale that have resulted in a greater concentration of ownership in larger corporations. Consequently, short-term spikes in price can occur due to strikes, labour shortages, transportation bottlenecks and mining problems at the larger mines. Typical production cost increases in major coal exporting counFigure 8.1 Largest coal exporters annual exports (thousand short tons) 400,000 350,000 300,000 Indonesia Australia Russia United States Colombia South Africa 250,000 200,000 150,000 100,000 50,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: EIA, international energy statistics 216 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 217 COAL tries outside the US have increased by around 200% since the late 2000s. These dramatic rises in cost vary across production areas and are due to a wide variety of reasons. The main impact has been to increase the integration of worldwide coal markets as producers look for more extensive markets and consumers search for competitive purchasing opportunities. Figure 8.1 shows the changing landscape of the top global coal exporters. Almost half of Australia’s exported coal goes to metallurgical use, mainly in Asia and Europe, with Japan, India, China and South Korea being the main Asian importers. Japan is also the largest buyer of Australian thermal coal. The US and Canada export significant quantities of metallurgical coal, but thermal coal comprises most of Indonesia’s rapidly growing export volumes. China, South Korea, India and Japan are the largest importers of US coal. Figure 8.2 shows the distribution of recoverable reserves for coal globally, while Figure 8.3 displays the trends for the largest importing countries. Consumption While there are other important trends in coal demand, such as continued growth in India’s consumption and imports, China alone has dominated global consumption and demand growth. Again Figure 8.2 World recoverable coal reserves (861 million tons) Other 26% US 28% Indonesia 6% Australia 9% China 13% Russian Federation 18% Source: BP, June 2013, “Statistical Review of World Energy” 217 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 218 COMMODITY INVESTING AND TRADING Figure 8.3 Largest coal importers annual imports (thousand short tons) 250,000 200,000 150,000 100,000 50,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Japan India China Taiwan South Korea Source: EIA, international energy statistics quoting from BP, “Statistical Review of World Energy” (June 2013) regarding 2012 annual growth in coal use: “Consumption outside the OECD rose by a below-average 5.4%; Chinese consumption growth was a below-average 6.1%, but China still accounted for all of the net growth in global coal consumption, and China accounted for more than half of global coal consumption for the first time. OECD consumption declined by 4.2% with losses in the US (–11.9%) offsetting increases in Europe and Japan. Global coal production grew by 2%, with growth in China (+3.5%) and Indonesia (+9%) offsetting a decline in the US (–7.5%). Coal reached the highest share of global primary energy consumption (29.9%) since 1970.” Thermal coal consumption in the US has decreased since 2008 compared with increasing consumption in Asia and Europe. In the US, natural gas continues to displace more and more coal generation due to the costs of upgrading old coal plants to meet ever-higher emission standards, and the low cost of gas due to greater expansion of supply. The relationship between natural gas prices and coal prices for power production has driven coal markets like never before. The 218 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 219 Figure 8.4 EIA historical and forecast annual coal consumption (quadrillion Btu) 100 90 80 70 60 50 China United States OECD Europe India OECD Asia Rest of World 40 30 20 10 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: EIA, international energy statistics database (as of November 2012), and “EIA Annual Energy Outlook 2013” (base case). COAL 219 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 220 COMMODITY INVESTING AND TRADING glut of natural gas in the US in 2012 drove natural gas prices to a level where, in July 2012, for the first time in history US electricity production from gas-fired plants was equal to that of coal-fired plants. Contrast this with the early 1990s, when coal represented more than 50% while gas represented roughly 5%. At prices above US$3.50/ MMBtu for gas, coal becomes competitive again. Gas-fired power displaced US coal in the international markets, where the cheap coal significantly increased European coal-fired generation at the expense of their natural gas plants. China’s consumption growth comes largely from increasing power generation. China has large domestic coal reserves, but it will always take advantage of low import prices and significantly increase imports appropriately. Since US demand has been down due to the explosion of inexpensive supplies of natural gas, China has imported US and other coals while reducing domestic production. When demand and prices increase in the US domestic markets, China will rely on its own production again. PANEL 8.1: FUEL TO POWER SPREADS A key ingredient in most liquid derivatives markets is the trading of spreads between one instrument and another. In effect, most commodity trading is based on the differential between two (if not more) prices. Few traders take on outright risk, but most do choose very specific relationships where they have developed expertise and expect that they can both recognise certain trends before the market has fully taken them into account and can, in any event, minimise the risk exposure made by each trade. In options trading, there is a whole unique vocabulary describing the various types of spreading between puts and calls on various strike prices for the same security or commodity. Often, commodity futures spreads are built on assessments of the likely trends in differentials between various contract months in the same commodity. Classic commercial hedgers spread the exposure between long and short positions for the same commodity for the same delivery period, with one side being in the actual purchase or sale of the physical commodity with an offsetting derivatives position. In theory, whatever loss accrues on one side should be offset by a corresponding gain on the other, keeping the producer, consumer or merchandiser of the actual commodity protected against swings in the market price of the commodity. Hedging thus frees up the firm to focus on operational and marketing efficiencies rather than worrying about its business being disrupted by volatile price movements. This is, of course, in theory. In practice, the “basis” of the differential between the underlying 220 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 221 COAL physical and the financial derivative must be managed closely. Hedging is often called an exchange of absolute price risk exposure for “basis” risk exposure. Most pertinent to coal are the spreads between inputs and outputs in a commodity production process. The classic spreads are the soybean “crush”, whereby trades are made on the differentials between the raw soybean inputs which are crushed to make soybean meal and soybean oil, with each having their own derivatives. With the advent of petroleum derivatives trading, the petroleum “crack” spread became a key differential, measuring the cost of raw petroleum being refined into heating oil and gasoline. Since petroleum refiners often had catalytic cracking units, and “crack” is similar to “crush”, the petroleum “crack” was the logical new name. With the advent of electricity, natural gas and coal trading, the derivatives world added the “spark” spread, the differential between natural gas fuel prices and electricity output prices. For coal-fired plants, the equivalent spread is the “dark” spread. Both of the spark and dark spreads can be called “dirty” when they do not incorporate the cost of purchasing carbon credits for emissions created by the plants. In all these input-to-output spreads, financial traders develop standardised relationships describing the amount of each input required for each unit of output. As the reality for each bean-crushing operation, each oil refinery or electric power plant will vary from these standard trading models, the hedging/risk management teams for those operators will adjust their trades accordingly. For a simple example of a dark spread calculation using US measurement units, the spread is measured by: Spread = [Power price (US$/MWh)] – [Coal cost (US$/ton) + Transport cost (US$/ton)] x [Heat rate of generator (MMBtu/MWh) ÷ Heat content (MMBtu/ton)] where MWh is megawatt hour, heat rate is the rate at which the electric generator converts heat from the coal combustion into power, measuring the efficiency of the generating unit, and heat content is how much heat is produced by burning a ton of that coal. Unlike spark spreads, which are calculated using natural gas costs and on-peak power prices, dark spreads often use a combination of on- and off-peak power prices. This combination (referred to as the flat price) reflects the different role that coal-fired generators play in the supply stack of a particular electric system. Coal-fired generators have traditionally served as base-load generation. They run throughout the day and night. The combination of on-peak (during the day) and off-peak (nights and weekends) power prices reflects this role. In addition, as gas-fired plants are typically more efficient than coal, typical spark spread heat rates correspond to an efficiency of around 0.5 (50%), while dark spread heat rates are near efficiencies of 0.38 (38%). 221 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 222 COMMODITY INVESTING AND TRADING CONCLUSION Typical production cost increases in the major exporting countries other than the US have increased by about 200% since the late 2000s, resulting in the integration of worldwide coal markets. Different coals compete with each other through a sometimescomplex value optimisation, combining quality, suitability, location and cost of transport. Quality differentials continue to play a bigger role in import decisions for coking coal because they play a bigger role in the suitability for various steel plants. This contrasts with steam coal, which is basically just “heat” and is very interchangeable. There are sufficient known and accessible reserves of met-quality coal; however, due to the increases in production costs, prices have to rise to bring them to market. Therefore, if demand for steel production is sufficient, met coal prices will rise to meet the input demand. Demand drivers are factors that move electricity demand such as weather, economic growth and, to some extent, the price of competing fuels including natural gas. Met coal demand depends directly on steel production. Multi-year coal contracts have been in a long process of evolution since the early 1990s. It used to be fairly easy to describe typical terms and conditions, but this is no longer the case as there are many types differing within countries and from country to country. Coal remains the single most important fuel for generating electricity worldwide. Traditionally, coal has been by far the cheapest fuel for generating electricity. The other cheaper form is hydropower, which is strictly limited by geography and annual weather conditions. However, due to technological improvements in extracting natural gas, that fuel has become consistently competitive to coal on price. Furthermore, natural gas is less carbon-intensive than coal, its burning produces fewer undesirable emissions and the capital costs of building natural gas-fired generation are much less than for coal. Therefore, coal has lost significant ground to natural gas. Due to its abundance and the high level of installed generating capacity, however, coal will continue to play a significant role in electricity generation. Since the beginning of the industrial revolution, coal has been – and continues to be – the workhorse of the energy world. The coal marketing chain from production to final consumer is typically much less diverse and complex than other commodities. Coal also has a 222 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 223 COAL much lower value per weight than other commodities. Also, industrial organisations are the exclusive end-user consumers for coal. The high proportion of transportation costs and less-diverse end-users result in few transactions from mine-mouth to final consumer. Therefore, among the major energy commodities, coal markets have been the slowest to adopt financial derivatives. However, coal has become a full member of the energy risk management jigsaw. APPENDIX 8.13 Coal conversion statistics and terminology Basis of analysis Definitions: as received (ar): includes total moisture (TM); erent moisture (IM) only; To obtain: Air dry Dry basis As received multiply ar by: (100 – IM%)/(100 – TM%) 100/(100 – TM%) – ad by: – 100/(100 – IM%) (100 – TM%)/(100 – IM%) db by: (100 – IM%)/100 – (100 – TM%)/100 [For daf, multiply db by 100/(100–A)] Example: ar ad db daf TM 11.0 – – – IM 2.0 2.0 – – Ash 12.0 13.2 13.5 – VM 30.0 33.0 33.7 39.0 FC 47.0 51.8 52.8 61.0 Sulphur 1.0 1.1 1.12 – 223 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 224 COMMODITY INVESTING AND TRADING MASS Units: ❏ Metric ton (t) = tonne = 1,000 kilograms (= 2,204.6 lb); ❏ Imperial or long ton (lt) = 1,016.05 kilograms (= 2,240 lb); and ❏ Short (US) ton (st) = 907.19 kilograms (= 2,000 lb). Conversions: ❏ From long ton to metric ton, multiply by 1.016; ❏ From short ton to metric ton, multiply by 0.9072; ❏ Mt – million tonnes; ❏ Mtce – million tonnes of coal equivalent (= 0.697 Mtoe); and ❏ Mtoe – million tonnes of oil equivalent. Calorific values (CV) Units: ❏ kcal/kg – Kilocalories per kilogram; ❏ MJ/kg* – Megajoules per kilogram; and ❏ Btu/lb – British thermal units per pound. * MJ/kg = 1 Gigajoule/tonne (GJ/t) Gross and net calorific values ❏ Gross CV or higher heating value (HHV) is the CV under laboratory conditions. ❏ Net CV or lower heating value (LHV) is the useful calorific value in boiler plant. The difference is essentially the latent heat of the water vapour produced. Conversions (units): ❏ From kcal/kg to MJ/kg, multiply by 0.004187; ❏ From kcal/kg to Btu/lb, multiply by 1.800; ❏ From MJ/kg to kcal/kg, multiply MJ/kg by 238.8; ❏ From MJ/kg to Btu/lb, multiply MJ/kg by 429.9; ❏ From Btu/lb to kcal/kg, multiply Btu/lb by 0.5556; and ❏ From Btu/lb to MJ/kg, multiply Btu/lb by 0.002326. Conversions – gross/net (per ISO, for as received figures): ❏ kcal/kg: Net CV = Gross CV – 50.6H – 5.85M – 0.1910; ❏ MJ/kg: Net CV = Gross CV – 0.212H – 0.0245M – 0.00080; and ❏ Btu/lb: Net CV = Gross CV – 91.2H – 10.5M – 0.340. 224 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 225 COAL where M is percentage moisture, H is percentage hydrogen, O is percentage oxygen (from ultimate analysis,4 also as received). For typical bituminous coal with 10% M and 25% volatile matter, the differences between gross and net calorific values are approximately as follows: 260 kcal/kg 1.09 MJ/kg 470 Btu/lb Power generation: ❏ 1 MWh = 3600 MJ; ❏ 1 MW = 1 MJ/s; 1 MW (thermal power) [MWth] = approx 1,000 kg steam/hour; th/3. 1 Aaron Blake, Washington Post, June 25, 2013: Obama science adviser calls for “war on coal”. 2 BP, 2013, “Statistical Review of World Energy”, June. 3 Source: World Coal Association website: http://www.worldcoal.org/resources/coalstatistics/coal-conversion-statistics/. 4 Ultimate analysis determines the amount of carbon, hydrogen, oxygen, nitrogen and sulphur. 225 08 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:58 Page 226 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 227 Part II Trading and Investment Strategies 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 228 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 229 9 Farmland as an Investment Greyson S. Colvin and T. Marc Schober Colvin & Co. LLP Although oil, metals, grains and financials are commodities key to making the world go round, only farmland has no substitute. Everyone has to eat in order to survive, and the production of almost all food can be traced back to farmland. Demand is growing for farmland as the world’s population and global need for food increases. However, what many do not realise is that the supply of farmland is not changing, thus creating a severe imbalance in its supply and demand. Over the long term, farmland will provide a steady stream of income and capital gains due to the increasing global demand for agricultural commodities, driven by the rising world population, rapid growth in emerging markets and continued demand for ethanol and bio-fuels. To understand it properly, we have to ask what exactly is farmland? The definition of farmland or agricultural land is the land suitable for agricultural production, both crops and livestock. According to the United Nations Food and Agriculture Organization (FAO), there are three primary types: 1. 2. 3. arable land: land under annual crops, such as cereals, cotton, other technical crops, potatoes, vegetables and melons; also includes land left temporarily fallow; orchards and vineyards: land under permanent crops (eg, fruit plantations); and meadows and pastures: areas for natural grasses and grazing of livestock. 229 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 230 COMMODITY INVESTING AND TRADING For our purposes, we will generally focus on arable land or row crop farmland that produces grains planted in rows harvested each year, including corn, soybeans and wheat. These are the grains that are (and will be) needed to feed the world’s growing population. We will also look at farmland located in the US, since it has some of the best producing farmland in the world, as well as the most advanced farmers and farming technology, the most developed infrastructure and uses the most leading technologies. According to the Natural Resource Conservation Service (NRCS), there are 12 recognised types of soil in the world. Of these, the most naturally fertile are mollisols, which is suitable or very suitable farmland. Mollisols are generally found in only four places: in the Pampas Region of Argentina, the Steppes of Ukraine and Russia, areas of Northeast China and the Grain Belt of America. Mollisols make up only 7% of the ice-free land in the world and are the best soils for farming because they contain large quantities of organic matter. Mollisols found in the Midwestern US are the best for agriculture due to the grasslands formed thousands of years ago. These prairies produced strong and fertile soils because each year the grasses (and animals) would break down, with nutrients in the organic matter decomposing into the ground. Once the Wisconsin Glacier retracted from Illinois and Iowa, great dust storms blew fertile silt on top of the young land, making it ideal for crop production. However, in terms of percentage of land area, not very much of the planet is actually appropriate for farming. Once you remove places that are too cold or too wet, the deserts, the forests, the bad soils and every other strange place that cannot host a decent haul of crops, there is not much left over. However, while America has 5% of the world’s population, half of its land is suitable for cultivating and growing crops. In comparison, China has 20% of the world’s population but only 7% farmable land, according to the FAO. Under the rule of law, US farmland cannot be hijacked by a totalitarian government or organised crime (yes, organised gangsters do terrorise and control some farms in the Ukraine and Russia), and the US Midwest Corn Belt sits in the optimum climate for production. When coupled with modern technology, the US farmer’s work ethic, excellent soil and infrastructure for transporting crops, the US is unsurpassed for production. All farmland is not created equal and no two properties are the 230 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 231 FARMLAND AS AN INVESTMENT same. The ability of the land to produce profitable crops is part art and part science; however, at the end of the day, so is analysing and valuing farmland. This chapter will therefore cover the following factors that drive the fundamental investment rationale for farmland investments. Land scarcity: there are approximately 3.5 billion acres of arable ng a mere 5% over for proteins will 231 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 232 COMMODITY INVESTING AND TRADING ❏ Cash returns: farmland is a performing asset, generating modest cash returns of 4–6%, depending on location and crop. ❏ Sustainable asset: farmland improves in productivity over time when well managed. The chapter is organised into the following sections: the first will examine value creation and investment in farmland, before we delve into renewables and their impact. The next section details production and its limitations, and we finish with an investigation into global farming. VALUE CREATION AND INVESTMENT Value creation from farmland Arable land for farming has been valued since the first crops were domesticated. Farmland creates multiple commodities: wheat, corn, animal products and meats, and even wind energy if a landowner chooses to lease out part of their land to host a wind turbine. An investment in farmland can provide a steady stream of income from demand for agricultural goods, driven by the rising world population and rapid growth in emerging market consumption. The continued demand for ethanol and bio-fuels also puts upward pressure on crop values. Demand for agricultural commodities is outpacing supply, which positions farmland for long-term appreciation. We should look at what makes something valuable as a commodity; is it, or does it offer, a broadly desired marketable item? Is it something that would be dearly missed if it disappeared from the worldwide market? In addition to being an end-user item, can something also serve as an investment vehicle? Farmland as lease property A farmland owner who does not intend to operate the farm often monetises the land’s value by leasing. A rental lease, in this case, is an agreement between the landlord and the farmer of the property. Often these agreements are legally binding documents drafted by attorneys, but can be as vague as a verbal commitment (in which case, it may be as solid as the paper it is written on). Leases span all different lengths of time, from one year to the life of the property, but in the Midwestern US they are often for between one and five years. Farmers aggressively seek leased land for their 232 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 233 FARMLAND AS AN INVESTMENT operations in order to expand and capture economies of scale without increasing the most expensive element of production: the land. Leased land allows farmers to spread equipment and other fixed operation costs over more acres to increase profit margins, and also allows them to increase income by farming more acres. There are several possible lease options available to a landlord, but any of them should return roughly a third of all revenues generated from the land per year. There are three main types of farmland leases: cash rent: fixed rate per acre per year; wner shares in the expenses and profits; and Figure 9.1 Farmland risk–return profile Low risk Low returns Cropland Prime farmland Timber Tree crops High risk High returns Own/hold Cash rent Crop share Custom farm Joint venture Operate 3% 5% 7% 10% 12% 12%+ 233 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 234 COMMODITY INVESTING AND TRADING landowner from taking on crop or credit risk from the farmer. The landowner does not have to worry about drought or the rate of crop growth. Land across the Midwest is typically leased at 4–5% of the market value of the land; target farmland for investment that can be leased for 5% or greater is recommended. Farmland in other regions of the US can have lower lease rates as a percentage of value due to the commodities produced and other factors affecting the value, such as potential development. Farmland as an investment Farmland has a proven record – it has been one of the top performing investments over the last 100 years. In the 20th century, farmland only decreased in value three times: during the Great Depression, the inflation crisis of the early 1980s and in the housing crisis of 2008/09. The US farm sector has a healthy balance sheet and, as mentioned, debt-to-asset ratios are low. Unsurprisingly, farmers historically have been the main buyers of US farmland and do not buy intending to flip for profit but rather to hold for decades or generations, keeping the land in the family. Farmland is the most valuable asset a farmer can own, which leads most to reinvest a significant part of their crop and livestock revenue back into the purchase of additional farmland to expand their operations. It is also important to understand that farmland values per acre are essentially a function of revenues generated per acre. Revenues are mainly dictated by two variables: price of the commodity and yield per acre. In the 20th century, grain prices were fairly stable while production increased a few percentage points per year, on average. The increase in production allowed farmland to become one of the most stable and consistent asset classes. Despite three downturns over the last 100 years, farmland returns in the US are historically one of the best investment vehicles, comparing favourably with more traditional assets such as stocks and bonds. Table 9.1 clearly shows the stability of farmland. Bear in mind, this includes crop years and/or regions that were wiped out or suffered severely diminished yields due to drought, flood and other disasters. In 2012, the Federal Reserve Bank of Chicago reported that farmland values grew by 16%, the third largest increase in the previous 35 years. Despite the worst drought in over 55 years, high commodity 234 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 235 FARMLAND AS AN INVESTMENT Table 9.1 Midwestern US farmland returns State Illinois Iowa Nebraska North Dakota South Dakota Wisconsin US 1 year (%) 5 years (%) 10 years (%) 20 years (%) 22.8 22.8 33.5 26.5 23.9 7.4 10.9 12.0 16.2 18.4 14.1 13.1 3.7 5.8 11.8 14.1 13.5 11.8 12.8 7.4 8.3 8.1 9.7 8.7 7.3 8.5 8.5 6.9 50 years 100 years (%) (%) 6.9 7.6 7.4 6.8 7.1 7.4 6.5 4.6 4.9 4.6 4.2 4.1 4.7 4.5 Source: USDA Economic Research Service prices and record farm incomes drove demand for agricultural land. Survey respondents anticipated that the momentum would continue over the next 12 months based on the record income expectations for 2013. Iowa farmland values led the pack, with a 20% return in 2012, followed by Illinois and Michigan with an 18% annual return. This was during a time many considered recessionary. One of the most attractive attributes of farmland is income realised from rental. Since 1967, rural cash rents have yielded roughly 5.7%, according to the USDA (this was calculated by the authors using historical data from: http://usda.mannlib.cornell. edu/MannUsda/viewDocumentInfo.do?documentID=1446). This compares very favourably to Treasury bonds and other incomeproducing assets. The cash rental contract is typically prepaid, so the investor does not have to take operational or credit risk from the farmer. Society will undoubtedly be drastically different by the mid21st century, but the US farmer will still be leasing farmland to raise livestock and crops. Farmland also provides investors with the chance to diversify from traditional investments, which makes it an excellent asset to balance a portfolio and offset financial and commercial real estate market volatility. Farmland has always shown a positive correlation to the Consumer Price Index (CPI), exceeding stocks, bonds and nonfarm real estate. Farmland is frequently compared to investing in gold because of its characteristic as an inflation hedge. However, unlike gold, farmland also produces a stable income stream, and as a consequence it has been described as “gold with yield.” Gold does not stock-split or 235 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 236 COMMODITY INVESTING AND TRADING Figure 9.2 Investment correlation with farmland (1971–2009) Historical correlations with US Farmland Correlations Negative -0.43 Long term US corporate bonds -0.22 US treasury bills -0.18 S&P 500 -0.15 International equities -0.07 US small cap equities US commercial real estate S&P GSCI Gold US inflation -0.50 -0.25 0 Positive +0.23 +0.28 +0.30 +0.36 +0.25 +0.50 Source: NCREIF, Ibbotson & Associates, Morningstar, Western Spectator (June 2010) pay dividends; you just hang on to it, pass it down or sell it. It can also be seen as similar to non-dividend paying equities. Eventually, the only way these stocks bring value to you or your family is when you sell them. However, farmland will bring returns to you and generations of your family as long as they continue to own and manage the land. RENEWABLES AND THEIR IMPACT Renewable fuels impact on the farm Social and political concerns regarding climate change and fossil-fuel dependency have led to a significant focus on renewable fuels, such as ethanol, as a replacement for petroleum-based fuel sources. Ethanol is primarily manufactured from crops such as corn, wheat and sugar cane. According to the USDA, ethanol production in the US increased from less than three billion gallons in 2003 to over six billion gallons in 2007, and is estimated to exceed 12 billion gallons by 2020. The Renewable Fuel Standard from the 2007 Energy Independence and Security Act calls for total renewable fuel to reach 36 billion gallons by 2022. Ethanol, no matter how viable or controversial, is mandated as a renewable source of energy. At its most basic, ethanol is grain alcohol, produced primarily from corn and sugar cane. The USDA estimates that more than 40% of US corn production was used to produce ethanol in 2011. In January 2011, the US Environmental Protection Agency (EPA) approved the use of E15 gasoline for vehi236 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 237 FARMLAND AS AN INVESTMENT cles manufactured in 2001 or thereafter. Almost all gasoline in the US is E10, or 10% ethanol content. The increase to E15 will help the US in its goal of using 36 billion gallons of renewable fuel by 2022, as per the Energy Act of 2007. In 2004, the US government passed a 45 cents-per-gallon tax credit, commonly known as the “blender’s tax credit”, to provide an economic incentive to blend ethanol with gasoline. The official name is the “Volumetric Ethanol Excise Tax Credit”, and it was part of the American Jobs Creation Act of 2004, although the incentive expired at the end of 2011. In response, critics have argued that ethanol is an inefficient source of energy and should no longer be supported by the government. However, it seems unlikely that ethanol production will disappear in the near future. The federal government does not look to be changing these mandates. Wind energy is another source of commodity revenue for the rural landowner. By its very nature, farmland usually lies in the vast expanses of open prairie that allows the wind’s unfettered flow. Wind energy could even meet 20% of the US electricity demand by 2030. According to the US Department of Energy (DoE), farmland owners can benefit from wind energy by having one or more wind turbines placed on their property and receive a lease-rate payment per turbine. Landowners can receive up to US$15,000 annually per turbine, although each wind company’s contract will differ. One wind turbine only requires roughly a single acre of land and has minimal effect on farming practices. One acre of cropland is lost, but is replaced with revenue from wind turbine leases. Once the wind turbines are finalised and constructed, landowners typically receive fixed and variable payments based on electricity production. South Dakota is in an excellent position to capitalise on wind energy, as the state is known as the “Saudi Arabia of Wind.” According to Dakota Wind Energy, South Dakota has the wind potential to meet 50% of US electricity demand. It ranks fourth in the nation in wind power, behind North Dakota, Texas and Kansas. Since the late 1980s, the cost to produce wind electricity has dropped a huge 90%, according to the American Wind Energy Association (AWEA). Although wind energy costs are not as low as for conventional power, ever-improving technology is driving wind energy costs down. The government has helped promote the development 237 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 238 COMMODITY INVESTING AND TRADING of wind energy through subsidies, such as accelerated depreciation and the production tax credit (PTC), which offsets the cost of development. The primary constraint of wind energy is the transportation of electricity. Since electricity must be used immediately or transported to a power plant, wind turbines must be closely connected to electric grids that can transmit the energy. The majority of the windy regions of the US are located in rural areas with limited amounts of energy demand and transmission capacity. One solution is the Green Power Express transmission line being developed by ITC Holdings Corporation. The transmission lines would span roughly 3,000 miles from the Dakotas into Wisconsin, Illinois and Indiana. The Green Power Express, due to be completed by 2020, will provide a path for newly generated electricity to travel to heavily populated areas such as Milwaukee and Chicago, and even open up the entire eastern seaboard. This may very well involve an opportunity for landowners to lease land for infrastructure development in support of the initiative. Fuels based on crops may be new, but a windmill on a US farm is as old as a Norman Rockwell painting. Farms started featuring windmills on their properties as early as 1900 for the purpose of powering the well pump. It was not electricity, but the mill generated power and reduced the need of human or animal power through harnessing natural wind energy. Efficiently introducing the new technologies of wind turbines and eco-fuels allows a landowner to even further diversify the sources of revenue from their farming enterprise. Increases in demand for agricultural products Grain supplies in the US and globally are at decade lows, driven by emerging market demand, disappointing US yields and demand for bio-fuels. The ending corn stocks-to-usage ratio has been trending downwards, from roughly 20% in 2004 to 5.6% in 2012, according to the USDA (these figures were calculated by the authors; the data on which this is based can be found here: http://www.usda.gov/oce/ commodity/wasde/). In the USDA’s October, 2012, update of “World Agricultural Supply and Demand Estimates” report, ending stocks for 2012/13 are projected to be down by 37% to 619 million bushels, as corn use is 238 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 239 FARMLAND AS AN INVESTMENT Figure 9.3 US corn stocks/usage ratio 70% 60% 50% 40% 30% 20% 10% 0% 1980 1986 1992 1998 2004 2010 Source: ERS/USDA expected to exceed production by 444 million bushels and the Midwestern US has had the worst drought in over 50 years. US corn stocks have declined to a 21-day supply, meaning that if corn production was halted, the US would run out of corn in a little over half a month. The global demands for food and rising commodities prices have driven agriculture fundamentals upwards. The USDA estimates that farm incomes have been steadily trending higher, increasing from 28% in 2010, 47% in 2011 and was recorded at 14% in July 2013, and will continue to rise – allowing farmers to reinvest their dividends back into farmland to expand their operations. Despite the rapid growth in agriculture, farmers’ balance sheets remain very conservative. Strong farm income and minimal use of Figure 9.4 Farm sector debt-to-assets ratio 25 20 15 10 5 0 1960 1970 1980 1990 2000 2010 Source: ERS/USDA 239 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 240 COMMODITY INVESTING AND TRADING debt have allowed the US farm sector to maintain conservative balance sheets as current debt-to-assets ratios continue at decadeslong lows. New banking regulations have restricted the access to capital for farmland buyers, and loans secured by farmland are typically limited to 50% of the purchase/appraised price. This secure financial situation bodes well for farmland (farmland owners tend to be more on the commonsense side of economics). PRODUCTION AND ITS LIMITATIONS Limits to production Farmland values are expected to continue their momentum into the 2020s and beyond due to the strong global and ever-increasing demand for food. The world’s gross agricultural output must increase by 3.4% to meet this demand, according to the FAO. The two primary ways to increase agricultural production are to either increase the amount of acres planted or increase productivity with technology. With urban sprawl and land development, increasing yield seems to be the logical answer. The future ability to expand arable acres will be difficult. The prime areas for farming have already been identified, are being used for production and have built-in transportation and infrastructure support. The marginal arable acres that can be put into production will be in odd, out-of-the-way places with less than optimal growing conditions and possible transportation issues. However, there is a way to grow yield and increase arable acres. Although the introduction of genetically modified organisms (GMOs) has been somewhat controversial, they have not only increased bushels per acre in standard farming regions, but they have also brought better drought and cold tolerance in the US, as well as expanding the land area that can be used for cold-sensitive crops. For instance, the land planted to both corn and soybeans since the late 1990s has extended into the colder north and drier west areas. The acreage allotted to corn and soybean production is expanding northwest to regions where the number of growing degree days are less. Crop insurance for corn acreage now expands 60 miles further north into Canada. As a result, the Corn Belt and, along with it the opportunity to invest in high-quality producing farmland, continues to grow. 240 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 241 FARMLAND AS AN INVESTMENT Acres in conservation programmes There is yet one more resource for production: farmland set aside under the Conservation Reserve Program (CRP) could be added to the amount of US arable acreage. According to the USDA, 31.3 million acres had been enrolled in the CRP under almost 738,000 contracts by the end of 2010. As the CRP contracts expire, much of this land may be put back into production, but a majority is marginable at best, which is the primary reason it was put into the programme in the first place. The CRP pays landowners not to farm their cropland in order to protect areas where wildlife can grow and fertile land can take a break from producing crops. Other environmental programmes include environmental quality incentives and wetland preservation. This must be done for the long-term health of the soil. CRP will provide more acres in the US for production, but due to the lack of soil quality, the effect on total production will be minimal. GLOBAL FARMING Farm growing in other global regions The amount of acres of arable farmland has been almost static as the non-farm development of farmland in North America and Europe has been offset by expansion of farmland in Africa and South America. There are approximately 1.5 billion hectares being farmed around the world. The FAO estimates that the world has a total of 2.5 billion hectares of “very suitable” or “suitable” land for farming and raising crops. About 80% of this reserve land is located in Africa and South America. The investment bank Credit Suisse estimates that there is only about 300,000 hectares of additional potential acreage, with the majority in Brazil and Indonesia. Table 9.2 summarises the acres in use in 2013 and potential global arable acres. The primary expansion opportunity lies in Brazil, where the government organisation Conab estimates there are an additional 106 million hectares available for agricultural development. Historically, the soil was thought of as unfarmable due to high acidity levels and lack of nutrients. However, technologies such as strip tilling, soil surveys and Global Positioning Systems (GPS) have allowed farmers to improve soil fertility, and a new type of soybean developed to grow in tropical climates from the early 1980s meant that farmers were able to start producing crops in previously unsuitable acreage. 241 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 242 COMMODITY INVESTING AND TRADING Table 9.2 Global acreage expansion Area (1,000 Ha) Acres (2013) Europe US Brazil Other Latin America countries Indonesia Russia Ukraine World total 94,294 173,158 66,500 59,290 37,500 123,368 33,333 1,553,689 Additional acres % of world total 1,000 12,950 106,000 76,000 102,000 10,397 1,120 309,467 20% Source: Conab, Indonesia Ministry of Ag, USDA, FAO, Credit Suisse Indonesia has a huge opportunity to expand acreage for palm oil cultivation. The Indonesian government estimates that it is only using half of its land available for cultivation. In January 2011, Indonesia targeted expanding the county’s agricultural land by two million hectares in the medium and long term, although this plan has received a great deal of criticism as it would result in the removal of tropical forests. Ukraine, Russia and Kazakhstan saw a substantial decline in arable acres and crop yields following the decline in communism during the early 1990s. This demonstrates the loss of the motivationto-yield prospect of farming: farming is hard work and if your labour goes into the pockets of organised crime or corrupt government, there is no incentive towards healthy crop production. The FAO estimates that arable acres declined 11% between 1992 and 2005. Credit Suisse estimates that if arable acres return to 1992 levels, that it would add 1.9% to the total global arable acres. Big (farm) trouble in China There has been much speculation, and even fear, about the rise of China. Chinese demand for agricultural products will likely be a key force in these markets for the coming decades. The year 2010 marked a new era for China as it announced it would no longer be selfsufficient in corn production. The demand of the most populated country in the world for corn and feed is now outpacing supply as the nation continues to consume more and more protein. China and its people are in the process of transitioning from a grain-based diet 242 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 243 FARMLAND AS AN INVESTMENT to a protein-based diet. On average, it takes seven pounds of grain to produce just one pound of meat, according to the Earth Policy Institute. One of the primary problems limiting China’s ability to feed itself is its land imbalance. China has roughly 20% of the world’s population with only 7% of the world’s arable land. The supply of arable farmland in China is decreasing rapidly as well. By 1950, China had lost a fifth of its arable land due to erosion, desertification and development, and is expected to lose 10–15 million more hectares by 2020, according to the UN. In order to be self-sufficient in grain production, the vice minister of agriculture, Wei Chaoan, stated in 2010 that China needed to maintain 120 million hectares for crop production until 2020. Government figures estimate that the amount of arable land is actually 122 million hectares, which has remained unchanged since 2005. Bank of America estimates that China’s arable land has already fallen below the 120 million hectare threshold and could decrease to 117 million hectares by 2015. As its economy and population grow, China will have to increasingly rely on the import market to solve their shortage of corn and other foodstocks. Chinese imports of corn will grow from 1.0 million tons in 2010 to 15 million tons in 2014–15, according to the US Grains Council. 15 million tons of corn translates to Chinese imports of 600 Figure 9.5 China corn supply demand Production (1000MT) 180,000 140,000 100,000 60,000 20,000 80/81 Total production 90/91 Total consumption 00/01 10/11 Ending stocks Source: USDA Foreign Agricultural Service 243 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 244 COMMODITY INVESTING AND TRADING million bushels, equal to 15 tons of corn, will have a substantial impact on global corn stocks. China’s transition to a net importer of corn is very similar to its transition to becoming a net importer of soybeans. Before 1995, China was a net exporter of soybeans, but by 2010 it was the world’s largest soybean importer, importing more than 57 million tons of the crop, 21.6% of world production, according to the USDA. The rapid industrialisation of developing markets will have serious repercussions on the demand for grain. In China specifically, there may be around 500 million more people demanding a protein-based diet. China is not the only example of a developing country that has an increasing appetite for grains. As the world’s middle class continues to develop, the demand for grains will continue to grow exponentially. Global demand for farm crops and commodities According to the US Census Bureau, there were approximately 7.0 billion people inhabiting the Earth in 2012, compared to just 1.7 billion in 1900 and 5.8 billion in 1985. The rate of population growth is not expected to temper as the United Nations estimates the world’s population is likely to reach 9.2 billion by 2050. Most of this population growth is expected to originate in emerging economies, with developed countries remaining stable. The global population growth rate is expected to decelerate due to lower fertility rates, to roughly 1% by 2030, down from a 2% annual growth rate in 1970, according to the United Nations. Despite the slower population growth rate, life expectancies have substantially improved from 30–40 years in pre-industrial times, to roughly 65 years. The prospect of feeding a demographic that is becoming less productive is another factor that puts a strain on food production. In order to feed the world’s growing population, agricultural output will need to double by 2050, according to the FAO. This will be a daunting goal to accomplish as agricultural resources are already strained. Since the early 2000s, agricultural output has grown by 2.4% annually. In order to double agricultural output by 2050, output must increase at 3.4% per year. To meet future demand, experts are predicting that global agriculture will need to produce more food in the next 50 years than what was produced during the previous 10,000 years, putting more and more pressure on future farmers and the land they use to produce our food. 244 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 245 FARMLAND AS AN INVESTMENT Figure 9.6 World population (1950–2050) Billions 10 8 6 4 2 0 1950 1970 1990 2010 2030 2050 Source: US Census Bureau, International Data Base Food demand is growing faster than population growth because of the development of middle classes in emerging markets, due to above-average GDP growth. The Brookings Institution estimates that, by 2021, China’s middle class could grow to over 670 million, compared to only 150 million in 2010. Economists have long shown that, as GDP rises, so does the consumption of animal protein as a percentage of diet. As emerging economies continue to develop, there will be a transfer from a grain-based diet to a protein-based diet. Over half the increase in global calorie consumption since the early 2000s has been a result of increased meat consumption, according to the FAO. It takes two pounds of grain to produce one pound of chicken, five pounds of grain to produce one pound of pork and seven pounds of grain to produce one pound of beef. Again, this represents a great demand for commodity production. SUMMARY Farmland values have been steadily increasing due to increased commodity production on farmland, but the primary driver of future value increases will derive from the supply and demand of the commodities grown from the land. Corn supplies are at their lowest levels in decades. The major difference between the 1995 corn supply and corn supply in 2013 is that global corn production was low in the mid-1990s due to poor production, which was only a short-term effect. That US corn supply has become an alarming 20 days is due to the increased usage of corn across the entire world. What is exciting about farmland is that the agriculture proposition 245 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 246 COMMODITY INVESTING AND TRADING is still the tip of the iceberg. Most agriculture investors are attracted to the sector because of the wealth creation due to the transfer to a protein-based diet in emerging markets. China is expected to increase corn imports from 1 million tons in 2010 to 15 million tons by 2014. The biggest demand for grain by the emerging markets has not even occurred yet. The basic supply and demand is in place for farmland to continue its bullish trends in the long term. Although the amount of farmland is limited in the US, farmable corn-producing land is expanding into areas with great soil but heretofore slightly unsuitable climates in the Midwest, primarily due to biotech seeds. Large seed and agrichemical companies have focused years of research on higher performing varieties and hybrids of important food and feed crops. The next generation of biotech traits focus on greater productivity, improved nutrient use, disease resistance, plant density and drought and cold tolerance. While GMOs may bring a degree of controversy, they also generate much-needed crop acreage and yield. And with people always looking for safe places to invest, this can translate to a great investment upside through increased commodity production. Although farmers make up the majority, people from many different walks of life own farmland, and outside investors have always had a minority interest. However, outside investor interest has grown latterly and will keep growing as farmland continues to feed the world’s growing population. Almost 200 investment firms are expected to invest US$30 billion in farmland by 2015, according to Michael Kugelman of the Woodrow Wilson International Center for Scholars. Worldwide media coverage now includes farmland on a daily basis and the expansion of farmland as an asset class continues to occur. The average age of the US farmer is steadily increasing. The 2007 Census of Agriculture reported their average age had increased from 50.3 in 1978 to 57.1 in 2007. The ageing farmer may provide an opportunity for the non-farmer investor to get into this commodityproducing market. There was a time when the family farm went to the son when the father retired or passed on. However, societal trends have seen people selling the family farm and getting out of the family business. Demand is growing for farmland as the world’s population and global needs for food increase. What many do not realise is that the 246 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 247 FARMLAND AS AN INVESTMENT supply of farmland is not changing, thus creating a severe imbalance in its supply and demand. An investment in farmland over the long term will provide a steady stream of income and capital gains due to the increasing global demand for agricultural commodities, driven by the rising world population, rapid growth in emerging markets and continued demand for ethanol and bio-fuels. Demand for agricultural commodities is outpacing supply, which positions farmland for long-term appreciation. 247 09 Chapter CIT_Commodity Investing and Trading 26/09/2013 09:59 Page 248 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 249 10 Agriculture Trading Patrick O’Hern Sugar Creek Investment Management The pool of participants trading in agriculture commodities has grown rapidly in number and type since the beginning of the 21st century, thus increasing diversification and liquidity across the agriculture sector. Increased participation has been witnessed across each subset of traders, including the commercial, non-commercial and index-trading communities. This growing diversification across agriculture markets has raised the bar for money managers and proprietary traders alike who are seeking to exploit positive risk– reward opportunities. This chapter will provide descriptions of these types of traders, their behaviour and objectives. This chapter is arranged into three sections, which look at, respectively, the participants in the agriculture markets, trading in these markets and the strategies utilised. PARTICIPANTS IN AGRICULTURE MARKETS Commercial traders It is important to consider the commercial subset of traders, and better understand their activities and objectives. Commercial traders as defined by the US Commodity Futures Trading Commission (CFTC) are those who use futures or option contracts in a given commodity for hedging purposes. Commercial traders hold positions in both the underlying commodity and in the futures (or options) contracts on that commodity. In agriculture, commercials can be producers, merchants and end-users, all of which come to the market to manage business, price and margin-related risks. 249 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 250 COMMODITY INVESTING AND TRADING Commercial trading activity has grown to become more sophisticated over time, as businesses have dedicated more capital to build out trading desks by instituting structured commodity marketing and risk-mitigating hedging plans for themselves and their customers. Figure 10.1 illustrates the growth in commercial participant volumes traded across agriculture markets since the year 2000. The expansion among the commercial trading community is viewed as imperative as the globalisation of agriculture commodities has increased the volatility in profit margins for all types of physical commodity businesses. The increased volatility in profit margins has driven commercials to put more emphasis on managing margin risk. For instance, consider a large livestock feeding operation that takes part in purchasing, feeding and selling the stock. The focus for this operation is not only on hedging or marketing the sale price, but also the purchase price and the input costs, including feed and energy usage. Profit margins can vary greatly over the ownership period due to changes in the price of input costs that can create enormous business risks for the producer. For non-commercial traders, it has become increasingly important to understand the behaviour and underlying economics of these commercial trading entities, as the business risk imbedded within participants such as the livestock feeder are just as crucial as the supply and demand of the commodity itself. Figure 10.1 also illustrates the difference in the level of participation between commercial and non-commercial participants. This difference highlights the importance for non-commercial participants to be more aware of the business and economic decisions being made by commercial market participants, as they generally account for 50–60% of the aggregate trading volume and total open interest across agriculture markets. In commodities, open interest is the total number of futures and/or options contracts in a contract month, while total open interest accounts for the total amount of contracts across the forward curve per commodity. Generally speaking, the non-commercial participation ranges around 40–60% of the commercial participation. As seen in Figure 10.2, CME Feeder Cattle non-commercial volumes are larger than that of commercial volumes. This is due to an unusual amount of commercial hedging activity falling into the non-reportable category, 250 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 251 Figure 10.1 Growth in commercial and non-commercial trading across agriculture markets CBT wheat, KCBT wheat, corn, MGE wheat, oats, soybeans, soybean oil, soybean meal, cotton, rough rice, orange juice, milk, lean hogs, live cattle, feeder cattle cocoa, sugar and arabic 7,000,000 Contracts 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0 1/4/2000 1/4/2001 1/4/2002 1/4/2003 1/4/2004 1/4/2005 1/4/2006 1/4/2007 1/4/2008 1/4/2009 1/4/2010 1/4/2011 1/4/2012 Source: US Commodity Futures Trading Commission Note: Total participation: commercial (black) and non-commercial (grey). AGRICULTURE TRADING 251 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 252 COMMODITY INVESTING AND TRADING Figure 10.2 Non-commercial trading as a percent of commercial participant volumes for various agriculture markets 160.0% 140.0% 120.0% 100.0% 80.0% 60.0% 40.0% 20.0% s O at rn Co Co co So a yb ea Cl n o as s i il ii m Su ga ilk rn o. 11 Fe ed er ca Le ttle an ho W gs Li he ve at ca – ttl cb e ot +k c Ro bo t ug h O ric ra e ng e ju Co ic e tto n no So . 2 yb So ea yb ns ea Ar n m ab ea ic l a co ffe e 0.0% thus being exempt from reporting. This occurs in all markets, but is more pronounced in the livestock complex in general. The traditional commercials in live and feeder cattle are the feed yards, most of which hedge their exposure in the live cattle. While cow/calf and stocker operators utilise the feeder cattle market for hedging purposes, the majority of their position sizes fall below the reporting requirements. Understanding the economics of physical commodity businesses requires a strong knowledge of the individual components that determine profit margins. This analysis of market fundamentals can give traders an edge in generating opportunities and determining the best types of trading strategy to implement. By understanding the nuances of producer and merchant margins, non-commercial traders can better assess buy-side and sell-side hedging activity that takes place in the futures market. The most margin-sensitive hedgers are active on both the buy- and sell-side; those include merchandisers, livestock feeders and processors. More traditional sell-side hedgers include producers who have less market-related margin risk, as their input costs are more tied to the operational overhead and productivity. For instance, consider a grain farming operation: in advance of each growing season, the producer must decide which crop to plant by assessing a variety of important factors such as the projected profitability per acre and the soil conditions across the acreage in which the crop will be planted on. While the price of the 252 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 253 AGRICULTURE TRADING underlying cash commodity is a driver of the producer’s margins, it is not the sole influence of what a producer ultimately decides to plant. The producer has to account for factors such as soil condition and potential yield variability based on crop rotation practices that can have important implications on the level of production per acre. Equally important to profitability are overhead and input costs such as seed, machinery, financing, labour and fertiliser. These factors create a fixed piece of the margin that producers must account for in advance of planting their crop; as a result, the selling or marketing of that crop is a vital decision. For non-commercial traders, understanding the economics behind the sell-side hedger’s decision-making can produce clear signals for the future change in supply of a particular commodity. For example, a noticeable lack of producer selling could indicate decreased production for a commodity. In agriculture this could be due to a poor growing season that has producers revising their expected output, or it could be driven by the lack of economic incentive to produce due to poor profit margins at the time of seeding. Figure 10.3 highlights the growth in commercial trading across individual markets. Note the growth in corn, sugar and soybeans, as those commodities – aside from traditional uses such as feed and food – have seen new demand come in the form of renewable energy initiatives across the world. This relatively modern dynamic has had both a direct and indirect impact across the agriculture market, increasing participation by commercials and non-commercial traders alike. For example, the US Renewable Fuel Standard (RFS) requiring gasoline refiners to blend corn ethanol was introduced in 2005. In 2007, the RFS mandate was increased to a 10% corn ethanol blend in gasoline. The introduction and subsequent increase in the US renewable fuels mandate has resulted in increased demand and competition for the US corn supply (see Figure 10.4). In 2011, around 40% of the domestic corn supply was consumed by the ethanol industry. This additional demand has not only increased corn prices but also that of competing row crops. As a result, the US RFS has had a direct and meaningful impact on the US and global grain industry. Consumers of grains have been affected as costs for feed and other related inputs have increased in value. Markets such as livestock have also been indirectly affected, as profit margins have at times 253 Figure 10.3 Commercial trading growth across individual agriculture markets 2,000,000 Corn 1,800,000 Contracts 1,400,000 1,200,000 Sugar No. 11 1,000,000 800,000 600,000 Soybeans 400,000 200,000 0 1/4/2000 Wheat – CBOT 7/4/2001 Corn 1/4/2003 Soybeans 7/4/2004 Cotton No. 2 1/4/2006 Lean Hogs 7/4/2007 Live Cattle 1/4/2009 Cocoa Sugar No. 11 7/4/2010 1/4/2012 Arabica Coffee Source: US Commodity Futures Trading Commission 254 COMMODITY INVESTING AND TRADING 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 254 1,600,000 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 255 AGRICULTURE TRADING been negatively impacted by higher corn values resulting in producers decreasing herd size or seeking alternative feed rations. Another indirect affect of the US RFS has been on the soybean meal market; during the ethanol production process, a third of the caloric value of corn is retained in a by product called distillers’ dried grains (DDGs). The introduction and prominence of DDGS have presented another source of feed for livestock and poultry producers that have altered pricing relationships between soybean meal, hay and other sources of protein and roughage. Non-commercial traders This section covers non-commercial traders by providing descriptions of each type. This class of trading participant includes fundamental discretionary and individuals trading proprietary capital, to systematic and technical trading (all of which will be detailed in this chapter). These traders can incorporate many different forms of risk-taking based on return objectives, opportunities in their market and their approach to trading. Agriculture markets present unique challenges and opportunities for noncommercial traders due to risks involving seasonality, liquidity and weather. The fundamental discretionary trader uses fundamental analysis Figure 10.4 Corn usage by segment, illustrating the importance of tracking usage by end-users 7,000 Feed/residual FSI 6,000 5,000 4,000 Exports 3,000 2,000 1,000 Carry out 0 ‘92 ‘93 ‘94 ‘95 ‘96 ‘97 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12* Source: USDA ERS, Feed Outlook * projection 255 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 256 COMMODITY INVESTING AND TRADING to make trading decisions in the agriculture markets. Many of the fundamental discretionary traders are registered with the US CFTC as commodity trading advisors (CTAs), allowing them to market themselves as an investment vehicle and manage client money in individually separate managed accounts. There are also agriculture specialist hedge funds that manage client money through onshore and offshore vehicles. Since the beginning of the 21st century, the agriculture markets have witnessed significant growth in the number and size of assets under management and managers. The increase in speculative trading across agriculture markets at the turn of the century can be attributed to the evolution of electronic trading as global speculators were increasingly allowed greater access, transparency and flexibility to execute trades on commodity exchanges. Inflationary risks have latterly attracted speculators, as global central bank’s stimulus and US Federal Reserve policy measures have increased the flow of money in the marketplace. Fundamentally speaking, agriculture markets have been attractive in regard to theories and scientific research surrounding climate change and its possible implications for the future of global agriculture production. Additionally, social economics involving population growth, changing dietary habits and emerging market demand have all had an impact. These traders commonly come from physical commodity backgrounds – for example, having worked as a grain merchandiser for Cargill or a sugar trader at Louis Dreyfus. Other traders that have built out money management businesses have come from the agriculture trading pits of Chicago, where they were successful proprietary traders or brokers for large commodity customers. In most cases, the fundamental discretionary commodity trader has spent an invaluable portion of their career working for commodity businesses, where they learned the fundamental pillars of what drives supply and demand for each commodity they trade. Figure 10.5 illustrates the percentage of non-commercial trading relative to commercial trading across agriculture markets since 2000. Proprietary traders: individuals and trading groups Proprietary traders are a diverse subset on their own, as this type of trader fills in all the cracks inside the non-commercial participant spectrum. The most common “prop” trader makes a living trading 256 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 257 Figure 10.5 Percent of non-commercial trading relative to that of commercial trading 100.00% 90.00% 80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 12 01 /2 0 04 / 01 1 04 /0 1/ 2 10 1/ 20 /0 04 1/ 20 09 /0 04 00 8 01 /2 /0 1 04 04 / /2 00 7 06 04 /0 1/ 20 5 /2 00 04 /0 1 00 4 /2 /0 1 04 1/ 20 03 /0 04 /2 00 2 04 /0 1 00 /0 1/ 2 04 04 /0 1/ 2 00 0 1 0.00% Source: US Commodity Futures Trading Commission AGRICULTURE TRADING 257 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 258 COMMODITY INVESTING AND TRADING their own capital. Historically, many of these traders operated on the commodity exchanges in the trading pits as “locals” (a pit trader who trades for themself), assuming 100% of their own trading risks. Over the years, the number of proprietary trading firms (groups of proprietary traders within one organisation) has grown due to the rise in electronic trading and also because of the profitability in profit sharing that owning a proprietary trading group can have. This business can be viewed as a private platform in which the owners of the business hire talented individual traders, provide the overhead – including back office, administrative, accounting and trading technology – for a share of any profits generated by the trader. Other types of proprietary traders sometimes get unfairly described as less knowledgeable or hot money. These are individuals who may not be solely dependent on their success in trading commodities and at the same time may not be aware of the significant risks that exist in trading commodity futures. Both the type of trader and the amount of capital traded is extremely diverse, from small accounts trading under US$100k to multi-million dollar programs. This group of parttime speculators participates in the same market as professional traders, and sometimes has very different views of the commodity they are trading. They may be prone to participate in crowded or popular trades. In agriculture markets, proprietary traders and trading groups provide significant daily liquidity for other participants. Systematic and technical traders Systematic and technical traders, much like the proprietary trading segment, are a vital part of the anatomy of the agriculture futures and options markets as their trading volume provides commercials and money managers essential liquidity that allows them to use structured, fundamentally based strategies. Increased trading volume can narrow bid–offer price spreads, allowing all trading participants a better trade execution. In the systematic world, there are very few money managers that trade purely in agriculture; many of the commodity systematic programs will allocate a risk bucket toward the agriculture markets in the range of 5–40% of their capital. This is largely due to targeted capacity of assets under management for the trading program relative to the capacity in the agriculture markets. Additionally, factors such as style, strategy and correlations 258 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 259 AGRICULTURE TRADING in respect to the systematic program models may dictate how much the program allocates to agriculture markets. Pure discretionary technical traders can be more opportunistic about their risk allocations across agriculture, which can provide outperformance relative to other commodity sectors, resulting in an increased risk bucket. Systematic programs trading in agriculture come in many different forms, such as trend, multi-model, short-term momentum and relative value. There has been considerable growth in systematic programs which incorporate historical seasonality of prices and spreads that have inherent fundamental ties. Some even will employ econometric supply and demand modeling, which evaluate fundamental data produced for each commodity and then generates a trading signal by way of a proprietary algorithm. This more sterile and indirect fundamental trading from systematics can increase the competitive advantage over discretionary participants due to the discipline in generating and maintaining the trade. At other times, this detachment can work against them as commodity fundamentals can occasionally behave counter-seasonally and price patterns can differ from historical norms – which can give the advantage to the discretionary manager who has the ability to adapt to the changing environment. Counter-seasonal price behaviour can occur due to supply/demand shocks. In turn, these shocks can be driven by issues such as supply chain logistics, global trade flow and currency valuations. On the macro side of things, geo-political and economic risks can alter price behaviour. High levels of adaptability can also be a characteristic of a talented chart technician who trades breakouts and mean-reversion strategies across the market. The chart technician relies on price data, behaviour and chart formations to produce trading signals, and participates in price discovery and provides liquidity to the market. Often, the discretionary technical and fundamental participants who are into the right side of a breakout do so more quickly. For the fundamental discretionary trader, this can be due to their fundamental analysis, while for the discretionary technician this can be reactionary as their technical indicators (non-fundamental statistics derived from the markets price data) signal them to enter a trade. On the other hand, multi-model and trend-based systematic programs will often be into a breakout or changing price environment only after a trend in price can be confirmed. 259 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 260 COMMODITY INVESTING AND TRADING Commodity index and swap trading A passive and increasingly common form of trade flows comes from commodity index fund and swap trading participation. A commodity index is an index that tracks a basket of commodities to measure their performance. Commodity indexes are often traded on exchanges, allowing investors to gain easier access to commodities without having to enter the futures markets. The value of these indexes fluctuates based on their underlying commodities, and this value can be traded on an exchange in much the same way as stock index futures. There is a wide range of indexes on the market, each of them varying by their components. The Dow Jones-UBS Commodity Index (DJUBSCI), which is traded on the Chicago Mercantile Exchange (CME), comprises 22 different commodities ranging from aluminium to wheat. Index funds also vary in the way they are weighted; some indexes, for instance, are equally weighted while others have a predetermined, fixed weighting scheme. For example, the DJUBSCI is reweighted and rebalanced annually on a price– percentage basis. While index fund trading flows are passive, they have become more dynamic in their re-balancing and positioning across the forward curves. Cleared commodity swap trading has also become a larger piece of agriculture trading business by both fundamental and speculative entities. A commodity swap is a product whose exchanged cashflows are dependent on the price of an underlying commodity. For commercial trading groups, a commodity swap is usually used to hedge against the price of a commodity. Therefore, in the case of a company that uses a lot of corn, it might use a commodity swap to secure a maximum price for oil. In return, the company receives payments based on the market price. There are also cleared, over-the-counter (OTC) commodity index swaps that allow investors to have direct exposure to a variety of commodity or agriculture-specific indexes. Commodity index swap contracts are based on indexes that are among those most closely followed for investment performance in the commodity markets. Investors, asset managers and financial institutions use them to track performance or as benchmarks for their actively managed accounts. 260 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 261 AGRICULTURE TRADING TRADING IN AGRICULTURE MARKETS Specialist traders in the agriculture sector use a wide range of nondirectional strategies, such as calendar/inter-commodity spreads, and geographical and volatility focused arbitrage. The main drivers of positive risk–reward opportunities from non-directional strategies come from the identification of possible structural shifts in the shape of the forward price curve or term structure, and the expected volatilities in between the spot month and deferred futures contracts. By identifying mispricing relative to forecasted expectations between differentials in terms of price and/or volatility, specialist traders can structure dynamic non-directional strategies across the forward price curve. Time horizons traded across agriculture traditionally have ranged from 1–3 months up to 6–12 months in order to provide sufficient time in which a strategy can reflect a trader’s supply/demand forecast. However, given increased volatility and short-term spikes in correlation driven by outside market influences, some more traditional intermediate to long-term discretionary fundamental traders have adapted by ratcheting down their trade durations in response to increased downside risks coupled with higher rates of return on underlying strategies over short periods of time. Latterly, outside market influences combined with increased speculative interest across agriculture markets made more accessible by electronic trading have resulted in short periods of high correlation across markets. Traders and larger investment funds that manage a diverse set of exposures can now more easily increase and decrease risk across all markets in a more efficient and timely manner. In the event of sudden geo-political or macroeconomic risks, these participants can now enter and exit trades in a more concentrated fashion – causing cross-asset correlation to rise, typically only over short periods of time (inside of one day to one week). At times where prices skew non-fundamental due to a “risk on/risk off” environment, fundamental specialists are presented with the challenge of appropriately managing risk while realising attractive trading opportunities due to mispricing. Market environments and volatility The wider range in volatility across agriculture markets has increased shorter-term trading by fundamental traders due to posi261 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 262 COMMODITY INVESTING AND TRADING tive risk–reward opportunities – ie, allowing traders to avoid tying up margin dollars for long periods of time while still allowing them to continue trading a long-term theme. There are risks which make shorter-term strategies more challenging, predicated on the trader being able to quickly filter possible risk–reward opportunities, all while determining an appropriate size of risk allocation that is necessary to achieve their profit target. Psychologically, this style of trading requires steady and consistent discipline due to the limited timeframe available to place the trade. Therefore, timing is critical in order to have success in short trading frames. For traders aiming to trade in and out of deferred contract months, narrow time horizons can particularly be a challenge as pockets of less liquidity and wide bid–offer spreads can cause slippage and dilute trading returns. For example, a short-term trade in the 4th option of Kansas City Wheat may look good on paper, but dried up liquidity as a result of a pending crop report could cause wide bid–offer spreads, making it difficult to implement or exit the strategy. In summary, most of the difficulties in short-term trading are created by timing, lack of discipline and varying degrees of liquidity. Figures 10.6 and 10.7 illustrate the average true range (ATR) that is a measure of volatility utilised by traders across the agriculture space. Note the increased volatility in the ATR in both examples shown. Strategy selection As volume and open interest vary across agriculture markets, so do the type of suitable strategies and accompanying risks. Generally speaking, total volumes and open interest in agriculture sub-sectors rank in the following order, from largest to smallest: grain/oilseeds, softs/tropicals and livestock/dairy. Given varying liquidity and behaviour, traders must identify what strategies are best suited for specific markets. This is especially the case for broadly diversified commodity traders who may prefer taking a one-size-fits-all approach to implementing and managing strategies across markets. Specialist, individual market traders typically have a stronger handle on risk tolerances and go-to strategies. For example, relative value strategies in livestock that focus more on pricing anomalies across the curve and less on absolute direction work extremely well. While in the grains and oilseeds, more of a mix 262 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 263 Figure 10.6 Soybeans, weekly price and ATR US$2,000.00 425.00 US$1,800.00 375.00 US$1,600.00 325.00 US$1,400.00 275.00 US$1,200.00 225.00 US$1,000.00 175.00 US$800.00 125.00 US$600.00 US$400.00 75.00 US$200.00 25.00 Soybeans cents/bushel 1 01 09 12 /0 6 /2 20 6/ /0 /0 12 12 6/ 20 20 6/ /0 12 /2 /0 6 12 07 05 3 00 01 /0 6/ 20 Average true range, weekly 263 AGRICULTURE TRADING Source: DTN ProphetX 12 12 / 06 /1 97 19 /0 6/ 12 6/ /0 12 /1 /0 6 12 19 9 99 3 1 12 /0 6/ 1 99 9 98 6/ 1 /0 12 99 9 -25.00 5 US$0.00 /2 0 03 6/ 11 09 20 6/ 20 12 /0 /0 12 07 6/ 20 /0 12 06 /0 6/ 20 05 12 12 / 1 9 00 /1 99 /0 6/ 2 /0 6 40.00 10 35.00 8.75 30.00 7.5 25.00 6.25 20.00 5 15.00 3.75 10.00 2.5 5.00 1.25 0.00 0 264 No.11 sugar, cents/pound 12 12 7 99 5 /1 99 /0 6 12 /1 3 99 /1 /0 6 91 89 /1 9 /1 9 06 /0 6 12 12 12 / 12 /0 6 COMMODITY INVESTING AND TRADING 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 264 Figure 10.7 No. 11 Sugar, weekly price and ATR Source: DTN ProphetX Average true range, weekly 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 265 AGRICULTURE TRADING in options volatility, inter/intra commodity spreads along with flat price strategies can offer better returns. Inter-spread is a crosscommodity spread, in this case inside the grains and oilseeds sector (for example, selling wheat and buying corn). Intra-spreads involve spreads across the same commodity forward curve. Grains and oilseeds offer traders a wide array of choices in terms of strategy utilisation. The grains and oilseeds sector offer such a diverse and attractive set of opportunities, such as inter-commodity relative value – that is, a spread between two commodities. Due to strong competition for global production acres and substitutability factors across grains and oilseeds products, traders like to implement strategies that can exploit these fundamental relationships. Palm oil versus canola oil or corn versus wheat are basic examples of global markets that not only compete for production capacity, but for demand. The fundamental competition inside the sector and the importance of these markets globally is a strong reason why they offer relatively deeper liquidity due to a more globally diverse set of participants. Other sectors similar to livestock can be found in the tropical commodity space, where sugar, coffee and cocoa specialists are heavily reliant on managing relative value spreads and geographical arbitrage. Table 10.1 outlines five types of trading strategies commonly implemented across the agriculture commodities space. Correlation benefit Broadly diversified fundamental commodity traders have strong incentives for including agriculture strategies in their portfolio, not only because of stark fundamental differences and attractive themes that exist across the sector. The diversity within the sector creates significant de-correlation that does not always exist in other commodity sectors, such as energy and metals. Correlations between RBOB Gasoline, WTI Crude Oil, Brent Crude Oil or other energy commodities can be high with each other, and they all tend to be influenced by global macroeconomic headline risk and volatile stock market fluctuations. Metals markets such as copper, aluminium, zinc and palladium also show high correlations to each other. On the other hand, across the agriculture markets one can find a number of different combinations that offer low correlations – for example, live cattle versus sugar and cocoa versus corn, which helps create natural diversification. 265 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 266 COMMODITY INVESTING AND TRADING Table 10.1 Strategy types Strategy types Description #1 Directional Entering long or short futures and or options across one or more contract months in one or more commodities. Example using futures Example using options Outright long December corn futures Long October No. 11 Sugar 22 cent calls and short 28 cent calls. #2 Calendar spreads Simultaneously entering a L/S futures and or options position across two different contract months in the same underlying months in the same underlying commodity market. Example using futures Long March soybean futures and short July soybean futures. Long March soybean calls and long July soybean puts. Example using options #3 Geographical spread arbitrage Simultaneously entering a long and short futures and/or options position across the same or different contract months in two different commodities. Example using futures Long May Arabica coffee and short May Robusta coffee. #4 Crush spreads Simultaneously entering three legs in the futures and/or options across three related commodities by entering two buys and one sell, or two sells and one buy. Often related to production margins of a particular commodity. Example using futures Soybean crush: Long soybeans, short soybean meal, short soybean oil. Cattle crush: Long feeder cattle, long corn and short live cattle. Example using futures #5 Options volatility Going L/S or spread commodities based on implied and historical volatilities. Example Relative value: Long December wheat calls at 25% volatility, short July wheat calls 40% volatility. Table 10.2 provides daily correlations across individual agriculture commodities and comparative to energy and metals commodities. The correlations in this table also show the distinct de- 266 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 267 Table 10.2 Daily correlations Commodity CC KC SB FC LH LC C W S SM BO CT RR CL HO NG HG SI Cocoa (CC) Arabica coffee (KC) 72.86 No. 11 Sugar (SB) 69.13 47.75 Feeder cattle (FC) –29.38 –54.30 3.81 29.79 –23.70 48.38 Live cattle (LC) –49.96 –6.60 –38.31 89.06 51.96 Corn (C) 25.84 46.29 0.49 16.58 63.64 30.97 Soft Red wheat (W) 47.38 23.57 32.39 –43.55 9.07 –32.20 57.21 Soybeans (S) 4.69 –9.04 –7.37 19.07 36.71 13.70 69.23 61.29 Soybean meal (SM) –14.21 –36.58 –23.40 20.08 23.46 9.78 50.74 55.22 94.10 Soybean oil (BO) 50.93 61.83 40.09 2.71 36.19 11.30 69.97 44.28 55.30 25.37 No. 2 cotton (CT) 83.91 72.27 53.60 –51.97 –0.69 –37.89 23.22 41.66 –0.66 –20.02 55.57 Rough rice (RR) 0.87 19.63 12.57 20.24 32.41 30.09 44.74 6.38 33.36 22.20 34.07 –25.90 WTI crude oil (CL) –2.08 31.11 –17.89 43.36 30.28 49.29 38.81 –10.17 10.66 –5.29 50.28 25.00 –9.47 Heating oil (HO) –11.22 33.30 –22.32 67.18 61.20 76.27 59.52 –15.80 23.82 5.90 52.91 –0.38 35.96 81.16 Natural gas (NG) 79.97 72.04 61.03 –74.30 –1.03 –59.59 16.69 41.39 –12.04 –28.39 33.90 69.12 1.17 –15.42 –25.36 Copper (HG) 80.12 63.62 67.44 –38.82 5.94 –34.09 30.69 43.83 17.80 5.54 72.08 77.27 –3.11 29.91 11.48 59.89 Silver (SI) 36.77 72.67 13.51 20.42 59.34 35.01 60.95 2.32 15.17 –11.59 67.59 34.22 42.24 55.74 71.68 29.83 47.29 Gold (GC) –49.45 –1.92 –34.87 72.60 43.93 76.59 29.81 –41.90 7.06 1.77 6.71 –56.82 59.29 27.02 66.97 –46.53 –37.45 47.76 267 AGRICULTURE TRADING –63.37 Lean hogs (LH) 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 268 COMMODITY INVESTING AND TRADING correlation across sectors such as tropical and livestock commodities (ie, cocoa versus live cattle). Figure 10.8 shows the correlation benefits across various pairings of agriculture commodities such as corn versus feeder cattle. Investment flows, seasonality and weather Low correlations across agriculture commodities are driven by market-specific supply/demand cycles, adverse weather and seasonality, which can create a rich set of diverse trading opportunities. It should be noted that, with increased volumes and participants, more traders are leaning on strategies tied to a variety of historical seasonality features, making it increasingly challenging to generate positive alpha. This has been witnessed in intracommodity relative value, which is individual commodity spreads. For example, flat price seasonality on spot month lean hog and live cattle markets has pronounced impacts on spreads between the nearby and deferred prices across their respective forward curves. With access to 30-plus years of historical futures spread data, more and more traders are implementing spreads based on these strong seasonal tendencies, thus at times diluting the risk–reward profile for spread trades relative to years passed. The popularity of seasonal relative value trades has also increased mean reverting opportunities for technical contrarians and fundamental specialists that are able to identify if a spread has moved too far too fast. The most successful traders are able to decipher the changing influence of market participants, such as commercials, systematic and swaps (as detailed in the first section of this chapter), and how they impact seasonality and contribute to short- and long-term cycles. For example, traditional or first-generation long-only swaps managers are known to roll long positions from the fifth to the ninth business day of the month; however, over time, the market response to this practice by other speculative participants has caused swaps or index funds to roll long positions earlier and later. In fact, index funds have evolved their product suite, offering what are called second- and third-generation products which adjust strategy for curve contango or backwardation, attempting to capture alpha by shifting their directional bets dynamically across the curve over optimised time horizons. In this case, the product suite is the index products created in addition to the conventional style index, such as 268 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 269 Figure 10.8 90-day rolling correlations 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% -10.00% -20.00% -30.00% Source: DTN ProphetX /2 20 24 /1 0 /0 9/ 24 01 1 24 /1 1/ 20 11 24 /1 2/ 20 11 24 /0 1/ 20 12 24 /0 2/ 20 12 24 /0 3/ 20 12 24 /0 4/ 20 12 24 /0 5/ 20 12 24 /0 6/ 20 12 24 /0 7/ 20 12 11 1 01 1 8/ 2 01 24 /0 20 11 /2 No.11 Sugar versus Cattle No.11 Sugar versus Corn Corn versus Feeder cattle 269 AGRICULTURE TRADING Cocoa versus Coffee 24 /0 7 1 24 /0 6/ 01 1 5/ 2 20 1 4/ 24 /0 24 /0 01 1 3/ 2 /2 /0 2 24 /0 01 11 20 24 1/ /0 24 1 -40.00% 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 270 COMMODITY INVESTING AND TRADING the second- and third-generation products which incorporate dynamic technical inputs such as open interest, volume and relative performance across contract months to determine which contract month to trade across the term structure. Traders who can filter and understand the impact of important market factors such as weather, demand and policy-related news (for example, changes in the regulatory environment) in an efficient manner will have a leg up on their competition. Figures 10.9 and 10.10 highlight the overall inconsistent correlations between individual agriculture commodities such as wheat and corn relative to gold and crude oil. Note that times of high correlation – for example, 90-day rolling correlation between corn and crude oil +50% – are often due to short-term periods of investment flows driven by macroeconomic data and speculative re-balancing. For discretionary agriculture traders, the main take away from understanding index fund activity is that successful strategies must withstand short-term periods of strong investment flows. Often, price differentials across the forward curve of agriculture commodities can become skewed by such activity, by pushing prices out of line with fundamental expectations. This type of price behaviour caused by money flows often allows discretionary traders the opportunity to place complimentary spread strategies which are designed to profit when the market corrects or reverts. As previously mentioned, seasonal price behaviour can also generate opportunities, as the underlying physical commodity values react to productions cycles, weather events and seasonal demand tendencies. These factors in normal environments have created price activity that has produced consistent patterns over the years (see Table 10.3 for more information about the planting of grains and oilseeds). For example, corn and soybean volatility seasonally strengthen during the US spring planting season and peak during the growing season. In the lean hog market during the late spring and early summer, increased demand for pork coupled with a seasonal slowdown in production historically have supported higher wholesale pork values and relatively higher lean hog futures market prices in the summer contract months. Conversely, in the autumn and winter, increased hog weights due to cooler temperatures and cheaper/higher-quality feed create some of the best feed conversions per animal units of the year, typically resulting in large 270 24 /2 0 12 12 /2 0 12 12 /2 0 /0 7 /0 6 24 /0 5 24 12 /2 0 4/ 20 24 /0 12 /2 0 /0 3 24 11 12 /2 0 /0 1 /2 0 11 /2 0 /1 2 /0 2 24 24 24 11 11 0/ 20 11 /1 1 24 /1 24 9/ 20 /0 24 11 /2 0 8/ 20 /0 24 1 11 01 /2 /0 7 24 24 /0 6 11 /2 0 11 /2 0 11 5/ 20 /0 4 /0 3 1 01 /2 2/ 20 /0 24 24 24 /0 24 01 24 / 40.00% 45.00% 30.00% 35.00% 25.00% 15.00% 20.00% 10.00% 5.00% 0.00% Wheat versus gold Source: DTN ProphetX 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 271 Figure 10.9 90-day rolling correlation between wheat and gold AGRICULTURE TRADING 271 272 24 24 24 24 24 24 24 /0 7 /0 6 /0 5 /0 4 /0 3 /0 2 11 12 /2 0 12 /2 0 12 /2 0 12 /2 0 12 /2 0 12 /2 0 12 11 /2 0 11 /2 0 11 /2 0 11 /2 0 11 /2 0 11 /2 0 11 /2 0 11 /2 0 11 /2 0 11 /2 0 11 /2 0 /2 0 /2 0 /1 2 /1 1 /1 0 /0 9 /0 8 /0 7 /0 6 /0 5 /0 4 /0 3 /0 2 /0 1 /0 1 24 24 24 24 24 24 24 24 24 24 24 24 COMMODITY INVESTING AND TRADING 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 272 Figure 10.10 90-day rolling correlation between corn and crude oil 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Source: DTN ProphetX Corn versus crude oil 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 273 AGRICULTURE TRADING market-ready supplies that drive cash and futures prices lower during the autumn and winter contract months. Figure 10.11 illustrates the seasonality in lean hog spreads. This specific spread is of the February versus October contracts (same calendar year). Note the bold black line (2012) has moved lower in price earlier then previous years seasonal price action, albeit in the same direction. Figures 10.12 and 10.13 show the US Drought Monitor for the beginning of the 2012 US summer growing season and near the end of the US summer growing season. Note the beginning of the US summer season was dry across much of the US Corn Belt but not in drought (as illustrated in Figure 10.12), while by the end of the summer most all of the US Corn Belt had fallen into severe drought conditions. Figure 10.14 shows the corresponding US crop conditions for corn as the early season dryness evolved into a severe drought across the US Corn Belt. Note the steep drop-off in conditions during the end of June and throughout July 2012. Figure 10.15 illustrates the corresponding response in corn prices as conditions were continually downgraded during the US summer growing season thus decreasing production forecasts. Fundamental data points When assessing agriculture markets, traders will often structure strategies around specific data points or fundamental reports that are issued for each commodity. In the US, official government fundamental supply/demand information is produced by the US Department of Agriculture (USDA). The USDA has many domestic field offices and divisions, along with foreign agriculture attachés stationed in the world’s key agriculture producing regions. These divisions are tasked with compiling, accounting and analysing important data involving such things as cash grain receipts, wholesale and retail meat prices, survey results regarding prospective plantings and on-farm grain stocks. Every month, the USDA releases a world agriculture supply demand estimate (WASDE) that produces global and domestic balance-sheet estimates for important agriculture commodities. This is just one of the many fundamental reports produced by the USDA. While some traders may not necessarily trade off of supply and demand data – for example, growing 273 Figure 10.11 Lean hog February versus October spread (10-year seasonal)-1.5250 22.5000 20.0000 17.5000 15.0000 12.5000 2012 10.0000 2013 7.5000 4.9850 5.0000 3.3350 2.6750 2.5000 -0.1750 -0.9500 -1.5250 -2.4850 -3.1500 0 -2.5000 -5.0000 -7.5000 -7.5000 -10.0000 -12.5000 -14.1600 -15.0000 2008 -17.5000 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 274 COMMODITY INVESTING AND TRADING 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 274 13.5900 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 275 AGRICULTURE TRADING Figure 10.12 US Drought Monitor (May 29, 2012) Source: National Drought Mitigation Center at the University of Nebraska-Lincoln Figure 10.13 US Drought Monitor (August 14, 2012) Source: National Drought Mitigation Center at the University of Nebraska-Lincoln 275 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 276 COMMODITY INVESTING AND TRADING Figure 10.14 US crop progress and conditions: corn USDA NASS Good and excellent (percent) M April May June July August September October November 80% 2010 Condition year 2008 2008 2009 2010 2011 2012 2009 2011 70% 60% 50% 40% 30% 2012 20% Nov 25 100% Condition (percent) 80% Condition type Excellent Good Fair Poor Very poor 60% 40% 20% 0% 100% Doughing 80% Progress (percent) Emerged Dented 60% Silking Mature 40% Planted Harvested 20% 0% M April May June Progress year(s) July 2012 August 2011 September October November 2007–2011 Source: National Agricultural Statistics Service (NASS), crop progress report conditions in corn – it is important to be cognisant of the release dates of fundamental reports, as price volatility can fluctuate sharply post the release of such information. For traders, an equally important endeavour, aside from analysing the report information, is to filter which sentiment indicators or reports best compliment their strategy and style. From a risk management standpoint, traders can judge sentiment more qualitatively by using their discretion regarding certain data and market response. For example, a trader will grade surveyed analyst expectations against actual reported information, as this type of methodology can provide them with a strong read on 276 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 277 AGRICULTURE TRADING Figure 10.15 Corn futures price, weekly line US$850.00 Cents per bushel US$800.00 US$750.00 US$700.00 ! ! ! ! 2012: drought inspired rally US$650.00 US$600.00 US$550.00 US$500.00 US$450.00 US$400.00 1/6/12 2/6/12 3/6/12 4/6/12 5/6/12 6/6/12 7/6/12 8/6/12 Source: DTN ProphetX market sentiment which can, in turn, help in the management of risk after the release of a fundamental report. Global macro commodity managers will utilise macroeconomic indicators as an overlay to trading in agriculture commodities, both for risk management and portfolio/strategy structuring. In doing so, some traders will build proprietary models or take advantage of experience and intuition when assessing price activity in macro markets such as stocks, US dollar index and energy and currency markets. Fundamentally, the USDA’s National Agriculture Statistical Service and World Supply and Demand Forecasts produce a wide range of agriculture research, surveys and periodic reports for commodities such as corn, cotton, sugar and live cattle that provide important information to the global market, offering guidance for future supply/demand expectations. For example, in the grain and oilseed commodities the USDA reports information on stocks, seeded acres and growing conditions. It is also important for agriculture traders to understand which commodities are most consumer-sensitive or can be most susceptible to macroeconomic risks. Commodities such as live cattle (beef), cotton and orange juice can quickly reflect changes in retail demand. Aside from tracking underlying cash and retail values of those commodities, traders will also assess economic data in order to gain an understanding of consumer sentiment, such as US monthly employment data and the Consumer Confidence Index (CCI). On a less-frequent basis, country-specific policy changes regarding such things as global trade and renewable energy initiatives can have a 277 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 278 COMMODITY INVESTING AND TRADING meaningful long-term impact on supply/demand and the global trade of agriculture commodities. For example, in 2011 the US entered into a bilateral free trade agreement with Colombia, which came into effect in 2012. This comprehensive trade agreement eliminates tariffs and other barriers to US exports, expands trade between the two countries and promotes economic growth for both. The International Trade Commission (ITC) has estimated that the tariff reductions in the agreement will expand exports of US goods by more than US$1.1 billion, supporting thousands of additional US jobs. The ITC also projected that the agreement will increase US GDP by US$2.5 billion. Many agricultural commodities also will benefit, as more than half of US farm exports to Colombia will become duty-free immediately, and virtually all the remaining tariffs will be eliminated within 15 years. Colombia will immediately eliminate duties on wheat, barley, soybeans, soybean meal and flour, high-quality beef, bacon, almost all fruit and vegetable products, wheat, peanuts, whey, cotton and the vast majority of processed products. The agreement also provides duty-free tariff rate quotas (TRQ) on standard beef, chicken leg quarters, dairy products, corn, sorghum, animal feeds, rice and soybean oil. This is an example of a trade policy between two nations that will have a long-term impact on prices and the supply chain of some commodities. Technical inputs From a technical chart trading standpoint, agriculture markets provide a good platform to trade a range of styles, including breakout, mean reverting and trend following. Technical indicators such as Fibonacci retracements, relative strength index (RSI), market profile and a variety of moving averages are utilised by traders. Studying open interest and volume as well as viewing charts across different time horizons – such as intra-day, daily, weekly and monthly – help put medium- to long-term strategies into perspective. For fundamental discretionary traders, technical indicators do not necessarily have to generate trade ideas, but rather provide a confirmation for the entry or exit of a strategy. An example would be a trader who has an underlying bearish directional bias in a market based on demand concerns, and at the same time recognises that the 278 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 279 AGRICULTURE TRADING RSI indicator has fallen below the overbought level; just below this price level, if the price weakness can be sustained, the price will be able to drop below both the 20- and 100-day moving averages. This confluence of signals can help confirm a potential entry point for the bearish directional strategy. Using this methodology helps in adding discipline, as it forces traders to adhere to the price action relative to the technical signals, which can often indicate future longer-term price movements before actual fundamental developments can be realised. This is an important filter that can temper traders’ expectations behind their fundamental conviction about a commodity market, and helps them to be patient in expressing strong convictions. Overall, there are a variety of technical indicators that can be used in assessing the agriculture markets and, most importantly, they offer a non-biased overlay to discretionary decision-making. Figure 10.16 illustrates a combination of technical indicators that can be used to signal a trading opportunity. Note, the moving average cross as the 20-day crosses over the 100-day to the downside. Additionally, in advance of this cross the RSI had been testing overbought territory, which indicates that the market maybe reaching a top. In the case of this illustration, this was true and the moving average cross provided a confirmation and a sell signal. Figure 10.17 illustrates a combination of Fibonacci retracement and moving average cross that can be used to signal a trading opportunity and provide the trader with a back drop in which to balance expectations. STRATEGIES AT PLAY IN THE AGRICULTURE MARKETS The previous section provided a general description of the types, behaviour and objectives of traders in the agriculture markets. This section will categorise the specific types of strategies being employed by those participants, along with their risks and management of such strategies. There are five main strategy types covered: directional, calendar spreads, geographical arbitrage, crush spreads and options volatility. Methodologies used in trading strategies involve the research and analysis of seasonality, forward curve structure and fundamental factors. Using those factors, traders are then tasked with choosing the most suitable strategy that aligns with their fundamental thesis or return objective. 279 Figure 10.16 Confluence of technical indicators signalling a trading opportunity 100.00 90.00 80.00 70.00 60.00 50.00 40.00 34.63 30.00 20.00 10.00 Arabica coffee, continuous daily bar 0.00 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Source: DTN ProphetX 280 COMMODITY INVESTING AND TRADING 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 280 300.00 290.00 280.00 270.00 260.00 250.00 240.00 230.00 220.00 210.00 200.00 190.00 180.00 170.85 170.00 160.00 150.00 140.00 Price falling below both the 20- and 100-day moving averages % Relative strength index (RSI) indicating near overbought values 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 281 Figure 10.17 Use of Fibonacci retracement and moving average cross to identify a trading opportunity 2.40 November 2013 soybeans to December 2013 corn ratio 2.34 (100.0%) 2.35 2.30 Moving average cross 2.25 2.20 (61.8%) 2.20 2.16 2.16 (50.0%) 2.15 2.11 (38.2%) 2.10 2.07 2.06 (23.6%) 2.05 2.02 2.00 1.97 (0.0%) 1.95 100% retracement from highs Jul-11 Aug-11 Source: DTN ProphetX Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 281 AGRICULTURE TRADING Jun-11 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 282 COMMODITY INVESTING AND TRADING Directional Directional trading strategies are a very common style of trade employed by both commercial and non-commercial trading participants. Commercial traders using this strategy will utilise flat price trades to market or hedge production or commodity risk. In its simplest form, this can be implemented as a flat price futures buy or sell or as a hedge against an underlying physical commodity exposure. For non-commercial traders, the flat price exposure is a source of beta that compliments their speculative ideas on future price direction. Flat price trades among the non-commercial and commercial trading community can be expressed in many different forms. Different style of directional bets include options spreads, risk reversals such as owning a call and selling a put against the same underlying contract month, and synthetic options that involve trading futures and options in the same contract month. Prior to entering a directional trade, traders must evaluate a variety of risk–reward factors such as selecting the appropriate contract month across the forward curve and choosing the expected time horizons for the trade, while also establishing risk allocation, profit targets and stop/loss level(s). Experienced traders looking to place a directional bet in an agriculture market are always aware of the calendar as seasonality plays a large role in the risk profile of a directional trade. After taking into account seasonal factors, the trader will determine which contract month can best express their ideas on fundamental price movements. Since many commodities futures in the agriculture sector span multiple crop years, traders have to make sure their fundamental thesis ties to the appropriate time horizon in which they are trading. For example, during the month of May, an oilseed trader becomes bearish and decides to sell the US soybean market on expectations for an above-average new crop production, but sells the old crop July contract in order to express their bearishness; while being short is the correct directional position, in this case it is not the correct contract month or season to be short based on the fundamental thesis. This trader is taking significant risk by holding a short position in an old crop contract that may be trading off of different supply and demand fundamentals. Additionally, the risk–reward expectation for such a trade could greatly underperform due to muted trade duration as the July contract will have expired before new crop production is 282 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 283 AGRICULTURE TRADING harvested, therefore never allowing the market to fully price in the trader’s fundamental price forecast. See Table 10.3, as the global crop timetable shows traditional planting and harvest time periods for corn, soybeans and wheat produced around the world. After determining the best point to be positioned, traders must decide how much risk or what level of conviction they have in the trade. This determination comes from a confluence of factors involving the price forecast, market volatility and expectations for trade duration. If a trader has strong confidence in their fundamental thesis and long-term price forecast, but the market volatility is high due to shorter-term factors, they may take a “scale in” approach to their directional position. Scaling into a strategy is a methodology in which a trader increases risk by adding positions to the existing strategy. This allows them to ultimately reach a high conviction or risk allocation, while withstanding near-term volatility pressures. Regardless of the conservative approach, traders still need to determine levels in which they will stop out of the directional position and go to the sidelines. While liquidity in executing directional trades is often better than liquidity available for more complex relative value strategies, the returns on an unhedged directional trade can often be more volatile, which makes risk management and position sizing important. Figure 10.18 offers an example of this type of risk differential, showing the difference in ATR between an old/new crop corn spread versus the individual components of the spread. Note the ATR of the individual components, in this case July 2012 and December 2012 corn traded as much as two or three times more on a daily basis than that of the July–December 2012 calendar spread. Additionally, note the convergence and divergence of the spread relative to the individual components, as the tug of war between old and new crop supply/demand played out over time. Calendar spreads Calendar spread strategies have grown in popularity among the speculative trading community due to their embedded alpha generation and strong relationship with fundamental price relationships. As defined in Table 10.3, a calendar spread trade is a strategy in which a buy and sell are simultaneously placed across the same commodity futures curve. Calendar spreads provide fundamental 283 F G H J K M N Q U V X Z Wheat Jan Feb March Apr May June July Aug Sep Oct Nov Dec US Winter Harvests Soft Red Winter (W) WH Hard Red Winter (KW) KWH US Spring WN KWK KWN Plants Hard Red Spring (MW) MWH Canada WU WZ KWU KWZ MWU MWZ Harvests MWK MWN Plants Harvests France Milling Wheat (PM) Plants WK Harvests PMF PMH PMK Plants PMQ PMX Germany Harvests Plants UK Harvests Plants Ukraine Harvests Turkey Harvests Egypt Plants Harvests Russia Winter Plants Harvests Russia Spring Plants Iran Harvests Pakistan China Plants Harvests Kazakhistan India Plants Plants Harvests Plants Harvests Plants Harvests Plants Harvests Plants 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:00 Page 284 Futures contracts symbols COMMODITY INVESTING AND TRADING 284 Table 10.3 Global crop timetable and futures contracts Plants Brazil Soybeans Jan Feb March Apr Harvests Plants SF SH China Jan Feb March Sep Oct Nov Dec Plants Harvests SK SN SQ Apr SX Harvests May June July Aug Sep Oct Nov Dec Plants US Plants Corn (C) CH China (North) Plants Harvests CK CN Plants CU CZ Harvests Plants Harvests France Plants Harvests Harvests Plants Russia Plants India Harvests Plants Harvests Harvests Plants 285 AGRICULTURE TRADING Plants Ukraine South Africa Aug Harvests Harvests Spain July Plants Argentina China (South) June Plants US Brazil May Harvests Harvests Argentina Corn Harvests Plants Brazil Soybeans (S) Harvests Plants Argentina 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 285 Australia 0 /2 01 24 0 /0 7/ 20 10 24 /0 8/ 20 10 24 /0 9/ 20 10 24 /1 0/ 20 10 24 /1 1/ 20 10 24 /1 2/ 20 10 24 /0 1/ 20 11 24 /0 2/ 20 24 11 /0 3/ 20 11 24 /0 4/ 20 11 24 /0 5/ 20 11 24 /0 6/ 20 11 24 /0 7/ 20 11 24 /0 8/ 20 11 24 /0 9/ 20 11 24 /1 0/ 20 11 24 /1 1/ 20 11 24 /1 2/ 20 11 24 /0 1/ 20 12 24 /0 2/ 20 12 24 /0 3/ 20 12 Cents/bushel 25 15 10 0 July 2012 Corn (Left Axis) December 2012 Corn (Left Axis) 286 5/ 20 1 24 /0 6 24 /0 COMMODITY INVESTING AND TRADING 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 286 Figure 10.18 20-day ATR: old versus new crop corn spread relative to outright contracts 7 20 6 5 4 3 2 5 1 0 July-December 2012 Corn Spread (Right Axis) Source: DTN ProphetX 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 287 AGRICULTURE TRADING traders with a non-directional bias and the opportunity to trade relative fundamentals across the term structure of a commodity. Non-directional reasons to trade calendar spreads can involve price relationships regarding cash basis and seasonality. From a directional standpoint, some traders may entertain trading a calendar spread as a hedge against being directionally positioned at different points on the futures curve or as a more conservative bet on directional price expectations against one leg of the spread. There are many possible fundamental and technical drivers for trading calendar spreads. Some of the most compelling calendar spread strategies can be seen in Table 10.4. Geographical spread arbitrage Geographical arbitrage is another form of inter-commodity spread in which a trader buys and sells the same type of commodity produced across different regions of the world. These commodity futures contracts often exist on different exchanges and have different quality or grade characteristics. An example of trading a geographical spread would be purchasing Arabica coffee and selling Robusta coffee. Trading a geographical arbitrage strategy is mainly carried out by fundamental specialists due to the high level of specific knowledge needed to understand the pricing relationships. For technical traders, this type of commodity spread can have appeal from a mean reverting standpoint, as the trader will seek opportunities when the spread between the two related commodities reaches extreme levels. Purely trading geographical arbitrage from a technical standpoint, however, does come with significant risk as the flat price direction of an individual leg of the spread can move oppositely for sustained periods of time based on specific micro-fundamental factors. Other inter-commodity spreads can have strong quality-based and seasonal aspects, such as trading lower-grade US soft red winter wheat versus higher-grade hard red spring wheat. See Table 10.5, which details fundamental drivers for trading inter-commodity or geographical arbitrage. The same technical drivers can apply for these types of spreads as that outlined for calendar spreads. Figure 10.19 shows how the soybean to corn ratio provides an example of blending technical, seasonals and fundamentals while 287 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 288 COMMODITY INVESTING AND TRADING Table 10.4 Strategy types: calendar spreads Fundamental reasons #1 Old crop S&D versus new crop S&D forecasts. #2 Individual flat price biases: bullish and bearish across different time horizons. #3 Seasonality of basis (cash minus futures) versus forecasted basis. #4 End-user and producer profit margins impact on underlying cash values. Technical reasons #1 Seasonality of the spread differential. #2 Bull or bear spread as a hedge against directional bias. #3 Bull or bear spread as a theoretical conservative bet on directonal bias. #4 Commitment of traders data. Geographical spread arbitrage Simultaneously entering a long and short futures and or options position across the same or different contract months in two different commodities. Example using futures Long May Arabica coffee and short May Robusta coffee. Crush spreads Simultaneously entering three legs in the futures and or options across three related commodities by entering two buys and one sell, or two sells and one buy. Often related to production margins of a particular commodity. Example using futures Example using futures Soybean crush: long soybeans, short soybean meal, short soybean oil. Cattle crush: long feeder cattle, long corn and short live cattle. Options volatility Going L/S or spread commodities based on implied and historical volatilities. Example Relative value: long December wheat calls at 25% volatility, short July wheat calls 40% volatility. assessing a possible geographical arbitrage spread opportunity. The eight-year seasonals show the behaviour of the ratio to be rather inconsistent, but do provide a range of expectations. It is up to the trader to deduce what fundamental drivers will result in the future performance of such types of geographical arbitrage, as each year can be extremely different from the next. 288 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 289 AGRICULTURE TRADING Table 10.5 Strategy types: geographic arbitrage Fundamental reasons #1 Trading differences in supply and demand across different regions. #2 Trading differences in quality grades of a similar commodity. #3 Trading differences in localised demand and its impact on underlying cash prices. #4 Trading the flow of a similar or competing commodity based on supply, demand and logistics. Technical reasons #1 Seasonality of the spread differential. #2 Bull or bear spread as a hedge against directional bias. #3 Bull or bear spread as a theoretical conservative bet on directonal bias. #4 Commitment of traders data. Geographical spread arbitrage Simultaneously entering a long and short futures and or options position across the same or different contract in two different commodities. Example using futures Long May Arabica coffee and short May Robusta coffee. Crush spreads Simultaneously entering three legs in the futures and or options across three related commodities by entering two buys and one sell, or two sells and one buy. Often related to production margins of a particular commodity. Example using futures Example using futures Soybean crush: long soybeans, short soybean meal, short soybean oil Cattle crush: long feeder cattle, long corn and short live cattle Options volatility Going L/S or spread commodities based on implied and historical volatilities. Example Relative value: long December wheat calls at 25% volatility, short July wheat calls 40% volatility. Crush spreads A crush spread is a form of arbitrage predominately used by commercial traders in order to manage production-related margin risk. Typically, a crush spread includes two or three individual components. Speculative participants with a keen understanding of production margins often like to implement crush or reverse crush spreads as a proxy as it allows them to participate synthetically in 289 Figure 10.19 March 2013 soybeans to corn ratio (eight-year seasonal) 3.40 3.23 3.20 2.80 2.62 2.60 2.51 2.46 2.40 2.35 2.25 2.20 2.09 2.02 2.00 1.89 1.80 2013 ratio – bold black line 1.60 Dec-11 Jan-12 Source: DTN ProphetX Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 290 COMMODITY INVESTING AND TRADING 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 290 3.01 3.00 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 291 AGRICULTURE TRADING physical commodity margins. A good example of a crush spread in agriculture can be found in soybeans, where a trader can replicate a physical soybean crushing plant, by purchasing soybeans and selling the output including soybean meal and soybean oil contracts. Other agriculture commodities in which crush trading is popular are livestock, where producers in the pork and beef industries will actively Table 10.6 Strategy types: crush spreads Fundamental reasons #1 Trading the production economics or margins of a specific commodity. #2 Trading differences in margins of a particular commodity across the forward curve via calendar crush spreads. #3 Trading the reverse crush by taking the opposing side of the relationship typically held by the physical commodity producer. Technical reasons #1 Seasonaility of the spread differential. #2 Bull or bear spread as a hedge against directional bias. #3 Bull or bear spread as a theoretical conservative bet on directonal bias. #4 Commitment of traders data. Geographical spread arbitrage Simultaneously entering a long and short futures and or options position across the same or different contract in two different commodities. Example using futures Long May Arabica coffee and short May Robusta coffee. Crush spreads Simultaneously entering three legs in the futures and or options across three related commodities by entering two buys and one sell, or two sells and one buy. Often related to production margins of a particular commodity. Example using futures Example using futures Soybean crush: long soybeans, short soybean meal, short soybean oil. Cattle crush: long feeder cattle, long corn and short live cattle. Options volatility Going L/S or spread commodities based on implied and historical volatilities. Example Relative value: long December wheat calls at 25% volatility, short July wheat calls 40% volatility. 291 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 292 COMMODITY INVESTING AND TRADING purchase soybean meal and corn against the lean hog or live cattle futures. Table 10.6 details the fundamental drivers for placing a crush trade. Options volatility Trading of options volatility strategies offers traders with a wide range of dynamic opportunities on a standalone basis, and also when coupled with futures directional and relative value spreads. Trading opportunities in options include individual commodity spreads and direction or across commodities in the form of arbitrage. Experienced relative value option specialists in agriculture are frequently able to find attractive opportunities by trading differentials in volatility on an inter/intra commodity basis. Additional strategies involve trading put versus call skews across one or more contract months in one or multiple commodities. Directional trading is also prominent in options by way of owning net, absolute gamma or premium in any contract month. An example of a net gamma options play would be to own a bull call spread in which the trader purchases an at-the-money call and sells an out-ofthe money call against it at a slightly lesser value, resulting in a net payment of premium and a net long volatility position. The number of options strategies which can be expressed across agriculture markets is seemingly endless, and they provide traders with unique and niche opportunities to generate profitable returns. Table 10.7 details the three different types of options strategies that are often traded across the agriculture space. CONCLUSION The speed of information flow and the sudden correlations across markets from time to time can in some ways be attributed to the success and growth of electronic trading, as a more diverse set of speculative participants from around the world have virtual around the clock access to trade and manage risk in most commodity markets. In general, this new normal in price behaviour and volatility offers more opportunities for multi-strategy and relative value driven traders. Periods of high volatility and relatively wider price ranges can frequently distort prices relative to perceived fundamentals, which can create unique opportunities. These types of price environments are often associated with adverse market conditions; 292 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 293 AGRICULTURE TRADING Table 10.7 Strategy types: options Price distribution Trading the difference or skew in the options pricing against same underlying futures contract. This can be done by trading straddles or strangles based on options pricing differentials. Relative volatility Trading statistical differences in volatility between correlated and or non-correlated commodities. This can be done by selling relatively high volatility in one commodity and purchasing relatively cheap volatility in another. Trading the difference between implied volatility and historical volatility in one commodity. This can be done by buying or selling volatility in one commodity based on the relationship between implied and historical volatility. Relative value Trading the price relationship of an underlying futures spread by way of using options. This can be done by trading put, call and butterfly options spreads on an inter/intra commodity basis. Example using futures Long May Arabica coffee and short May Robusta coffee. Crush spreads Simultaneously entering three legs in the futures and or options across three related commodities by entering two buys and one sell, or two sells and one buy. Often related to production margins of a particular commodity. Example using futures Example using futures Soybean crush: long soybeans, short soybean meal, short soybean oil. Cattle crush: long feeder cattle, long corn and short live cattle. Options volatility Going L/S or spread commodities based on implied and historical volatilities. Example Relative value: long December wheat calls at 25% volatility, short July wheat calls 40% volatility. those traders which can realise the difference between an event that is normally anticipated (seasonal or fundamental data point) and one that is rare and unexpected will find success in trading and managing risk in agriculture markets. The ability to recognise, filter, and accurately assess changing market developments is critical in making trading decisions. With 293 10 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 294 COMMODITY INVESTING AND TRADING the globalisation of agribusiness and trade expected to grow, so will the expansion and enhancement of global agriculture futures and options markets, which will further increase the set of trading opportunities available to all traders. 294 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 295 11 Quantitative Approaches to Capturing Commodity Risk Premiums Mark Hooker and Paul Lucek State Street Global Advisors and SSARIS Advisors Many institutional investors now allocate to commodities alongside the traditional asset classes of equities and fixed income, based on the primary motivations of diversification and protection against the risk of inflation. While commodities have indeed been less correlated to equities and many other risky assets (and offered comparable risk–return trade-offs, see Gorton and Rouwenhorst, 2008), in this chapter we will show that those diversification benefits may be enhanced through a deeper understanding of how and why different passive and active strategies tend to perform in different market environments. Our conceptual frame of reference views most investment strategies as either convergent or divergent – performing well in either “normal” or more dislocated periods – and is applicable at any level of aggregation, from individual securities to sectors and markets as well as combinations of asset classes. We will begin with a brief review of commodity benchmarks, highlighting the degree to which they are considerably less passive than traditional equity and fixed income benchmarks, as well as an overview of active approaches to commodity investing. We will then present a detailed discussion of the convergent/divergent paradigm, and demonstrate with an example how it can be applied within an active commodities strategy, underscoring its effectiveness during the most recent global financial crisis when traditional approaches to diversification largely failed. 295 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 296 COMMODITY INVESTING AND TRADING REVIEW OF COMMODITY BENCHMARKS AND OVERVIEW OF ACTIVE APPROACHES TO COMMODITY INVESTING Commodity benchmarks differ from their stock and bond counterparts in two main ways. First, there is no straightforward analogue to market capitalisation for determining component weights – eg, the index weight of crude oil relative to that of soymeal. Instead, various commodity indexes, including the prominent DJ-UBS and GSCI indexes, use factors such as trading volumes of the futures contracts and worldwide production statistics to derive individual component weights. The collection of production and trading volume data is also subject to a series of decisions regarding sources, timing, data revisions and additional factors. Commodity benchmarks are therefore subject to a much greater degree of subjectivity in determining benchmark weights. Second, since commodity futures contracts have a limited time before their expiration, a set of rules must be constructed to determine when contracts are rolled from the near month to a later-dated month. These rules must indicate whether adjacent contract months are used, or if certain months are skipped. In order to minimise the impact of the change over from one contract to the next, the roll usually occurs over a period of several days, which also must be specified within the rules. In this sense, passive commodity investing should be considered semi-active. Active commodities strategies The broad universe of commodity futures contracts exhibits a very low average correlation of its components, a wide dispersion of individual commodity futures returns, high volatility and large drawdowns. For example, pairwise correlations between industry group returns in the MSCI World Equity Index average about 0.5, while analogous correlations between the constituents of the DJ-UBS commodity index are closer to 0.2, and volatilities average about 50% greater for commodities, at 30% versus 20% for equities.1 This volatility and dispersion provides considerable opportunity for skilled active managers to implement strategies that can provide alpha over commodity index beta, while using risk controls to reduce volatility and preserve capital. The combination of these opportunities for active managers, in conjunction with the semiactive nature of the commodity index providers, makes a strong case for active commodity management within an institutional portfolio. 296 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 297 QUANTITATIVE APPROACHES TO CAPTURING COMMODITY RISK PREMIUMS Strategies for active commodity management generally fall within two categories: discretionary and systematic. In this chapter, we will focus on systematic strategies, which are quantitative in nature, using historical data to develop models that drive trading decisions directly from feeding live data through the models. Quantitative trading strategies are of course sensitive to the performance of their underlying models, which typically have positive periods where they perform as designed, and negative periods where factors external to those included within the model drive more of the market movements. For this reason, diversification of differently designed trading models and approaches can greatly enhance the overall efficiency of a quantitatively managed portfolio of commodity futures. CONVERGENT AND DIVERGENT STRATEGIES The convergent/divergent paradigm was introduced in Chung, Rosenberg and Tomeo (2004). It focuses on distribution of monthly returns, their statistical properties and the cross-correlations between those returns and aspects of the market environment. Convergent return streams have monthly return distributions represented by the shaded curve in Figure 11.1, and are generally derived from fundamental or value-based methodologies. In a convergent strategy, a manager often calculates an intrinsic or “fair” value for an asset: a target price. If the asset is trading below the intrinsic target price, the manager would seek to buy the undervalued asset. Conversely, if the asset is trading above the intrinsic target price, the manager would seek to sell the overvalued asset. The goal of the traded position would be for the current asset price to converge to the target price and generate a positive return. The manager seeks over- or undervalued assets with the expectation that these assets will move toward their fair values, allowing them to exploit the temporary mispricing. Convergent strategies tend to be based upon fundamental methodologies, although certain quantitative methods – for example, mean reversion strategies – also tend to produce convergent return streams. Most passive investments – indexes – are also convergent in their nature. Passive index investing has the goal of capturing the risk premium of the asset class. Fixed income risk premiums come from credit and duration risks. The equity risk premium is associated with earnings growth. Commodity risk premiums are derived from the 297 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 298 COMMODITY INVESTING AND TRADING Figure 11.1 Convergent and divergent monthly return distributions CONVERGENT DIVERGENT CONVERGENT | -2 | 0 DIVERGENT | 2 | 5 Source: SSARIS/SSgA inventory levels of the underlying commodities (Gorton, Hayashi and Rouwenhorst, 2006). A passive investor in these indexes is looking for the index return to converge to the expected risk premium. Furthermore, as emphasised in Ilmanen (2011), asset class risk premiums tend to be larger for investments that perform poorly during crisis periods (“bad times”) so that they have some characteristics of selling insurance. Assets that produce positive returns in normal periods and suffer large losses in crisis periods are convergent. Convergent investments normally exhibit fairly consistent return streams with a high frequency of small positive returns. Their consistency and low volatility can give them high Sharpe ratios and make these types of strategies very attractive to investors. One of the weaknesses that convergent strategies exhibit is their negative skewness. As shown in Figure 11.1, the convergent return distribution has a significant left-hand fat tail. After a series of several monthly returns clumped around zero with a positive mean, market events can occur where convergent strategies experience significantly (2–3 standard deviation or more) negative returns. These events tend to be termed “crisis events”, such as the 1987 stock market crash, the 1997/98 Asian currency/Russian debt/LTCM crises, the 2007–08 global 298 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 299 QUANTITATIVE APPROACHES TO CAPTURING COMMODITY RISK PREMIUMS financial crisis (GFC) and the 2011 European debt crisis. During these crisis events, fundamental and value-based strategies often have significantly negative performance. When behavioural finance concepts such as “fear” and “greed” drive market movements, asset prices succumb to panic and overshoot their fair values. Convergent approaches have great difficulty in this type of crisis environment because, as an asset price drops due to panic and fear, the convergent model suggests that the asset is an even more attractive buy. The model will eventually be correct when the asset price hits a bottom and the crisis passes, but trading positions taken along the way may experience heavy losses. Unrealised losses in commodity futures contracts force future commission merchants (FCMs) to issue margin calls. If further capital is not produced, the manager’s positions are liquidated and the losses are realised. This situation was aptly described by a quote attributed to John Maynard Keynes: “Markets can remain irrational longer than you can remain solvent.” A prime example of crisis price dynamics is illustrated in Figure 11.2: the price of the December 2008 Nymex crude oil futures contract. Within a span of 10 months, the contract rose from US$84.62 per barrel to US$146.68, before sinking to US$49.62. Somewhere within the range of a 73% run-up and a 66% decline was an intrinsic value for crude oil, but the price had been driven far beyond fair value in both directions. During market dislocations, such large directional moves are common. The most striking characteristic of these crisis events is an increase in market volatility (almost, by definition, a crisis event includes an increase in market volatility). A secondary effect is an increase in magnitudes of correlations. Assets that previously exhibited low correlations tend to become correlated during a crisis. A tertiary effect is the increase in serial price correlation or autocorrelation within individual markets. Table 11.1 shows these three effects during the 2007–08 GFC: over 2007, the DJ-UBS index had an annualised volatility of 12%, average correlation of its components of 0.15 and near-zero autocorrelation of those components’ returns. During 2008, each of those statistics more than doubled, with serial correlation rising more than five-fold. When markets become driven beyond fair value and fundamental convergent methodologies fail, it is the divergent category of strategies that can capitalise on the increase in market autocorrelation. 299 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 300 COMMODITY INVESTING AND TRADING Figure 11.2 WTI crude oil contract (December 2008) 145 US$/barrel 125 105 85 65 2/ 1 16 /08 /1 30 /08 /1 13 /08 /2 27 /08 /2 12 /08 /3 26 /08 /3 / 9/ 08 4/ 23 08 /4 / 7/ 08 5 21 /08 /5 / 4 / 08 6 18 /08 /6 / 2/ 08 7 16 /08 /7 30 /08 /7 13 /08 /8 27 /08 /8 10 /08 /9 24 /08 /9 8/ /08 1 22 0/0 /1 8 0 5/ /08 11 19 /0 /1 8 1/ 08 45 Source: Commodity Systems Inc Divergent strategies capitalise on directional market moves. These strategies, which include momentum and other trend-following approaches, seek to take positions based upon the analysis of historical price data and the direction the market is currently moving. They tend to perform well as the rate of change in volatility levels increases, which is also when markets tend to exhibit more pronounced degrees of autocorrelation. While in normal or rational market environments convergent and divergent strategies are usually uncorrelated, during crisis events and irrational market environments the two become negatively correlated. Divergent strategies perform well and experience righthand tail events at the same time that convergent strategies have their negative left-hand tail events. When markets exhibit strong directional moves such as with crude oil in 2008, momentum/trend strategies can capitalise on the shifts away from fair value. Divergent strategies in this sense are directly opposite to convergent strategies. As crude oil rose in 2008 and became more and more expensive, 300 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 301 QUANTITATIVE APPROACHES TO CAPTURING COMMODITY RISK PREMIUMS Table 11.1 DJ-UBS index – trailing 52-week statistics, weekly data points 2/1/2008 31/12/2008 increase Annualised standard deviation Average correlation of components Average auto-correlation within components 0.120 0.293 2.44× 0.150 0.429 2.87× 0.025 0.145 5.81× Source: DJ-UBS index convergent models saw the asset as overpriced. Divergent models saw the increasing price as a trend and favoured the asset. Divergent strategies require a significant retracement in market price before they will change their assessment of a market trend. Similarly, during the market decline in the second half of 2008, as crude oil became less and less expensive, convergent models favoured the asset, while the strong downward move forced divergent trend models to sell the asset. The contrasting styles of convergent and divergent strategies and the diversification of their respective return stream distributions leads to the benefit of allocating to both strategies. Commodity markets facilitate this diversification, because with the wide dispersion and low average correlation within the commodity universe, divergent events can occur in one commodity sector while other sectors exhibit a largely convergent environment. For example, in 2012 significant bullish moves in agricultural markets took place due to the drought conditions in the US, with corn up more than 60% and soybeans, meal and oil up roughly 25% between mid-June and early August. These markets exhibited strong directional trends that divergent strategies were able to capture, while other market sectors provided strong performance from convergent strategies. Investment strategies that allocate to successful convergent and divergent techniques will outperform those that allocate to only one or the other on a risk-adjusted basis. A CONVERGENT/DIVERGENT ACTIVE COMMODITIES EXAMPLE In order to demonstrate the beneficial effect of a convergent/divergent quantitative approach to commodity investing, we present here examples of the two trading methodologies, their individual performance relative to a passive benchmark index and the increased 301 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 302 COMMODITY INVESTING AND TRADING efficiency achieved by their combination. The sample period for this analysis is January 1996 to October 2012. A simple divergent momentum strategy described by Spurgin (1999) uses three lookback timeframes in order to determine long or short positions in each market traded. The three timeframes – 15, 27 and 55 days – were selected to best replicate an index of commodity trading advisor (CTA) managers trading a broad range of futures contracts. The signal derived from the momentum strategy is generated by comparing the price at time t with the price at a fixed number of days ago. For example, in the 15-day system, if Pt > Pt-15, the market trend is considered to be positive and a long position is taken. If Pt<Pt-15, the market direction is considered to be negative and a short position is taken. If the prices are the same, no market direction is indicated and no position is taken. Trading signals from the three lookback timeframes are averaged. In this chapter, we modify the momentum trading methodology by not taking any net short positions. If an aggregate signal is negative, indicating a short, a flat position is taken instead. This modification has the effect of making the momentum system track the index more closely, since the index itself does not take short positions. Signals for each of the 20 components of the DJ-UBS index are generated on a daily basis. Profits and losses were calculated by equally weighting the system’s return streams on each of the 20 components and rebalancing on a monthly basis. The DJ-UBS index is presented as a benchmark for comparison in Table 11.2. The momentum strategy outperforms the DJ-UBS index while exhibiting less than half of its volatility. For convergent strategies, we investigate two quantitative approaches. The first relates to the Gorton–Hayashi–Rouwenhorst view that inventories are the key fundamental for commodity futures returns, and that the degree of contango or backwardation in the futures curve reflects those fundamentals. Here, we construct an alpha signal for each commodity each month. That alpha is a simple function of the relationship between the second-from-expiration futures price and the next-to-expiration contract price. The second convergent approach models each commodity’s returns using a Markov switching model. Here, each commodity’s monthly return is assumed to be drawn from one of three different normal distributions, called regimes, each with its own mean and variance. The process moves from one distribution to another (a 302 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 303 QUANTITATIVE APPROACHES TO CAPTURING COMMODITY RISK PREMIUMS Table 11.2 Performance of divergent and convergent strategies versus the DJ-UBS DJ-UBS commodity index total return Annualised return Annualised standard deviation Return/risk ratio Divergent Convergent momentum backwardation & strategy (15-27-55 regime switching day lookbacks) strategy Combined convergent & divergent strategy (50%/50%)* 0.048 0.053 0.106 0.083 0.167 0.077 0.203 0.132 0.289 0.681 0.523 0.626 Data based upon DJ-UBS Commodity Index returns (January 1996–October 2012) * The combined convergent/divergent strategy is rebalanced monthly different normal distribution contributing the return draw) according to a set of Markov transition probabilities. Expected returns are computed each month for each commodity by multiplying the estimated probabilities of being in each regime by their respective means. Those means, variances and transition probabilities are estimated periodically through time and evolve as new data accumulates. The alpha estimates from these two convergent approaches are averaged, and then run through a mean-variance optimisation to produce over- and under-weights relative to the DJ-UBS Commodity Index benchmark weights that also satisfy various constraints, such as limits on short positions and on active exposures to individual commodities and commodity groups. The return stream produced is summarised in the final column of Table 11.2. The convergent strategy also outperformed the DJ-UBS index, but with about a third greater volatility, for a return-to-risk ratio somewhere in between the index and the divergent strategy. As mentioned above, convergent strategies tend to perform well when assets move toward intrinsic or fair valuations, which tends to be when markets are in more normal regimes or recovering toward normality after severe shocks. By contrast, divergent strategies tend to perform well during crises when markets are driven beyond fair values. Consistent with this logic, the convergent backwardation– Markov switching strategy had average excess returns that were slightly negative in 2008 as markets reacted severely to the global financial crisis, but outperformed by more than 17 percentage points 303 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 304 COMMODITY INVESTING AND TRADING in 2009 as markets dramatically recovered. In contrast, the divergent momentum strategy outperformed the index by more than 45% in 2008, and underperformed by more than 12% in 2009. The most striking aspect of the convergent and divergent excess return streams is how their correlation varies across time. The overall correlation is slightly negative, at –0.16. However, during the crisis and recovery period of 2008–09, it rose dramatically (in absolute terms) to –0.51, demonstrating the very powerful benefit through the diversification achieved by combining these two return streams. A programme allocating one half of the portfolio to each strategy and rebalanced on a monthly basis showed an 8.3% annualised rate of return with a 13% annualised standard deviation (outperforming the benchmark index by more than 3%, with volatility reduced by more than 3%) in a backtest over the test period of January 1996–October 2012. CONCLUSION Most approaches to diversification focus on average correlations over periods of time that encompass full market cycles – indeed, that is often by design, implicitly assuming that fluctuations in correlations through time are primarily noise and so should be averaged out. That approach has disappointed investors during crises as realised correlations, particularly within the dominant convergent set, “all go toward one”. The convergent/divergent paradigm, by contrast, views variations in correlations – particularly as a function of market stress and stability – as fundamental attributes of a strategy that should be incorporated into portfolio design. The example in this chapter showed that combining convergent and divergent active quantitative strategies can provide significant alpha over a passive index and stabilise the overall return stream of the portfolio, especially during crisis event periods. In practice, we have seen this concept can apply to fundamental active strategies, passive strategies, other asset classes and the overall portfolio level as well, where it may help overcome the challenge that diversification has often worked least well when it has been needed most. 1 There are 23 industry groups in the MSCI GICS system versus 20 commodities in DJ-UBS, so this level of aggregation makes them reasonably comparable. Correlations and volatilities are computed using monthly returns from 1999 to 2009. 304 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 305 QUANTITATIVE APPROACHES TO CAPTURING COMMODITY RISK PREMIUMS REFERENCES Chung, S., M. Rosenberg and J. Tomeo, 2004, “Hedge Fund of Fund Allocations Using a Convergent and Divergent Strategy Approach”, The Journal of Alternative Investments, Summer. Gorton, G., F. Hayashi and K. G. Rouwenhorst, 2007, “The Fundamentals of Commodity Futures Returns”, Yale ICF Working Paper No. 07–08. Gorton, G. and K. G. Rouwenhorst, 2006, “Facts and Fantasies about Commodity Futures”, Financial Analysts Journal, 62(2), March/April. Ilmanen, A., 2011, Expected Returns: An Investor’s Guide to Harvesting Market Rewards (Hoboken, NJ: Wiley). Spurgin, R., 1999, “A Benchmark for Commodity Trading Advisor Performance”, Journal of Alternative Investments, Fall. 305 11 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:01 Page 306 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 307 12 Structural Alpha Strategies Francisco Blanch; Gustavo Soares and Paul D. Kaplan Bank of America Merrill Lynch; Macquarie Funding Holding Inc. and Morningstar, Inc. Investors can get exposure to market-neutral returns in commodities – commodity alpha – in many different ways. Active management is, of course, one means of obtaining exposure to commodity alpha. However, as commodities have grown as an asset class, a large number of rules-based strategies (examples of which will be provided throughout the chapter) designed to generate marketneutral returns have emerged. These systematic commodity alpha strategies exploit structural characteristics of commodity markets, and will be referred to here as “structural commodity alpha strategies”. They are not a source of risk-free returns. Their returns are the reward for taking on risks that other market participants are unwilling to take on a systematic basis. The main goal of this chapter is to outline the major investment themes among these structural commodity alpha strategies and suggest a simple methodology for combining them into an absolute return portfolio. After briefly introducing the three major investment themes in commodities alpha, this chapter will examine each in turn. First, it will cover curve placement strategies, discussing their rationale and relationship to storage economics. This section will also explore how curve placement strategies are generally constructed and their risks, as well as issues including seasonality and market segmentation. The next section looks at momentum strategies, going over the principle behind such strategies and their relationship with the economic cycle. The section discussed the construction of momentum strategies using price as a signal, and also using the 307 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 308 COMMODITY INVESTING AND TRADING shape of the forward curve as a signal. It also assesses the distinction between absolute and relative momentum. The third section covers volatility strategies, examining the rationale of such strategies and comparing different implementations using variance swaps and variance swap calendars and the risk– return profile expected of each implementation. The final main section discusses how to combine different alpha strategies into a basket in order to achieve particular risk–return goals for the overall portfolio. In the process, it also explores how the approach of choosing a set of relatively simple, uncorrelated strategies is a means to mitigate backtesting bias relative to out-of-sample performance. Finally, we conclude by highlighting the main points considered throughout the chapter. In general, there are three major investment themes on structural commodity alpha: curve placement, momentum and volatility. Strategies that provide price insurance and liquidity to market participants on a systematic basis are rewarded with positive returns. These strategies are not riskless, but can be constructed to be more or less independent of the factors that affect commodity price. As a result, their returns have low correlation with market returns. Even although these strategies are not independent of market fundamentals, they cannot be replicated by simply getting exposure to a broad-based commodity market benchmark. Hence, they constitute pure commodity alpha. Curve placement strategies are one of the most basic and popular ways to generate commodity alpha. In essence, they exploit market segmentation (ie, the fact that different market participants have different hedging needs) across different commodity forward curves, as consumers, producers and index trackers tend to use different contracts for their hedging needs. Curve placement strategies aim to generate returns by taking advantage of the differences in hedging needs between producers, consumers and index trackers. In addition, curve placement strategies are rewarded for providing liquidity to market participants in less liquid parts of the forward curve. Momentum strategies can be used by commodity investors as a source of alpha in many different ways. Momentum alpha is the 308 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 309 STRUCTURAL ALPHA STRATEGIES reward for taking price risk from market participants ahead of the market using the fact that commodity prices and inventories follow persistent fundamental economic trends. In particular, roll returns are closely linked to inventory cycles. Given that changes in inventories are the differences between supply and demand, momentum in commodities is ultimately the result of persistence in inventory levels and changes. As inventories build (or draw) slowly over time, momentum generates alpha by identifying the commodity markets that need to create incentives for market participants to balance markets by moving physical commodities in and out of storage, or incentivising changes in demand or supply. Volatility strategies provide insurance to market participants and are rewarded for taking price risk from market participants that are unwilling to bear those risks. As in any other derivatives market, implied volatility in commodity markets serves as the key parameter for market participants – eg, producers, consumers, processors and investors – to match supply and demand for options. However, there is often a structural imbalance between buyers and sellers of options in commodity markets. Market participants’ hedging needs cause biases in the options markets, offering a source of market-neutral alpha for investors. CURVE PLACEMENT STRATEGIES To understand how alpha can be generated by curve placement strategies, we need to understand how commodity forward curves are shaped and how different market participants segment themselves across the curves. Moreover, we need to be aware of when and how these market participants position themselves throughout the year and the trading flows associated with these positions. Forward curves and the market value of storage Commodity forward curves embed not just expectations about future prices, but also the net costs of carrying physical commodities over time. Hence, storage and financing costs largely explain the shape of the curve in most commodity markets. A simple arbitrage argument shows how the cost of physical storage should be equal to the difference between forward and spot prices (see Figure 12.1). If the net cost of physically storing a commodity is higher (lower) than 309 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 310 COMMODITY INVESTING AND TRADING Figure 12.1 Storage economics determines the shape of the forward curve: cost of financing plus storage costs 102 100 $/bbl Risk premium: a producer would accept a lower price than expected in exchange for locking-in his margins: F0,T – S0 = E0(ST) – S0 – Risk Premium 98 Actual future price, F0,T 96 Market expectation of future prices, E0(ST). How do we determine them? Actual spot price, S0 94 92 90 Purchasing the commodity in the spot market, storing it and selling the future generates F0,T – S0 = cost of storage + financing Futures expiry 88 22-Feb-11 22-May-11 22-Aug-11 22-Nov-11 the difference between spot and forward prices, owners of the physical commodity would rather sell (buy) the commodity on the spot market and buy (sell) it forward than store it. This dynamic would force spot prices down and forward prices up when the forward curve is not steep enough to compensate for storage costs. Similarly, it would force spot prices up and forward prices down if the forward curve is too steep. However, storage costs interact with market expectations and the need of physical players to own the physical commodity. Depending on market conditions, one of the factors may be more relevant than the others. For commodities that are hard and expensive to store – such as natural gas, crude oil and lean hogs (a commonly used type of pork that is traded in Chicago) – the cost of storage tends to play an important role in determining the slope of the forward curve, but the shape of the forward curve can, at times, deviate widely from the storage cost implied contango. But what determines the curvature of the forward curve? That is, what determines the difference between the 1M–2M timespread and the 3M–4M timespread? Using the same physical arbitrage argument, it should be the cost of financing and storing a commodity for a month starting in one month versus the cost of financing and storing a commodity for a month starting three months from now. 310 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 311 STRUCTURAL ALPHA STRATEGIES Hence, if having access to a storage facility now is more valued by the market than having access to a storage facility only available in three months, then our cost of storage argument implies a certain concavity in the shape of the forward curve. Concavity in the shape of forward curves suggests that the 4M contract should experience less price decay as time passes than the 2M contract. In other words, the price of the 4M contract falls less as it becomes the 3M contract than the price of the 2M falls as it becomes the 1M contract. Curve placement strategies take advantage of concavity in the forward curves by rolling long positions in commodity futures further out in the forward curve versus rolling short positions in commodity futures closer to maturity. Historically, this strategy has generated consistent outperformance and a longer date exposure produces a better risk-adjusted return. These strategies can be implemented with any set of weights. However, using DJ–UBS weights has been the most popular way of implementing the curve placement strategies (see Figure 12.2). Market segmentation across commodity forward curves Curve placement strategies exploit differences in the market value of storage across contract maturities, and can also take advantage of market segmentation across the forward curve. Producers and consumers are willing to pay a premium to protect their profit Figure 12.2 Risk-return of DJ-UBS based curve placement strategies (bubble sizes and labels are information ratios) 8% Returns 7% 2.83 6% 5% 3 month forward 2.80 4% 2.53 3% 2% 1% 1.0% 2 month forward 1 month forward Volatility 1.2% 1.4% 1.6% 1.8% 2.0% 2.2% 2.4% 311 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 312 COMMODITY INVESTING AND TRADING margins against large price movements, as do index hedgers. However, these market participants tend to favour transactions across differing tenor segments of the forward curve. Producers tend to hedge their long positions on the back-end of the curve, often accepting a lower price than they would expect in order to secure the profitability of their investments. In contrast, consumers tend to hedge their short positions on the front-end of the curve, often accepting to pay a premium for the physical ownership of the commodity. Finally, index hedgers provide systematic buying and selling pressure, selling the front-end contract and buying the second or third most nearby contract, on a recurring basis. Curve placement strategies benefit from market segmentation because they roll long positions in contracts further out in the forward curve (facing the producers as they search to offload their natural long price risk) and roll short positions in contracts close to maturity (facing the buying pressure created by consumers and the index hedgers in the front-end of the forward curve). Seasonality in curve placement strategies Seasonality patterns can be found in a variety of commodity markets – such as livestock, refined products, natural gas, grains, sugar and coffee. Seasonality can then be used to enhance the risk– return profile of curve placement strategies by leveraging the seasonal patterns of contract liquidity, storage needs and market segmentation. Because of the seasonality in production, certain commodities tend to come into the market at a very specific time of the year. For example, corn tends to be harvested in the northern hemisphere – where the bulk of the world production is located – between the months of August and November. Inventories reach their lowest point in Q3, just as the corn harvest starts in the northern hemisphere. Hence, there is seasonality in the market value of storage. There is also seasonality in the hedging needs of consumers and producers. For example, corn producers have to decide how much to invest in terms of seeds, fertilisers and other production inputs during the planting and growing seasons. In order to fix their margins, they increase their hedging demand during the planting season and decrease it during the harvest season. In particular, producers start closing down their short corn futures positions on 312 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 313 STRUCTURAL ALPHA STRATEGIES the September contract (when the harvest starts coming in) during the months of June, July and August, exerting some buying pressure on the September contract during those months. Risks of curve placement strategies One of the characteristics of curve placement alpha is that it faces headwinds when beta commodity investments perform well. It is a stylised feature of commodity forward curves that spot prices tend to tilt the forward curve into backwardation as they move higher. As demand starts outpacing supply, the spot price tends to rise and inventories tend to draw. Lower levels of inventories should decrease storage costs, and push down forward prices relative to spot prices. In fact, a backwardated curve is the market’s way of offering storage holders an incentive to supply the commodity into the spot market. Therefore, when the market is tightening, spot prices move up and the forward curve flattens or moves into backwardation. This link between spot prices and the shape of the forward curve is behind one of the most important characteristics of curve placement alpha: its negative correlation with the market. By being long contracts with longer maturity and short the contracts on the front end of the curve, curve placement alpha strategies tend to get hurt when commodity prices rally. A common solution to this problem is to use the monthly rebalancing of the curve alpha strategy to neutralise its exposure to the market by having less notional exposure on the short leg than on the long leg. The result is a beta-neutralised curve placement strategy. While beta neutralisation is not a performance enhancement feature, it eliminates the negative correlation between curve placement alpha and commodity beta. As a result, investors are left with a purer alpha strategy that is not negatively impacted by commodity price rallies. Investors who are looking for a more “market-neutral” strategy should neutralise their beta exposure in their curve placement alpha strategies. Another often proposed solution to this problem is the dynamic allocation across maturities. If curve placement alpha suffers when forward curves move into backwardation, then it may be better to dynamically adjust the strategy according to the shape of the forward curve. For instance, the investor may choose the position in the forward curve that has the best-implied roll yield (ie, the 313 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 314 COMMODITY INVESTING AND TRADING expected price appreciation/depreciation of the contracts as it approaches expiry) to the contract with lower maturity. In principle, this would give us a forward-looking estimate of how much implied roll costs will be the following month. However, this seems to be an overly simplistic approach. These strategies do not seem to work in practice. The fact that these strategies fail to differentiate themselves from static exposure is illustrated in Figure 12.3. The Dow Jones–UBS Roll Select Commodity Index, which rolls into the futures showing the most backwardation or the least contango, seems to underperform simple static allocations such as the Dow Jones–UBS 5M Forward Commodity Index. Perhaps, this is not surprising. The current “yield” or current “implied roll cost” of a contract can only be a good predictor of its future performance if the shape of the forward curve remains the same. However, the slope and curvature of commodity forward curves are not random walks and their best predictors are not their current values. It is fairly easy to statistically reject the random walk hypothesis for the slope and the curvature of the forward curve across most commodities. In fact, the slope and the curvature of commodity forward curves tend to show a large degree of mean Figure 12.3 Dynamic curve placement strategies have failed to differentiate themselves from static exposure 200 180 2% Jan-06=100 2% 160 1% 140 120 1% 100 0% 80 -1% 60 -1% 40 -2% 20 0 -2% 06 07 08 Monthly outpeformance (rhs) 314 09 DJUBSF5 10 11 DJUBS Roll Select 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 315 STRUCTURAL ALPHA STRATEGIES reversion. Hence, “yield” or “implied roll cost” strategies are unlikely to work in practice because they do not even work in theory. MOMENTUM STRATEGIES Momentum strategies can be used by commodity investors as a source of alpha in a range of different ways. For instance, many managed futures funds (also called commodity trading advisors, CTAs) employ computer-based algorithms that aim to identify upward and downward price trends across a variety of markets. Most of these algorithms work under high frequency and try to take advantage of statistical patterns and inefficiencies not only in commodities, but across a many futures markets. Alternatively, momentum strategies can be profitably implemented in lowfrequency models such as those based on monthly returns. High-frequency systematic momentum trading (as defined above) can be a profitable strategy in certain market circumstances, and is likely to be a diversifying strategy on a broad portfolio of alpha trades. However, they are hard for investors to access outside of a fund format. Low-frequency momentum, on the other hand, can be easily implemented. Most importantly, high-frequency momentum and low-frequency momentum are not competing strategies, but rather complementary on a broad basket of commodity alpha strategies. Where does low-frequency momentum come from? For commodities such as crude oil, refined products and base metals, momentum comes from their cyclical nature – that is, from the fact that demand follows the upward and downward trends of the business cycle (see Figure 12.4). More broadly, persistence is a direct consequence of determined demand growth combined with the inability of production to respond immediately to demand shocks, in addition to low short-term elasticity of supply. Hence, momentum results from persistence in the supply and demand fundamentals of the commodity. Given that changes in inventories are the differences between supply and demand, momentum in commodities results from a sustained trend in the levels of inventories. As such, we should find an even stronger link to the shape of the forward curve. In fact, statistical analysis shows momentum in the shape of the curve seems to be more prevalent and easier to detect than momentum on returns (see Figure 12.5). 315 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 316 COMMODITY INVESTING AND TRADING Figure 12.4 t-statistics of previous month performance for DJ-UBS ER sub-indices Aluminium Copper Crude oil (WTI) Heating oil Nickel Gasoline Sugar DJ-UBS ER Live cattle Zinc Corn Natural gas Soybean oil Soybean Cotton Silver Wheat Lean hogs Gold Coffee Statistically insignificant at the 10% level -4 -3 -2 -1 0 Jul-05 to Jul-10 1 2 3 4 Jul-00 to Jul-10 Figure 12.5 Degree of persistence on the shape of the forward curve (From Jan-06 to Dec-10) Gold Silver Coffee Nickel Zinc Copper Aluminium Sugar Heating oil Cotton Corn Crude oil (WTI) Gasoline Natural gas Lean hogs Soybean Soybean oil Cocoa Live cattle Wheat 39.2 24.2 15.7 15.3 13.7 10.5 9.0 9.0 8.9 8.4 6.7 6.3 6.0 6.0 5.6 5.5 5.4 4.9 4.4 2.6 0 10 All commodities have statistically significant persistance in the shape of the forward curve 20 30 40 50 Whether using excess returns, momentum or momentum based on the shape of the curve, momentum strategies exploit persistence in the levels of inventories. Months of low inventory levels – which are associated with backwardation, low roll costs and rising prices – 316 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 317 STRUCTURAL ALPHA STRATEGIES tend to be followed by months of low inventories. Hence, positive price performance and low roll costs are likely to be persistent. Similarly, months of high inventory levels – which are associated with contango, high roll costs and falling prices – tend to be followed by months of high inventories. Momentum generates alpha by identifying the commodity markets that need to create persistent incentives for the market to balance supplies with demands. The strategy is then rewarded for taking price risk in anticipation of future price movements. In that regard, momentum strategies are not pure alpha strategies designed to be market-neutral at all times, quite the contrary; in times of price appreciation, momentum strategies would be expected to participate – and have notable positive correlation – with the market. In times of price declines, short positioning would result in negative correlation with the market. Still, momentum strategies do not have an inherent bias to one side or another, and in that sense are market-neutral alpha strategies. The drawback of momentum strategies is that they are only likely to generate returns when markets are trending, and are less likely to generate much alpha in range-bound markets. While price and curve momentum strategies roughly exploit the same source of alpha, there is an important difference when it comes to implementation. Momentum can be used as a relative value signal that generates cross-commodity alpha by selecting which commodities to go long. For instance, some strategies select the most “backwardated” commodities or the least “contangoed” to construct a long-only portfolio. These are relative momentum strategies that allow investors to pick the best–performing commodities, imposing the constraint to be 100% long at all times. However, one can also use momentum as an absolute value indicator – ie, as a signal to be used when deciding whether to go long or short a particular commodity. A portfolio using an absolute momentum strategy does not need to be 100% long at all times. Unlike relative momentum strategies, a portfolio using this type of implementation could be long for some commodities without any offsetting short positions. Similarly, the portfolio could have only short positions or stay neutral depending on the combination of signals it receives. 317 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 318 COMMODITY INVESTING AND TRADING VOLATILITY STRATEGIES Commodity volatility can also provide a powerful source of alpha for investors. Just as in any other derivatives market, implied volatility in commodity markets serves as the key parameter for market participants – such as producers, consumers, processors and investors – to match the supply and demand for options. However, there is often a structural imbalance between buyers and sellers of options in most commodity markets. Market participants’ hedging needs cause persistent biases in the commodity options markets, offering a source of market-neutral alpha for investors. Commercial market participants are natural buyers of insurance against large price swings – ie, buyers of volatility. Producers and consumers are willing to pay a premium to protect their profit margins against large price movements. At the same time, there are few natural sellers of volatility in the commodity options markets apart from speculators. Because of the relatively low participation of speculators in commodity options markets, this imbalance between buyers and sellers of volatility has helped to create structural alpha opportunities for investors. For market participants willing to take on price risk, there is an opportunity to profit from this demand for insurance. Generally, there is high demand for long option positions among commercial market participants, such as producers, consumers and distributers. Option sellers collect the premium of an option and often delta hedge their exposure to the underlying contract. However, at inception, option sellers do not know whether the final profits of delta hedging the position will be positive. The difference between the option price change and the profit or loss of the underlying delta hedge is the hedging error that affects the profit and loss (P&L) of selling options and delta hedging. Hence, option market makers need to be compensated for the risk of losing money on their delta hedges. This hedging risk is a function of the “gamma” of the option, as well as the future realised price volatility of the underlying future. As a result, option prices (and consequently implied volatility) need to be high enough to compensate market makers for the risk of volatility realising at high levels over the lifetime of the option. While the high demand for options from commercial players pushes up 318 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 319 STRUCTURAL ALPHA STRATEGIES implied volatility away from realised volatility, current realised volatility is an estimate of the risk of delta hedging. Hence, the implied versus realised volatility spread can be seen a measure of the implicit supply and demand for volatility in the options market. As the P&L of delta hedging short options positions is linked to the spread between implied and subsequently realised volatility, option market markers then embed a premium on implied volatility over realised volatility. Investors can benefit from the imbalances between buyers and sellers of commodity volatility through variance swaps. The payout of a variance swap depends directly on the difference between implied volatility and the subsequently realised volatility of the underlying asset. Hence, commodity variance swaps can be utilised to take advantage of the structural premium between implied and realised volatility in commodities. Systematic variance selling offers a sources of structural alpha for investors. A variance swap can be sold short at the close of the day that the previous swap expires so that short variance positions can be rolled over continually (see Figure 12.6). Selling variance is vulnerable to large price movements common in many commodity markets. One way to mitigate this risk is to hedge the short variance position with a long variance position with Figure 12.6 MLCX WTI vol arbitrage excess return index MLCXCVA1 index 5% 215 4% 3% 195 2% 175 1% 0% 155 -1% 135 -2% -3% 115 -4% -5% Dec-02 95 Jun-04 Dec-05 Jun-07 Monthly returns Dec-08 Jun-10 Dec-11 Jun-13 Index levels (rhs) 319 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 320 COMMODITY INVESTING AND TRADING longer maturity, further out in the volatility term structure. Such calendar spread variance swaps can be used to create consistent structural commodity alpha strategies in many commodity markets. Combining strategies with different tenors and then adjusting notionals to make the exposure less sensitive to changes in implied vols – ie, vega neutral – is a classic way of mitigating the tail risk in short volatility strategies. Options have convex payouts and their price movements are not exactly equal to the movements in the underlying delta hedge. The more convex the option, the harder it is to delta hedge, the higher risks the option seller faces and the higher the compensation for bearing those risks should be. Hence, the alpha generated by systematically selling variance should be proportional to the degree of convexity of the option payout function – ie, to the option’s “gamma”. As a result, systematically selling variance in short maturity tenors should outperform systematically selling variance in long maturity tenors. This is so because the short-dated options have higher gamma than long-dated options, everything else being constant. Similar “gamma” strategies can also be used to generate structural commodity alpha in many commodity markets (see Figure 12.7). Figure 12.7 MLCXCVSB index with monthly returns (WTI crude oil 1M versus 3M variance swap calendar spreads) 5% 175 4% 165 3% 155 2% 145 1% 135 0% 125 -1% 115 -2% 105 -3% -4% Dec-02 95 Jun-04 Dec-05 Jun-07 Monthly returns 320 Dec-08 Jun-10 Index levels (rhs) Dec-11 Jun-13 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 321 STRUCTURAL ALPHA STRATEGIES PUTTING IT ALL TOGETHER The objective of any alpha portfolio should be to capture the benefits that a diversified portfolio of different sources of alpha can provide. In general, a portfolio’s risk is a function of the number of strategies held in the portfolio as well as of the correlation between them. Hence, a portfolio of a few alpha strategies, more or less independent from each other, generally will produce better risk-adjusted returns than any single strategy by itself. A simple example illustrates the power of a diversification in an alpha portfolio. Suppose we have an alpha strategy (strategy A) that generates returns of 5% and volatility of 2% per annum, providing an information ratio of 2.5. At the same time, suppose we have a set of three uncorrelated strategies (strategies B, C and D), each generating annual returns of 3% with the same 2% volatility, each of these providing an information ratio of 1.5. Despite each of those strategies being far worse than strategy A on an individual basis, it turns out that an equally weighted portfolio of strategies B, C and D produces a better allocation in risk-adjusted terms than an allocation to strategy A. Backtesting bias In any historical backtest, it is hard to identify whether the good historical performance of a strategy is a product of its design or pure luck. This is a classic problem with backtests and other types of model-selection algorithm. By searching for the alpha holy grail, we may end up spuriously choosing a methodology that would have performed well in that period by sheer luck. Complex strategies may perform well on a backtested basis not because of any fundamental reason, but only because their many bells and whistles were chosen so the strategy would perform well on the backtest in the first place. In fact, a set of sufficiently complex rules can overfit history and give any strategy a great backtest. One way to mitigate the risk of backtesting bias is to always choose simple implementations of each investment theme. Simple strategies have fewer degrees of freedom and therefore are likely to suffer less from the overfitting problem that complex strategies intrinsically embed. Overfitting rules and parameters are what ultimately generate the backtesting bias. Investors are better off combining simpler strategies – potentially with worse backtested 321 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 322 COMMODITY INVESTING AND TRADING performance, but for which they can understand the sources of returns – than more complex versions of the same strategy. The three major investment themes in the structural commodity alpha space outlined above – curve placement, momentum and volatility – can be accessed through extremely simple rules-based strategies. Of course, one could think of many ways to try to improve the performance of these simple strategies. However, in practice, many of the more complex strategies only marginally improve the risk-adjusted returns of the simpler strategies. At the same time, simpler strategies are less vulnerable to the backtesting bias problem purely because they have less rules and parameters to be calibrated. Weaving an alpha basket The simple example above suggests an easy methodology for creating high-quality alpha in any asset class. Using simple strategies, investors should create an alpha portfolio that captures different sources of risk premium. Generally, the diversified alpha portfolio will produce better risk-adjusted returns than any single strategy if the strategies are combined in an optimal way. However, what are the weights that should be given to each alpha strategy when constructing a portfolio of alpha strategies? The concept of “basket weights” is somewhat meaningless for commodity alpha investments. What really matters is not “notional weight” but “volatility weight” – ie, the contribution of each strategy to the overall risk of the portfolio. To make alpha strategies comparable, investors can dynamically adjust the allocation to the strategy in order to target a desired level of volatility. This technique, called volatility targeting, is a means of creating a level playing field for different alpha strategies. Because commodity alpha strategies are typically unfunded, changing the degree of participation is only limited by the amount of collateral needed to fund the strategy. On the level playing field of volatility-targeted strategies, how do we then best combine different sources of commodity alpha into a single alpha portfolio? After defining expected returns and a measure of risk (eg, volatility) for every alpha strategy, we can construct an efficient frontier by finding the portfolio that maximises expected returns for a given amount of risk. Because commodity alpha strategies are unfunded, the weights of a commodity alpha 322 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 323 STRUCTURAL ALPHA STRATEGIES portfolio do not need to add to 100% as they do in the classic Markowitz’s efficient frontier problem.1 In the absence of any weight constraint, the efficient frontier for commodity alpha portfolios is a straight line in which all portfolios have exactly the same information ratio as that of the maximum-information ratio portfolio (MIP) of a frontier obtained with portfolio weights constrained to add to 100% (see Figure 12.8). However, defining expected returns and a measure of risk for each commodity alpha strategy involves the real problem of trying to optimise different sources of commodity alpha into a portfolio. That is, it is a statistical rather than a financial issue. One way to avoid the statistical difficulties relating to asset allocation decisions is to simply put statistics aside and follow an appropriate rule of thumb. On the level playing field of volatility-targeted strategies, an equally weighted (EW) basket is a straightforward way to combine commodity alpha strategies. One advantage of the EW basket is its robustness over time, as the information ratios of the EW basket tend to be more stable than the ones for individual strategies. However, the EW basket is more than just a naïve diversification technique. In our selected set of commodity alpha strategies, a case could be made for all pairwise correlations being zero on average. After all, Figure 12.8 The application of CAPM to commodity alpha suggests that investors should only care about the “Maximum Information Ratio Portfolio” Efficient frontier: max returns given a targeted level of risk 6.0% 5.5% 5.0% Returns MIP: Maximum Information Ratio Portfolio with weights adding to 100% 4.5% 4.0% Portfolios with unconstrained weights have the same information ratio as the MIP 3.5% 3.0% 0.75% 0.95% 1.15% 1.35% Targeted volatility Weights constrained to 100% No constraints (weights adding to more than 100%) No constraints (weights adding to less than 100%) Source: BofA Merrill Lynch Global Commodity Research 323 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 324 COMMODITY INVESTING AND TRADING Figure 12.9 In practice, the EW basket or the “Minimum-Variance Portfolio” can get investors quite close to the efficient frontier Efficient frontier: max returns given a targeted level of risk 6.0% 5.5% 5.0% Returns MVP: Minimum-Variance Portfolio with weights adding to 100% 4.5% Efficient frontier with unconstrained weights 4.0% Leveraging up and down the MVP 3.5% 3.0% 0.8% 1.0% 1.2% 1.4% Targeted volatility Weights constrained to 100% No constraints (weights adding to more than 100%) No constraints (weights adding to less than 100%) Source: BofA Merrill Lynch Global Commodity Research the strategies were designed to be more or less independent sources of alpha. If that is the case, then on the level playing field of volatilitytargeted strategies, we know that the EW basket is one with weights adding up to 100% with the lowest level of volatility. Formally, if all pairwise correlations are equal to zero and the volatility of each strategy is equal to s, then the EW basket is the portfolio with weights adding to 100% with the lowest level of volatility. Under those assumptions, this is the minimum-variance portfolio (MVP). Of course, the weights of a commodity alpha portfolio in the efficient frontier do not need to add to 100%. However, once the MVP is found, investors can leverage weights up and down proportionally to achieve any level of targeted volatility on the overall portfolio. In practice, this technique can get investors quite close to the MIP without having to ever care about estimating expected returns of commodity alpha strategies (see Figure 12.9). CONCLUSION Systematic commodity alpha strategies attempt to capture different risk premiums, such as insurance and liquidity, prevalent in commodity markets. These systematic strategies capture risk premiums that are structural to commodity markets and therefore 324 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 325 STRUCTURAL ALPHA STRATEGIES likely to be a robust source of market-neutral returns in the long run. In addition, a portfolio of alpha strategies more or less independent of each other will yield higher risk-adjusted returns than any standalone, single commodity alpha strategy. This paves the way for a simple recipe for generating high-quality alpha in commodities. Investors should pursue simple and easy to understand strategies that exploit a broad range of sources of alpha. In particular, using equally weighted baskets of volatility-targeted strategies is a simple and robust way to construct a long-term allocation to structural commodity alpha strategies. Reprinted by permission. Copyright 2013 Merrill Lynch, Pierce, Fenner & Smith Incorporated. Further reproduction or distribution is strictly prohibited. APPENDIX: PUTTING MOMENTUM INTO COMMODITIES Paul D. Kaplan Strategies that take a momentum-based long/short approach to commodity investing serve investors better than long-only strategies. Following weaker investor activity in 2011, investment flows into commodities grew in 2012, with a net inflow of US$5.3 billion across all sectors alone in August 2012, with commodity exchangetraded products (ETPs) one of the fastest-growing asset classes. Commodity ETPs hit an all-time high of US$207.4 billion total assets in September 2012. In comparison, commodity ETPs saw inflows of US$10 billion throughout the entire year of 2011, and the year ended with total assets in commodities ETPs of US$152 billion. This surge in assets mirrors equally impressive gains in many commodities’ spot prices. Unfortunately, and to the chagrin of many investors, products linked to commodity indexes often experience much lower returns. Negative roll yield (which occurs when distant delivery prices exceed near delivery prices) means that many investors lose out even as prices rise. In response, a growing number of commodity investors are eschewing the traditional long-only approach in favour of alternative strategies that are better able to manage roll yield. With the rise of more innovative strategies, there is reason to question how well investors are being served by the traditional long-only commodity indexes either as benchmarks or proxies for investment 325 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 326 COMMODITY INVESTING AND TRADING products. Traditional approaches to representing pure beta exposures work well for stocks and bonds but not so well for the commodities “asset class”. In fact, we argue that there is no such thing as commodity beta. Moreover, we also assert that new passive strategies that use a momentum-based long/short approach rather than the long-only approach of the most common commodity indexes are better benchmarks for active strategies. NO SUCH THING AS COMMODITY BETA For many asset classes, it is very easy to take a pure beta exposure. Multiple asset class proxies are available, many of which are reasonable substitutes for each other. The Russell 3000, S&P 500 and Dow Jones Wilshire 5000 indexes, for example, are representative of the broad stock market and have similar performance characteristics, just as the Citigroup Broad Investment-Grade (BIG), Barclays Capital US Aggregate and Merrill Lynch US Domestic Master bond indexes mirror the wider fixed income market and perform alike. However, for commodities fewer choices and more disparity exist among the index options. NOT ALL INDEXES ARE ALIKE Figure 12A.1 illustrates the similar risk and return characteristics of the broad stock and bond indexes and the disparity among the three traditional commodity indexes – the S&P GSCITM Commodity Index, Dow Jones UBS Commodity Index, and Reuters/Jefferies CRB Index. When we plot standard deviation and compound annual return for each index over a common time period (January 1991– September 2012), we see that the nearly identical risk and return characteristics of both the stock and bond indexes place the plot points on top of one another. The commodity indexes, however, do not display the same level of consistency. Dramatic differences in constituents and weighting schemes as well as rebalancing rules are likely the cause of the performance differences in the commodities indexes. The S&P GSCI index, for example, has about double the weighting to the energy sector as the Dow Jones UBS Commodity and Reuters/Jefferies CRB indexes and only one third of the weighting to agriculture. 326 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 327 STRUCTURAL ALPHA STRATEGIES Figure 12A.1 Standard deviation versus compound annual returns for various indexes Compound annual return % Stock indexes Morningstar long/short commodity Morningstar long-only commodity Bond indexes Reuters/Jefferies CRB (inception: 02/01/1994) Commodity indexes BarCap US agg. bond Dow Jones UBS commodity Standard deviation % Source: Morningstar BOTH LONG AND SHORT POSITIONS FOR POSITIVE RISK PREMIUMS Long-only commodity futures strategies can prove inadequate in providing investment exposure to commodities, which is why professional CTAs tend to take both long and short positions in commodity futures, often based on trends in prices. SOURCES OF EXCESS RETURN A futures strategy generates excess return (ie, return in excess of the risk-free rate) from two sources: 327 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 328 COMMODITY INVESTING AND TRADING 1. 2. changes in futures prices; and the roll yield – which can be either positive or negative – that results from replacing an expiring contract with a further out contract in order to avoid physical delivery yet maintain positions in the futures markets. A complete understanding of these two sources of return requires an analysis of three interrelated markets for each commodity: 1. 2. 3. spot market – the cash market for the commodity itself; futures market – the market for contracts to deliver the commodity in the future for a price set today; and storage market – the market for the service of storing the commodity on behalf of its owner. What happens in spot markets is important to futures investors because changes in spot prices impact futures prices. The storage market is important because it interacts with the spot market and influences the slope of the futures price curve, which is the source of roll yield. At times of high demand, spot prices will be strong and the futures price will be lower than the spot price so that the further out the futures contract, the lower the price. When this is the case, we say that there is “backwardation” in the futures market or that the futures curve is “backwardated.” Investors who are taking long positions in futures contracts can realise this compensation monetarily by replacing the contracts that they are holding with longer-term ones, thus locking in profits. This component of excess return realised by investors is referred to as “roll yield”. As Figure 12A.2 shows, in backwardated markets roll yields are positive. Likewise, when the marginal benefits of owning spot supplies are low, the relationship between time to expiration and the futures price is positive, a condition known as contango. In contango markets, roll yields are negative because replacing contracts with ones of later maturity results in locking in a loss. When a commodity is scarce spot prices are strong, leading to backwardation and positive roll yields. Conversely, plentiful spot supply leads to contango and negative roll yields. Since inventory 328 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 329 STRUCTURAL ALPHA STRATEGIES Figure 12A.2 Futures price curves Contract price Positive roll yield Contract price 0 (spot) months to delivery Negative roll yield 0 (spot) months to delivery conditions in some commodities are slow to adjust due to the time it takes to increase their production, backwardation or contango could persist for a period of time, causing investors to consistently experience positive or negative roll yield over the period. Thus, a passive investor should benefit from a trend-following strategy that incorporates roll yield into its signal. 329 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 330 COMMODITY INVESTING AND TRADING ROLL YIELD AND EXCESS RETURN The effect of roll yield on excess return can be substantial. In fact, several studies have shown that excess return is attributable primarily to roll yield, not to changes in futures prices. Long-term excess returns on commodities that exhibit mean reversion in price and that tend to trade in contango will generally be negative, and those that tend to trade in backwardation will generally be positive. This behaviour can be seen in Figure 12A.3, which shows the relationship between roll yield and excess returns on the commodities listed for the 21-year period April 1990–September 2011. Commodities that tended to trade in contango experienced negative excess return, while those that tended to trade in backwardation saw positive excess return. Of particular interest here are natural gas futures. Because the price of natural gas grew at 4.1% per year over the 21-year period, one might have expected a natural gas futures index to provide a comparable rate of return. However, because natural gas futures traded in contango (and consequently experienced negative roll yield), the excess return was an abysmal negative 12.5%. BUILDING A BETTER STRATEGY Passive strategies that use a momentum-based long/short approach rather than the long-only approach of the most common commodity Figure 12A.3 Roll yield and excess return Positive excess return positive roll yield negative roll yield 330 Soybean meal Brent crude WTI crude Live cattle Gasoline-oil-petroleum Heating oil Lean hogs Soybean oil Wheat, hard winter Natural gas Negative excess return 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 331 STRUCTURAL ALPHA STRATEGIES indexes can better serve investors by attempting to capture the full excess return from a futures strategy. Such passive strategies are also likely to prove a better benchmark for the active strategies of professional futures investors. To make this idea operational, we created a family of commodity indexes that includes combinations of long commodity futures, short commodity futures and cash (see Figure 12A.4). The primary index, called the Morningstar Long/Short Commodity Index, holds commodity futures both long and short based on momentum signals. The other indexes are derived from this long/short index. The family includes a long/flat version, which holds cash in place of the short positions in the primary version so that investors who do not want or cannot have short positions can still get some benefits of a momentum-based long/short strategy. The family also includes a short/flat version for investors who already have long-only exposure to commodities and want some benefits of the momentum strategy without having to replicate or drop their long-only exposure. We created a set of single commodity indexes to serve as constituents for the long/short index and the related composite indexes by calculating a “linked” price series that incorporates both price changes and roll yield. The weight of each individual commodity index in each of the composite indexes is the product of two factors: magnitude and the direction of the momentum signal. We initially set the magnitude based on a 12-month average of the dollar-weighted open interest of the commodity. We then capped the top magnitude at 10% and redistributed any overage to the magnitudes for the remaining commodities. The direction depends partly on the type of composite index and, as we explain below, partly on the type of commodity in the long/ short index. In the long/short index each month, if the linked price exceeds its 12-month daily moving average, the index takes a long position in the subsequent month. Conversely, if the linked price is below its 12month moving average, the index takes the short side. An exception is made for commodities in the energy sector. If the signal for a commodity in the energy sector is short, the weight of that commodity is moved into cash – that is, we take a flat position. Energy is unique in that its price is extremely sensitive to geopolitical 331 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 332 COMMODITY INVESTING AND TRADING Figure 12A.4 Morningstar commodity indexes construction Morningstar commodity indexes construction. The Morningstar commodity index family consists of five indexes that employ different strategic combinations of long futures, short futures, and cash. The long/short commodity index is a fully collateralised commodity futures index that uses the momentum rule to determine if each commodity is held long, short, or flat Commodity universe Morningstar commodity universe Individual commodity indexes Long-only Long/flat Long/short Long/flat Short-only 332 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 333 STRUCTURAL ALPHA STRATEGIES events and not necessarily driven purely by supply/demand imbalances. For the remaining indexes, the direction is set as follows: long-only – always long for every commodity; tions as the long/short index, but Figure 12A.5 Morningstar commodity indexes: risk–return profile s r d d r 333 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 334 COMMODITY INVESTING AND TRADING Figure 12A.6 Commodity index correlation index DOWNSIDE PROTECTION While all long-only commodity indexes tend to provide strong protection when the stock market is down and in inflationary environments, the Morningstar Long/Short Commodity index limits downside risk while negotiating ups and downs in the commodity markets themselves. The Long/Short index’s maximum drawdown in the February 1991–September 2012 period, as seen in Figure 12A.5, was substantially lower than that of the S&P GSCI and Dow Jones– UBS Commodity indexes. We also compared maximum drawdowns experienced by the listed indexes during five-year sub-periods within that overall period, and the Morningstar Long/Short Commodity index suffered much smaller drawdowns in all subperiods. Clearly, a long/short strategy is better equipped to tap into 334 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 335 STRUCTURAL ALPHA STRATEGIES the underlying momentum of commodity prices, thereby limiting losses in down markets. THE LONG AND SHORT OF IT The long-only strategies that dominate the commodity index market do not best serve investors as investment vehicles or as benchmarks. Since futures price changes and roll yields are the sources of excess return, long-only indexes have no way to capture the returns available from shorting futures when there is downward price pressure or a positively sloped futures price curve. Long-only indexes generate negative roll yields when markets are in contango (when distant delivery prices exceed near delivery prices), and thus can have negative returns when commodity prices are rising. Furthermore, since many actively managed CTAs invest in long and short futures based on momentum trading rules, the long-only indexes are not appropriate benchmarks, rendering traditional approaches to representing beta exposure unsuitable. By using a momentum-based approach that takes into account both price change and the slope of the futures price curve, these Morningstar indexes aim to maximise both sources of excess return – price change and roll yield – to produce better performance. In addition, these indexes are logically consistent with the underlying economics of commodities futures markets, and backtested results show an attractive risk profile, low downside risk and low correlations to both traditional asset classes and long-only commodity indexes. As passive investment alternatives, these rules-based indexes could offer easier access to actively managed commodities trading strategies. 2013 Morningstar. All Rights Reserved. Used with permission. Further reproduction or distribution is strictly prohibited. The views and the opinions expressed here are those of the authors and do not represent the opinions of their employers. The authors are not responsible for any use that may be made of the contents of this chapter. No part of this text is intended to influence investment decisions or promote any product or service. 1 The Markowitz efficient frontier problem is: how do you select a portfolio with the lowest possible risk given a targeted expected return for the portfolio? The solution was developed by several authors in the 1950s and 1960s, but Harry Markowitz’s 1952 paper “Portfolio Selection” (Journal of Finance, 7(1), March) was among the first to address the problem. 335 12 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:03 Page 336 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 337 13 Energy Index Tracking Kostas Andriosopoulos ESCP Europe Business School In this chapter, a geometric average Spot Energy Index (SEI) will be constructed before its performance is reproduced with stock portfolios. The investment methodology employs two self-adaptive stochastic optimisation methods, superior to other rival approaches when applied to this index-tracking problem. To test the performance of the tracking baskets, three different rebalancing scenarios are examined, that also take transaction costs into consideration. It will be shown that energy can be effectively tracked with stock portfolios selected by the investment methodology used here. Passive investment strategies are becoming increasingly popular. Sharpe (1991) argues that, on average, active managers cannot beat passive strategies and active trading strategies are a zero-sum game. Other studies have found that passive strategies outperform active strategies on average (Malkiel, 1995; Sorenson et al, 1998; Frino and Gallagher, 2001). In addition, Barber and Odean (2000) claim that in active trading strategies the presence of high transaction costs, and sometimes the overconfidence of investors in their predictions, reduces profits substantially and potentially leads to losses. One of the most popular forms of passive trading strategies, index tracking, attempts to replicate/reproduce the performance of an index. Portfolio managers can choose between two methods. Full replication, purchasing all the stocks in an index, has some practical limitations and disadvantages. According to Beasley et al (2003), replicating exactly an index entails frequent revisions1 to reflect the updated weightings in the index, leading to high transaction costs. 337 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 338 COMMODITY INVESTING AND TRADING One-to-one replication also suffers from the disadvantage that some stocks can be very illiquid. For these reasons, many passive strategy managers prefer the alternative of partial replication, where managers hold the subset of stocks chosen to replicate the index most effectively. Since the early 2000s, impressive gains have been witnessed in commodity prices. This has attracted investors’ attention and led to growth of index investing in the commodity markets. In general, there are three major ways of investing in a commodity index: first, by choosing an index and replicating it by following the related rule book; second, by investing in a fund that replicates the chosen index; finally, a popular approach is buying the shares of an exchangetraded fund (ETF) that mimics the commodity index. This trend toward commodity index investing prompted the first commodity ETF in November 2004.2 As of January 2010, the market capitalisation of ETF exceeded US$39 billion. Many other ETFs investing in physical commodities, futures and commodity-related equities have followed. This chapter will propose a new approach that reproduces the performance of a geometric average SEI by investing only in a subset of stocks from various equity pools. For the purposes of our analysis, the Dow Jones Composite Average, the FTSE 100 and Bovespa Composite indexes, and two pools that include only energy-sector stocks from the US and the UK, respectively, are used. Daily data are analysed and the index-tracking problem addressed by two evolutionary algorithms – the differential evolution (DE) algorithm and the genetic algorithm (GA). The performance of the resulting investment strategy is tested under three different scenarios: buy-and-hold, quarterly and monthly rebalancing, accounting for transaction costs. This chapter has the following structure. The next section will discuss the importance of commodity index investing and major innovations, before we present the innovative approach used in this chapter for replicating the price behaviour of an energy commodity index using equities. We then explain in more detail the optimisation model, describing the two evolutionary solution techniques employed. The following section will outline the methodology used for developing the constructed energy commodity index, along with the commodity and equity data used, and discussion of the results 338 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 339 ENERGY INDEX TRACKING from tracking the energy index with the proposed investment approach will then follow. COMMODITIES INDEX INVESTING Commodity indexes have been around for many years, used mostly for benchmarking and to track spot commodity prices. One of the first published commodity indexes was the Economist’s Commodity-Price index, which started in 1864. Then, in 1957, the Commodity Research Bureau (CRB) index was established, tracking spot commodity processes; after undergoing major revisions in its composition, it is still published today. Nevertheless, since the early 1990s, the development of commodity indexes has witnessed tremendous changes. The first generation of investable commodity indexes appeared only in 1991, when the S&P GSCI (originally the Goldman Sachs Commodity Index) was introduced. In 1998, the Dow Jones–UBS Commodity Index (originally the Dow Jones–AIG Commodity Index) and the Rogers International Commodities Index (RICI) were both launched. Both the S&P GSCI and the RICI indexes are heavily weighted towards the energy sector, while the Dow Jones–UBS, because of the rule that no sector can weigh more than one-third of the index, has energy at its limit; in many instances, this limit is exceeded between the annual rebalancing periods. The common characteristic, and a major disadvantage of these early indexes, is that they invest in commodity futures contracts that are close to expiration, thus they roll forward their futures positions more frequently – making it very expensive to follow an indexreplication strategy using ETFs. In addition, holding a long futures position via an index that invests in the front of the curve is suboptimal, especially latterly, because many commodity futures curves have been experiencing steep contango (a state when the futures price curve is upward sloping) at the front end of the curve, which diminishes the ultimate returns. This previous observation was the main driver behind the creation of the so-called “second-generation” commodity indexes such as the UBS Bloomberg Constant Maturity Commodity Index and the JP Morgan Commodity Curve Index. Both of these indexes have a constant weighting scheme across commodities, but their investments allocation is spread across several contract expirations within individual commodities. The DJ–UBSCI 3-Month Forward index 339 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 340 COMMODITY INVESTING AND TRADING takes a similar approach and invests in contracts farther out the futures curve, reducing the effect of backwardation (a state when the futures price curve is downward sloping) or contango as the curve tends to be flatter for longer maturities. These type of indexes outperform the first-generation indexes because, when the front end of the curve is in steep contango, as has been the case with crude oil, the losses tend to be mitigated or reversed across the longer maturity contracts. Nonetheless, the opposite happens when futures markets are in backwardation, since the concentration usually occurs at the front end of the curve. It can be argued, however, that the chronology of the indexes has a significant impact on their construction methodology, and hence their performance, as later ones have had the benefit of improving on the methodology used by previously developed indexes. The latest addition to the family of commodities indexes are thirdgeneration indexes that attempt to improve the returns of the previous two by incorporating commodities selection, overweighting or including only commodities that are expected to deliver higher returns in the near future, while underweighting or omitting completely commodities that are expected to perform poorly. The UBS Bloomberg CMCI Active Index introduced in 2007 and the SummerHaven Dynamic Commodity Index introduced in 2009 are two examples of the third-generation commodity indexes. The latter index includes 14 equally weighted commodities from a total of 27, rebalancing its futures portfolio every month using basis and momentum to identify the greatest possible risk premium. The former index, on the other hand, uses the discretionary approach of its research analysts who adjust the component weightings of the index according. However, these types of indexes carry with them a new risk since the method of the research analysts used to select the commodities and their respective weightings can be unsuccessful, and thus underperform passive indexes. Commodity indexes attempt to replicate the returns equivalent to holding long positions in various commodities markets without having to actively manage the positions. Being uncorrelated with the returns of traditional assets such as stocks and bonds, commodity index investments’ returns provide a significant opportunity to reduce the risk of traditional investment portfolios. This explains the economic rationale for including a commodity index investment in 340 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 341 ENERGY INDEX TRACKING institutional portfolios such as those of pension funds and university endowments. There are now numerous publicly available futures’ indexes, with different risk and return profiles, offering exposure to commodity markets; each of these indexes also offers specific exposure to certain commodity sectors via their traded sub-indexes. Commodity index investing is still relatively “young” – compared to other more established asset classes such as stocks and bonds – and we would expect continued interest and innovation by market players in the coming years. AN INNOVATIVE APPROACH The above addresses a question that has received almost no attention in the literature: can returns of equity portfolios be used to replicate the performance of physical energy price returns, proxied by a spot index? The aim of this chapter is to replicate the price behaviour of direct energy commodity investment using equities. The proposed approach is based on previous research findings that the returns of equally weighted long-only portfolios of commodity futures are similar to those of stocks (Bodie and Rosansky, 1980; Fama and French, 1987; Gorton and Rouwenhorst, 2006). In addition, after the 2000s, commodities went through a financialisation process, exposing them to the wider financial shocks (Tang and Xiong, 2010). The replication method uses two very efficient strategies, the DE algorithm and the GA, to solve the index-tracking problem for the constructed SEI. These low tracking-error strategies provide several advantages to investors: they result in better-diversified portfolios, make the long-only constraint of a fund manager less binding and, in general, tend to provide higher returns for equity strategies. The performance of the SEI is reproduced by investing in a small basket of stocks picked either from the stocks comprising three wellknown financial indexes, or from two pools of energy-related stocks. In particular, the cases of the US, UK and Brazilian investors are considered under the assumption that they want to invest in the SEI and prefer to access only their local stock markets due to cost savings and/or better knowledge of the respective markets. They represent two developed and one developing stock market, with the latter having its unique energy significance in the global scene. Reforms and regulations that have taken place in Brazil have brought transparency, sophistication and additional liquidity to its financial 341 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 342 COMMODITY INVESTING AND TRADING markets. Oil and other energy prices influence companies’ earnings and thus their stock prices. Hence, based on intuition and previous research findings, the two pools of energy-related stocks used in the analysis should perform very well in tracking the SEI. Moreover, the stocks of various companies operating in other, non energy-related industries will still be affected by the movements in energy prices. The methodology implemented can track the SEI or any other benchmark index by investing in a basket of stocks that each of the evolutionary algorithms will determine. Baskets of a maximum of 10, 15 and 20 stocks are selected from the following stock pools: Dow Jones Composite Average, FTSE 100, Bovespa Composite, and the two pools of energy-related stocks from the US and the UK stock markets. The SEI represents a basket of energy commodities and serves as a performance benchmark with limited ability for direct investment. However, the proposed approach provides investors with an option to track the performance of this SEI using a basket of equities that are liquid and fully investable. This allows investors to get closer to the underlying commodity market price trends, something they cannot achieve using a futures price index. Historically, futures index returns have lagged price index returns, with this decoupling of performance being a constant frustration for index investors. For comparison, the performance of two well-established energy excess return indexes are reported, namely the Dow Jones–UBS Energy Sub-Index and the Roger’s Energy Commodity Index, against the performance of the constructed SEI and the selected portfolios. This chapter’s findings have several positive implications for investors. They provide a low cost – compared to actively managed funds – means of accessing the energy spot markets. In particular, sector rotation investment managers can benefit from the findings. By tactically shifting assets, they can over- or under-weigh specific sectors according to their economic outlook or market objective. Index tracking and problem formulation In the search for optimally replicating an index, different studies (Gaivoronski et al, 2004; Frino and Gallagher, 2001) focus on the performance deviations of the tracking portfolio – ie, the tracking error. Additionally, single-factor and Markowitz models (Larsen-Jr and Resnick, 1998; Rohweder, 1998; Wang, 1999) have been used to 342 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 343 ENERGY INDEX TRACKING replicate the performance of an index. Furthermore, the use of the cointegration concept in building portfolios for index tracking is highlighted by Alexander and Dimitriu (2002) and Dunis and Ho (2005). This chapter follows the approach used in Andriosopoulos et al (2012) for reproducing the performance of an international market capitalisation shipping stock index and two physical shipping indexes by investing only in US stock portfolios. First, the tracking error is measured through the root mean square error (RMSE) criterion. In particular, is assumed that there exist price data on N stocks and the price of an index over an (in-sample) time period [1, 2, …, T]. The goal is to create a tracking portfolio consisting of at most K stocks (K < N) that replicates, as closely as possible, the index for an (out-ofsample) period [T + 1, T + Δt]. The replication error of the tracking portfolio is defined as follows: T ! (r ! R ) RMSE = t 2 t /T (13.1) t=1 where rt and Rt are the returns for the tracking portfolio and the index, respectively. Second, except for the replication error, the return of the tracking portfolio is also of interest. To this end, the mean excess return (ER) is considered over the benchmark index, defined as follows: T ER = " ( rt ! Rt ) /T (13.2) t=1 Let Pit denote the price of stock i at time t, C the available capital and xi the number of units bought of stock i. The complete formulation of the objectives and constraints used to solve the index tracking problem can then be expressed as follows: Minimize: f = ! ! RMSE " (1! ! ) ! ER Subject to: (13.3) N !P iT xi = C (13.4) i=1 zi! C ! PiT xi ! ziC "i = 1,..., N (13.5) 343 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 344 COMMODITY INVESTING AND TRADING N !z i (13.6) !K i=1 xi ! 0, zi ! {0,1} !i = 1,..., N (13.7) where 0 ≤ l ≤ 1 is a user-defined parameter that outlines the tradeoff between the two objectives (tracking error and excess return). In the case l = 1, the tracking portfolio has as its objective to minimise the tracking error (pure index tracking), whereas when l = 0, the portfolio’s goal is to maximize the excess return. Constraint 13.4 guarantees that the value of the portfolio at the end of the in-sample period is equal to the available capital C. This budgetary limitation ensures that for all alternative tracking portfolios an identical amount C is invested at the beginning of the out-of-sample period. Constraint 13.5 associates a binary variable zi to each stock i, which is used to consider whether stock i is included in the tracking portfolio (zi = 1) or not (zi = 0). The parameter e is used to impose a lower bound on the proportion of the capital invested in each stock (in this study e is equal to 0.01). Finally, constraint 13.6 defines the maximum number of stocks K that can be included in the tracking portfolio. Evolutionary solution techniques The optimisation model of equations 13.3–13.7 is a complex combinatorial problem that is difficult to solve with analytical techniques. Thus, evolutionary algorithms have become particularly popular in this context. Evolutionary algorithms were first used for addressing the index-tracking problem by Goldberg (1989), who apply a genetic algorithm for index replication. More recent applications of genetic algorithms in index-tracking and portfolio optimisation can be found in the works of Oh et al (2005), Chang et al (2009) and Soleimani et al (2009). Beasley et al (2003) propose an evolutionary population heuristic, accounting for transaction costs and the possibility for revision of the tracking portfolio. Their results indicate that deriving the optimal portfolio directly from past data and not from the distribution of stock returns ultimately achieve better results. Maringer and Oyewumi (2007) apply DE for tracking the Dow Jones Industrial Average assuming different cardinality constraints in their selected 344 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 345 ENERGY INDEX TRACKING portfolios. They report that the maximum number of stocks included in the tracking portfolio must be roughly 50% of the benchmark index to achieve good results; any additional stocks only marginally improve the algorithm’s performance. The DE algorithm has also been used in other studies using hybrid and multi-objective schemes (Krink et al, 2009; Krink and Paterlini, 2011), as well as in the context of loss aversion (Maringer, 2008) and mutual fund replication (Zhang and Maringer, 2010). Other proposed algorithmic procedures include immune systems (Li et al, 2011), hybrid algorithms (Ruiz-Torrubiano and Suárez, 2009; Scozzari et al, 2012), robust optimisation (Chen and Kwon, 2012) and mixed-integer programming formulations (Canakgoz and Beasley, 2008; Stoyan and Kwon, 2010). An overview of different methods can be found in WoodsideOriakhi et al (2011). In the context of this chapter, the DE algorithm and a genetic algorithm are employed. Both are well established in the computational intelligence literature, easy to implement and well suited for complex financial optimisation problems, particularly in the context of index tracking and constrained portfolio optimisation. The application of both algorithms enables the examination of the robustness of the results under different solution approaches. GAs are probably the most popular evolutionary techniques. They are computational procedures that mimic the process of natural evolution for solving complex optimisation problems (Goldberg, 1989). A GA implements stochastic search schemes to evolve an initial population (set) of solutions through selection, mutation and crossover operators until a good solution is reached. Similarly to the GA framework, DE is also a stochastic optimisation method. It was developed by Storn and Price (1995) as an alternative to existing metaheurtistic approaches, and it is well suited to continuous optimisation problems. According to Storn and Price (1997), compared to other rival approaches, the main advantages of DE include its fast convergence, the use of a small set of tuning parameters, its reduced sensitivity to the initial solution conditions and its robustness. Overall, comparisons on various benchmark problems show that DE is superior when compared to other evolutionary algorithms (Sarker et al, 2002; Sarker and Abbass, 2004). Both algorithms are implemented with a real-valued solution 345 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 346 COMMODITY INVESTING AND TRADING representation scheme. In particular, each solution is represented by a real-valued vector x ∈ °N, where N is the number of stocks in the sample. The largest positive elements of x are used to identify the stocks comprising the tracking portfolio,3 and after normalisation (to sum up to 1) they define the corresponding stock weights (w1, …, wN). The number of units bought from each stock can then be specified as xi = Cwi / PiT. The appendix to this chapter provides a brief description of the implementations of the two evolutionary methods used here. The parameters of the algorithms were calibrated after experimentation in order to achieve a good balance between the quality of the results and the solution times. The selected parameters are summarised in Table 13A.1. BENCHMARK ENERGY INDEX, SPOT AND EQUITY DATA Because many commodities lack centralised trading, the most reliable spot prices are for those that trade active and liquid futures contracts, since these are typically used as a pricing benchmark. In the case of energy commodities, the Nymex is the world’s largest futures exchange. Initially, a spot price energy index is constructed, constituting daily prices of the following six energy commodities, which also trade futures contracts on the Nymex: 1. 2. 3. 4. 5. 6. Heating Oil, New York Harbour No. 2 Fuel Oil, quoted in US dollar cents/gallon (C/gal); Crude Oil, West Texas Intermediate (WTI) Spot Cushing, quoted in US dollars/barrel; Gasoline, New York Harbour Reformulated Blendstock for Oxygen Blending (RBOB), quoted in US C/gal; Natural Gas, Henry Hub, quoted in US dollars/million British thermal units (Btus); Propane, Mont Belvieu Texas, quoted in US C/gal; and PJM, Interconnection Electricity Firm on Peak Price Index, quoted in US dollars/megawatt hour. The SEI is constructed as an unweighted geometric average of the individual commodity ratios of current prices to the base period prices, set at January 31, 2006, until February 1, 2010. The base date for the SEI is the same date that the equity sample is obtained. Considering that the boom in commodity index investing is a rela346 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 347 ENERGY INDEX TRACKING tively new phenomenon, more recent data are utilised to test the proposed investment strategy. The index’s construction methodology is similar to that of the world-renowned CRB Spot Commodity Index. The SEI is designed to offer a timely and accurate representation of a long-only investment in energy commodities using a transparent and disciplined calculation. Geometric averaging provides a broad-based exposure to the six energy commodities, since no single commodity dominates the index. It also helps increase the index diversification by giving even the smallest commodity within the basket a reasonably significant weight. Gordon (2006) finds that a geometrically weighted index is preferred to alternative weighting schemes, because the daily rebalancing allows the index not to become over- or underweighted. This avoids the risks that other types of indexes are subject to, such as potential errors in data sources for production, consumption, liquidity or other errors that could affect the component weights of the index. Furthermore, through geometric averaging the SEI is continuously rebalanced, which means that the index constantly decreases (increases) its exposure to the commodity markets that gain (decline) in value, thus avoiding the domination of extreme price movements of individual commodities. As Erb and Harvey (2006) point out, the indexes that rebalance annually eventually become trend followers because commodity prices movements constantly change the weightings, whereas those that rebalance daily stay closer to the original intent of the index. In addition, Nathan (2004) shows that the indexes that use geometric rebalancing, and thus rebalance their weightings daily, generally exhibit lower volatility. The mathematical specification used to calculate the geometric average SEI is the following: 1 " i Pi %n P1 P 2 Pi SEIt = $! ti ' ! 100 = n t1 ! t2 !…! ti ! 100;i = 1, 2,…,6;n = 6 i=1 P P0 P0 P0 # 0 & (13.8) where, SEIi is the index for any given day, i represents each one of the six commodities comprising the index, Pti is the price of each commodity for any given day, and P0i is the price of each commodity in the base period. The SEI provides a stable benchmark structure for the index, making SEI suitable for institutional investment strategies. The 347 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 348 COMMODITY INVESTING AND TRADING stable composition of the index is an important element, because when the composition of an index changes over time, the average return of the index does not equal the return of the average index constituent, especially when indexes are equally weighted. The latter makes historical index performance a bad proxy to prospective index returns, thus distorting the information that investors seek (Erb and Harvey, 2006). Moreover, it is a better means for evaluating the movement in energy commodity prices because it is based on spot prices and not on prices for future delivery that are subject to roll yields driven by contango and backwardation. The equity data includes daily prices for stocks picked from the Dow Jones Composite Average, FTSE 100 and Bovespa Composite indexes. The equity dataset also includes stocks from a unique pool of energyrelated stocks from the US and UK stock markets. The selection of the equities included in the two pools is made according to the Industry Classification Benchmark (ICB) jointly developed by Dow Jones and the FTSE (see Appendix at the end of this chapter). In the sample used, the two filtered pools include all stocks from the US and UK stock markets that are engaged in the various phases of energy production and processing, listed in the following four sectors: oil and gas producers; oil equipment, services and distribution; alternative energy; and electricity. After applying the filtering procedure to the US and UK stock markets, two energy-related stock pools are constructed, hereafter named US Filter and UK Filter, respectively. To test the proposed heuristic approach and the efficiency of both the DE and GA as index-tracking methodologies, five datasets are selected. All stock prices are closing prices adjusted dividends according to the annualised dividend yield, and they are all obtained on a daily basis for the period January 31, 2006 to February 1, 2010 from Thomson Financial Datastream. All stock prices are in US dollars, thus reflecting the local currency exchange rate against the US$ at every point in time for the period examined. Should a company cease trading due to an event (merger, bankruptcy, etc) within the test period, it is dropped from the sample – that is why the total number of stocks in the FTSE 100 and Bovespa pools is less than the total number of stocks included in each index. Moreover, after adjusting for all US and UK bank holidays, 1,008 observations are sorted to calculate daily returns for each stock. Considering 252 trading days in a calendar year, the heuristic approach is tested 348 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 349 ENERGY INDEX TRACKING under various assumptions by selecting the first year as the insample period and the last three years as the out-of-sample period. The final five datasets have the following number of stocks: N = 41 (UK Filter), N = 53 (Bovespa Composite), N = 65 (Dow Jones Composite Average), N = 77 (US Filter) and N = 97 (FTSE 100 index). TRACKING THE SPOT ENERGY INDEX The performance characteristics of the proposed strategy are examined. The stocks picked by both the DE and the GA are used to track the performance of the SEI. The initial capital of the investment portfolio is set equal to C = US$100,000, where both the DE and the GA converge at the end of the in-sample period. In the empirical analysis, tracking portfolios consisting of maximum K stocks are used with K = 10, 15 and 20. Three different trade-offs between tracking error and excess return are also considered, with l = 0.6, 0.8 and 1, thus moving from maximising excess return to minimising tracking error. The heuristic is then repeated 10 times with the same set of parameters per run, from which the best solution is chosen. Figure 13.1 displays the SEI against quarterly rebalanced portfolios selected from the DE and GA, respectively. The portfolios consist of a maximum of 15 stocks, the FTSE 100, DJIA, Bovespa and UK Filter and US Filter, respectively; results are shown for l = 1. Looking at the figures, it is clear that during and towards the end of the recession period, the benchmark index can be best tracked with the Bovespa baskets, followed by the UK Filter baskets; whereas, during the last year (2010) it is the US Filter and DJIA baskets that perform better. The portfolios comprised of optimally selected energy-related stocks can successfully track the SEI, generating similar returns for most of the out-of-sample period. The US Filter and UK Filter results verify that, when energy-related stocks are selected, they can better replicate the risk and return trade-off of the SEI. The same applies for the Bovespa baskets, since the Brazilian stock exchange has a large number of energy- and commodity-related listed companies that would closely follow any developments in the international energy markets. In addition, between the DE and GA selected portfolios, from the graphs it seems that the latter ones can follow more closely the performance of the SEI, achieving highest excess returns for the final out-of-sample year. Table 13.1 presents the RMSEs and the mean excess returns of 349 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 350 COMMODITY INVESTING AND TRADING Figure 13.1 Out-of-sample tracking of the SEI with the Bovespa, DJIA, FTSE 100, UK Filter and US Filter baskets respectively; λ = 0.8, with maximum 15 stocks in the basket, rebalanced quarterly 100K Portfolios – Q_reb K15L08 (DEA) 200000 180000 160000 140000 120000 100000 80000 60000 40000 20000 Feb-10 Feb-10 Oct-09 Dec-09 Oct-09 Aug-09 Dec-09 Jun-09 Aug-09 Jun-09 Apr-09 Apr-09 Feb-09 Dec-08 Oct-08 Aug-08 Jun-08 Feb-08 Apr-08 Dec-07 Oct-07 Aug-07 Jun-07 Apr-07 Feb-07 0 100K Portfolios – Q_reb K15L08 (GA) 200000 180000 160000 140000 120000 100000 80000 60000 40000 20000 Bovespa DJIA FTSE UK FILTER Feb-09 Dec-08 Oct-08 Aug-08 Jun-08 Apr-08 Feb-08 Dec-07 Oct-07 Aug-07 Jun-07 Apr-07 Feb-07 0 US FILTER SEI both the genetic and differential evolution algorithms employed, under all three rebalancing strategies: buy-and-hold, monthly and quarterly rebalancing. Using formal statistical evaluation criteria, the better tracking performance of the UK Filter and US Filter baskets is also confirmed. In terms of the competing portfolios’ RMSEs, the DE is more consistent across the various portfolios, whereas the GA selects portfolios that exhibit larger differences between the worstand best-performing ones. Additionally, in general, GA tends to select portfolios that have fewer tracking errors and thus track better 350 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 351 ENERGY INDEX TRACKING the benchmark index when compared to the ones selected from the DE. Another interesting observation is that, although the RMSEs are improved when rebalancing occurs, increasing the frequency from quarterly to monthly has only a marginal effect. These results are more profound for the portfolios selected by the DE, and align with Dunis and Ho (2005), who find that, when comparing alternative rebalancing frequencies, a quarterly portfolio update is preferable to monthly, semi-annual or annual reallocations. In terms of their excess returns, in most cases the portfolios selected by the GA tend to outperform the ones selected by the DE. The UK Filter and US Filter baskets, which also have the lowest tracking errors (see panels D and E on Table 13.1), have excess returns that in some cases are positive, indicating that the selected portfolios, on average over the out-ofsample period, outperform the SEI. In the case of the US Filter baskets selected by the GA, the index is constantly outperformed in terms of excess returns (8.10% for K = 20 and l = 0.6 under monthly rebalancing, and 6.14% for K = 15 and l = 0.6 under quarterly rebalancing); there is only one exception for both rebalancing frequencies, in which l = 1 and K = 10 when the portfolios underperform the index. This is an indication that the trade-off criterion does work, and leads to portfolios that compromise any excess return over a better tracking performance as expressed by the smaller RMSEs. Thus, taking into account the fact that commodity indexes performed better compared to the financial indexes over the three-year out-of-sample period (except the Bovespa Composite), with the methodology employed the performance of the SEI is closely replicated, and in the case of the energy-related stock portfolios, the benchmark index is even outperformed. For Table 13.1, panels A, B, C, D and E report the out-of-sample daily RMSE and mean daily percentage excess returns, as defined in equations 13.9 and 13.10, respectively. Under both rebalancing strategies, the weights of the tracking portfolios are estimated based on the available data in the rolling window in-sample period (one year) every month and quarter, respectively. Portfolios’ returns are adjusted for transaction costs of 0.5% for each transaction. In terms of the risk–return trade-off (l), it is observed that results are very similar among portfolios where l = 0.8 and 1. In most cases, the risk–return trade-off criterion tends to perform well, selecting 351 RMSE (K) (λ) Panel A: Bovespa 10 0.6 0.8 1 Monthly rebalance Mean ER (%) RMSE Quarterly rebalance Mean ER (%) RMSE Mean ER (%) DE GA DE GA DE GA DE GA DE GA DE GA 0.0346 0.0343 0.0343 0.0344 0.0359 0.0362 0.0136 0.0176 0.0189 0.0324 0.0347 0.0133 0.0331 0.0330 0.0330 0.0329 0.0326 0.0327 –0.0432 –0.0480 –0.0545 –0.0104 –0.0471 –0.0689 0.0333 0.0332 0.0333 0.0332 0.0329 0.0332 –0.0389 –0.0438 –0.0472 0.0134 –0.0416 –0.0236 15 0.6 0.8 1 0.0345 0.0343 0.0343 0.0359 0.0361 0.0356 0.0161 0.0181 0.0180 0.0239 0.0334 0.0238 0.0331 0.0330 0.0330 0.0327 0.0327 0.0327 –0.0427 –0.0487 –0.0533 –0.0063 –0.0298 –0.0418 0.0333 0.0332 0.0332 0.0332 0.0331 0.0333 –0.0411 –0.0431 –0.0442 –0.0148 –0.0280 –0.0312 20 0.6 0.8 1 0.0345 0.0343 0.0343 0.0354 0.0358 0.0357 0.0148 0.0186 0.0164 0.0233 0.0329 0.0284 0.0331 0.0330 0.0330 0.0331 0.0327 0.0328 –0.0436 –0.0488 –0.0541 0.0094 –0.0052 –0.0346 0.0333 0.0332 0.0333 0.0335 0.0333 0.0334 –0.0417 –0.0427 –0.0461 0.0209 0.0000 –0.0210 Panel B: DJIA 10 0.6 0.8 1 0.0319 0.0319 0.0319 0.0328 0.0330 0.0330 –0.0232 –0.0238 –0.0249 –0.0257 –0.0210 –0.0218 0.0318 0.0318 0.0318 0.0315 0.0316 0.0313 –0.0479 –0.0511 –0.0522 –0.0115 –0.0312 –0.0274 0.0319 0.0318 0.0319 0.0319 0.0318 0.0317 –0.0302 –0.0323 –0.0314 –0.0243 –0.0273 –0.0172 15 0.6 0.8 1 0.0320 0.0319 0.0319 0.0329 0.0330 0.0328 –0.0244 –0.0240 –0.0246 –0.0200 –0.0250 –0.0239 0.0319 0.0318 0.0318 0.0315 0.0314 0.0313 –0.0503 –0.0515 –0.0515 –0.0332 –0.0244 –0.0410 0.0319 0.0319 0.0319 0.0318 0.0319 0.0319 –0.0297 –0.0311 –0.0314 –0.0172 –0.0192 –0.0283 20 0.6 0.8 1 0.0319 0.0319 0.0319 0.0328 0.0329 0.0328 –0.0228 –0.0235 –0.0253 –0.0251 –0.0289 –0.0323 0.0319 0.0318 0.0318 0.0315 0.0315 0.0313 –0.0514 –0.0529 –0.0505 –0.0239 –0.0300 –0.0344 0.0319 0.0319 0.0319 0.0319 0.0318 0.0317 –0.0313 –0.0301 –0.0308 –0.0005 –0.0332 –0.0051 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 352 No rebalance COMMODITY INVESTING AND TRADING 352 Table 13.1 Out-of-sample index tracking performance of the selected portfolios. 0.0315 0.0317 0.0316 0.0318 0.0316 0.0314 –0.0450 –0.0469 –0.0495 –0.0359 –0.0246 –0.0193 0.0309 0.0309 0.0310 0.0299 0.0302 0.0300 –0.0597 –0.0701 –0.0735 –0.0260 –0.0416 –0.0635 0.0308 0.0309 0.0310 0.0303 0.0305 0.0307 –0.0438 –0.0475 –0.0461 0.0106 –0.0255 –0.0334 15 0.6 0.8 1 0.0315 0.0316 0.0316 0.0318 0.0313 0.0312 –0.0512 –0.0477 –0.0490 –0.0253 –0.0220 –0.0175 0.0309 0.0309 0.0310 0.0303 0.0302 0.0303 –0.0674 –0.0634 –0.0699 –0.0327 –0.0449 –0.0682 0.0308 0.0309 0.0310 0.0303 0.0306 0.0306 –0.0468 –0.0416 –0.0456 –0.0180 –0.0127 –0.0349 20 0.6 0.8 1 0.0315 0.0316 0.0316 0.0317 0.0313 0.0313 –0.0507 –0.0484 –0.0492 –0.0271 –0.0297 –0.0245 0.0309 0.0310 0.0310 0.0303 0.0303 0.0301 –0.0705 –0.0681 –0.0679 –0.0311 –0.0656 –0.0600 0.0308 0.0309 0.0310 0.0305 0.0305 0.0306 –0.0442 –0.0445 –0.0449 –0.0092 –0.0145 –0.0208 0.0318 0.0315 0.0317 0.0309 0.0312 0.0307 –0.0900 –0.0818 –0.0809 –0.0834 –0.0834 –0.0751 0.0299 0.0300 0.0300 0.0294 0.0290 0.0292 –0.0712 –0.0680 –0.0713 0.0019 –0.0725 –0.1371 0.0300 0.0301 0.0301 0.0296 0.0296 0.0297 –0.0681 –0.0611 –0.0632 –0.0032 –0.0412 –0.1049 Panel D: UK Filter 10 0.6 0.8 1 15 0.6 0.8 1 0.0312 0.0313 0.0313 0.0309 0.0309 0.0308 –0.0825 –0.0847 –0.0846 –0.0519 –0.0408 –0.0531 0.0299 0.0300 0.0300 0.0294 0.0293 0.0293 –0.0782 –0.0720 –0.0782 –0.0427 –0.0501 –0.1083 0.0300 0.0300 0.0301 0.0298 0.0296 0.0297 –0.0711 –0.0707 –0.0601 –0.0341 –0.0410 –0.0459 20 0.6 0.8 1 0.0311 0.0311 0.0311 0.0305 0.0303 0.0304 –0.0796 –0.0858 –0.0763 –0.0586 –0.0451 –0.0516 0.0299 0.0299 0.0300 0.0297 0.0294 0.0295 –0.0764 –0.0752 –0.0747 –0.0508 –0.0790 –0.0794 0.0300 0.0300 0.0301 0.0299 0.0298 0.0296 –0.0717 –0.0697 –0.0676 –0.0446 –0.0391 –0.0494 0.0307 0.0308 0.0309 0.0329 0.0321 0.0318 –0.0258 –0.0265 –0.0234 –0.0442 –0.0780 –0.0314 0.0306 0.0309 0.0310 0.0297 0.0295 0.0294 –0.0449 –0.0603 –0.0688 0.0710 0.0607 –0.0278 0.0309 0.0310 0.0310 0.0307 0.0300 0.0298 –0.0364 –0.0345 –0.0367 0.0249 0.0240 –0.0172 Panel E: US Filter 10 0.6 0.8 1 0.6 0.8 1 0.0307 0.0308 0.0308 0.0321 0.0327 0.0322 –0.0246 –0.0244 –0.0254 –0.0581 –0.0511 –0.0566 0.0309 0.0309 0.0309 0.0306 0.0296 0.0295 –0.0497 –0.0575 –0.0648 0.1241 0.0212 –0.0027 0.0310 0.0310 0.0310 0.0308 0.0301 0.0302 –0.0322 –0.0336 –0.0342 0.0614 0.0016 0.0204 20 0.6 0.8 1 0.0307 0.0308 0.0307 0.0327 0.0319 0.0311 –0.0261 –0.0251 –0.0226 –0.0668 –0.0320 –0.0649 0.0309 0.0309 0.0309 0.0301 0.0296 0.0294 –0.0510 –0.0603 –0.0662 0.0810 0.0210 0.0071 0.0310 0.0310 0.0310 0.0308 0.0303 0.0301 –0.0274 –0.0329 –0.0352 0.0345 0.0369 0.0126 353 ENERGY INDEX TRACKING 15 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 353 Panel C: FTSE 100 10 0.6 0.8 1 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 354 COMMODITY INVESTING AND TRADING portfolios with higher returns and also relatively higher RMSEs. Moreover, the portfolios selected by the GA tend to be more consistent when the risk–return trade-off rule is applied, compared to the ones selected by the DE. Overall, when considering both the tracking performance and the excess returns of the various portfolios, those with l = 0.8 should be preferred. As far as the criterion regarding the maximum number of stocks is concerned, in all three rebalancing scenarios, portfolios with K = 10 tend to perform worst in terms of RMSEs, but do slightly better in terms of excess returns, for both the DE and GA selected portfolios. This is also an indication that the more stocks that are included in the portfolio, the higher the transaction costs when a rebalancing occurs. Overall, it is suggested that portfolios with a maximum of 15 stocks should be selected, as there still seems to be a valuable compensation for the additional information and diversification when rebalancing, against the extra rebalancing costs. According to the results, for both algorithms, monthly rebalancing is overall the best option in terms of RMSEs, closely followed by quarterly rebalancing, whereas when looking at excess returns, quarterly rebalancing appears to improve portfolio performance. The return of a buy-and-hold portfolio may be higher than that of a rebalanced portfolio when transaction costs are considered, but it is important to determine the source of the higher return – whether it is greater capital efficiency as expressed by a higher Sharpe or information ratio, or greater risk. Plaxco and Arnott (2002) showed that rebalanced portfolios typically have higher Sharpe ratios than buyand-hold portfolios, a finding that suggests that the possible outperformance of a buy-and-hold portfolio may be the result of greater risk. Results are more apparent for the GA portfolios, as for the DE portfolios the difference between monthly and quarterly rebalancing is only marginal. In the case of the UK Filter basket picked by the GA, there is an obvious difference in performance when rebalancing quarterly as opposed to monthly rebalancing. A more in-depth analysis comparing the portfolios’ information ratios is presented in the following section. On average, based on the results from Table 13.1, K = 15 and l = 0.8 is the most desirable combination providing the best results for most tracking portfolios. It is, of course, up to the investors’ risk–return appetite to decide whether rebalancing the portfolio quarterly, which comes with an 354 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 355 ENERGY INDEX TRACKING extra cost, is better than no rebalancing at all. The same applies regarding whether l = 0.8 should be used instead of the more risky trade-off when l = 0.6. Statistical properties of selected portfolios Table 13.2 presents some distributional statistics of the selected portfolios’ returns under the quarterly rebalancing scenario.4 Also, in panel F, the statistics and relevant performance measures for the following indexes are reported for comparison reasons: two total return energy commodity indexes – the DJ UBS-Energy and Rogers Energy Commodity; the three stock indexes from which stocks were drawn to construct the tracking portfolios – Bovespa, DJIA and FTSE 100; and, finally, the most commonly used benchmark in the finance industry, the S&P 500. According to the historical annualised volatilities for the out-of-sample period, the SEI is more volatile than the DJ UBS-Energy and Rogers Energy Commodity Indexes – 48.40% as compared to 36.21% and 41.11% respectively. The respective volatility of the equity indexes is in the range of 27–38%. However, when comparing the information ratios, only the Bovespa index is able to generate a better risk–return performance compared to the SEI. Table 13.2 presents the annualised returns and volatilities of the tracking portfolios, the skewness and kurtosis, the correlation coefficient between the returns of the benchmark index and the portfolio that is used each time to replicate this benchmark, and the information ratio under the no rebalancing strategy. Panels A, B, C, D and E represent the portfolios that include stocks picked each time from the Dow, FTSE 100, Bovespa, UK Filter and US Filter stock pools. Panel F presents, for comparison, the relevant performance measures for two total return energy commodity indexes, the DJ UBS-Energy and Rogers Energy Commodity; for the three stock indexes from which stocks were drawn to construct the tracking portfolios, Bovespa, DJIA and FTSE 100; and the S&P 500. Moving from no rebalancing to monthly rebalancing, the information ratios tend to go down in all cases, except in the case of the US Filter baskets for GA, and that of the UK Filter baskets for both DE and GA. This can be explained by the higher transaction costs, which have a greater impact on the portfolios’ returns, especially in falling markets. It can be argued that when rebalancing, the additional 355 (K) (λ) Panel A: Bovespa 10 0.6 0.8 1 An. Vol. (%) Skewness Ex. Kurtosis Correl. Info Ratio DE GA DE GA DE GA DE GA DE GA DE GA –6.79 –8.04 –8.88 6.38 –7.48 –2.94 35.68 35.39 35.49 38.32 36.15 37.28 –0.572 –0.541 –0.537 –0.588 –0.499 –0.565 7.688 7.696 7.846 7.146 7.198 7.791 23.76 23.72 23.62 27.67 26.04 26.46 –0.185 –0.209 –0.225 0.064 –0.200 –0.113 15 0.6 0.8 1 –7.36 –7.86 –8.14 –0.73 –4.05 –4.87 35.72 35.49 35.45 38.38 37.33 36.76 –0.578 –0.548 –0.532 –0.516 –0.620 –0.461 7.699 7.910 7.734 7.113 7.932 7.889 23.84 23.79 23.65 28.06 26.89 25.36 –0.196 –0.206 –0.211 –0.071 –0.134 –0.149 20 0.6 0.8 1 –7.49 –7.77 –8.62 8.27 3.01 –2.29 35.73 35.42 35.50 38.45 37.53 37.69 –0.570 –0.544 –0.534 –0.494 –0.481 –0.485 7.661 7.675 7.801 7.896 7.498 8.467 23.95 23.57 23.64 26.36 26.21 25.94 –0.199 –0.204 –0.220 0.099 0.000 –0.100 Panel B: DJIA 10 0.6 0.8 1 –4.61 –5.14 –4.90 –3.13 –3.87 –1.33 19.76 19.79 19.76 22.72 22.40 22.87 0.543 0.563 0.630 0.329 0.444 0.437 12.944 13.201 13.884 9.405 9.707 10.343 8.96 9.13 8.97 13.36 13.44 14.63 –0.151 –0.161 –0.156 –0.121 –0.136 –0.086 15 0.6 0.8 1 –4.48 –4.83 –4.91 –1.33 –1.83 –4.12 19.85 19.80 19.87 22.44 23.63 24.36 0.536 0.563 0.600 0.405 0.210 0.475 12.659 13.169 13.712 10.195 8.742 12.793 9.01 9.04 8.97 13.63 14.64 15.65 –0.148 –0.155 –0.156 –0.086 –0.095 –0.141 20 0.6 0.8 1 –4.87 –4.58 –4.75 2.88 –5.36 1.72 19.84 19.83 19.86 22.41 24.40 23.42 0.543 0.542 0.587 0.335 0.355 0.526 12.801 13.054 13.684 7.553 9.969 10.842 9.00 9.07 8.93 12.49 16.10 15.57 –0.156 –0.150 –0.153 –0.002 –0.165 –0.026 –8.03 –8.96 –8.62 5.68 –3.41 –5.42 25.87 25.82 26.14 28.61 29.42 28.74 0.040 –0.019 0.039 –0.010 0.082 0.018 5.981 5.743 6.319 6.623 8.084 8.876 24.57 24.11 24.07 30.30 30.01 28.52 –0.225 –0.244 –0.236 0.056 –0.132 –0.173 –8.78 –7.49 –8.47 –1.54 –0.19 –5.78 26.18 26.03 26.26 29.32 28.89 30.48 0.006 0.004 –0.016 0.060 –0.026 –0.106 6.170 6.140 6.310 7.373 7.309 7.594 25.07 24.12 24.01 31.08 29.36 30.57 –0.241 –0.214 –0.233 –0.094 –0.066 –0.180 Panel C: FTSE 100 10 0.6 0.8 1 15 0.6 0.8 1 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 356 An. Ret (%) COMMODITY INVESTING AND TRADING 356 Table 13.2 Distributional statistics of portfolios’ daily returns under quarterly rebalancing 0.6 0.8 1 Panel D: UK Filter 10 0.6 0.8 1 –8.12 –8.22 –8.32 0.68 –0.64 –2.24 26.12 26.12 26.17 29.30 29.07 29.43 0.033 –0.023 –0.037 0.091 0.076 0.068 6.108 6.140 6.138 7.646 7.321 7.613 25.00 24.23 23.62 29.88 30.02 29.92 –0.228 –0.229 –0.230 –0.048 –0.075 –0.108 –14.16 –12.40 –12.91 2.21 –7.37 –23.42 18.43 18.40 18.47 23.56 23.53 22.11 –1.545 –1.540 –1.506 –0.908 –1.322 –1.353 11.532 11.741 11.692 5.806 8.974 9.453 22.81 22.59 22.38 29.94 30.14 28.14 –0.360 –0.323 –0.333 –0.017 –0.221 –0.560 15 0.6 0.8 1 –14.91 –14.81 –12.13 –5.58 –7.32 –8.57 18.45 18.57 18.59 23.98 23.19 24.84 –1.556 –1.602 –1.560 –0.908 –1.126 –0.947 11.403 12.077 11.759 4.967 6.813 5.099 23.06 22.93 22.40 28.91 30.08 30.45 –0.376 –0.373 –0.317 –0.181 –0.220 –0.245 20 0.6 0.8 1 –15.06 –14.55 –14.03 –8.22 –6.86 –9.44 18.38 18.38 18.48 24.71 24.85 23.93 –1.595 –1.600 –1.611 –1.115 –0.995 –1.037 11.618 11.910 11.846 6.180 5.192 6.240 22.97 22.74 22.36 29.35 30.23 30.48 –0.379 –0.368 –0.357 –0.237 –0.209 –0.265 –6.16 –5.70 –6.23 9.29 9.06 –1.33 20.51 20.64 20.68 26.77 24.56 24.22 –0.303 –0.246 –0.289 0.650 0.018 –0.217 28.721 27.642 29.105 16.322 6.268 7.641 17.51 16.95 17.55 26.39 28.30 29.06 –0.187 –0.177 –0.188 0.129 0.127 –0.091 Panel E: US Filter 10 0.6 0.8 1 15 0.6 0.8 1 –5.12 –5.47 –5.62 18.48 3.41 8.15 20.57 20.63 20.73 26.87 25.42 24.86 –0.252 –0.200 –0.194 –0.104 –0.165 0.000 28.952 28.577 28.466 5.516 8.188 6.699 17.48 17.38 17.42 25.97 28.33 27.10 –0.165 –0.172 –0.175 0.317 0.008 0.107 20 0.6 0.8 1 –3.91 –5.27 –5.87 11.69 12.30 6.19 20.58 20.65 20.84 27.18 26.32 26.44 –0.289 –0.206 –0.235 –0.154 0.287 0.371 28.874 28.549 28.229 5.360 7.590 11.545 17.46 17.31 17.32 26.41 27.99 29.28 –0.141 –0.168 –0.180 0.178 0.193 0.067 An. Ret (%) 3.01 13.21 –7.07 –6.01 –9.46 –18.94 –6.15 An. Vol. (%) 48.40 38.04 28.03 27.42 30.07 36.21 41.11 Skewness Ex. Kurtosis Correl. Info Ratio 0.094 0.026 –0.053 –0.009 –0.162 –0.166 –0.189 2.283 4.875 4.636 5.374 5.999 1.102 2.099 – 20.09 12.90 24.34 14.51 43.83 44.02 – 0.185 –0.191 –0.182 –0.235 –0.477 –0.192 357 ENERGY INDEX TRACKING Panel F: Indexes SEI Bovespa DJIA FTSE 100 S&P500 DJ UBS Energy-TR Rogers Energy Commodity-TR 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 357 20 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 358 COMMODITY INVESTING AND TRADING information available from the latest price data does make a difference in reducing the portfolios’ volatility, but the small return improvement coupled with the rebalancing costs outweighs the volatility benefits. Results are consistent for all cases for the risk– return trade-off l. Between monthly and quarterly rebalancing, the differences are relatively small, but the information ratios are, in most cases, higher for the quarterly rebalanced portfolios. Under the buy-and-hold scenario, the best performance in terms of information ratios is reported for the Bovespa portfolios, and under both monthly and quarterly rebalancing this is reported for the US Filter portfolios. In most cases, negative information ratios are reported, indicating that these portfolios over the out-of-sample period underperform against the benchmark, as they are associated with the lowest excess returns.5 This observation can be explained by the fact that energy markets, as represented by the SEI, have been resistant to the economic recession, even although they have experienced one of the most severe up-and-down trends in their history. The relatively low correlations of the selected equity portfolios with the SEI (between 9% and 31%) suggest that investors who want to participate in the energy sector can still benefit from the addition of the selected baskets. This observation aligns with the findings of Buyuksahin et al (2010), that the correlation between equity and commodity returns is not often greater than 30%. Also, correlation is not the most appropriate performance measure, as it only measures the degree to which the selected equity baskets and the SEI move in tandem, and does not capture the magnitude of the returns and their trajectories over time. Equity returns deviate from a normal distribution, displaying skewness and fat tails. The same is true for the returns of the SEI that exhibit positive skewness and relatively high excess kurtosis. Both futures commodity indexes have excess kurtosis similar to the SEI, with their skewness, however, being negative. Most equity portfolios selected by both the DE and GA exhibit negative skewness, indicating that the equity portfolios have more weight in the left tail of the distribution, in contrast with the SEI, which has more weight in the right tail. Finally, as a robustness check, a “naïve” strategy of randomly selected stocks has been tested, forming equally weighted portfolios constituted of 10, 15 and 20 stocks. The stocks are selected from the same five equity pools used by the EAs from a uniform distribution, 358 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 359 ENERGY INDEX TRACKING thus giving equal probability for all stocks chosen. The evidence confirms that the strategy and methodology used in this chapter are much more efficient and stable in achieving a good tracking performance (low RMSEs), and good returns relative to the SEI (positive or very small negative ERs). Under the “naïve” strategy, there is a large dispersion of outcomes and no consistency.6 CONCLUSIONS In this chapter, a geometric average Spot Energy Index is constructed and then its performance is reproduced with stock portfolios. This is achieved by investing in small baskets of equities selected from five stock pools: the Dow Jones, FTSE 100, Bovespa Composite and the UK and US Filters. The investment methodology used employs two advanced evolutionary algorithms: the GA and the DE. Both algorithms are self-adaptive stochastic optimisation methods, superior to other rival approaches when applied to the index-tracking problem. To test the performance of the tracking baskets, three different rebalancing scenarios were examined, also taking transaction costs into consideration: buy-and-hold; monthly rebalancing; and quarterly rebalancing. For comparison reasons, the performance of a “naïve” investment strategy of randomly selected stocks forming equally weighted portfolios was also reported. It was found that energy commodities, as proxied by the SEI, can have equity-like returns, since they can be effectively tracked with stock portfolios selected by the investment methodology followed here. Overall, during the three-year period examined, which reflects a period before, during and towards the end of the global economic recession, an investor would realise positive returns by investing in commodities, as the SEI returns suggest. With the methodology employed, that performance is closely replicated and, in the case of the energy-related stock portfolios and those selected from the Bovespa equity pool, the benchmark index is even outperformed. In most cases, there seem to be no major differences between the DE and GA selected portfolios, although the GA tends to select portfolios that have a lower tracking error. Both algorithms mostly do not utilise the maximum number of stocks allowed to select, with the DE being more stable in the number of stocks picked between the various cases of the risk–return trade-off; the GA tends to select portfolios quite different in terms of their composition. 359 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 360 COMMODITY INVESTING AND TRADING On average, based on the results presented here, portfolios with 15 stocks and a risk–return trade-off value of 0.8 are the most desirable combination providing the best results for most tracking portfolios. Also, it was found that when rebalancing, the additional information available from the latest price data does make a difference on reducing the portfolios’ volatility; the resulting return deterioration, however, outweighs the volatility benefits leading to smaller information ratios. Moving from the buy-and-hold strategy to quarterly rebalancing and then to the more frequent monthly rebalancing strategy, returns tend to deteriorate for most selected portfolios, by both the DE and the GA. Nonetheless, the same holds for the portfolios’ volatilities that also tend to go down when moving from no rebalancing to the more frequent one. Between monthly and quarterly rebalancing, the differences are relatively small in terms of the portfolios’ return and volatility performance; however, the information ratios are in almost all cases higher for the quarterly rebalanced portfolios. The only exception is for the US Filter in the case of the baskets selected by the GA. Thus, it was concluded that greater capital efficiency can be achieved with rebalancing, preferably every quarter, compared to the buy-and-hold strategy. The investment approach proposed in this chapter for tracking the performance of the energy sector with stocks selected by two innovative evolutionary algorithms promotes a cost-effective implementation and true investability. While most mutual funds cannot invest in commodities directly, they can track the performance of the SEI by investing in the stocks selected by the evolutionary algorithms used here. There are many investment houses around the globe that use evolutionary algorithms for tactical asset management.7 The work and findings presented in this chapter can encourage asset and fund managers to recognise the importance of the energy sector and prompt them to set up similar funds that will track the constructed Spot Energy Index. To that end, the proposed methodology suggests an effective, and at the same time least-expensive, way to operate such a fund, giving the full flexibility of any investment style, long or short, that equities can provide. 360 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 361 ENERGY INDEX TRACKING APPENDIX Differential evolution algorithm DE is a population-based stochastic optimization algorithm that employs mutation, recombination (crossover) and selection operators to evolve iteratively an initial set (population) of NP randomly generated N-dimensional solutions. At each iteration (generation), the algorithm applies the aforementioned evolutionary operators to each one of the available solutions. In particular, let xiG denote the solution vector i (i = 1, …, NP) at a generation G, xijG be the jth element of xiG, and x*G the best solution from generation G (specified according to the problem’s objective function). Having xiG as the starting basis, a new solution xiG+1 is constructed replacing xiG in the next generation G + 1. The solution updating process is performed in the following three steps: 1. 2. 3. A mutant solution is constructed by combining xiG with x*G and two other randomly selected (different) solutions x’ and x’’ from the current generation: vi = xiG + F × (x*G – xiG) + F × (x’ – x’’). The mutation constant F ∈ (0,2] controls the rate at which the population evolves. The parent solution xiG and the mutant vector vi are recombined to produce a crossover solution ui, using the exponential scheme as shown in Figure 13A.1 (for simplicity the generation index G is not shown in the figure), where l and j* are randomly selected from {1, 2, …, N}, such that the part of ui derived from vi is analogous to a user-defined crossover probability CR (with higher values corresponding to a stronger impact of vi). The crossover solution ui is compared against the parent vector xi,G on the basis of the problem’s objective function f. If f(ui) ≤ f(xiG), then xiG+1 is set equal to ui (ui replaces xi,G in the next generation); otherwise, xiG+1 is set equal to xiG. The iterative procedure terminates when a stopping criterion is met (eg, after a predefined number of generations is explored). Genetic algorithm Similarly to the DE algorithm, a GA is also a population-based stochastic optimisation process. It uses the same evolutionary operators, but implements them in a different way and does not follow the 361 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 362 COMMODITY INVESTING AND TRADING Figure 13A.1 DE’s exponential crossover scheme Parent solution xi1, xi2, …, xiN Crossover solution xi1 xi2 xi,l–1 Parent solution vi1, vi2, …, viN vil vi,l+1 vi, j*–1 xij* xiN greedy approach adopted by DE. Starting with an initial (random) population of solutions, the algorithm proceeds iteratively over a number of generations. In the GA implemented in this chapter, the following algorithmic steps are performed at each iteration (generation). 1. 2. 3. A pair of parent solutions x and y is selected from the current population using a tournament selection procedure. Under this scheme, k individuals (tournament size) are randomly selected from the population with replacement, and only the best individual (according to the problem’s objective function) is selected as a parent. The parent solutions are used to perform the crossover operation with a pre-specified crossover probability (this probability controls the frequency with which crossover is performed). Under the arithmetic crossover scheme this operation leads to a new pair of solutions x’ = rx + (1 – r)y { x’, y’} and y’ = (1 – r)x + ry, where r is a random number drawn from the uniform distribution in [0, 1]. The crossover solutions are subject to mutation. In this study the uniform mutation strategy is employed, under which pmN randomly selected elements of a solution vector are replaced by random values selected uniformly from a pre-specified range. The mutation probability pm controls the frequency of the mutation changes. The pair of solutions resulting from the mutation operator is placed in the next generation of solutions, and the above three steps are repeated until the new population is fully formulated. The procedure ends as soon as a termination criterion is met (eg, the 362 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 363 ENERGY INDEX TRACKING Table 13A.1 Parameters of the algorithms GA DE Population size: Generations: 100 Crossover: arithmetic (80% probability) Selection: tournament (size = 4) Mutation: uniform (0.5% probability) Population size: Generations: 100 Mutation: rand-to-best/1 (F = 0.7) Crossover: exponential (CR = 0.5) population converges or the pre-specified number of generations is reached). INDUSTRY CLASSIFICATION BENCHMARK The ICB is a company classification system developed jointly by Dow Jones and FTSE. It is used to segregate markets into a number of sectors within the macroeconomy. The ICB uses a system of 10 industries, partitioned into 19 super sectors, which are further divided into 41 sectors, which then contain 114 subsectors. The principal aim of the ICB is to categorise individual companies into subsectors based primarily on a company’s source of revenue or where it constitutes the majority of revenue. If a company is equally divided among several distinct subsectors, the judging panel from both Dow Jones and FTSE makes a final decision. Firms may appeal their classification at any time. Table 13A.2 Industry Classification Benchmark (ICB) codes Industry Super-sector Sector Sub-sector 0001 Oil & gas 0500 Oil & gas 0530 Oil & gas producers 0533 Exploration & production 0537 Integrated oil & gas 0570 Oil equipment, services & distribution 0573 Oil equipment & services 0577 Pipelines 0580 Alternative energy 0583 Renewable energy equipment 0587 Alternative fuels 7000 Utilities 7500 Utilities 7530 Electricity 7535 Conventional electricity 7537 Alternative electricity 363 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 364 COMMODITY INVESTING AND TRADING The ICB is used globally (although not universally) to divide the market into increasingly specific categories, allowing investors to compare industry trends between well-defined subsectors. The ICB replaced the old classification systems used by Dow Jones and FTSE on January 3, 2006, and it is still used by the NASDAQ, NYSE and several other markets around the globe. All ICB sectors are represented on the New York Stock Exchange except Equity Investment Instruments (8980) and Non-equity Investment Instruments (8990). Table 13A.2 presents the ICB codes used for filtering all US and UK stock markets, creating the two energy-related stock pools: the US Filter and UK Filter, respectively. 1 Revisions can occur for a number of reasons, including additions or deletions, mergers, splits and dividends. 2 The first listed commodity ETF was the streetTRACKS Gold Shares ETF, with its sole assets being gold bullion and, from time to time, cash. 3 If the number of positive elements of x is smaller than K, then all positive elements of x are used. 4 The results for both the “no rebalancing” and “monthly rebalancing” scenarios are available upon request. 5 Note that investors who would have taken short positions on these baskets would realise the highest excess returns. 6 The results of the “naive” strategy are available upon request. 7 First Quadrant, a US-based investment firm, started using EAs in 1993 to manage its investments; at the time, US$5 billion was allocated across 17 countries around the world, claiming to have made substantial profits (Kieran, 1994). REFERENCES Alexander, C. and A. Dimitriu, 2002, “The Cointegration Alpha: Enhanced Index Tracking and Long-short Equity Market Neutral Strategies”, ISMA Discussion Papers in Finance, 2002–08, ISMA Centre, University of Reading. Barber, B. M. and T. Odean, 2000, “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors”, The Journal of Finance, 55(2), pp 773–806. Beasley, J. E., N. Meade and T.-J. Chang, 2003, “An Evolutionary Heuristic for the Index Tracking Problem”, European Journal of Operational Research, 148(3), pp 621–43. Bodie, Z. and V. Rosansky, 1980, “Risk and Return in Commodity Futures”, Financial Analyst Journal, 36(3), pp 27–39. Buyuksahin, B., M. S. Haigh and M. Robe, 2010, “Commodities and Equities: A ‘Market of One’?”, Journal of Alternative Investments, 12(3), pp 76–95. 364 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 365 ENERGY INDEX TRACKING Canakgoz, N. A. and J. E. Beasley, 2008, “Mixed-integer Programming Approaches for Index Tracking and Enhanced Indexation”, European Journal of Operational Research, 196, pp 384–99. Chang, T.-J., S.-C. Yang and K.-J. Chang, 2009, “Portfolio Optimization Problems in Different Risk Measures Using Genetic Algorithm”, Expert Systems with Applications, 36(7), pp 10,529–37. Chen, C. and R. H. Kwon, 2012, “Robust Portfolio Selection for Index Tracking”, Computers & Operations Research, 39, pp 829–37. Commodity Futures Trading Commission, 2008, “Staff Report on Commodity Swap Dealers and Index Traders with Commission Recommendations”, September, pp 1–70. Dunis, C. L. and R. Ho, 2005, “Cointegration Portfolios of European Equities for Index Tracking and Market Neutral Strategies”, Journal of Asset Management, 6(1), pp 33–52. Erb, C. B. and C. R. Harvey, 2006, “The Strategic and Tactical Value of Commodity Futures”, Financial Analyst Journal, 62(2), pp 69–97. Fama, E. F. and K. R. French, 1987, “Commodity Futures Prices: Some Evidence on Forecast Power, Premiums and the Theory of Storage”, Journal of Business, 60(1), pp 55–73. Feoktistov, V. and S. Janaqi, 2004, “Generalization of the Strategies in Differential Evolution”, presented at the 18th International Parallel and Distributed Processing Symposium, Santa Fe, New Mexico, US. Frino, A. and D. R. Gallagher, 2001, “Tracking S&P 500 Index Funds”, The Journal of Portfolio Management, 28(1) pp 44–55. Gaivoronski, A. A., S. Krylov and N. Van der Wijst, 2004, ”Optimal Portfolio Selection and Dynamic Benchmark Tracking”, European Journal of Operational Research, 163(1), pp 115–31. Goldberg, D. E., 1989, Genetic Algorithms in Search, Optimization, and Machine Learning (Reading, MA: Addison-Wesley). Gordon, R., 2006, “Commodities in an Asset Allocation Context”, Journal of Taxation of Investments, 23(2), pp 181–89. Gorton, G. and G. Rouwenhorst, 2006, “Facts and Fantasies about Commodity Futures”, Financial Analyst Journal, 62(2), pp 47–68. Krink, T., S. Mittnik and S. Paterlini, 2009, “Differential Evolution and Combinatorial Search for Constrained Index-tracking”, Annals of Operations Research, 172, pp 153–76. Krink, T. and S. Paterlini, 2009, “Multiobjective Optimization Using Differential Evolution for Real-world Portfolio Optimization”, Computational Management Science, 8, pp 157–79. Konno, H. and T. Hatagi, 2005, “Index-plus-alpha Tracking Under Concave Transaction Cost”, Journal of Industrial and Management Optimisation, 1(1), pp 87–98. Larsen-Jr, G. A. and B. G. Resnick, 1998, “Empirical Insights on Indexing”, The Journal of Portfolio Management, 25(1), pp 51–60. Li, Q., L. Sun and L. Bao, 2011, “Enhanced Index Tracking Based on Multi-objective Immune Algorithm”, Expert Systems with Applications, 38, pp 6,101–06. Malkiel, B., 1995, “Returns from Investing in Equity Mutual Funds, 1971 to 1991”, The Journal of Finance, 50(2), pp 549–72. 365 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 366 COMMODITY INVESTING AND TRADING Maringer, D., 2008, “Constrained Index Tracking Under Loss Aversion Using Differential Evolution”, in A. Brabazon and M. O’Neil (Eds), Natural Computing in Computational Finance, Studies in Computational Intelligence (Berlin: Springer): pp 7–24. Maringer, D. and O. Oyewumi, 2007, “Index Tracking Constrained Portfolios”, Intelligent Systems in Accounting, Finance and Management, 15, pp 57–71. Markowitz, H., 1952, “Portfolio Selection”, The Journal of Finance, 7(1), pp 77–91. Nathan, R., 2004, “A Review of Commodity Indexes”, Journal of Indexes, June/July, pp 30–35. Oh, K. J., T. Y. Kim and S. Min, 2005, “Using Genetic Algorithm to Support Portfolio Optimization for Index Fund Management”, Expert Systems with Applications, 28, pp 371–79. Plaxco, L. M. and R. D. Arnott, 2002, “Rebalancing a Global Policy Benchmark”, Journal of Portfolio Management, 28(2), pp 9–22. Price, K. V., R. M. Storn and J. A. Lampinen, 2005, Differential Evolution: A Practical Approach to Global Optimization (Heidelberg: Springer). Rohweder, H. C., 1998, “Implementing Stock Selection Ideas: Does Tracking Error Optimization Do Any Good?”, The Journal of Portfolio Management, 24(3), pp 49–59. Ruiz-Torrubiano, R and A. Suárez, 2009, “A Hybrid Optimization Approach to Index Tracking”, Annals of Operations Research, 166, pp 57–71. Sarker, R. and H. Abbass, 2004, “Differential Evolution for Solving Multi-objective Optimization Problems”, Asia-Pacific Journal of Operations Research, 21(2), pp 225–40. Sarker, R., K. Liang and C. Newton, 2002, “A New Multi-objective Evolutionary Algorithm”, European Journal of Operational Research, 140(1), pp 12–23. Scozzari, A., F. Tardella, S., Paterlini and T. Krink, 2012, “Exact and Heuristic Approaches for the Index Tracking Problem with UCITS Constraints”, Center for Economic Research (RECent) 081, University of Modena and Reggio E., Dept. of Economics, Italy. Sharpe, W., 1991, “The Arithmetic of Active Management”, The Financial Analyst Journal, 47(1), pp 7–9. Soleimani, H., H. R. Golmakani and M. H. Salimi, 2009, ”Markowitz-based Portfolio Selection with Minimum Transaction Lots, Cardinality Constraints and Regarding Sector Capitalization Using Genetic Algorithm”, Expert Systems with Applications, 36(3), pp 5,058–63. Sorenson, E. H., K. L. Miller and V. Samak, 1998, ”Allocating Between Active and Passive Management”, Financial Analyst Journal, 54(5), pp 18–31. Stopford, M., 2009, Maritime Economics (3e) (London: Routledge). Storn, R. and K. Price, 1995, “Differential Evolution: A Simple and Efficient Adaptive Scheme for Global Optimization Over Continuous Spaces”, Technical Report TR-95–012, International Computer Science Institute, Berkeley. Storn, R. and K. Price, 1997, “Differential Evolution, A Simple and Efficient Heuristic Strategy for Global Optimization Over Continuous Spaces”, Journal of Global Optimization, 11(4), pp 341–59. 366 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 367 ENERGY INDEX TRACKING Stoyan, S. J. and R. H. Kwon, 2010, “A Two-stage Stochastic Mixed-integer Programming Approach to the Index Tracking Problem”, Optimization and Engineering, 11(2), pp 247–75. Sullivan, R., A. Timmermann and H. White, 1999, Data-snooping, Technical Trading Rule Performance, and the Bootstrap”, The Journal of Finance, 54(5), pp 1,647–91. Tang, K. and W. Xiong, 2009, “Index and the Financialization of Commodities”, working paper, September. Wang, M. Y., 1999, “Multiple-benchmark and Multiple-portfolio Optimization”, Financial Analyst Journal, 55(1), pp 63–72. White, H., 2000, “A Reality Check for Data Snooping”, Econometrica, 68(5), pp 1,097–126. Woodside-Oriakhi, W., C. Lucas and J. E. Beasley, 2011, “Heuristic Algorithms for the Cardinality Constrained Efficient Frontier”, European Journal of Operational Research, 213(3), pp 538–50. Zhang, J. and D. Maringer, 2010, “Index Mutual Fund Replication”, in A. Brabazon, M. O’Neil and D. Maringer (Eds), Natural Computing in Computational Finance, Studies in Computational Intelligence (Berlin: Springer): pp 109–30. 367 13 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:11 Page 368 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 369 Part III Market Developments and Risk Management 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 370 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 371 14 Enterprise Risk Management for Energy and Commodity Physical and Financial Portfolios Carlos Blanco NQuantX LLC and MTG Capital Management This chapter will present an enterprise risk management (ERM) framework for energy and commodity physical and financial portfolios based on the three usual building blocks of policies and governance, methodologies and metrics, and infrastructure.1 The framework can be used to structure as well as conduct due diligence on the soundness of the risk-management process for all material risks – such as market, credit, operational and liquidity risk – as well as their interactions. This chapter is divided according to these blocks, with the first section examining policies and governance, and the need to integrate risk management in the governance structure of the firm. We then discuss methodologies and metrics, particularly valuation, risk and performance metrics for physical and derivatives portfolios, before moving on to infrastructure, and delving into people, data, operations and systems. POLICIES AND GOVERNANCE A “risk governance” framework integrates risk management into the governance structure of the firm to ensure that risk groups have the independence, stature and adequate resources to fulfill their responsibilities within the overall business strategy of the firm. Over the years, many risk management groups that were believed 371 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 372 COMMODITY INVESTING AND TRADING to follow “best practices” have been repeatedly unable or unwilling to prevent their institutions from engaging in excessive risk taking, which eventually resulted in heavy losses that bankrupted those firms. Some of the key reasons for this are the assymetric compensation structures at trading desks that encourage excessive short-term risk taking and the lack of stature of the risk groups compared to the revenue generating units, as well as the willingness of management teams and boards to turn a blind eye when profits are rolling in. Board and senior management teams have the responsibility to manage the main risks of the firm. However, few board members have a strong background in financial risk management and few risk managers have the breadth of skills and experience required to interact directly with board members and understand or influence the firm’s strategy and the process that sets the risk appetite and associated boundaries. The large exposures accumulated in the real estate and credit markets at large financial institutions such as Bear Stearns, Lehman Brothers, Merrill Lynch and AIG before the global financial crisis of 2007–08 caught many boards, senior management teams and risk groups by surprise. The governance structure in those firms ultimately failed to provide the oversight and early warning signals that would have prevented firms from taking on too much risk in certain areas. In other cases, even although risk managers informed senior management about the magnitude of the risks taken and the potential catastrophic consequences for their firms, senior-level executives decided to sugarcoat it for their boards, or omitted critical details. Lehman Brothers, AIG, Bear Stearns and BP are painful examples of risk groups’ lack of independence and inability to communicate the firm’s risk all the way to board level. Another example is BP’s lack of preparedness and its incompetent response to the oil drilling platform explosion and subsequent oil spill in the Gulf of Mexico in 2008, which has become a case study on “crisis mismanagement”. Boards can also ensure that the risk management group roles and responsibilities are aligned with value creation (or at least the prevention of value “destruction”). Unless the risk management efforts are structured in the right context, risk management activities will take a secondary role, and may ultimately end up destroying value and negatively interfering with the business strategy of the firm. 372 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 373 ENTERPRISE RISK MANAGEMENT FOR ENERGY AND COMMODITY PORTFOLIOS An example of best practices in the integration of risk management within the overall governance structure is the risk management policy of BHP Billiton PLC, one of the largest diversified resources companies in the world (see Panel 14.1). PANEL 14.1: BHP BILLITON RISK MANAGEMENT POLICY2 BHP Billiton’s risk management policy (see below) defines the group’s approach to risk management, linkage to the corporate objective and integration into its business processes. ❏ “Risk is inherent in our business. The identification and management of risk is central to delivering on the corporate objective. ❏ Risk will manifest itself in many forms and has the potential to impact ❏ ❏ ❏ ❏ ❏ ❏ ❏ ❏ ❏ ❏ the health and safety, environment, community, reputation, regulatory, operational, market and financial performance of the group and, thereby, the achievement of the corporate objective. By understanding and managing risk we provide greater certainty and confidence for our shareholders, employees, customers and suppliers, and for the communities in which we operate. Successful risk management can be a source of competitive advantage. Risks faced by the Group shall be managed on an enterprise-wide basis. The natural diversification in the Group’s portfolio of commodities, geographies, currencies, assets and liabilities is a key element in our risk management approach. We will use our risk management capabilities to maximise the value from our assets, projects and other business opportunities and to assist us in encouraging enterprise and innovation. Risk management will be embedded into our critical business activities, functions and processes. Risk understanding and our tolerance for risk will be key considerations in our decision-making. Risk issues will be identified, analysed and ranked in a consistent manner. Common systems and methodologies will be used. Risk controls will be designed and implemented to reasonably assure the achievement of our corporate objective. The effectiveness of these controls will be systematically reviewed and, where necessary, improved. Risk management performance will be monitored, reviewed and reported. Oversight of the effectiveness of our risk management processes will provide assurance to executive management, the board and shareholders. The effective management of risk is vital to the continued growth and success of our Group.” Source: BHP Billiton 373 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 374 COMMODITY INVESTING AND TRADING Any investment and trading operation should clearly articulate and communicate the core investment strategies and the firm’s risk tolerance. Written policies can establish the link between its business strategy and its tolerance for risk. A final component of the policy dimension is the existence of clear lines of authority and an appropriate level of risk disclosure, which makes the risk transparent to internal and external stakeholders. The degree of authority and independence of the risk group is a function of the relative stature of the group within the firm. For example, a risk group that reports directly to the heads of the business unit in charge of revenue generation is unlikely to have the independence and authority to prevent excessive risk taking. It is important not to confuse detailed investment strategy and position-level disclosures (often considered highly proprietary by portfolio managers) with risk disclosures designed to provide assurances that the risk levels are within the parameters expected by investors. For example, an investment manager that provides valueat-risk (VaR) disclosures to investors is not giving away proprietary information that could be used by counterparties against the firm’s portfolio. VALUATION AND RISK METHODOLOGIES AND METRICS The second building block of the risk process consists of the methodologies and metrics used to measure and manage risk, as well as their integration in risk-adjusted performance measures. Given the continued high volatility and extreme moves in the energy and financial markets, one of the main contributions of the risk groups is the calculation of key risk metrics that can assist decision-makers with the process of identifying, measuring and managing the firm’s material risks. Since the first generation financial risk models were published in the mid-1990s, there have been significant developments in the modelling of market, credit, liquidity and operational risk of energy and commodity portfolios. However, the excitement and quick progress of the “early years” has now gone, and change tends to be slower and incremental and driven by regulatory and external pressures. 374 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 375 ENTERPRISE RISK MANAGEMENT FOR ENERGY AND COMMODITY PORTFOLIOS “At-risk” metrics: Cashflow at risk, VaR and earnings at risk Below are listed the most commonly used market risk metrics for energy and commodity portfolios. VaR is a measure of the potential variability in the mark-to- nce level and time rm risk metric for ntial variability of Table 14.1 Differences between VaR, CFaR and EaR Market scenarios Mark to market/mark to model Multiple time steps (periods) Portfolio ageing and walk-forward analysis Netting agreements Collateral and margin clauses Portfolio trading/hedging strategies Counterparty default Hedge effectiveness rules Rating downgrade Operational risks Dynamic hedging strategy Volumetric risks VaR Collateral at risk (CaR) and CFaR EaR YES YES NO NO NO NO NO NO NO NO NO NO NO YES YES YES YES YES YES YES YES NO YES YES YES YES YES YES YES YES YES YES YES YES YES YES YES YES YES Source: NQuantX 375 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 376 COMMODITY INVESTING AND TRADING calculations involve modelling costs and revenues related to the operation of physical assets (for example, generation, storage), spot purchases and sales in the spot market, as well as profit and losses from the hedging and trading portfolio. The process for calculating CFaR and EaR requires careful analysis and understanding of each portfolio’s material risks. For example, volume-related variability embedded in many physical and derivative contracts and operations-related constraints – such as ramp-up and ramp-down rates and plant outages – need to be explicitly accounted for to obtain a realistic value and risk estimates. The same is true for critical operating constraints from assets and the material clauses in contracts, as well as the limitations of physical and financial arbitrage strategies such as market liquidity and available hedging instruments. Figure 14.1 shows some of the components required to compute CFaR and EaR. Failure to incorporate material risks when evaluating a hedging or trading strategy such as CFaR and collateral implications may have unintended consequences and expose the firm to unwanted risks. Figure 14.1 Cashflow-at-risk models require the integration of multiple source of risk and portfolio components MtM changes and volumetric variability (market risk) Collateral changes (MtM-based, AR/AP, premiums, downgrades) Counterparty losses (MtM-based, netting guarantees, AR/AP, collateral) Source: NQuantX LLC 376 CFaR and EaR 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 377 ENTERPRISE RISK MANAGEMENT FOR ENERGY AND COMMODITY PORTFOLIOS When energy and commodity prices collapsed in the summer of 2008, many firms experienced a large volume of collateral calls that forced them to go to the capital markets to raise extra capital at a time when banks were not extending credit to their counterparties. Firms without contingency plans in place that had funding problems ended up having to pay exorbitant borrowing costs or were just unable to continue funding their hedges. For example, airlines that had hedging programmes in place at the time accumulated large mark-to-market losses in their hedge portfolios when crude oil and jet fuel prices fell over 50% in just a few months in 2008. In addition, the global financial crisis caused a sharp drop in business travel worldwide that impacted their operating revenues. Rating agencies downgraded many airlines due to the worsening liquidity picture caused by the combination of lower forecasted revenues and the large cash outflows due to collateral calls from their existing hedges. As a result, hedging costs increased considerably at a time when financial institutions were attempting to reduce their credit risk exposures. The response by many airlines was to discontinue or reduce the size of their hedging programmes. Forward-looking key risk indicators such as CaR can measure the maximum collateral outflows for a given confidence level, taking into account initial and variation margin requirements for over-thecounter (OTC)-cleared and exchange-traded contracts, as well as the material margin clauses such as the credit support terms for OTC transactions (eg, thresholds, independent amounts, downgrade triggers, eligible collateral). Figure 14.2 shows the potential future collateral outflows for a derivatives portfolio, as well as the potential counterparty future exposures as a function of simulated market environments. Both metrics in Figure 14.2 are calculated for a 95% confidence level and provide an indication of the potential magnitude of unsecured credit exposures and potential margin payments. Stress tests In order to manage extreme event risk, the risk process should also include stress tests that question the model assumptions and also the “market consensus view” at any given moment. Stress tests are particularly relevant in markets that experience large sudden fluctuations as well as regime changes, and the results from the analysis 377 Figure 14.2 Potential future exposure and potential collateral requirement report US$30,000,000 Potential future exposure at the 95% confidence level US$10,000,000 US$0 –US$10,000,000 Walk forward – collateral requirements Potential collateral outflows at the 95% confidence level –US$20,000,000 –US$30,000,000 4/1/2010 5/1/2010 6/1/2010 7/1/2010 Collateral walk forward 8/1/2010 9/1/2010 10/1/2010 11/1/2010 12/1/2010 1/1/2011 95% Collateral at risk profile 2/1/2011 3/1/2011 4/1/2011 95% Potential future exposure Source: NQuantX LLC 378 COMMODITY INVESTING AND TRADING 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 378 US$20,000,000 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 379 ENTERPRISE RISK MANAGEMENT FOR ENERGY AND COMMODITY PORTFOLIOS can provide key insights to portfolio managers to develop contingency plans. Stress test committees that have representatives from the main groups in the firm – such as fund managers, risk managers and analysts – can proactively identify scenarios that would prove useful preludes to market crisis and feed that information into strategic planning, capital allocation, hedging and other major decisions. If stress test results (as illustrated in Figure 14.3) indicate that the hedge fund’s losses are beyond their tolerance level or the available capital, then immediate instructions could be sent to the fund managers to reduce the exposure to such event or increase its capital. Another area where stress tests are critical is liquidity risk management and capital adequacy. Liquidity risk management is often mistaken for “crisis management”, as lack of planning often forces companies to address liquidity risk management issues only Figure 14.3 Stress-test results for price and volatility changes broken down by desk US$100,000 P&L (thousands) US$50,000 US$0 -US$50,000 -US$100,000 -US$150,000 -US$200,000 -US$250,000 Power Crude oil and products Pr % ic e +2 Pr 5% ic e Vo +5 la 0% til i t Vo y -2 la 0% til ity +2 0% -2 5 Agricultural ic e Pr Pr ic e -5 0% -US$300,000 Agricultural Metals Crude oil and products Gas Power Portfolio Source: NQuantX LLC 379 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 380 COMMODITY INVESTING AND TRADING when crises occur. In order to estimate liquidity risk, companies need a framework that explicitly addresses the potential demand and supply of cash. This framework should address medium- and long-term horizons as well as the cost of liquidating positions in a stressed market environment. Risk managers can use scenario analysis and reverse stress tests to identify scenarios that could result in liquidity shortfalls, particularly under stress market conditions. Funding liquidity risk measurement requires metrics such as CFaR, CaR and margin-at-risk, which identify potential margin and collateral calls in stress situations. The most sophisticated risk and stress test models incorporate more realistic assumptions about market dynamics, particularly in properly modelling the tails of the distribution, including a dynamic approach to correlation to allow firms to incorporate credit and liquidity considerations, and finally a method to anticipate the risk taker’s response to various market events. A set of principles to measure and manage tail risk is presented in Panel 14.2. Backtesting Backtesting a risk model consists of evaluating whether the risk model forecasts are adequately capturing the magnitude and frequency of profit and losses (P&Ls). There is a wide range of quantitative and qualitative backtests,3 but most individual tests have low statistical significance. As a result, the most common way to perform backtesting is by analysing a chart with P&L series and VaR forecasts. The backtest procedure consists of comparing the daily VaR with the subsequent P&L for T+1 as the VaR forecast attempts to determine the magnitude of future P&L. The most common VaR backtests analyse whether the number and magnitude of “exceptions” is within the VaR model predictions. Loss exceptions are those losses greater than the prior day VaR, while gain exceptions are gain larger than the prior day VaR on the positive tail of the distribution (VaR+). Many firms exclusively focus on loss exceptions and ignore gain exceptions, but that may lead to situations where large gains could go unexplained for long periods of time and eventually turn into large unexpected losses. An additional test consists of checking whether those exceptions are autocorrelated, which would result in many exceptions taking place during short periods of time that potentially could result in 380 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 381 ENTERPRISE RISK MANAGEMENT FOR ENERGY AND COMMODITY PORTFOLIOS PANEL 14.2: TAIL RISK MANAGEMENT PRINCIPLES Risk management is ultimately the art of managing risk based on the presence of imperfect (and constantly evolving) information. Measuring and managing risks in the tail of the distribution is both an art and a science. A few basic risk management principles for extreme events will now be examined. Include all plausible scenarios of material risk factors in the analysis Stress scenarios should integrate all material risk factors, such as market risks (eg, price, basis, volatility), counterparty risks, and also relevant funding and market liquidity risks in a coherent fashion. Ignoring key risks may result in risk information offering a simplistic and inaccurate view of tail risk that can give a false sense of security. Choose appropriate tail risk metrics and modelling horizons The most common risk metrics used, such as VaR and standard deviation, fail to capture the dynamics of the tail of the distribution of potential outcomes. Fortunately, there are other metrics, such as stress test results, expected tail loss (ETL) and expected shortfall (ES), spectral risk measures and probable maximum loss (PML), that can complement a risk limit structure (see Chapter 2 of Dowd, 2005). Measurement is just the starting point Adequate preparation for any future crises requires forward-looking and creative thinking, as well as carefully designed contingency plans. Designing and conducting realistic stress tests that provide insights into the likely portfolio gains and losses under particular extreme events is necessary but not sufficient. The development of contingency plans to respond to those hypothetical extreme events have lagged behind as most firms have been shown to be ill-prepared to respond to crises. Expect the unexpected: Account for model risk While crises in financial, credit and energy markets often share some similarities with prior ones, each new crisis has differentiating elements that tend to catch most players by surprise. The lesson is that any contingency plan against extreme events should leave a significant buffer to account for variations from expected extreme scenarios. cumulative losses or gains considerably higher than the risk model forecasts. As a general rule, any exceptions should be investigated by the market risk management group, and the reasons for the exception should be recorded to identify regular “culprits” and corrective action taken if necessary. If the backtests show that the risk models 381 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 382 COMMODITY INVESTING AND TRADING ultimately failed to capture actual P&L variability, they should be replaced as the primary market risk control tool. Valuation models for physical assets, contracts and financial derivatives Energy and commodity markets are dominated by asset-based traders that optimise their strategies around physical assets such as storage facilities, pipelines and power plants. The traders and operators of those assets attempt to maximise risk-adjusted profits based on observable market spreads and the specific asset operating constraints. The valuation, risk metrics and hedging ratios calculated from a static model are not just likely to be inaccurate, but could lead to suboptimal decisions that would impact the profitability. In order to capture the multiple risk dimensions involved in hedging and trading, a dynamic simulation framework with three critical components is needed: the ability to handle multiple risk factors (eg, price risk, credit events, operational issues), multiple instruments (eg, physical contracts, derivatives) and the ability to capture events taking place at multiple steps in time. Dynamic risk simulation involves modelling the variability of one or more metrics (eg, cash flow, earnings, mark-to-market, liquidity) based on a realistic evolution of a set of key state variables, as well as the firm’s response to those changes (eg, operating, hedging and trading strategies). The analysis consists on “leaping forward” in time by simulating risk variables at various point in time in the future and evaluating a series of value and risk metrics (eg, costs, revenues, profits, VaR) under each of those scenarios. An added benefit of using dynamic simulation-based risk tools is the potential for risk management to play a larger role in strategic business decisions at various levels of the firm. For example, simulation analysis can assist trading and operating groups in developing asset optimisation and hedging strategies based on the evaluation of risk–return trade-offs. It can also help finance groups creating forward-looking earnings projections by ensuring they are consistent with the risk appetite of the firm. Another critical area is the evaluation of important investment and divestment decisions from a marginal and stand-alone risk point of view. Advances in financial engineering and computational finance such as least squares Monte Carlo and dynamic programming have 382 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 383 ENTERPRISE RISK MANAGEMENT FOR ENERGY AND COMMODITY PORTFOLIOS allowed for the widespread use of dynamic risk simulation solutions in energy firms. Risk-adjusted performance measurement Identifying, measuring, managing and pricing risk involves designing appropriate policies and systems so different business units and risk-taking activities can be evaluated with a risk-adjusted return in mind. The practical requirements to implement such changes involve modifying performance measurement mechanisms to integrate the risk and return numbers in the bonus allocation process, as well as changing the risk systems, to allow for risk numbers calculations at the risk-taking unit level. Risk-adjusted return on capital (RAROC) measures, which are widely used in the financial services industry, provide a common measurement unit for risk-adjusted returns on allocated (ex ante) and utilised (ex post) risk capital. A RAROC system can assist managers to determine the most efficient generators of revenue on a risk-adjusted basis, as well as set the threshold returns given the risk assumed to generate them. Let us assume that we are the trading manager of a commodity trading desk and have two traders. Both of them made a profit of US$10 million, but on average one of the traders used 80% less risk capital than the other. If the trading manager only considers the size of the gains, both should get a similar bonus. However, from a riskadjusted perspective, the trader that took less risk should receive a higher bonus. An investment evaluation process based on economic capital considerations, where decisions are based on a risk-adjusted return basis, encourages corporate managers to become risk managers because they must take risk into consideration when allocating resources internally and making investment and divestment decisions. Determining the economic capital allocated to each activity or business unit provides senior management with a mechanism to link risk and return, and therefore provide a risk–reward signal that can be used at different levels of the firm. INFRASTRUCTURE The third building block is the risk infrastructure. The infrastructure subcomponents are: people, systems, data and operations. 383 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 384 COMMODITY INVESTING AND TRADING Risk management functions have too often been built around quantitative risk managers who lacked market experience and requisite managerial skills. A chief risk officer (CRO) with the right skills, experience, independence and courage to perform the job is a critical component in the risk management organisation. The CRO’s effectiveness is a direct function of the power and independence granted that position, the quality of the people in the risk organisation, the associated culture, and incentives and experience. If we were to boil down empowerment to one question, then we might ask an organisation if its CRO is empowered to be proactive, as opposed to remaining reactive. The budget of the overall risk management function determines the scope and depth of activities that can be performed. The education and experience of the risk management personnel is a direct reflection of an organisation’s ability to hire and retain first-class risk managers. The stature of risk managers is also important; if risk management personnel do not have the stature to be able to stand up for their beliefs under pressure, it is a recipe for eventual failure. Risk groups must balance the day-to-day “tactical” issues such as risk measurement, reporting and limit checking with the more strategic aspects of evaluating business decisions that have a material impact on the firm’s risk profile and whose effect may only be felt further into the future. Risk management systems and data Financial risk management and technology advances have made possible the integration of data from multiple sources in order to provide the firmwide perspective required to forecast risk scenarios involving multiple risk dimensions. However, many energy trading and risk systems have failed to keep up to date with the advances in risk analytics. Those systems excel at performing tasks such as scheduling, nomination or accounting of physical and financial trades, but offer limited risk functionality and lag behind in their ability to perform sophisticated risk analysis. Many of the pioneering risk software firms that greatly contributed to important methodological advances in energy risk modelling are now part of larger software and consulting firms. Experience has painfully shown that their ability to innovate beyond 384 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 385 ENTERPRISE RISK MANAGEMENT FOR ENERGY AND COMMODITY PORTFOLIOS PANEL 14.3: RISK MANAGEMENT LESSONS FROM OSPRAIE CAPITAL MANAGEMENT4 Ospraie Management LLC, one of the largest commodity trading funds in the world, was forced to liquidate its largest fund after losing 38.6% in the first three quarters of 2008. The investment firm was run by Dwight Anderson, an experienced commodities trader with an excellent trade record up to that point. In a letter to investors after closing the fund, Anderson wrote that, “I am extremely disappointed with this result and the fund’s sudden reversal in performance. After nine years of striving to be a good steward of your capital, I am very sorry for this outcome.” Just a few months before closing the fund because of the large losses, Anderson told Bloomberg “We do everything that we can to manage the risk, and I think we’re better at it today than we were a year ago.” The sudden reversal in the fund’s performance caught most investors by surprise. For example, in 2007 the head of Credit Suisse’s New York-based alternative investments group, which managed US$134 billion in private equity and hedge fund assets, said that “Anderson’s the best-in-class player in dealing in the world of basic industries and commodities”. pure technology and computational solutions has come to a near halt. For example, most valuation and risk models are still based on static portfolios over short time periods that ignore material risks such as volumetric and operational risks. In addition, most models used by risk practitioners still assume that market changes are lognormal, which fail to account for key characteristics of energy and commodity prices such as mean reversion and jumps.5 One of the major gaps that exists in the risk management process at many firms is the lack of effective communication between risk groups and the senior management team. A poorly informed management exposes the organisation to risk “blind spots”. Some risk managers have taken a proactive role, and regularly identify those key risk information gaps (see Table 14.3) and continually develop and improve the tools to breach them. SUMMARY AND CONCLUSIONS Energy and commodity markets are some of the most volatile markets in the world, and firms operating in those markets should approach risk management with caution. Firms that implement a rigorous enterprise risk management 385 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 386 COMMODITY INVESTING AND TRADING Table 14.3 Main information gaps from a risk management perspective Organisational level Risk management information gaps Reports and metrics Board of directors Greater transparency on material risks and better understanding of high-level risk– return trade-offs of alternative hedging alternatives. Risk and hedging strategy dashboards. Senior management Knowledge of firmwide exposures and interactions. Impact of hedging on shareholder value maximisation. Evaluation of risk–return trade-offs and optimisation based on risk tolerance and multiple constraints. Firmwide exposure and “at-risk” reports. Hedge recommendations Stress-test reports. CFO/Treasury Anticipate potential cashflow shortfalls and develop contingency plans. Evaluation of pre- and post-hedge effectiveness. Negotiation of key price and collateral clauses in long-term contracts. Risk-adjusted pricing for large transactions. CFaR; CaR; hedge effectiveness; EaR. Procurement/ logistics groups Assistance with (re)negotiation of critical contract price and volume-related clauses. Increased focus on operational efficiency around physical procurement contracts. Benchmarks to determine group performance. Cost-at-risk; operating cashflow reports. Market risk managers In-depth understanding of multiple risk dimensions before and after hedging at the portfolio level (market, collateral, liquidity, cashflow…). Dynamic risk simulation of material risks. Valuation and risk adjustments. Credit risk managers Dynamic counterparty risk assessments. Impact of netting and collateral clauses in OTC master agreements (netting and collateral). Integration of accounts payable and receivables, as well as potential collateral needs in the cashflow management programme. Potential future exposure and credit risk reports. Risk charges and risk-adjusted pricing. Source: NQuantX LLC process can develop a competitive advantage that will allow them to weather the storm of adverse market conditions. Being aware of best practices and striving to implement them are therefore key not just to success, but to having good prospects for longer-term survival. A risk management process is as effective as its weakest link, and 386 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 387 ENTERPRISE RISK MANAGEMENT FOR ENERGY AND COMMODITY PORTFOLIOS therefore it is important to ensure that all the elements of the process are robust and integrated. The framework based on policies and governance, methodologies and infrastructure introduced in this chapter can assist energy and commodity market participants design a robust and comprehensive risk management process. 1 For more information, see Blanco and Mark (2004). 2 BHP Billiton Risk Management Policy (see http://www.bhpbilliton.com/home/aboutus/ ourcompany/Documents/Risk%20Management%20Policy.pdf). 3 There is an excellent overview of backtests in Dowd (2005). 4 Burton, K., S. Kishan and C. Harper, 2008, “Ospraie to Close Flagship Hedge Fund After 38% Loss”, Bloomberg, September 3. 5 For readers interested in a more detailed discussion of energy and commodity spot and forward price models, see Blanco and Pierce (2012). REFERENCES Aragonés, J. R., C. Blanco, K. Dowd and R. Mark, 2006, “Market Risk Measurement and Management for Energy Firms”, in P. C. Fusaro (Ed), Professional Risk Managers’ Guide to Energy and Environmental Markets (Wilmington, DE: PRMIA Publications): pp. 69–82. Blanco, C. and M. Pierce, 2012, “Spot Price Process for Energy Risk Management”, Energy Risk, March. Blanco, C. and M. Pierce, 2012, “Multi-factor Forward Curve Models for Energy Risk Management”, Energy Risk, April. Blanco, C. and R. Mark, 2004, “ERM for Energy Trading Firms: ERM Starts with Risk Literacy”, Commodities Now, September, pp 78–82. Blanco, C., 2010, “Collateral, Cash Flow and Earnings at Risk”, WorldPower, Isherwood Publications. Blanco, C. and M. Pierce, 2010, “Integrated Risk Modeling for Trading and Hedging Decisions”, WorldPower, Isherwood Publications. Dowd, K., 2005, Measuring Market Risk (2e) (Hoboken, NJ: Wiley). 387 14 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:12 Page 388 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 389 15 Credit Valuation Adjustment (CVA) for Energy and Commodity Derivatives Carlos Blanco and Michael Pierce NQuantX LLC and MTG Capital Management; NQuantX LLC Traditionally, counterparty and liquidity risks have been largely ignored in the valuation and risk measurement of energy and commodity portfolios. The main reasons for this were the lack of commonly accepted methodologies to measure and price those risks, as well as the general perception that they were relatively immaterial. However, large credit losses and funding liquidity problems, significant advances in credit risk measurement technology and changes in accounting standards and regulations such as the Dodd– Frank Act have led to an increased focus on improving counterparty and liquidity risk management practices. At the centre of the credit revolution is the concept of credit valuation adjustment (CVA), which likely to play as great a role for credit risk management as value-at-risk (VaR) did for the practice of market risk management. In this chapter, we will examine the concept of CVA and show how to calculate CVA at the trade and portfolio levels. We will also discuss the allocation of portfolio CVA and active credit risk management with CVA desks, as well as how to set up a system of credit risk charges. CVA IN A NUTSHELL In simple terms, CVA is the price of credit risk for a deal or portfolio with a given counterparty. When two entities enter into a derivative transaction, they also exchange an implicit option to default. 389 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 390 COMMODITY INVESTING AND TRADING From a valuation perspective, the fair value measurements of derivative contracts should include a risk adjustment reflecting the amount market participants would demand because of the credit risk in the future cashflows that will be exchanged through the life of the contract. The fair value of the embedded default option that could result in a credit loss is the CVA. Calculating CVA requires estimating the difference between the mark-to-market discounting expected cashflows using the risk-free rate and the credit-adjusted mark-to-market, which consists of incorporating the credit risk of the transaction into the mark-to-market calculations. CVA = Mark-to-market (risk-free) – Mark-to-market (credit-adjusted) CVA and debt valuation adjustment CVA can be unilateral or bilateral, depending on whether the adjustments are based on one or two of the parties in the deal. In unilateral adjustments, the entity performing the CVA calculations only discounts the derivatives assets (eg, in the money transactions) using the credit-adjusted curves of the counterparties, while no adjustments are made for liabilities (out-of-the-money transactions). In addition, the entity performing the calculations could also perform a similar adjustment for its liabilities, but using its own credit riskadjusted curves. These adjustments are also known as the debt valuation adjustment (DVA). In bilateral adjustments, the entity performing the calculations takes into account the effect of the counterparty’s credit risk in determining the prices they would receive to transfer an asset, as well as the effect of the entity’s credit risk in determining the prices they would pay to settle that liability. The main differences between bilateral and unilateral CVA calculations is that the former integrates the credit risk from the two parties in the transaction, and therefore is calculated as the net difference between the unilateral CVA and the DVA. Another risk adjustment is the funding valuation adjustment (FVA), which incorporates funding costs for the position – such as initial and variation margin, and collateral. 390 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 391 CREDIT VALUATION ADJUSTMENT (CVA) FOR ENERGY AND COMMODITY DERIVATIVES Figure 15.1 Steps in the CVA process Calculate credit risk adjusted curves Allocate portfolio CVA to individual deals Calculate CVA for each counterparty Determine CVA method Source: NQuantX LLC Credit-adjusted rate curves In order to calculate CVA, one of the critical set of inputs is the creditadjusted curves for the parties in the deal, which reflect the rates at which each counterparty is able to borrow money for different maturities in the capital markets. There are several alternatives for creating credit-adjusted curves, such as using credit default swap (CDS) spreads, corporate bond yield spreads, and default probabilities from rating agencies, hybrid models and internal rating systems. Table 15.1 provides a summary of the alternative inputs. Figure 15.2 Encana CDS spreads for various maturities (September 2007–September 2012) 500 1Y 3Y 5Y 7Y 10Y CDS Spreads (basis points) 450 400 350 300 250 200 150 100 50 9/ /0 03 03 /0 9/ 20 20 12 11 01 0 /2 09 03 / 9/ 20 09 /0 03 20 /0 9/ 03 03 / 09 /2 00 7 08 0 391 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 392 COMMODITY INVESTING AND TRADING Table 15.1 Main inputs used to build credit-adjusted rate curves Benefits Cons CDS spreads Research shows CDS premium changes provide earlier warning signals of credit risk problems. Very liquid markets for some of the larger firms. Empirical research points that CDS spreads tend to overestimate probability of default (PD). Not all counterparties have traded CDS. Changes in credit spreads driven by non-credit risk factors (eg, liquidity, risk premium). Bond yield spreads Very liquid markets for some counterparties. Credit spreads can be derived from corporate bond yields. Less liquid than CDS. Yield spreads changes driven by non-credit risk factors. Historical default probabilities More stable than market based assessments. Readily available for most counterparties and sectors based on external rating. Not market-based. Slow to react to changing conditions. Hybrid models More reactive than external ratings or historical probabilities. Not directly based on credit market assessments. Likely to follow changes in CDS and bond yields. Internal ratings Incorporates information from different sources. Consistent with internal credit assessments. More subjective elements. Not necessarily market-based. Slow to react to changing conditions. Source: NQuantX LLC CVA methods There are several ways of calculating CVA, but we can group the various methods in three categories. The first is the discount rate adjustment, which requires the use of credit risk-adjusted discount curves to calculate fair values. A common way of creating the credit risk-adjusted curves for a given counterparty is by adding the CDS spread to the risk-free rate curves used for present value calculations. Figure 15.3 shows the CDS spreads for various North American firms, as well as the zero-coupon risk-free curve and the riskadjusted curves. The risk-free rate curve is the US dollar zero coupon curve for September 3, 2012. The credit-adjusted curves for each entity in Figure 15.3 are created by adding the CDS spread to the zero-coupon rate for each maturity. 392 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 393 CREDIT VALUATION ADJUSTMENT (CVA) FOR ENERGY AND COMMODITY DERIVATIVES Figure 15.3 Sample CDS spreads and credit risk-adjusted curves 9.000% 8.000% 7.000% 6.000% 5.000% 4.000% 3.000% 2.000% 1.000% 0.000% 0 2 4 6 Risk free Chesapeake 8 10 Morgan Stanley Encana Source: NQuantX LLC The discount rate adjustment is the most widely used method for fair value reporting due to its simplicity. One of the main shortcomings is that the credit exposure is assumed to be static, and therefore the CVA is not dependent on the volatility of the mark-to-market (MtM) of the deal, making it more likely to underestimate the credit risk of the instrument. The second type is known as the exponential CDS default method, and requires the estimation of probabilities of default and recovery rates. We can approximate the probability of default from quoted CDS spreads for a given term by applying the following formula: ! CDSSpread t ( years) $ PD = 1! e # ! & 10000 % " (1! R ) where: ❏ PD is the probability of default; ❏ CDS Spread is the credit spread in basis points; 393 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 394 COMMODITY INVESTING AND TRADING ❏ T (years) is the maturity of the CDS measured in years; and ❏ R is the recovery rate (a common assumption made in published CDS spreads is that the recovery rate is 40%). Once the probabilities of default and recovery rates are estimated, we can calculate the CVA for the deal based on the fair value using the risk-free rate multiplied by the probability of default and the loss given default (LGD), which is 1 less the recovery rate. CVA = MtM(risk free) × PD × (1 – R) Again, the credit exposure is assumed to be static with this method, so potential future exposures will tend to be underestimated. The third method for calculating CVA is the exposure-based approach, which requires an estimation of expected exposures (both positive and negative) over the life of the deal, default probabilities and recovery rates at different time steps. Exposure-based methods combine market and credit risk elements. In exposure-based methods, in addition to the forward curves and other market variables, CVA is a function of the volatility of market prices over time, the timing of cash inflows and outflows, the existence of collateral and netting agreements, the term structures of default probabilities, as well as the expected recovery values. Expected future positive and negative exposures can be calculated using closed-form solutions or simulation methods. Following Stein (2012), CVA is calculated as: T CVA = (1! R ) ! 0 S (t ) P (t ) dt where S(t) is the expected exposure of the deal at time t, and P(t) is the default probability time function. As an alternative to calculating the full integral, we can divide the – time interval [0,T] into periods [ti, ti+1] and select ti ∈ [ti, ti+1]. A common choice for the time unit in each time interval is the average between the two points: T T CVA = (1! R ) ! 0 S (t) P (t )dt " (1# R ) ! S ( ti )P (ti ) t=0 where P (ti ) = 394 ! ti+1 ti P (t ) dt 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 395 CREDIT VALUATION ADJUSTMENT (CVA) FOR ENERGY AND COMMODITY DERIVATIVES is the probability of default in the interval [ti, ti+1]. If we simplify to just one period, CVA and DVA for a one-period horizon can be calculated applying the following formula: CVA = PDcpty × EPE × LGDcpty ≈ Spreadcpty × EPE DVA = PDown × ENE × LGDown ≈ Spreadown × ENE where PD is probability of default, EPE and ENE are the expected positive and negative exposures, respectively. We can see the expected positive exposure (EPE) and the expected negative exposure (ENE) profile for a set of nettable contracts with a given counterparty in Figure 15.4. The EPE is used for CVA calculations and represents the expected exposure in the event of default by our counterparty at different horizons. The ENE represents the expected exposure in the event of our own firm defaulting. Exposure-based methods are the more comprehensive ones, as they overcome the shortcomings of assuming that the credit exposure is static. The three main methods are summarised in Table 15.2. Figure 15.4 Expected positive exposure and expected negative exposure profiles $30,000,000 $20,000,000 $10,000,000 Expected positive exposure (EPE) $0 -$10,000,000 Expected negative exposure (ENE) -$20,000,000 13 20 1/ /1 01 3 20 13 01 /1 0/ 01 3 9/ 2 8/ 20 1 01 /0 01 /0 3 20 13 7/ /0 01 13 /2 01 06 5/ 20 01 / 20 13 /0 4/ Expected positive exposure 01 20 13 3/ 01 /0 20 13 2/ /0 01 20 13 1/ /0 /0 01 20 12 01 12 / 01 / 01 /1 1/ 20 12 -$30,000,000 Expected negative exposure Source: NQuantX LLC 395 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 396 COMMODITY INVESTING AND TRADING Table 15.2 Main CVA methods CVA type Description Discount rate adjustment (I) After calculating the MtM, the value is discounted using the credit spread to calculate the CVA. Discount rate adjustment (II) The MtM is calculated discounting each of the flows using the risk-adjusted curves of one or two of the parties in the deal. Exponential CDS default method Formula-based approach that introduces the CDS spread, survival rates and recovery rates. Exposure-based methods Involve the estimation of expected potential exposures over different time horizons, probability of default and recovery rates. Source: NQuantX LLC CVA at the counterparty level To perform the credit adjustment to the value of a derivatives book, we need to calculate the CVA and DVA for each counterparty in the book. The net adjustment is the difference between the sum of the CVA minus the sum of the DVA for all counterparties. The calculation of the CVA and DVA for each counterparty is not simply the sum of the individual trades CVA and DVA. This is because, in order to calculate CVA at a portfolio level, it is necessary to take into account netting, collateral and other credit risk mitigants. We can use any of the CVA methods to perform calculations at the portfolio level. The main difference is that, instead of just adding the individual MtM and potential exposures of each instrument, we need to perform those calculations after taking into account any credit mitigants. For example, if we use the discount rate method, we could calculate the net exposure for each counterparty after applying netting and collateral rules, and then calculate CVA by multiplying the net exposure times the credit spread. For portfolio level calculations, it is common to perform simulation of risk exposures at the counterparty level for multiple scenarios after taking netting and collateral into account. The steps involved in calculating portfolio CVA in a simulation framework are shown in Figure 15.5. Although CVA calculations are based on EPE and ENE, credit risk charges are often based on potential future exposures at a high confidence level. Figure 15.6 shows a potential future exposure (PFE) 396 MtM Citigroup BNP Paribas Goldman Sachs Glencore JP Morgan Shell Source: NQuantX LLC US$5,034,352 US$3,775,764 US$4,14,604 US$100,651 US$9,165 US$6,873 # trades US$45 US$32 US$12 US$7 US$23 US$11 Collateral US$2,500,000 US$1,000,000 Net exposure US$2,534,352 US$2,775,764 US$414,605 US$100,651 US$9,165 US$6,874 CVA US$74,375 US$74,171 US$11,127 US$2,753 US$258 US$158 % MtM 1.48% 1.96% 2.68% 2.73% 2.81% 2.30% 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 397 Counterparty 397 CREDIT VALUATION ADJUSTMENT (CVA) FOR ENERGY AND COMMODITY DERIVATIVES Table 15.3 CVA report at the counterparty level 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 398 COMMODITY INVESTING AND TRADING Figure 15.5 Steps to calculate CVA in a simulation framework 1. Generate spot and forward curve scenarios for multiple time steps 2. Value each deals for each scenario time step 3. Apply netting rules at the counterparty level for each scenario time step 4. Calculate net exposure for each scenario time step 5. Repeat process for multiple scenarios 6. Calculate exposure profile metrics (EPE, PFE, …) 7. Calculate credit valuation adjustment at the counterparty level Source: NQuantX LLC report at the counterparty level with the PFE profiles for each counterparty. From portfolio CVA to deal CVA When two entities enter into a series of transactions, they also exchange an implicit option to default. CVA is the price or cost of credit risk for a deal or portfolio with a given counterparty. CVA can be calculated at the individual transaction or at each counterparty portfolio level. The overall CVA for the exposures with a given counterparty is not simply the sum of the individual deal CVA, because of the need to take into account credit risk mitigation rules that apply to those exposures. For example, a trading entity may have several deals with the same counterparty that have large stand-alone CVAs, but if those exposures offset each other and there are netting agreements in place, the overall portfolio CVA will be considerably lower than the sum of the individual CVAs. Despite the non-additive nature of portfolio CVA, it is possible to 398 US$14,000,000 US$12,000,000 US$10,000,000 US$8,000,000 US$6,000,000 US$4,000,000 US$2,000,000 US$– 1M Source: NQuantX LLC 3M 6M 12M Citigroup Goldman Sachs JP Morgan BNP Paribas Glencore Shell 2Y 3Y 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 399 US$16,000,000 399 CREDIT VALUATION ADJUSTMENT (CVA) FOR ENERGY AND COMMODITY DERIVATIVES Figure 15.6 Potential future exposure (PFE) at the counterparty level 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 400 COMMODITY INVESTING AND TRADING allocate it among the various portfolio constituents in a similar fashion than we can calculate marginal VaR for individual portfolio components to determine the contribution to diversified VaR of a given trade or strategy. The allocation of the portfolio CVA into each individual trade is important for individual hedge accounting designations, as well as improving the understanding of the marginal impact of individual trades on the overall CVA. The process to allocate portfolio CVA into individual components consists of determining the marginal contribution of each trade to the portfolio CVA. The marginal contribution of a given trade could be positive, negative or neutral, depending on the change in the portfolio CVA before and after including that trade. CVA allocation approaches There are various approaches to allocating CVA among individual portfolio constituents. It is important to understand the differences between them because the choice of allocation method may have material implications on how credit risk adjustments of assets and liabilities are reported, as well as hedge effectiveness tests and qualitative derivatives disclosures. The most common CVA allocation methods are:1 ❏ In-exchange or full credit: the stand-alone CVA for each derivative instrument is directly applied. There is no need to calculate portfolio CVA or apply any allocation methodologies. ❏ Relative fair value: the portfolio CVA is allocated to each derivative instrument according to the sign and magnitude of the fair value of each derivative asset and liability. ❏ Relative credit adjustment: the portfolio CVA is allocated to each derivative instrument according to the sign and magnitude of the stand-alone CVA for each derivative asset and liability. ❏ Marginal contribution: the portfolio CVA is allocated to each derivative instrument based on the sign and magnitude of the marginal contribution to CVA of each individual derivative asset and liability. A numerical example of the application of the relative creditadjustment method is shown in Tables 15.4, 15.5 and 15.6; note that the application of this method in particular is investigated because 400 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 401 CREDIT VALUATION ADJUSTMENT (CVA) FOR ENERGY AND COMMODITY DERIVATIVES Table 15.4 Stand-alone CVA report Counterparty BP Trading Mark-tomarket Stand-alone CVA WTI swap US$1,243,550 Brent swap US$672,946 Natural gas swap US$(831,503) Natural gas basis swap US$97,690 Totals US$1,182,682 Portfolio MtM Stand-alone CVA Relative weights Credit-adjusted MtM US$10,724 US$5,114 US$(6,363) US$302 109.63% 52.27% –65.04% 3.08% US$1,232,826 US$667,832 US$(825,141) US$97,388 100% US$1,172,905 Credit-adjusted MtM US$9,777 Undiversified CVA Source: NQuantX LLC Table 15.5 Portfolio-level CVA Portfolio Netting ALL Collateral held/(posted) US$1,000,000 Counterparty BP Trading Mark-to-market Net exposure Portfolio CVA Credit Adjusted MtM US$1,182,682 US$182,682 US$3,654 US$1,179,029 Source: NQuantX LLC the relative credit adjustment method is relatively easy to implement, and superior to the in-exchange or full credit, and the relative fair value methods. The first step involves calculating the stand-alone CVA for each individual trade. If we add the stand-alone CVAs at the trade level, we can calculate the “undiversified” portfolio CVA assuming that the portfolio consists of non-nettable, non-collateralised trades, effectively ignoring credit-mitigation effects. The magnitude and sign of each stand-alone CVA determines the relative weights for the deals that are part of that counterparty’s portfolio. Table 15.5 shows the deal-level breakdown of MtM and CVA of the portfolio with trades made with EDF Trading as the counterparty. The bottom row shows the portfolio MtM, the “undiversified” CVA as a sum of stand-alone CVA, as well as the credit-adjusted MtM. The relative percentage weights are calculated by dividing each individual CVA by the undiversified portfolio CVA. 401 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 402 COMMODITY INVESTING AND TRADING Table 15.6 Allocation of portfolio CVA to individual trades Trade # Mark-to-market CVA weights WTI swap US$1,243,550 109.63% US$4,005 US$1,239,545 Brent swap US$672,946 52.27% US$671,036 Natural gas swap US$(831,503) –65.04% US$(2,376) US$(829,127) Natural gas basis swap US$97,690 3.08% US$113 US$97,577 Portfolio CVA bilateral Portfolio creditadjusted MtM Portfolio MtM (risk free) US$1,182,682 Marginal CVA US$1,910 100.00% US$3,652 Credit-adjusted MtM US$1,179,031 Source: NQuantX LLC The next step consists of calculating the portfolio CVA based on the unsecured exposure with each counterparty, which is estimated after taking into account any relevant netting and credit-mitigation tools. Portfolio CVA calculations can be made using current or expected exposure methods for the various trades in the portfolio. The combined MtM exposure, the net exposure and the portfolio CVA are shown in Table 15.5. In our example, as the current exposure is largely collateralised, the portfolio CVA is substantially lower than the sum of the stand-alone CVAs. The last column shows the combined credit-adjusted MtM for the exposures with BP Trading. As a final step, we can calculate the portfolio CVA portion that will be allocated to each individual deal by multiplying the relative weights calculated in Table 15.4 times the portfolio CVA. This is shown in Table 15.6. A comparative analysis of the different CVA allocation methodologies is shown in Table 15.7. The relative credit adjustment and the marginal contribution approaches are the most accurate ones, but require the calculation of new metrics such as stand-alone and marginal CVAs. Under those approaches, the CVA of a portfolio of trades with a given counterparty is allocated among its individual constituents according to the relative weight of each individual stand-alone or marginal CVA. The state of the practice of CVA reporting by energy trading firms is still in its infancy. Several publicly traded entities still do not calculate portfolio CVA and most do not allocate portfolio CVA into 402 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 403 CREDIT VALUATION ADJUSTMENT (CVA) FOR ENERGY AND COMMODITY DERIVATIVES individual deals. The main reason given is that the allocation of credit risk would not materially impact the fair value or the determination of the hedge effectiveness of a hedging relationship. Credit limits, charges and CVA desks Traditionally, credit risk management at energy and commodity trading firms has been a passive exercise, where credit risk managers set and monitor exposure limits and traders can continue dealing with a given counterparty as long as those limits are not breached. Those limits are often defined based on the current exposure at the counterparty level, which is generally calculated by taking the markto-market value of open positions, adding account receivables and accounts payable, and open settlements and applying appropriate netting rules and credit risk mitigation tools. In addition, the limits may be scaled as a function of the evolution of the creditworthiness of the counterparty. A sample credit report is shown in Table 15.8 with limits based on current exposures as a function of the counterparty’s internal rating. One of the main problems of this “binary” approach based on Table 15.7 Portfolio CVA allocation methodologies Approach Advantages Limitations In-exchange or Simplicity of approach. No full credit need to perform portfolio CVA calculations. Netting and collateral agreements not taken into account. Overestimates credit risk at the individual instrument level. Relative fair value Simple to implement. Only requires ability to calculate CVA at the counterparty portfolio level. Allocation weights based on fair value may differ considerably from those based on stand-alone or marginal CVA. Relative credit adjustment Relatively simple to implement. Allocation based on actual CVA of each instrument. Stand-alone CVA may not represent marginal contribution, but often a good proxy. Marginal contribution Technically, the most Marginal CVA contributions may accurate method. Allocation be volatile. Requires ability to based on marginal impact on calculate marginal CVA. portfolio CVA of each derivative instrument. Source: NQuantX LLC 403 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 404 COMMODITY INVESTING AND TRADING Table 15.8 Sample credit risk limit report (US$ 000s) Counterparty Barclays Morgan Stanley J Aron & Co Shell BP Exxon Southern Company Internal rating Current exposure Limit Limit usage Potential future exposure PFE/ limit 3 4 3 2 3 1 5 US$2,092 US$4,021 US$(461) US$(18) US$1,682 US$1,729 US$714 US$5,000 US$3,000 US$5,000 US$2,000 US$5,000 US$10,000 US$1,000 42% 134% 0% 0% 34% 17% 71% US$7,540 US$5,650 US$12,350 US$325 US$4,500 US$3,450 US$1,250 151% 188% 247% 16% 90% 35% 125% limits is that it creates a situation where traders become the frontline credit risk managers for the firm while their goals become that of maximising profitability, not managing that risk. As a result, the firm may end up with excessive credit risk concentrations to a given industry, geographical region or tenor due to the combined trader exposures. These concentrations could be exacerbated in the future if the exposures are driven by the same market risk factors. To complement static current exposure limits, many credit risk departments have also added, as part of the limit structure, forwardlooking exposure and risk metrics such as maximum PFE at a given confidence interval. Those metrics can alert credit risk managers of the exposures that may grow beyond the maximum thresholds as a result of market fluctuations. In the last column of Table 15.8, we can see that the existing exposures with Barclays, Morgan Stanley, J. Aron and Southern Company may exceed the credit limits in the future, even although they are within the approved current exposure limits. The next level in sophistication of the credit risk function involves designing a system of credit risk charges that can ensure that risk takers become actively involved in the risk management process. A system of credit risk charges and reserves can assist the front office in setting the right price for each new transaction based on the risks incurred by the firm, and also to create a fund with reserves to protect the firm against future credit losses. There are two main types of counterparty risk charge systems. The first is based on setting upfront charges for each new deal as a function of the potential credit losses over the life of the deal using CVA 404 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 405 CREDIT VALUATION ADJUSTMENT (CVA) FOR ENERGY AND COMMODITY DERIVATIVES Table 15.9 Sample trader-level allocation of pay-as-you-go charges for a single counterparty Counterparty Current exposure Credit spread (bp) Credit spread Daily charge Credit Suisse 2,091,546 245 2.45% US$140.39 MtM Charge allocation Daily charge Trader M. Smith J. Arnold C. White M. Ford S. Chance Totals US$1,235,000 US$(212,456) US$324,500 US$750,700 US$1,069,002 US$3,379,202 36.5% 0.0% 9.6% 22.2% 31.6% 100.0% US$51.31 US$– US$13.48 US$31.19 US$44.41 US$140.39 Source: NQuantX LLC or PFE metrics.2 Traders often strongly oppose these types of systems due to the fact that charges for the full life of the deal are applied upfront, and if the deal is reversed before maturity that would result in overcharges. The other type is known as pay-as-you-go, and consists of applying a daily credit risk charge based on current unsecured credit exposures.3 Pay-as-you-go systems are relatively easy to implement as the only metrics required are the unsecured credit exposure against each counterparty and the daily cost of capital of that counterparty. Pay-as-you-go systems are conceptually appealing for many trading organisations, but the success of the implementation of the credit risk charge system is often dependent on the details. For example, if traders are charged on the stand-alone credit risk of each deal, they are likely to be overcharged on an overall basis and therefore be at a competitive disadvantage over other firms. The best systems strike the right balance in terms of taking into account diversification benefits at the counterparty portfolio level and also impact the behaviour of the risk takers directly. Although pay-as-you-go systems apply daily charges, the credit risk managers can provide traders with the distribution of their maximum potential future credit charges before they conduct a new deal group using forward-looking probability-based credit metrics such as PFE. 405 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 406 COMMODITY INVESTING AND TRADING Active risk management with CVA desks As a response to the increased magnitude and complexity of the credit risk dimension in derivatives trading, many firms have created internal groups, known as CVA desks, with a mandate to measure, price and manage counterparty risks. CVA desks act as specialised units that manage the credit risk of the consolidated exposures with each major counterparty. Some CVA desks are in charge of implementing the system of credit charges and reserves for the firm. A sample decision flow diagram is shown in Figure 15.7. When a trader wants to conduct a new deal, the CVA desk determines the cost to protect the credit risk of that new deal and communicates it to the trader. The credit charge can be calculated based on the size, liquidity and duration of the exposure, the credit risk mitigation tools in place (netting, collateral, guarantees, etc), as well as the creditworthiness of the counterparty. If the trader decides to go ahead with the transaction, it may pass the fees to the counterparties by pricing the deal taking into account the cost of protection. The CVA desk can also play an active role by encouraging traders to use collateral to minimise credit exposures, and also to trade with certain counterparties that reduce overall portfolio exposures. In order to do so, they need to have the ability to calculate credit risk on Figure 15.7 Active credit risk management with CVA desks Trader approaches CVA desk before conducting new deal CVA desk calculates fee for credit risk protection Trader pays CVA premium Trader CVA collects fee and protects credit exposure Credit markets Source: NQuantX LLC 406 CVA desk CVA purchases protection for unsecured exposures from trading position 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 407 CREDIT VALUATION ADJUSTMENT (CVA) FOR ENERGY AND COMMODITY DERIVATIVES an aggregate portfolio from multiple potential trades, as well as to determine credit charges, pricing, hedging and reserves from those hypothetical trades. In certain instances, the CVA desk could potentially allow certain deals to be priced at a discount if they reduced the counterparty risk from a portfolio perspective. In some financial institutions, the CVA desk is structured as a profit centre whose traders attempt to take active credit bets. For most energy and commodity firms, however, the starting goal of the CVA desk is likely to be the active management of credit exposures with an emphasis on credit risk hedging and loss minimisation. CONCLUSION Counterparty and liquidity risk management in energy and commodity portfolios is undergoing a revolution driven by efforts to price and hedge those risks. CVA is gradually becoming an integral part of the risk management process of energy and commodity trading firms by helping to adjust valuations, and also in setting credit and liquidity risk charges. There are various methods to calculate CVA, from relatively simple discounting of cashflows using credit risk-adjusted curves to the more complex simulation-based potential exposures coupled with default and recovery rates. Valuation and risk measurement models and systems that fail to incorporate counterparty and liquidity risk adjustments are ignoring a material risk that could impact the accuracy of fair value and P&L calculations, as well as the validity of risk metrics used throughout the firm. The implementation of CVA at the valuation and risk measurement level introduces other risks, such as potentially higher P&L volatility and increased model risk arising from potential CVA estimation errors, but the benefits often outweigh the risks. Firms with the ability to price and manage credit risk proactively will have a competitive advantage over those that continue to manage those risks in a passive and reactive fashion. 1 For a more detailed explanation of the different methods, we recommend: PricewaterhouseCoopers, 2008, “Consideration of Credit Risk in Fair Value Measurements: An Addendum to PwC’s Guide to Fair Value Measurements”. 2 The first part of this chapter covers the main CVA calculation methodologies. 3 For more details, see Humphreys and Shimko (2005). 407 15 Chapter CIT_Commodity Investing and Trading 26/09/2013 12:38 Page 408 COMMODITY INVESTING AND TRADING REFERENCES Blanco, C., 2010, “Collateral, Cash Flow & Earnings at Risk: Time to update your risk metrics and policies?”, Commodities Now, July. Blanco, C., 2010, “Credit Valuation Adjustment for Commodity Derivatives”, Commodities Now, December. Blanco, C., K. Dowd, R. Mark and W. Murdoch, 2006, “Credit Risk Measurement and Management for Energy Firms”, in P. C. Fusaro (Ed), Professional Risk Managers’ Guide to Energy and Environmental Markets (New York, NY: McGraw-Hill): pp 69–82. Humphreys, B. and D. Shimko, 2005, “Pay As You Go”, Energy Risk, January. Stein, H., 2012, “Counterparty Risk, CVA, and Basel III”, Columbia University Financial Engineering Practitioners Seminar, March. 408 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 409 16 The Past, Present and Future of China’s Futures Market: Trading Volume Analysis Wang Xueqin Zhengzhou Commodity Exchange This chapter will review the development of China’s futures market since the early 1990s, with corresponding analysis of futures trading volume. It will discuss the two phases of clean-up and rectification necessitated by the development of China’s futures markets and the establishment of its regulatory regime in the 1990s. In this context, it analyses the trading volumes of China’s futures market between 2000 and 2011, particularly trading characteristics in 2011. This analysis will help to explain why the trading volume of futures and options rose worldwide but dropped in China during the same period, as well as the reason why China’s futures market has latterly been experiencing greater success. The last part of this chapter will offer some predictions based on the huge potential for furthering the futures market in China. These predictions include a trend towards loosening product control, incorporating exchanges and the further opening up of the futures market in China. Finally, this chapter will conclude that a futures market with a stable trading volume will conform to the principle of “making progress while ensuring stability”. Such progress will be aided by research on the insurance function of futures options, grasping the developing direction of options early on and accelerating the innovation of futures products and new futures business. 409 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 410 COMMODITY INVESTING AND TRADING THE PAST In 1990, with the approval of the State Council, the Zhengzhou Grain Wholesale Market1 was founded as the first futures pilot programme in China. Since then, China’s futures market has continued to develop, moving from “chaos” to “governance” – including two phases of clean-up and rectifications in the 1990s, as well as standardisation development in the 2000s. The futures market has grown steadily in scale, with laws and regulations increasingly implemented, market functions well-performed and international influence becoming even more significant. This has been especially true since 2004, with more futures contracts being listed and traded, forming an almost complete commodity futures market system consisting of agricultural, metal, energy and chemical products. The first 10 years (1990–2000) In the 1990s, along with the establishment of a market-based economic policy, China gradually opened its free commodity market, resulting in frequent fluctuations in commodity prices. The government began to develop a wholesale market of food, metals, materials and other commodities, and futures trading of these products was gradually promoted. For a time, the commodity wholesale markets and futures exchanges flourished everywhere in China. From 1990 to 1993, the number of futures exchanges increased rapidly, while futures contracts became multiply listed and the markets were over-speculated. There were then more than 50 futures exchanges in China, leading to vicious competition between the exchanges. Disorderly market trading, market manipulation and insider trading also occurred frequently during that time.2 Over a thousand futures commission companies were founded, although their operation and management verged on the chaotic. Customers were often cheated and the interests of investors violated. The brokerage services for overseas futures trading developed too fast to be brought under regulation in a timely manner. The futures market entered a stage of blind development. The first phase of clean-up and rectification On November 4, 1993, the State Council of the People’s Republic of China issued the “Notice to Resolutely Stop the Blind Development of the Futures Markets”, and started the first clean-up and rectifica410 Trading turnover 50 20 40 15 30 10 20 5 10 0 3 5 6 8 9 0 1 3 5 6 1 8 9 0 4 7 2 4 7 2 199 199 199 199 199 199 199 200 200 200 200 200 200 200 200 200 200 201 201 201 0 Number of listed futures Trade volume US$ trillion US$ equivalents Listed Contracts (right axis) 25 411 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS 60 30 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 411 Figure 16.1 Estimated Chinese trading volume (US$ trillion US$ equivalents) and number of listed futures 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 412 COMMODITY INVESTING AND TRADING tion in the futures market. The key measures adopted included reducing the number of futures exchanges and futures products, as well as suspending bulk trading for several commodities that were closely related to the people’s livelihood but the price of which were still subject to policy control – such as steel, sugar, coal, petroleum and vegetable oil. On May 18, 1995, the Treasury bond futures contract was also suspended. By the end of the first clean-up and rectification, only 14 exchanges were approved to remain in business, while just 35 futures contracts were approved, divided into formally listed contracts and trial-based contracts. Figure 16.1 shows the number of listed futures and total futures trading notional turnover by year. Therefore, the main measures taken in the first clean-up and rectification were: ❏ reduce the amount of futures exchanges and futures contracts; ❏ suspend bulk trading for several commodities that were closely related to the people’s livelihood and the prices and were still subject to policy control, such as steel, sugar, coal, petroleum and vegetable oil; ❏ suspend trading for Treasury futures on May 18, 1995; ❏ suspend approval for futures companies, review futures companies and implement a licence system; ❏ strictly control overseas futures trading; ❏ strictly control the participation of state-owned enterprises and institutions, and financial institutions in futures trading; and ❏ establish a centralised and unified regulatory regime. The second phase of clean-up and rectification After the first phase of clean-up and rectification, there were still too many futures exchanges and futures brokerage firms with problematic operations, and a few institutions and individuals were manipulating the market to make exorbitant profits. There were numerous incidences of illegal futures trading in overseas markets. The supervisory administration had weak supervision powers and retrograde supervisory methods. In August 1998, the State Council issued the “Circular on Further Rectification and Regulation of Futures Market”, in which the principles of continuing the pilot project, strengthening regulation, 412 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 413 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS Table 16.1 Exchanges, brokerage firms, listed commodities and turnover in Chinese futures Year Futures exchanges 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 08 09 10 11 12 1 2+ 5+ 32+ 14 14 14 14 14 3 3 3 3 3 3 3 3 3 3 3 4 4 4 Brokerage firms ≈1000** 144 330 329 294 278 213 178 184**** 187 176 172 166 164 165 163 164 163 161 161 Listed commodities contracts 52+** 35 35 35 35 35 12 12 12 11*** 11 11 11 14 18 19 23 24 27 31 Trading turnover (in US$100 million)* 443.18 2536.23 8071.05 6751.14 4909.36 2966.87 1793.18 1290.71 2419.34 3169.35 8698.96 11792.56 10790.40 16857.65 32883.02 57716.05 104743.76 248087.05 220727.81 274675.97 Trading volume (contracts) 4,453,450 60,553,600 318,060,350 171,283,850 79,381,600 52,227,850 36,819,550 27,305,350 60,231,750 69,716,316 139,932,111 152,848,800 161,423,761 224,737,051 364,213,397 681,943,551 1,078,714,909 1,566,764,672 1,054,088,664 1,450,462,383 Source: Compiled from data in CSRC, 2001, China Securities and Futures Statistical Book, apart from the number of exchanges in 1993 being taken from 100 Questions and Answers of Futures Operation (China Material Publisher): p.138 (while the number of exchanges is put at 32 in this report, it was generally recognised that there were over 40 exchanges operating in 1993; the number of exchanges in 1990, 1991 and 1992, and the number of brokerage firms in 1993, are the author’s estimates). *Trading turnover in Chinese yuan (Yn) was converted to US dollars at an exchange rate of 6.23 Yn/US$. **The 1993–2001 listed commodities contracts data and the number of 1993–2000 brokerage firms was taken from Xueqin and Gorham (2002). ***2002–12 listed commodities contracts dates came from: http://www.cfachina.org/news.php?classid=108. ****The 2001 brokerage firms number was taken from: http://www.yafco.com/show.php?contentid=40670, while the 2002–12 brokerage firms number came from: “China Futures Industry Development Report” and the CSRC. standardising according to law and preventing risk were determined for the second clean-up and rectification in China’s futures market. The main measures included the further rectification, cancellation and consolidation of futures exchanges. Three futures exchanges 413 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 414 COMMODITY INVESTING AND TRADING were retained, in Shanghai (Shanghai Futures Exchange, SHFE), Zhengzhou (Zhengzhou Commodity Exchange, ZCE) and Dalian (Dalian Commodity Exchange, DCE), and the exchange management system was upgraded. In order to fully perform the functions of price discovery and hedging for futures markets and further contain excessive speculation, the listed futures contracts were reduced from 35 to 12, with 23 futures contracts de-listed. The 12 commodities remaining were copper, aluminium, soybeans, wheat, soybean meal, mung bean, natural rubber, plywood, long-shaped rice, beer barley, red bean and peanuts. The measures for the second phase also included the level of minimum registered capital for futures brokerage firms being increased to US$4.82 million. In 1998, after the increase of registered capital, there were about 180 futures brokerage firms remaining in normal operation. In addition, the China Securities Regulatory Committee (CSRC) was created and “Interim Regulations on Administration of Futures Trading” implemented.3 Determine the regulatory regime After the clean-up and rectification, CSRC was appointed as the centralised and unified regulatory commission for China’s futures market, a regulatory change that created steady and wellfunctioning futures markets. In addition, China’s futures market withstood the impact of the financial crisis of 2007–08; due to the influence of the crisis, price volatility increased, especially in commodity futures. The global financial crisis also impacted upon the growth rate on China’s futures market. In 2009, this plunged to 20.72% from 87.24% in 2008, down 66.52%, showing that the centralised and unified regulation had been successful and deserved high credit, and also that it provides useful experience for the development and supervision of other commodity futures and financial derivatives in China. On November 24, 1998, the CSRC approved six modified contracts for soybean, wheat, mung bean,4 copper, aluminium and natural rubber, and on November 27, it approved modified contracts for wheat and mung bean, to be re-listed and traded again. These approvals marked a turning point in China’s futures markets in the latter stages of its first decade. The second significant event was the implementation of “Interim Regulations on Administration of 414 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 415 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS Figure 16.2 Regulations on administration of futures trading CSRC 36 CSRC were distributed to various places in 1998 China Futures Association was founded in 2000 Shanghai Futures Exchange Dalian Commodity Exchange China Futures Margin Monitoring Centre in 2008 Zhengzhou Commodity Exchange China Financial Futures Exchange Futures Trading”,5 and the third was the founding of the China Futures Association on December 28, 2000.6 The second 10 years (2000–10) In the first ten years of 21st century, China’s futures market developed rapidly. The most significant events included new futures contracts listed for trading, futures companies gradually opening up and financial futures being launched successfully. Figure 16.3 Chinese yearly futures trading volumes (millions of contracts) 1600 Trading volume (millions of contracts) 1400 1200 1000 800 600 400 200 0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 415 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 416 COMMODITY INVESTING AND TRADING Table 16.2 Futures contracts list for trading on China futures exchanges Exchanges Contracts Time Shanghai Futures Exchange Aluminium Copper Natural rubber Fuel oil Zinc Gold Deformed steel bar Wired rod Lead Silver Volume 1992 March 1993 November 1993 August 25, 2004 March 26, 2007 January 9, 2008 March 27, 2009 March 27, 2009 March 24, 2011 May 10, 2012 9,953,918 48,961,130 104,286,39 1,971,141 53,663,483 7,221,758 81,884,789 3,242 293,280 – 308,239,140 3,942,680 57,284,835 75,176,266 9,132 21,100,924 5,916,745 180,562,480 2,717 68,646 21,264,954 365,329,379 Zhengzhou Commodity Exchange Excellent strong gluten wheat No. 1 cotton Sugar PTA (pure terephthalic acid) Rape oil Regular white wheat March 28, 2003 June 1, 2004 January 6, 2006 December 18, 2006 June 8, 2007 March 24, 2008 7,909,755 139,044,152 128,193,356 120,528,824 4,320,115 152,901 (hardwhite wheat) 25,802,102 21,016,438 148,278,025 121,245,610 6,248,568 6,262 April 20, 2009 October 28, 2011 December 3, 2012 December 28, 2012 December 28, 2012 5,925,454 316,107 406,390,664 3,838,320 3,797,412 16,136,920 137,084 421,207 347,028,203 July 17, 2000 March 15, 2002 September 22, 2004 December 22, 2004 January 9, 2006 50,170,334 25,239,532 26,849,738 10,662 58,012,550 325,876,653 45,475,425 37,824,356 10,400 68,858,554 95,219,058 22,593,961 9,438,431 1,512,734 289,047,000 71,871,537 43,310,013 6,900,153 32,915,885 633,042,976 50,411,860 50,411,860 105,061,825 105,061,825 1,054,088,664 1,450,462,383 Early long-grain non glutinous rice Methanol Glass Rape seed Rape meal Volume Dalian Commodity Exchange China Financial Futures Exchange Futures trading volume in China Soybean meal No. 1 yellow soybean Corn No. 2 yellow soybean Soybean oil LLDPE (linear low-density polyethylene) Palm oil PVC (polyvinylchloride) Coking coal Volume Shanghai–Shenzhen 300 stock index Volume Total July 31, 2007 October 29, 2007 May 25, 2009 April 15, 2011 Apr. 16, 2010 Trading volume Trading volume in (2011) (2012) New futures contracts promoted By the end of 2011, there were 31 futures contracts listed in four futures exchanges in China, covering agricultural, industrial, energy and financial products. Futures contracts for Treasury bonds, crude oil, coking coal and even potato and egg were also being considered. 416 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 417 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS In addition, steam coal futures contracts at the Zhengzhou Commodity Exchange, coking coal and iron ore futures contracts at the Dalian Commodity Exchange, crude oil futures contracts at the Shanghai Futures Exchange and debt futures contracts at the China Financial Futures Exchange were prepared and subject to regulatory approval (see Table 16.2). Futures companies gradually opened up Chinese brokerage companies also became qualified for overseas futures business. At the end of June 2001, the CSRC officially published “Administrative Method for Overseas Futures Hedging Business of State-owned Enterprises”, a list of state-owned enterprises that were allowed to participate in overseas futures hedging business. By end-2005, 31 enterprises obtained the qualification of overseas futures business. Foreign capital participated shares into Chinese futures companies By 2013, there were only three Sino–foreign joint venture futures companies in China: Galaxy Futures, CITIC Newedge and JPMorgan Futures. On December 2, 2005, ABN of Royal Bank of Scotland was approved to set up the first joint venture futures company with Galaxy Futures in China. The foreign party, ABN Financial Futures Asia Co Ltd, held 40% of the shares, while on the Chinese side, Galaxy Securities held the remaining 60% of shares. CITIC Newedge was formerly known as CITIC Futures – in January 2007, overseas strategic partner Newedge Group was launched, founded by Société Générale and Banque de L’lndochine with a 50–50% ownership ratio. The futures business of the group was carried out by Banque de L’lndochine and the Pegasus Group. On September 26, 2007, Guangzhou Zhongshan Futures was renamed as JPMorgan Futures, with JPMorgan holding about 49% of shares indirectly.7 Chinese FCMs started to set up branches in Hong Kong The China Securities Regulatory Commission approved six Chinese future commission merchants (FCMs) to set up branches in Hong Kong in March 2006, namely China International Futures, Yong’an Futures, GF Futures, Nanhua Futures, Jinrui Futures and Green Futures. 417 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 418 COMMODITY INVESTING AND TRADING Table 16.3 Latest trading volume of stock index futures in China financial futures exchange Year CSI 300 2010 2011 2012 Total 91,746,590 50,411,860 105,061,825 247,220,275 Financial futures successfully launched China Financial Futures Exchange (CFFEX), approved by the State Council and the CSRC, was set up by five shareholders: Shanghai Futures Exchange, Zhengzhou Commodity Exchange, Dalian Commodity Exchange, Shanghai Securities Exchange and Shenzhen Securities Exchange, with each of the shareholders contributing US$16.05 million. The CFFEX was founded on September 8, 2006, in Shanghai. On April 16, 2010, CSI300 stock index futures started to be listed and traded on CFFEX. Trading volume of China’s futures market (2000–10) Since the early 2000s, the trading volume of Chinese futures has increased exponentially. The annual average growth rate of China’s futures market between 2000 and 2010 was 43.16%. In 2001, the trading volume of Chinese futures stood at 60.23 Figure 16.4 Growth in trading (log scale) for China’s futures market Trade volume (US$ trillion, US$ equivalent) 100 10 1 0.1 0.01 3 4 5 6 7 9 8 3 4 1 2 0 5 6 7 8 9 0 1 2 199 199 199 199 199 199 199 200 200 200 200 200 200 200 200 200 200 201 201 201 418 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 419 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS million contracts. The trading volume of global futures and options was 4.4 billion contracts, and trading volume of global futures was about 1.8 billion. The trading volume of global commodity futures and options was about 400 million, and the volume of global commodity futures was about 380 million contracts. A decade later, the trading volume of Chinese futures had grown to 1.52 billion lots and global futures was about 11.2 billion. The growth in size of China’s markets as a percentage of the total global market for all futures and for commodity futures is shown in Figure 16.5. Global futures volumes in China’s futures markets increased from 3.34% in 2001 to 13.6% in 2010. For the first half of that period, the market share of China was no more than 5%. Over the period 2001– 10, the ratio for futures and options increased from 1.37% to 6.82%, illustrating the slower growth of options trading relative to futures trading in China. During the 11th five-year plan, the market share of China’s futures market to global futures and options market increased exponentially. For commodity futures, the ratio of China’s increased from 15.99% of the global volume to 53.65% in 2010. When including options volumes, China’s market increased from 14.61% to 50.95% of global futures and options volume in 2010. To summarise, between 2001 and 2010 the rapid increase in trading volume made China’s futures market the largest commodity Figure 16.5 China markets as a percentage of global trading volume 60 Commodity futures 50 Commodity futures and options Futures 40 Futures and options 30 20 10 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 419 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 420 COMMODITY INVESTING AND TRADING market in the world. On the other hand, the average annual share of the Chinese futures market share to global futures and options remained low, reflecting that the trading volume of China’s futures market in commodity options, stock futures and stock options are not yet fully developed, with some products being totally absent from China’s derivatives market. In 2010, China’s futures market was one of the largest commodity futures market in the world, accounting for a trading volume of 53.65% of the global commodity futures market. THE PRESENT The micro characteristics of the market operation The healthy development of the Chinese futures market has been mainly based on the powerful spot market and an upward macroeconomic environment. China’s consumption volume of nearly all the commodities underlying the futures contracts ranks among the global top three consuming nations (see Table 16.4). Open interest As research shows,8 legal persons9 hold 40–60% of the 10 futures varieties’ open interest,10 offering a reasonable market structure in Figure 16.6 The historical ranking of Chinese futures exchanges among all global exchanges 0 ZCE DCE SFE CFFEX 5 10 15 20 25 30 35 2000 2001 2002 420 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 421 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS Table 16.4 China’s international consumption status of its futures underlying commodities China positioned in the world Futures underlying commodities The biggest consumer Copper, aluminium, rebar, wire, rubber, PTA, PVC, cotton, soybean N0.1, soybean meal, soybean oil, strong gluten wheat, hard wheat, rapeseed oil, palm oil, early long-grain non-glutinous rice, lead, coke, methanol Number 20 The second biggest consumer Gold, silver, LLDPE, sugar, corn 5 The third biggest consumer Fuel oil, soybean No. 2 2 The second biggest stock market Stock index futures 1 open interest.11 The percentages for aluminium, soybean No. 1, palm oil, hard wheat and rapeseed oil are high above 60%, which is overhigh. The percentages for gold, rebar, rubber, LLDPE, soybean No. 2, coke, sugar, early long-grain non-glutinous rice and stock index future are below 40%, which is relatively low. Individuals are the main trading participants, usually more than half of total trading volumes. The volume percentage12 of individuals for soybean No. 2 and rubber is over 80%; for gold, rebar, LLDPE, coke, sugar, early long-grain non-glutinous rice, stock index, zinc, PVC, strong gluten wheat, cotton and PTA is 50–80%; for aluminium, lead, fuel oil, copper, soybean N0.1, soybean meal, soybean oil, corn, palm oil, hard wheat and rapeseed oil is below 50%. Price volatility between futures and spot The assessment shows that the price volatility between futures and spot is almost at the same level, except for the price of strong gluten wheat, hard white wheat and early long-grain non-glutinous rice contracts, whose volatilities are slightly higher than the actual price volatility. Research data reveal that price correlation between futures and spot on the majority of products in China’s futures markets are stable and functional. 421 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 422 COMMODITY INVESTING AND TRADING Declared hedging positions Research shows that commercial enterprises mainly took short positions to hedge, based on the application for hedging quota, the use of that hedging quota and the hedging of open interest. Based on the actual situation in China, upstream enterprises often have a large production capacity and therefore exhibit great enthusiasm for futures market participation, while the downstream enterprises are mainly small businesses, usually lacking hedging abilities and willingness. This results in a large amount of short hedging. In the futures market, the manufacturers naturally hold short positions, which creates a downward pressure on futures price. As the counterparty, speculators generally tend to hold long positions, hoping to profit when the futures prices increase. Manufacturers pay a premium to manage the risks coming from price fluctuations. Price changes and price hit limits Generally, the futures market prices ran smoothly in 2011, with the hitting of the upper or lower price limits three times in a row decreasing year-on-year.13 However, the futures prices of copper, rubber, LLDPE, PVC, coke and palm oil experienced rather frequent fluctuations, with each hitting the price limit more than 25 times. LLDPE hit the price limit three times in a row on 16 occasions. Short-term trading activity in the market The short-term trading of futures was active, with intra-day trading generally over 50% of total trading volume. In 2011, the three varieties that generated the largest proportion of day trading volume were rubber, cotton and stock index futures. The intra-day trading activity for these contracts accounted for over 80% of the total. The three varieties with the lowest proportion of intra-day trading were soybean No. 2, corn and hard wheat, all of which had an intra-day trading proportion below 50%. ANALYSIS OF TRADING CHARACTERISTICS IN 2011 The trading volume of futures and options rose worldwide but dropped in China Global futures and options market trading volume increased Statistics show14 that the global futures trading volume increased by 7.4% from 12.049 billion transactions in 2010 to 12.945 billion transac422 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 423 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS tions in 2011, and that global options trading volume increased by 15.9% from 10.375 billion transactions in 2010 to 12.027 billion transactions in 2011. In 2011, the global futures and options trading volume was 24.972 billion contracts, an increase of 11.4% from 22.425 billion transactions in 2010. Futures trading volume in China decreased According to the overall analysis from CFA data, in 2011 the trading volume of the China’s commodity and financial futures was 1.054 billion transactions, a decrease of 32.72% from 1.567 billion transactions in 2010. China’s proportion of commodity and financial futures trading volume in the world decreased from 6.82% in 2010 to 4.22% in 2011. China’s commodity futures exchanges accounted for 53.65% and 38.03% of the world’s futures trading volume for 2010 and 2011, respectively. It is worth noting that, despite an 11.36% growth in the global futures and options markets trading volume in 2011, the global commodity futures and options trading volume fell by 6%. Agricultural commodity futures trading volume dropped by 26% and non-precious metal futures fell by 33%. Although the national futures trading volume declined by more than 30%, China’s financial futures trading volume grew in 2011. CFFEX’s trading volume was 50.41 million transactions in 2011, an increase of nearly 10 % over 2010. China’s commodity markets still world’s largest In FIA’s “Annual Volume Survey”, ZCE ranked 11th in 2011 (12th for 2010), SHFE ranked 14th in 2011 (11th for 2010) and DCE ranked 15th (13th for 2010). In 2011, the trading volume of ZCE decreased only by 18%, while DCE’s decreased by 28% and SHFE by 50%. Among the 32 countries for which FIA collected data, there are commodity futures markets in 25 of those countries/regions. There are 45 commodity derivatives exchanges, with total trading volume reaching 2.64 billion transactions. Despite a decline of 34.01% between 2010 and 2011, the trading volume of China’s commodity futures in 2011 amounted to 1.003 billion contracts, accounting for 38.03% of the world volume and ranking first place globally. Figure 16.7 shows the proportion of total commodity future trading volume by country. 423 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 424 COMMODITY INVESTING AND TRADING Figure 16.7 Proportion of commodity futures (2011) US 28% China 38% UK 15% India 15% Japan, Russia, others 1% respectively Source: Based d on FIA data Of the global top 20 agricultural contracts by volume in 2011, nine were in China. ZCE cotton futures ranked first and sugar ranked second. The other seven contracts were from DCE (soybean oil ranked fifth, soybean meal ranked sixth, corn ranked ninth, soybean N0.1 ranked 10th and palm oil ranked 14th), SHFE (rubber ranked third) and ZCE (strong gluten wheat ranked 20th). Moreover, SHFE’s rebar, zinc and copper futures ranked first, fifth and seventh, respectively, among global top listing on metal derivatives. Why the trading volume of futures and options rose worldwide but dropped in China The increase of the trading volume of futures and options globally Below are some of the reasons behind the increase in trading volumes. ❏ Most of global futures exchanges experienced an increasing trading volume: among the 77 exchanges around the world, the trading volume of 59 exchanges grew (accounting for 77%), 14 exchanges grew by 50% (accounting for 18%) and 11 exchanges grew by 100% (accounting for 14%). ❏ Several exchanges experienced a rapid or steady increase in trading volume: in 2011, the Singapore Mercantile Exchange, C2 Options Exchange in the US, BATS Exchange and Australian Stock Exchange enjoyed the highest growth rate, India Joint 424 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 425 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS Stock Exchange achieved a growth rate of 181%, Thailand Futures Exchange saw a growth rate of 136% and IntercontinentalExchange (ICE) futures trading volume hit a record high. Precious metals futures contracts enjoyed a significant increase ted to 0.179 billion 0. Worldwide, three d futures contracts. million globally, an xchanges launched d. 15 The decline in China’s futures trading volume In 2011, although China’s futures market made significant achievement in improving the market structure, market function and futures product innovation, the trading volume of the market suffered a marked decline after five years’ rapid growth.16 There were three reasons for this. First, the turmoil of the global economy, the structural transformation the domestic economy was facing and the slowdown of the economic growth rate adversely impacted the futures market. Second, factors such as the global loose-monetary environment and the speculation of some commodities boosted the price and volume of the futures market. Third, since the fourth quarter of 2010 many measures have been taken to curb excessive speculation, such as suspending the trading fee preferential system, restricting the size of opening positions and raising the margin requirement. FUTURES COMPANIES AND TRADING VOLUMES Futures companies At the end of 2011, the margin held by the futures industry was nearly US$25.59 billion. The various reserves that can be used to deal with market risks was US$1.74 billion, out of which the risk reserve of futures brokerage companies was US$304.98 million, the risk reserve of future exchanges was US$1.09 billion and investor protection funds was US$345.10 million, which enhanced the industry’s ability to control risk. However, compared to other financial 425 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 426 COMMODITY INVESTING AND TRADING institutions, futures brokerage companies’ overall strength was still quite low. At end-2011, there were 161 futures brokerage companies in China, and their total net capital was US$5.28 billion, only US$32.10 million for each company on average. The net capital of the top 10 futures brokerage companies only accounted for 28% of the industry total, 32% for clients’ margin and 28% for fee income. Futures brokerage companies’ income source was mainly brokerage fee income and interest income from customers’ margin deposits. In 2011, the revenue of 161 futures brokerage companies was US$2.46 billion, out of which brokerage fees were US$1.60 billion and interest income from customers’ margin was US$513.64 million. The annual net profit was US$369.18 million, and some futures companies even suffered a loss (data from CSRC).17 2012 trading volumes In 2012, the total volume of futures market in China was 1.45 billion contracts, with a notional value of approximately US$27.47 trillion, increasing by 37.60% and 24.44% from 2011, respectively. The trading volume of Shanghai Futures Exchange was 0.365 billion contracts, with a notional value of approximately US$7.12 trillion, increasing by 18.52% and 2.63% from 2011, respectively, and with a market share of 25.19% and 26.06%, respectively. The trading volume of Zhengzhou Commodity Exchange was 0.347 billion contracts, with a notional value of approximately US$2.79 trillion, decreasing by 14.61% and 48.04% from 2011, respectively, and with a market share of 23.93% and 10.15%, respectively. The trading volume of Dalian Commodity Exchange was 0.633 billion contracts, with a notional value of approximately US$5.35 trillion, increasing by 119.01% and 97.45% from 2011, respectively, and with a market share of 43.64% and 19.47%, respectively. The trading volume of China Financial Futures Exchange was 0.105 billion contracts, with a notional value of approximately US$12.17 trillion, increasing by 108.41% and 73.29% from 2011, respectively, and with a market share of 7.24% and 44.32%, respectively. THE FUTURE The development of China’s futures market The year 2012 witnessed the 22nd anniversary of the establishment and development of China’s futures market. Since the early 1990s, 426 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 427 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS China’s futures market has grown to become one of largest commodity futures exchanges in the world on the basis of trading volume. In 2009, the total trading volume of China’s commodity accounted for 43% of global volume, the biggest commodity futures market globally. There are three reasons for the prosperity of China’s futures market. First, China’s futures market enjoys great support from governmental policy. Since 1988, the establishment of a sound and steady futures market has been included and referred to in the government’s working report six times. Since 2004, requirements have been raised in the No. 1 central document18 on the futures market that futures derivatives for commodities should be transformed to a risk management instrument used by the real economy. Second, the regulatory agency has strengthened the supervision of the futures market to control risk. The regulatory agency always gives top priority to strengthening the infrastructure of the futures market. In addition, a good environment has been created for the development of the futures market through continuously reinforcing the basic regulations and institutions, steadily promoting new products, enhancing frontline supervision and strictly preventing market risk. Third, China’s futures market is generally managed well, not only attracting a number of commercial enterprises to hedge, but also Figure 16.8 China’s futures transactions and GDP 1600 60.00 Contracts in millions GDP in trillions 1400 50.00 40.00 1000 800 30.00 600 GDP in trillions Contracts in millions 1200 20.00 400 10.00 200 0 0.00 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 427 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 428 COMMODITY INVESTING AND TRADING increasing the integration of the futures market, cash market and industrial entities. Also, the key reason is that the futures market keeps up with China’s rapid economic development and soaring commodity cash market. Huge development space of China’s futures market Although the trading volume of China’s futures market tops any other, some development-restricting factors cannot be ignored. For example, the futures market is faced with an environment of excessive regulatory restrictions, community monopoly,19 OTC disguised futures,20 over-speculation and the problem of a lack of creativity in development, competitiveness in exchange and low level of diversity of futures varieties. While the domestic futures market is active, the international pricing power is still out of China’s control. Additionally, the monotonous operating system, improper regulatory system and single futures agent business21 have held back the development of the futures market. It should be admitted that China’s futures market has a long way to go. For instance, cash settlement of commodities has not been implemented and cross-product arbitrage trading, transactions after closing (post-market session trading), margin netting, SPAN, exchanges of futures for swaps and options trading have not been instigated. It is not yet possible to determine the steps necessary to achieve these innovative projects or how long it will take and how difficult it will be. To improve the international status of China’s financial sector, a strong futures market is needed for support. To improve China’s international competitiveness, the price discovery function of futures markets should be given full play; to cope with the impact from the international financial crisis, the hedging function of the futures market should be further promoted; to improve the national economy growth, service level of the futures markets should be improved. Therefore, China enjoys a huge development opportunity in the future. Possible changes to China’s futures market In spite of the high trading volume, the operating quality of China’s futures market is not completely satisfactory. Since the financial crisis of 2007–08, the global financial environment has changed constantly, and the futures market has been confronted by great 428 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 429 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS uncertainty, offering both risks and opportunities. However, since the early 1990s, China’s futures market has gone through stages of blind development, rectification and regulatory change, and come to a critical period of development, namely a development process from quantitative change to qualitative change. Undoubtedly, through this process some essential changes will occur in China’s futures market. The first is that the futures market will operate within the rule of the law, although there is still no national futures law in China. Second, with the increasing number of futures varieties, the coverage of futures products will be wider, and futures markets should tightly track the actual underlying markets. In addition, a speculative component will be more suitable for the operation of the market. Third, there will be an increasing number of innovations in the market-operating mechanism. The investor structure will be optimised and the proportion of institutional investors will be raised. Fourth, with the improvement of international competitiveness, the pricing power of the futures market will be strengthened. Finally, new ways should be constantly opened up to prevent market risks. THREE MAJOR DEVELOPING TRENDS OF CHINA’S FUTURES MARKET The trend to loosen product-listing control In order to curb the excessive amount of different types of futures that were listed by the exchanges in the early days of the futures market in the 1990s, an approval mechanism for the listed futures varieties has been implemented. This prevents premature futures varieties from listing, prevents the futures market from deviating from the real economy, ensures the consistence of the futures and cash market, controls market risk and standardises the market order. However, under the approval mechanism, despite strong efforts for promoting new products by the regulators and exchanges, a new product often has a slow introduction process and may miss the best time to market owing due to cumbersome procedures.22 This indicates that the inefficient administrative approval mechanism fails to keep pace with the needs of the market and may hinder the pricing function of the futures market. Thus, futures markets do not always provide the risk management tools needed by all enterprises. In addition, in the majority of futures exchanges around the world, 429 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 430 COMMODITY INVESTING AND TRADING nearly all varieties of agricultural futures have corresponding futures options trading to allow flexible hedging of the agricultural market risks. However, options trading has not appeared uniformly in China’s futures markets, preventing domestic investors from taking a more flexible approach to avoid market risks and also restricting enterprises from participating in hedging. Therefore, in the future, China’s futures market should relax product control and gradually allow more listing of new products. Corporatisation of the exchanges China’s futures exchanges are structured uniquely, and their ownership is ambiguous and confusing, even to professionals in China.23 Although, in economic terms, according to the “Regulations on Administration of Futures Trading”, 24 exchanges are seen as corporate legal persons or other economic organisations, in reality, in terms of management, the institutional arrangements stipulated by the “Futures Exchange Management Regulations”25 implies very strong administrative factors. Therefore, the exchanges that act as administrative organisations should be institutional legal persons. On the other hand, organisationally, judging by the source of their capital and their stated aims,26 exchanges that have features of social community should be seen as social group legal persons (legal persons are classified under several different categories in China). Therefore, exchange systems should come under a special organisational model.27 In the author’s opinion, since the futures market is market-oriented, complex and has high risk, it should be dynamically regulated for specialisation and legalisation, and even the regulatory system itself should be market-oriented. The trend of the corporatisation28 of exchanges around the world proves that corporatisation does not contradict the unified regulation of the futures market by the government. Therefore, with the further opening-up of China’s futures market as a part of its regulatory system, exchanges should be equipped with a more advanced independent market development force and much stronger competitiveness. As a result, corporatised exchanges will become a development trend of China’s futures market. 430 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 431 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS The further opening up of the futures market Since 2008 (and especially since 2010), the internationalisation of the China’s futures market has been a hot topic in the domestic futures industry. A consensus has been reached, that it is the basic strategy of China’s economic development to insist in opening up to allow active participation in the international market. Since the futures market directly serves the national economy, its internationalisation is both an internal need for the development of China’s economy and an irresistible development trend. There are two reasons to explaining this. On one hand, our enterprises’ competing for the pricing power of commodities requires the international futures companies to provide intermediary services, and the prices of international commodities are based on the prices of international commodity futures prices. Only by actively participating in the same markets with the leading international futures companies and gradually expanding its influence, can China’s enterprises overcome the difficulty of gaining pricing power. On the other hand, internationalisation can enhance the competitiveness of the futures companies. In the process of internationalisation, in addition to domestic brokerage business, futures companies can expand their businesses to foreign business, as well as business that combines domestic and foreign operations, which can improve operations and competitiveness. As predicted, a series of opening-up measures, including product crosslisting, stock holding of foreign investors and international product listings will become one of the main developing trends of China’s futures market. SUGGESTIONS Stable trading allows for progress while ensuring stability Influenced by factors such as state macro-control and complicated market conditions, there has been a large fluctuation in the trading volume of China’s futures market, especially in 2008. China’s futures trading volume increased to 87.24% as a result of the international financial crisis, before the rate decreased again by 20.72% in 2009. In 2010, it rocketed up again to 84.74%, but then sharply declined to 30.69% negative growth in 2011. On the contrary, since the early 2000s the proportion of US futures and options trading volume in the world increased by more than 30%. Since the financial crisis, the trading volume of the US market has gone up steadily. In 2011, its 431 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 432 COMMODITY INVESTING AND TRADING futures and options trading volume was 8.119 billion contracts, 14.01% more than the 7.121 billion contracts of 2012, occupying 32.51% of the total world shares, a small increase on the 31.94% of 2010. Thus, compared with the futures market of the US and other developed countries, the stability of China’s futures trading volume should further improve. Therefore, in a situation where futures trading volume might decline, the relation between trading volume and upgrading the quality of the markets should be handled correctly and the scale of the futures market should be kept relatively stable, both of which are not inconsistent with the principle of “making progress while ensuring stability” of the Central Economic Working Conference.29 That is to say, it would promote the transformation of China’s futures market from quantity expansion to quality expansion. The insurance function and development of options International experience shows that, since the early 2000s, the global options market has developed quickly. Statistics show that the trading volume of options outpaced futures, apart from in 2010 and 2011. However, as the data of different classes of futures shows, the trading volume of stock index option was several times that of stock index futures, but commodity options trading volume was only onetenth of the futures volume.30 Figure 16.9 Global options volume as percentage of futures 12% 10% 8% 6% 4% 2% 0% Global commodities Global energy Source: http://www.futuresindustry.org 432 Global agricultural Global metals 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 433 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS As shown in Figure 16.9, in 2011 global energy options transactions accounted for 11% of its futures trading volume, global agricultural options trading was 7.88% of the agricultural futures and global non-precious metals and precious metals options trading volume accounted for only 2.8% of the futures trading volume. It can be seen that the original intention and purpose of listing commodity options was mainly to serve as an insurance function for futures and to enhance the quality of the futures market, not to increase trading volume. For this reason, it is recommended that a further study on the insurance function of options for futures and a project on options training including simulated options trading is needed. CONCLUSIONS For the optimal development of China’s futures market, the following should be carried out: further research and development of the crude oil futures; rules of Treasury bond 433 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 434 COMMODITY INVESTING AND TRADING overall operations, despite the growth rate having slowed. Under these conditions, the development of the real economy needs a rapid development of China’s futures market through greater specialisation, diversification and internationalisation. It offers the futures markets a historic opportunity, but also some serious challenges. China’s futures market needs not only a stable and functioning market operation, but also much more innovation and opening up to the world. This is the common aspiration for people in the industry and is also the objective requirement for economic development in China. The Chinese market has a great deal of room to develop, with more new products to be listed, more market innovation and to be more involved in the world’s derivatives business. Finally, the question remains whether it is possible that these markets will open to foreign traders. There is no schedule for foreign investors to start trading in China’s commodity markets, but that time is getting closer every day. Regulators are taking much more interest in allowing foreign investors to trade in domestic markets, as researched and provided by futures exchanges. Regulators are even guiding exchanges to research some of the programmes aimed at attracting foreign investors. In 2012, China’s regulators implemented a series of measures to speed up the opening of the capital markets to the outside world, including the qualified foreign institutional investor (QFII) and renminbi qualified foreign institutional investor (RQFII) systems. In 2012, 72 QFIIs were approved. At the time of writing in 2013, a total of 213 qualified QFIIs had gained an approved investment quota amounting to US$39.985 billion. At the same time, in order to further expand opening to the capital market, in September 2012 the Shanghai and Shenzhen stock exchanges, as well as the China financial futures exchange, held several QFII promotional activities in the US, Canada, Europe, Middle East, Japan and South Korea to introduce foreign investors to China’s capital market. Furthermore, the Shanghai futures exchange’s crude oil futures are expected to be introduced in 2013, with the aim of attracting more international investors to participate in the financial and capital market in China. 1 Zhengzhou Grain Wholesale Market is the predecessor of Zhengzhou Commodity Exchange. It is located on the south bank of the Yellow River, and is the first experimental futures market in mainland China. Henan is a large agricultural province, whose output of grain, cotton and oil rank among the top in China. It is an important base of quality agricultural products. 434 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 435 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS 2 Natural rubber R708, China Commodity Futures Exchange, Inc of Hainan (CCFE) in 1997; Coffee F605, F607, F609, F703, China Commodity Futures Exchange, Inc of Hainan (CCFE) in 1996-1997; Jun Plywood 9607, Shanghai Futures Exchange (SHFE) in 1996; Red bean, Suzhou Commodity Exchange in Jan-Mar 1996; Soybean meal 9601, 9607, 9708 Guangdong United Futures Exchange (GUFE) in Oct-Nov 1995; Sticky rice 9511, Guangdong United Futures Exchange (GUFE) in Oct 1995; Red bean 507, Tianjin Commodity Exchange in MayJun 1995; 3-year T-bond 314, 327, Shanghai Securities Exchange (SHSE) in 1995; Palm Oil M506, China Commodity Futures Exchange, Inc of Hainan (CCFE) Mar 1995; Corn C511, Dalian Commodity Exchange (DCE)Futures in 1995; Steel wire, Suzhou Commodity Exchange in 1994-1995; Japonica rice, Shanghai Food and Oil Exchange in Jul-Oct 1994. 3 Including a serial of documents, such as “Provisional Regulations on Futures Trading”, “Futures Exchange Management Regulations”, ”Futures Brokerage Corporate Management Approach”, “Futures Brokerage Company’s Senior Management Personnel Qualifications Management Approach” and “Futures Industry Practitioners Qualified Management Methods”. 4 In the early 1990s, the Zhengzhou Commodity Exchange listed mung bean futures, the first batch of domestic listed contracts. In 1998 and 1999, for two consecutive years it traded at a peak of more than half of the national futures trading volume. In late 1999, after the margin increased from 5% to 15–20%, the mung bean futures had no trades. In May 2009, after the CSRC approved the “Request for Suspension of Mung Bean Futures Trading”, which was delivered by ZCE in 2008, the mung bean contract was delisted. 5 On June 2, 1999, the State Council issued the “Interim Regulations on Administration of Futures Trading”. After it was revised, the new “Regulations on Administration of Futures Trading” took effect on April 15, 2007. The newest “Regulations on Administration of Futures Trading” were approval by the State Council on September 12, 2012, taking effect on December 1, 2012. 6 China Futures Association consists of group members, including members of the futures brokerage firms, special members of futures exchanges and individual members in the futures industry. It accepts business guidance and management from the China Securities Regulatory Commission and the Organization of National Social Group Registration Administration. 7 http://futures.hexun.com/2012–05–15/141434876.html. 8 According to the internal research materials of regulators (and the below is the same). 9 Refers to an individual or group that is allowed by law to take legal action as plaintiff or defendant. It may include natural as well as fictitious persons (such as corporations). 10 Includes lead, fuel, copper, zinc, PVC, soybean meal, corn, strong gluten wheat, cotton, PTA. 11 Refers to the ratio of the position of legal person to the total position in the related contract market. 12 Refers to the ratio of individuals trading volume to total trading volume in the related contract. 13 For example, if the accumulative price increase (decrease) based on settlement price in three successive trade days (D1, D2, D3) of a futures contract reaches three times of the stipulated increase (decrease) price limit in the contract, the exchange has the right to increase the margin rate with the scale no more than three times of the trading margin standard in the contract applicable at that time. Under circumstances of significant increased market risk caused by the special situation of some futures contract, the exchange may take the following measures according to the market risk of some futures contract, such as putting limitations on margin movements, putting limitations on opening position and closing position, adjusting the trading margin standard of this futures contract and adjusting the range of price limits of the contract. 14 Analysis and calculation based on data from the Futures Industry Association. 435 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 436 COMMODITY INVESTING AND TRADING 15 http://www.tygedu.com/newsviews.php?newsid=4234. 16 Annual growth rate from 2006 to 2010 is, respectively, 32.22%, 62.06%, 87.24%, 20.27% and 84.74%. 17 http://www.pbc.gov.cn/image_public/UserFiles/goutongjiaoliu/upload/File/%E4% B8%AD%E5%9B%BD%E9%87%91%E8%9E%8D%E7%A8%B3%E5%AE%9A%E6%8A%A5 %E5%91%8A%EF%BC%882012%EF%BC%89.pdf. 18 “No. 1 central file” refers to the first document issued by the Central Committee of Communist Party of China every year. It has become the proper noun for showing that the Central Committee of Communist Party of China attaches great importance to rural problems. 19 The monopoly behaviour of the futures industry in China is mainly reflected in the administrative monopoly, futures exchanges monopoly and futures brokerage industry monopoly. For example, the regulatory department dominates the approval of varieties of futures and products, listing locations as well as restricting every product to be listed on one exchange without saying that listed procedures are cumbersome. In addition, in relation to a futures company, an exchange has a much stronger voice and negotiation ability, etc. 20 In China, outside of futures exchanges, there are more than 200 electronic commodity trading markets that trade almost the same contracts and use trading mechanisms and rules similar to futures exchanges. This is called “disguised futures” or ‘quasi futures”. The markets lack strict regulation and market rules, and their operation and implementation are in chaos. To some extent, they inhibit the healthy development of China’s futures markets. 21 Since the early days, risk events have occurred with futures companies misappropriating customer funds and allowing customers to carry out overdraft trading. However, futures brokers firms are not allowed to trade their own accounts and can only trade for customer accounts, promulgated and provisioned by the regulations on futures trading of September 1999. The main business of futures companies in China is to trade on behalf of their customers, so the firm’s income mainly comes from commission. 22 The listing mechanism for new futures contracts in China adopts a non-market-approval system. In order to list a new variety of futures contract, it must first undergo a repeated research and review process by the futures exchange and then report to the CSRC accordingly. After examination and verification, CSRC then submits a report to the State Council, which needs to consult the relevant state ministries and commissions, related industry administration departments and even relevant provinces and cities. After getting all feedback, the State Council might make written instructions. A new variety of futures contract will finally be launched. 23 China’s three commodity futures exchanges are institutional units implementing enterprise management, while China Financial Futures Exchange is a corporate system, an enterprise is a legal person. In fact, they are all to different extents the subsidiary of the regulatory department. 24 Article 7: non-profit futures exchanges shall carry out self-regulation according to their constitutions, and assume the civil liabilities with all their properties. A futures exchange bears civil liabilities to the extent of all of its property. The persons in charge of futures exchanges shall be appointed and dismissed by the futures supervision and administration authority of the State Council. Article 18: The revenues obtained by a futures exchange shall be managed and used in accordance with the relevant state regulations and may not be distributed to members or diverted for other uses. 25 A futures exchange shall establish a board of directors. The chairman and the vice-chairman shall be nominated by the CSRC and elected by the board. 26 Article 4: Registered capital of the membership futures exchange is divided into equal shares, which is subscribed to by its members. 27 This is not only difficult to explain to most Westerners, but also to some Chinese. 28 The meaning is similar to “demutualisation” – ie, the move from a member-owned organisation to a publicly listed organisation. 436 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 437 THE PAST, PRESENT AND FUTURE OF CHINA’S FUTURES MARKET: TRADING VOLUME ANALYSIS 29 The Central Economic Working Conference of the Central Committee of the Communist Party and the State Council is the highest economic conference in the nation. Its mission is to carry out economic achievements, deal with international and domestic economic changes, formulate macroeconomic development planning and deploy the following year’s economic work. 30 Data source from FIA statistics and calculated by author (the below is the same). REFERENCES Falloon, William D., 1998, Market Maker: A Sesquicentennial Look at the Chicago Board of Trade (Chicago, Ill: CBOT). Gorham, Michael and Nidhi Singh, 2009, Electronic Exchanges: The Global Transformation from Pits to Bits (Burlington, MA: Elsevier). Hieronymus, Thomas A., 1996, “A Revisionist Chronology of Papers”. Hieronymus, Thomas A., 1997, “Economics of Futures Trading: For Commercial and Personal Profit”, Commodity Research Bureau. Melamed, Leo, 1993, Leo Melamed on the Markets: Twenty Years of Financial History as Seen by the Man Who Reolutionized the Markets (New York, NY: Wiley). Ronalds, Nick and Wang Xueqin, 2006, “The Dawning of Financial Futures in China”, Futures Industry, November/December. Ronalds, Nick and Wang Xueqin, 2007, “China: Futures Take Dragon Steps”, Futures Industry, September/October. Ronalds, Nick and Wang Xueqin, 2007, “Chinese Commodity Markets: History, Development and Prospects”, in Hilary Till and Joseph Eagleeye (Eds), Intelligent Commodity Investing: New Strategies and Practical Insights for Informed Decision Making (London: Risk Books). Xueqin, Wang, 2008, Research on Options on Commodity Futures (China Financial & Economic Publishing House). Xueqin, Wang and Michael Gorham, 2002, “The Short, Dramatic History of Futures Markets in China”, Journal of Global Financial Markets, Spring, pp 20–28. Xueqin, Wang and Nick Ronalds, 2005, “The Fall and Rise of Chinese Futures 1990–2005”, Futures Industry, May/June. 437 16 Chapter CIT_Commodity Investing and Trading 26/09/2013 10:15 Page 438 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 439 Index (page numbers in italic type refer to figures and tables) A agriculture: and farmland as investment, see farmland and impact of non-fundamental information on commodity markets 7–9, 8, 9 market participants 249–60 commercial traders 249–55, 251, 254 commodity index and swap traders 260 non-commercial traders 255–6 proprietary traders: individual and trading groups 256–8 systematic and technical traders 258–9 market strategies in 279–92 calendar spreads 283–7, 284–5, 288 crush spreads 289–92, 291 directional 282–3 geographical spread arbitrage 287–9, 289 options 293 and options volatility 292 markets, trading in 261–79 and correlation benefit 265–8, 267, 269, 271, 272 fundamental data points 273–8 and investment flows, seasonality and weather 268–73 market environments and volatility 261–2 and strategy selection 262–5, 266 technical inputs 278–9 and mollisols 230 trading in 249–94, 251, 252, 254, 255, 257, 263, 264, 266, 267, 269, 271, 272, 274, 275, 276, 277, 280, 281, 284–5, 286, 288, 289, 290, 291, 293 and weather 66, 72–3 see also farmland American Petroleum Institute 103 Anderson, Dwight 385 APX-ENDEX 119 Australian Stock Exchange 424 439 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 440 COMMODITY INVESTING AND TRADING B Barnett Shale 36–8 base metals: exchanges that list 144–5, 144 price movement in 6 BATS Exchange 424 BHP Billiton 373 BP 91 Brazil: and coffee prices 74 growing economic prominence of 86 as major meat exporter 177 see also BRIC economies Brent 4–5, 5, 14, 93–5, 94, 97–9 Dated 94, 97–8 BRIC economies 105 see also oil and petroleum products: historical price perspective on Brookings Institution 245 C C2 Options Exchange 424 capacity allocation and congestion management (CACM) 119 CBOT, see Chicago Board of Trade CFFEX, see China Financial Futures Exchange Chávez , Hugo 106 Chevron 83 Chicago Board of Trade (CBOT) 166, 184 Chicago Mercantile Exchange (CME) 27, 89, 101, 214–15, 250, 260 China: and farmland 242–4, 243 futures market of 409–37, 411, 440 413, 415, 416, 418, 419, 420, 421, 422, 424, 427, 432 clean-up and rectification, first phase of 410–12 clean-up and rectification, second phase of 412–14 companies 425–6 and corporatisation of exchanges 430 development of 426–7 and exchanges, corporatisation of 430 and financial futures, successful launch of 418 first ten years (1990–2000) 410 and foreign capital 417 further opening up of 431 and futures and spot, and price volatility between 421 and hedging positions, declaring 422 and Hong Kong branches of future commission merchants (FCMs) 417 huge development space of 428 and insurance function and development of options 432–3 major developing trends 429–31 market operation, microcharacteristics of 420 and open interest 420–1 and opening of futures companies 417 possible changes to 428–9 and price changes and price hit limits 422 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 441 INDEX and product-listing control, loosening 429–30 and promotion of new futures contracts 416–17 regulatory regime, determining 414–15, 415 second ten years (2000–10) 415–18 and short-term trading activity 422 and stable trading and stability 431–2 trading characteristics 2011, analysis of 422–5 trading volumes (2000–10) 418–20 trading volumes (2012) 426 increased number of refineries in 99 as key driver in metals 137 and LNG imports 60; see also BRIC economies MMT growth of 56 net oil consumption of 107 China Financial Futures Exchange (CFFEX) 416, 418, 426 coal 207–25, 209, 216, 217, 218, 219, 223 characteristics of 208–13, 209 metallurgical 210–11 thermal 210 conversation statistics and terminology 223–5 financial markets for 214–15 CME product slate 215 and fuel-to-power spreads 220–1 market structure for 213–14 overview 207–8 and supply, demand and regulation 215–20 consumption 217–20 regulation 215–16 supply and trade 216 terminology and conversion statistics 223–5 and transportation 211–13 Comex Copper Exchange 144 commodities index investing 339–41 Commodity Futures Trading Commission (CFTC) 249 commodity markets: coal 207–25, 209, 216, 217, 218, 219, 223 characteristics of 208–13, 209, 210, 210–11 conversation statistics and terminology 223–5 financial markets for 214–15, 215 and fuel-to-power spreads 220–1 market structure for 213–14 overview 207–8 and supply, demand and regulation 215–16, 215–20, 216, 217–20 terminology and conversion statistics 223–5 and transportation 211–13 and energy and commodity physical and financial portfolios, enterprise risk management for, see main entry excess capacity enjoyed by 3 farmland 229–47; see also farmland 441 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 442 COMMODITY INVESTING AND TRADING grains and oilseeds 165–206, 169, 170, 172, 175, 180, 182, 191, 194, 195, 202 and agribusiness investors, listed 206 feed, food and vegetable proteins 166–201; see also under grains and oilseeds and genetic modification 166, 240 impact of non-fundamental information on 3–24, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19 and agriculture 7–9, 8, 9; see also farmland and base metals 6 and Dow Jones- UBS (DJUBS) 10–13, 20–2 and energy 4–5, 5 increased influence of 4 and precious metals 6 and sentiment 9–20, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19 and SG sentiment indicator 9–11 in metals 133–64, 135, 136, 137, 138, 139, 140, 141, 142, 143, 144, 149–50, 151–2, 153–4, 155–6, 157, 158, 159–60, 161–2, 163, 164; see also metals aluminium 149–50 base 144–5 bulk 145–6, 158 copper 151–2 demand 135–6 gold 159–60 inventory 134–5, 135 iron ore 157 442 nickel 153–4 palladium 164 physical factors driving market in (listed) 148 platinum 163 precious 145–7 prices 139–44, 139, 140, 141, 142, 143 scrap 138 silver 161–2 supply 136–8 zinc 155–6 North American natural gas 25–64, 26, 28, 29, 31, 32, 34, 35, 37, 38, 39, 40, 45, 48, 50, 51, 55; see also natural gas and coming decade, key issues for 53 and demand-side dynamics 28–36 and futures, price dynamics in 49–53 geography of production and demand 47 measures and conversions, common units of 26 overview 25–6 and regasification 58 storage 43–6, 45, 47, 48 oil and petroleum, history and fundamentals 75–110; see also oil and petroleum products putting momentum into 325–35 and better strategy, building 330–3 and commodity beta 326 and downside protection 334–5 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 443 INDEX and long and short 327, 335 and roll yield and excess return 330, 330 and sources of excess return 327–9 and sentiment 9–20, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19 in “risk-off” versus “risk-on” environments 19–20, 19, 21, 22, 23 structural shift in 12–18 and SG sentiment indicator 9–11 and structural alpha strategies, see main entry and weather 65–74 data basics 66–7 “day in the life” 67–70 impacts: on agriculture 72–3 impacts: on livestock 73–4 impacts: on softs 74 impacts: on transport 73 tropical conditions 70–2 in wholesale power 113–31; see also wholesale power markets and coming decade, key issues for 128–30 electricity 114–18 and hedging strategies and price formation 121–2 and historical price perspective 122–8 sources of information concerning 130–1 trading of, European markets 118–21 see also specific commodities commodity prices: in metals 139–44 principal component analysis conducted on 4 strong gains in xvii commodity risk premiums 295–305, 298, 300, 301, 303 active strategies 296–7 benchmarks and overview 296–7 convergent and divergent strategies 297–304, 298, 303 active example 301–4 Conservation Reserve Program 168, 241 credit valuation adjustment (CVA) 391, 392, 393, 395, 396, 397, 398, 401, 402, 403, 404, 405, 406 and active risk management with CVA desks 406–7, 406 allocation approaches 400–3 and credit-adjusted rate curves 391 and credit limits, charges and CVA desks 403–5 CVA methods 392–5 and debt valuation adjustment 390 for energy and commodity derivatives 389–407 explained 389–90 from portfolio CVA to deal CVA 398–400 crude grades and locations 79–83 see also oil and petroleum products CVR Energy 91 D Dalian Commodity Exchange 166, 414, 416, 417, 418, 426 443 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 444 COMMODITY INVESTING AND TRADING Dated Brent 94, 97–8 day-ahead and intraday markets 119–20 Department of Agriculture (US) 174, 231 Dodd–Frank Act 130, 389 Dow Jones-UBS (DJUBS) 10, 10–13, 10, 11, 12, 23 simple overlay example 20–2 Dubai Mercantile Exchange (DME) 27, 99, 100, 146 E electricity 114–18 market design 117–18 unique characteristics of 114–17 dispatch arrangements 114–16 locational issues concerning 116–17 and quality 117 and scientific laws 114 see also commodity markets; wholesale power markets energy and commodity derivatives: credit valuation adjustment (CVA): and active risk management with CVA desks 406–7, 406 allocation approaches 400–3 and credit limits, charges and CVA desks 403–5 credit valuation adjustment (CVA) for 389–407, 391, 392, 393, 395, 396, 397, 398, 401, 402, 403, 404, 405, 406 and credit-adjusted rate curves 391 CVA methods 392–5 444 and debt valuation adjustment 390 explained 389–90 from portfolio CVA to deal CVA 398–400 energy and commodity physical and financial portfolios: enterprise risk management for 363, 375, 376, 378, 379, 386 backtesting 380–2 infrastructure 383–5 and Ospraie Management LLC, risk management lessons from 385 policies and governance 371–4 risk-adjusted performance measurement 383 and risk management systems and data 384–5 stress tests 377–80 valuation models for physical assets, contracts and financial derivatives 382–3 and valuation and risk methodologies and metrics 374–83 “at-risk” metrics: cashflow at risk, VaR and earnings at risk 375–7, 375, 376 energy indexes: tracking 337–64, 350, 352–3, 356–7, 362, 363 benchmark energy index, spot and energy data 346–9 differential evolution algorithm 361 evolutionary solution techniques 344–6 genetic algorithm 361–3 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 445 INDEX industry classification benchmark 363–4 innovative approach 341–6 and problem formulation 342–4 and SEI performance 349–59 and selective portfolios, statistical properties of 355–9, 356–7 Energy Information Administration (EIA) 78 Energy Market Observatory 130 EPEX Spot 119 Essar Oils 99 European Network of Transmission System Operators (ENTSO) 130 exchanges: Australian Stock 424 BATS 424 C2 Options 424 Chicago Mercantile (CME) 27, 89, 101, 214–15, 250, 260 China Financial Futures (CFFEX) 416, 418, 426 Comex Copper 144 Dalian Commodity 166, 414, 416, 417, 418, 426 Dubai Mercantile (DME) 27, 99, 100, 146 India Joint Stock 424–5 Intercontinental (ICE) 27, 94, 101, 214, 215, 425 London Metal (LME) 144, 145 Minneapolis Grain (MGE) 184 Multi Commodity (MCX) 146 New York Mercantile (Nymex) 27, 68, 69, 70, 71, 146, 299, 346 New York Stock 364 Shanghai Futures (SHFE) 144, 146, 414, 416, 417, 418, 423, 424, 426 Shanghai Securities 418 Shenzhen Securities 418 Singapore Mercantile 424 Thailand Futures 425 Zhengzhou Commodity (ZCE) 414, 416, 417, 418, 423, 424, 426 Exxon 105 F farmland: bio-fuels from 231 cash returns from 232 and debt levels 231 and declining worldwide inventories 231 defined 229 and food demand 231 versus population growth 245, 245 and global farming 241–5, 242 China 242–4, 243 demand for crops and commodities 244–5 and inflation hedge 231 as investment 229–47, 233, 235, 236, 239, 242, 243, 245 and mollisols 230 and production, limitations of 240–1 and conservation programmes 241 and renewables, impact of 236–40 agricultural products 238–40; see also agriculture fuels 236–8 445 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 446 COMMODITY INVESTING AND TRADING and resource conservation 231 scarcity of 231 as sustainable asset 232 and US infrastructure 231 and value creation and investment 232–6 and farmland as lease property 232–3 and risk–return profile 233–4, 233 see also agriculture forward curves and market value of storage 309–11, 310 forward markets: physical versus financial 120; see also wholesale power markets products 120–1 G gas futures: price dynamics in 49–53; see also natural gas see also commodity markets Germany: and wholesale power markets, historical price perspective 122–4, 123 grains and oilseeds 165–206, 169, 170, 172, 175, 180, 182, 191, 194, 195, 202 feed, food and vegetable proteins 166–201 feed 170–83 food 183–95 vegetable proteins (oilseeds) 196–201 and genetic modification 166, 240 and rotation 201–4 446 storage 198 trends and swing factors for future 204–5 Great Britain: and wholesale power markets, historical price perspective 124–6, 125 Gulf War, first 104, 107 see also oil and petroleum products: historical price perspective on H Henry Hub 27, 62, 346 high-fructose corn syrup (HFCS) 179 Hubbert, M. King 103, 105, 108, 110 Hurricane Ike 92 Hurricane Katrina 42 Hurricane Rita 42 Hurricane Sandy 76 I ICE, see IntercontinentalExchange India: Jamnagar complex in 99 and LNG imports 60; see also BRIC economies meat consumption in 177–8 MMT growth of 56 India Joint Stock Exchange 424–5 IntercontinentalExchange (ICE) 27, 94, 101, 214, 215, 425 International Financial Reporting Standards (IFRS) 121 Iran–Iraq war 103, 105 see also oil and petroleum products: historical price perspective on 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 447 INDEX Iranian revolution 103 see also oil and petroleum products: historical price perspective on Iraq, Kuwait invaded by 104; see also oil and petroleum products: historical price perspective on J Jamnagar 99 Japan, MMT growth of 56 JBS 199–200 K Kuwait, Iraq invades 104; see also oil and petroleum products: historical price perspective on L Lehman Brothers 3, 4 liquefied natural gas (LNG) 54–9, 59, 60, 61 exports of 54–8 future flow considerations for 63 global 54–64 imports of 59, 60 imports of, and import growth 58–61 supply chain 62–3 London Metal Exchange (LME) 144, 145 M market information, sources of 130–1 market strategies in agriculture 279–92 calendar spreads 283–7, 284–5, 288 crush spreads 289–92, 291 directional 282–3 geographical spread arbitrage 287–9, 289 options 293 and options volatility 292 Markets in Financial Instruments Directive (MiFID) 129–30 metals 133–64, 135, 136, 137, 138, 139, 140, 141, 142, 143, 144, 149–50, 151–2, 153–4, 155–6, 157, 158, 159–60, 161–2, 163, 164 aluminium 149–50 base: exchanges that list 144–5, 144 price movement in 6 bulk 145–6, 158 copper 151–2 demand 135–6 gold 159–60 inventory 134–5, 135 iron ore 157 nickel 153–4 palladium 164 physical factors driving market in (listed) 148 platinum 163 precious 145–7 exchanges that list 146 gold among most actively traded 146 gold market an outlier among 6 many trading centres for 146 most actively traded 146 447 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 448 COMMODITY INVESTING AND TRADING prices 139–44, 139, 140, 141, 142, 143 scrap 138 silver 161–2 supply 136–8 zinc 155–6 meteorology, see weather Minneapolis Grain Exchange (MGE) 184 Mobil 105 mollisols 230 Multi Commodity Exchange (MCX) 146 N National Hurricane Center 70 National Weather Service, US 66, 67 natural gas: demand-side dynamics for 28–36 exports 34–6, 46 industrial use 28–30, 28, 29 power generation 30–4, 31, 32, 34 residential and commercial demand 34, 35, 37 futures, price dynamics in, and futures, price dynamics in 49–53 liquefied (LNG) 25, 34, 36 global 16, 55, 57 North American market in 25–64, 26, 28, 29, 31, 32, 34, 35, 37, 38, 39, 40, 45, 48, 50, 51, 55 and coming decade, key issues for 53 and demand-side dynamics 28 448 and futures, price dynamics in 49–53 geography of production and demand 47 measures and conversions, common units of 26 overview 25–6 and regasification 58 storage 43–6, 45, 47, 48, 49, 52 peak in (2011) xvii supply-side considerations of 36–43 and ethane rejection 42–3 shale 36–42, 38 weather impacts on 42 Natural Resource Conservation Service (NRCS) 230 New York Mercantile Exchange (Nymex) 27, 68, 69, 70, 71, 146, 299, 346 New York Stock Exchange 364 New York Times 72, 74, 104, 207 non-fundamental information: impact of, on commodity markets 3–24, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19; see also commodity markets and agriculture 7–9, 8, 9 and base metals 6 and Dow Jones- UBS (DJUBS) 10–13, 20–2 and energy 4–5, 5 increased influence of 4 and precious metals 6 and sentiment 9–20 and SG sentiment indicator 9–11, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 449 INDEX North American market in natural gas 25–64, 26, 28, 29, 31, 32, 34, 35, 37, 38, 39, 40, 45, 48, 50, 51, 55 and coming decade, key issues for 53 and demand-side dynamics 28 and futures, price dynamics in 49–53 geography of production and demand 47 measures and conversions, common units of 26 overview 25–6 and regasification 58 storage 43–6, 45, 47 “Notice to Resolutely Stop the Blind Development of the Futures Markets” (China) 410 O oil: peak in (2011) xvii and petroleum, history and fundamentals 75–110; see also oil and petroleum products oil and petroleum products 75–110, 77, 78, 80, 81, 82, 84, 85, 86, 87, 88, 90, 91, 92, 93, 94, 96, 97, 100, 102, 104, 107, 108, 109 and critical fuel and elasticity 75–8 and crude grades and locations 79–83 and crude markets and trading 97–101 and crude pricing and trading 89–97 and crude production trends since 1960 104 and crude transport and choke points 87–9, 87, 88 historical price perspective on 101–10 and OPEC 101–6 passim major supply, locations of 83–7; see also oil and petroleum products: and crude grades and locations reason for oil 75–101 and seasonality 78–9, 80 storage 89–90 oilseeds and grains 165–206, 169, 170, 172, 175, 180, 182, 191, 194, 195, 202 feed, food and vegetable proteins 166–201 feed 170–83 food 183–95 vegetable proteins (oilseeds) 196–201 and genetic modification 166, 240 grains and oilseeds 206 and rotation 201–4 storage 198 trends and swing factors for future 204–5 Organization of Petroleum Exporting Countries (OPEC) 101–6 passim, 102 modern oil pricing begins with birth of 101 Ospraie Management LLC 385 449 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 450 COMMODITY INVESTING AND TRADING P PCA, see principal component analysis petroleum and oil products, see oil and petroleum products PetroPlus 84, 100 Ponca 91 precious metals 145–7 exchanges that list 146 gold among most actively traded 146 gold market an outlier among 6 many trading centres for 146 most actively traded 146 principal component analysis (PCA), explained 4 Purchasing Manager’s Index(PMI)4 R regasification 54, 56, 58, 60–3 passim, 61 Regulation on Energy Market Integrity and Transparency (REMIT) 130–1 Renewable Fuel Standard (RFS) (US) 253 rice, as percentage of world’s dietary energy 192 “risk-off” versus “risk-on” environments 21, 22, 23 Russia: becomes largest producer of crude 101 growing economic prominence of 86 and LNG capacity 63 and natural-gas pipeline exports, decline in 63 see also BRIC economies 450 S Saddam Hussein 104 Saudi Arabia, as swing oil producer 105 scrap metals 138 see also metals sentiment: and commodities 9–20, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19; see also commodity markets see also SG sentiment indicator SG sentiment indicator, and commodities 9–11 shale 36–42, 38 Shanghai Futures Exchange (SHFE) 144, 146, 414, 416, 417, 418, 423, 424, 426 Shanghai Securities Exchange 418 Shenzhen Securities Exchange 418 SHFE, see Shanghai Futures Exchange Shuanghui International 205 Singapore Mercantile Exchange 424 Smithfield Foods: JBS acquires beef business of 200 Shuanghui International acquires 205 South Korea, MMT growth of 56 Soviet era, and assertion for energy dominance 103; see also oil and petroleum products: historical price perspective on spark and dark spreads 121 Spot Energy Index 337–64 see also energy indexes: tracking storage: forward curves and market value of 309–11, 310 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 451 INDEX of grains and oilseeds 198 of natural gas 43–6, 45, 47, 49, 52 of oil and petroleum 89–90 structural alpha strategies 305–35, 310, 311, 314, 316, 319, 320, 323, 324 and backtesting bias 321–2 curve placement 308, 309–15, 311, 314 market segmentation across commodity forward curves 311–12 risks of 313–15 seasonality in 312–13 momentum 308–9, 315–17 and commodities 325–35 and commodity beta 326 and downside protection 334–5 and long and short 327, 335 and roll yield and excess return 330, 330 and sources of excess return 327–9 volatility 309, 318–20 weaving an alpha basket 322–4 T tail-risk management principles 381 Taiwan, MMT growth of 56 Texas Railroad Commission 101, 103 Thailand Futures Exchange 425 “Three Cheers for US$5 Oil” 104 trading volume analysis: and China’s futures market 409–37, 411, 413, 415, 416, 418, 419, 420, 421, 422, 424, 427, 432 clean-up and rectification, first phase of 410–12 clean-up and rectification, second phase of 412–14 companies 425–6 and corporatisation of exchanges 430 development of 426–7 and exchanges, corporatisation of 430 and financial futures, successful launch of 418 first ten years (1990–2000) 410 and foreign capital 417 further opening up of 431 and futures and spot, and price volatility between 421 and hedging positions, declaring 422 and Hong Kong branches of future commission merchants (FCMs) 417 huge development space of 428 and insurance function and development of options 432–3 major developing trends 429–31 market operation, microcharacteristics of 420 and open interest 420–1 and opening of futures companies 417 possible changes to 428–9 and price changes and price hit limits 422 451 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 452 COMMODITY INVESTING AND TRADING and product-listing control, loosening 429–30 and promotion of new futures contracts 416–17 regulatory regime, determining 414–15, 415 second ten years (2000–10) 415–18 and short-term trading activity 422 and stable trading and stability 431–2 trading characteristics 2011, analysis of 422–5 trading volumes (2000–10) 418–20 trading volumes (2012) 426 U United Nations Food and Agriculture Organization 229 US National Weather Service 66, 67 W weather: and agriculture markets, trading in 268–73; see also agriculture and commodities 65–74 data basics 66–7 “day in the life” 67–70 impacts: on agriculture 72–3 impacts: on livestock 73–4 impacts: on softs 74 impacts: on transport 73 tropical conditions 70–2 and North American gas market 42 452 West Texas Intermediate (WTI) 20, 76 wholesale power markets 113–31, 123, 125 and coming decade, key issues for 128–30 changing consumer requirements 130 evolving market design 128–9 financial market regulation 129–30 electricity 114–18 dispatch arrangements 114–18 and functioning wholesale markets, location of 118 locational issues concerning 116–17 market design 117–18 and quality 117 and scientific laws 114–18 and hedging strategies and price formation 121–2 and historical price perspective 122–8 and European markets, wider relationship between 126–7 Germany 122–4, 123 Great Britain 124–6, 125 new developments 127–8 sources of information concerning 130–1 trading of, European markets 118–21 design principles, and importance of balancing regime 118–19 forward markets 120–1 Wood River Refinery 91 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 453 INDEX Z ZCE, see Zhengzhou Commodity Exchange Zhengzhou Commodity Exchange (ZCE) 414, 416, 417, 418, 423, 424, 426 453 17 Index CIT_Commodity Investing and Trading 30/09/2013 14:41 Page 454