Derivatives 2006 - Roll in the new
With commodity prices not expected to repeat the performance of recent years, dealers are concentrating their efforts on non-directional trading strategies and products. Negative roll issues are challenging both new and experienced commodity investors and giving rise to new products and trading strategies. Jean Haggerty reports.
The changing pattern in commodity term structures has become dramatic, particularly in terms of commodity index performance. Heating oil has a negative roll return of 20%, according to Deutsche Bank projections. Heating oil and crude oil both saw a 22% negative roll return in 2005.
Given this, and the energy bias of many commodity indices, rolling futures contracts on a pre-defined schedule has become a poor strategy for passive, long-only commodity index investing.
“If an index investor does nothing, [that investor] is likely to lose money in a sideways moving market because of the negative roll yields,” said Torsten de Santos, head of the commodity investor solutions team at Barclays Capital in London.
“New investors entering the commodities markets are looking carefully at indices because of the roll mechanism. They also want to know the impact of each individual commodity in the index,” said Lionel Semonin, managing director in commodity investor structured products at JPMorgan. Some dealers, such as JPMorgan, have launched commodity versions of algorithmic trading strategy-based structured products based on momentum. Investable Global Asset Rotator (IGAR), JPMorgan’s incarnation of the concept, captures only the best performing commodities in its basket and rebalances monthly.
According to some dealers there is a potential misunderstanding of negative roll issues. “This perception is based on a misinterpretation of prices published in the press,” said David Burns, head of commodities markets at Commerzbank in London. “The prices that you see in the press reflect the spot prices for a certain commodity today. Futures prices refer to today’s price for delivery at different points of time in the future. When futures are purchased only price changes in each individual contract matter, and money cannot be lost or gained by rolling between them,” he added.
The apparent conundrum is resolved when it is realised that commodities cannot usually be readily stored and that, for most commodities, the amount of trading far surpasses the amount which is actually held in store, he said. “This means that spot prices observed at different points in time are not directly comparable because there is no way to take delivery of the asset at one time and to deliver it elsewhere at a time very far in the future,” Burns said. “In short, there is no way to profit from a difference in spot prices at two different points in time… With an Index, however, it is possible to compare the prices during time because we are always looking at the same delivery date. Over a roll period we should look only at each future in isolation, otherwise we fall once more into the same trap.”
Although most commodity markets remain at high levels, few market participants expect huge increases akin to those over the past three years.
According to some banks, the contango that energy markets are experiencing will extend into next year.
“You would need crude oil prices to fall to US$50 and OPEC to withdraw some oil from the market for this [contango] to end,” said Michael Lewis, global head of commodities research at Deutsche Bank. Agricultural commodities, like corn and wheat, are the next engines to fire commodity index returns, he added, noting that industrial metals did much of the heavy lifting this year.
Requests for customisation of commodity index roll mechanics to deal with the positive roll yield in backwardated term structures or to minimise the losses from rolling up the curve in contangoed markets have been on the rise.
Some firms, such as Deutsche Bank, have launched separate indices that address the changing patterns in commodity term structures. The Deutsche Bank Liquid Commodity Indices-Optimum Yield (DBLI-OY) is an example of how products can change as a market matures.
With the negative roll problems facing traditional commodities indices in mind, Deutsche Bank in June replaced the DBLI with the DBLI-OY as the underlying index in its exchange traded fund (ETF) listed on the American Stock Exchange.
In addition to new indices and index customisation, dealers are pitching products aimed at hedging or avoiding paying the current cost of contango in commodity futures. Against this backdrop, products that offer different roll rules or option pay-offs on the shape of the curve are proving popular, said BNP Paribas’s Sebastien Lemoine, head of structured transactions in commodity derivatives.
Another aspect of this situation is the development of correlation trading, via dispersion swaps or structures by which investors gain from a decorrelation. “What I find interesting is that hedge funds are not the only ones looking at it, some institutional investors are too,” Lemoine said.
Commodity variance and volatility swaps are increasingly trading in the interdealer market. About 10 dealers are now trading these instruments.
“We really want this market to develop,” de Santos said. “What it means is that it is cheaper to execute [structured commodity-linked products] because there is an interbank market for dealers to offload their risk,” he added.
The development of these markets is an indication that the commodities markets are catching up with the equity and credit structured products markets. Crude oil, natural gas, aluminium and copper are the most common underlying commodities in variance and volatility swaps currently.
Few investors trade commodity variance swaps and volatility swaps today, but some dealers expect hedge funds to start moving into these instruments in greater numbers later this quarter.
Commodity-triggered swaps (CTSs) are also coming of age. “Collateralised commodity obligations (CCOs) make money in sideways markets,” said Barclays Capital’s de Santos. Like Barclays, which in late 2004 started using CTS in its CCOs, ABN Amro, Deutsche Bank and JPMorgan recently signalled their intention to start offering structured products underpinned with CTS.
A CTS is a digital put option that has a trigger event based on commodity price levels. The instrument enables investors to leverage some of the most interesting aspects of the commodities markets, such as high volatility, robust macro-economic fundamentals and in some cases backwardated forward curves.
CTS have merit has a product, but the rise in contango in some commodities markets makes it less attractive, said Tim Owens, head of JPMorgan’s currency and commodity solutions group. “The value in the trade is driven because you are taking a view that commodity prices are not going to collapse, whereas forward curves have typically been downward sloping. But forward curves are not as backwardated as they have been, so the triggers on those swaps on the downside have less value,” he said. Nonetheless, as the volatility in many commodities markets is high, CTS are still a valuable product for certain commodities, he added.
“The value in the trade is driven because you are taking a view that commodity prices are not going to collapse, while forward curves are downward sloping. But forward curves are not as backwardated as they have been, so the triggers on those swaps on the downside have less value,” he said. As the volatility in the commodities markets is high, CTS are still a valuable product.
Barclays Capital in June closed Everest, the first managed CCO to debut since it launched the market’s first static CCO, Apollo, in late 2004.
The move from a static to a managed product was a logical step in the development of the CCO. An increasing number of investors are looking for portfolio diversification and CCOs offer investors commodity risk in a format that they understand, Barclays Capital said when Everest closed.
Despite the sharp rises in commodity prices during the past few years, 48% of the 22 attendees at Barclays Capital’s commodities conference in February said that they view portfolio diversification as the most attractive aspect of investing in commodities. Most of those surveyed were institutional investors, a group that tends to be skewed towards long-term investments and use of indexed investments.
Answers to the issues arising from the crippling effect that energy is having on commodities indices are what investors who are signing up for next February’s conference are seeking, de Santos said, noting that his firm is now in the process of organising next year’s event.
In Europe, UCITS 3 is changing the ballgame for institutional investors seeking commodity investments. The full force of this change is not expected to be felt until at least next year.
The mutual fund directive, which took hold a year ago, will lead to more semi-active structured products wrapped into UCITS fund form, dealers say. Under UCITS 3 commodities can be included in mutual funds sold in Europe.
“The theme here is more growth and a broadening out of the institutional investor market,” Owens said.
Ultimately, commodity-based UCITS funds are expected to lead to a levelling off in the currently booming business in the commodity-linked structured note market, which has been exploding in tandem with the eye-popping increases in commodity prices in recent years.
“The big question in the commodity structured products market is: ‘What happens if everyone turns bearish on commodities in 2007-2008?’” said BNPP’s Lemoine.