Commodity Derivatives House
Let’s get physical: Exceptional volatility hit commodities in 2011 with even the most historically stable derivatives suffering price turbulence. To offset that uncertainty, banks increasingly went back to basics in managing the entire distribution channel. For combining physical transactions and taking derivatives financing to new heights, JP Morgan is IFR’s Commodity Derivatives House of the Year.
Price swings became the norm in 2011. Gold surged ever higher, energy prices rose and oil volatility catapulted back to 2009 levels, all the while electricity derivatives and some exotics became more liquid. But while the sector became more volatile, exchange traded commodities hit volume records as end-users, hedgers and even pension funds upped their usage in the hopes of finding some returns.
“It’s been a quite difficult year to trade the commodities markets,” said Blythe Masters, global head of commodities at JP Morgan. “You had very positive growth outlook for the first quarter of this year and then a period of tremendous correction, uncertainty and volatility.”
Utilities, for one, were prominent users of OTC commodities in 2011. As one energy broker explained, attracting and expanding utilities’ usage of commodities is a key strategy for banks, and part of the reason they are looking more at the physical side of the business.
“The reason these banks have to be involved in the physical market is their clients, the utilities, come to them looking to do structured products and hedges and they may need to do those physically,” he said. Storage and warehousing are becoming increasingly popular.
For successfully expanding its physical commodities business, JP Morgan stood out among some of the larger players. “They know they need to be involved in the physical market in order to be a full-service shop for their customers,” said the broker.
JP Morgan’s physical commodities presence dates back to 2008 with the purchase of Bear Stearns, a firm that had a deeply entrenched physical business through Bear Energy. It subsequently followed with asset purchases from MF Global, UBS, and more recently from RBS Sempra – initially with its global oil, metals and European power and gas business in 2010, and later that year, with the assets of the North American gas and power operations.
It wasn’t until 2011, however, that JP Morgan truly stood shoulder to shoulder with more established commodity houses, and even pushed ahead of them in some key areas.
JP Morgan ranked first globally in market penetration for metals and energy corporate OTC derivatives in a survey released earlier this year by Greenwich Associates. It also tied for first place in service quality among corporate users of OTC derivatives on energy. Similarly, in metals JP Morgan took first place in overall service quality for metals OTC trading.
“It’s really gratifying to see us there,” said Masters, commenting on the recent rise in industry reports.
The achievement is particularly impressive given that four years ago, the commodities operation was just a derivatives-only shop with about 150 employees.
“We had no agricultural capability whatsoever, no emissions capability, and had limited physical capability,” she added.
But that has all changed. Playing catch-up to its larger rivals, JP Morgan spent a good part of 2011 integrating the RBS Sempra acquisition. The purchase enabled the bank to increase its business in the power sector by more than 50%. JP Morgan paid US$1.6bn for the first Sempra buy and another US$220m for the US operations.
Several banks bid for Sempra at the time, with market participants believing JP Morgan initially overpaid for the acquisition. Subsequent departures from key staff also raised questions.
The overall purchase, though, brought 2,000 clients to its platform, with the US buy opening up natural gas opportunities in the West coast. In London, JP Morgan now has a large warehousing capability known as Henry Bath.
“Without that group, we wouldn’t have been able to do what we’ve done in terms of taking a business from really a very immature state to a world-class scale.” Masters said, referring to her 650-person commodities department.
“We are physically and financially enabled all over the world. We have a complete product capability in all of the major underlying asset classes,” she said.
Capturing the physical side of the business like storage and transport has helped the firm’s revenues, market participants said. An industry report ranked the house either first or third in commodities revenues (depending on accounting nuances) for 2011, which is a spot it previously only coveted.
“When we built up the business, we decided we were going to have as a goal to be the most physical player in the industry,” said Paul Posoli, head of global power, gas, coal and emissions at JP Morgan.
“For a producer of natural gas, we are buying their physical gas, we’re there for them when they want to hedge financially next year, whatever their term is, to accomplish their development programme, and we are there for larger structured transactions,” he said.
Similarly, combining the physical and derivatives side of commodities has also helped the bank in agricultural commodities.
“It’s a business where we sit between producers and consumers and investors and act as lead provider in both,” said Michael Camacho, head of global sales and structuring, global investor products and global agricultural at JP Morgan.
Putting on hedges
The firm also showed stellar performance in derivatives risk management for the agricultural sector. “Where we tend to excel is the option markets and risk management products. That has really been key for us,” said Camacho.
An International Finance Corporation US$4bn food hedging project in 2011 highlights that strength well. JP Morgan was the lead bank involved in partnering with the IFC, whereby the World Bank’s private sector arm will underwrite US$200m in credit exposure for producers and consumers of soft agricultural commodities while JP Morgan will take on a corresponding US$200m. Clients should be able to use the facility by early 2012.
The initiative provides emerging market counterparties with price hedging through the use of forwards and commodity swaps. “We hope once the facility grows to bring in other product partners from there. We view this as one stepping stone,” said Camacho.
The project should ultimately help reduce food price volatility, a key G20 agenda item, all along the supply chain.
“When that facility was announced basically every big bank in the world that is in this business as well as some of the physical commodity traders contacted us and said ‘Hey we’d like to do the same thing with you’,” said an IFC official. “JP Morgan has a particularly strong franchise in Latin America.”
European risk management initiatives have also stood out for the bank. In May, JP Morgan provided an options hedging mechanism for a Scandinavian structured product distributor. The previous December it also set up an agreement with Swiss private bank Vontobel regarding the distribution of securities linked to JP Morgan Commodity Curve Indices. JP Morgan will also offer principal-protected notes on the indices.
JP Morgan also placed renewed emphasis on index strategies in 2011. This past February, the bank added new commodity indices called 3-C Family, named after various methodologies such as commanding fundamentals, employing continuum technical signals and a combination of inter-commodity spread relationships.
The firm’s growth, however, has not come without pain. A bad coal trade in 2010 put the firm back around US$200m. It also faced criticism over futures trades in the silver market.
But JP Morgan’s commodities team is in it for the long haul. According to Masters, the firm will continue to adapt to clients’ hedging needs. “It’s not just a financial transaction that is overlaid on top of their business, this is their business,” she said.
