Commodity Derivatives House

IFR Review of the Year 2012
7 min read
mike kentz

Against the odds: An onslaught of derivatives regulations and stagnant volatility restricted profitability in 2012, so much so that some players exited the commodities business entirely. Success was defined by an ability to provide liquidity where others could not. For remaining liquid and continuing to build out its global platform, Deutsche Bank is IFR’s Commodity Derivatives House of the Year.

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There was not much room for profit in the commodities business in 2012. High regulatory and capital costs looming via Basel III and Dodd-Frank, as well as increasing difficulties in gleaning trading profits in a slow-moving and directionless market, scared off several firms from the space. But top-tier banks remained successful by using the entire portfolio and expertise across the firm to provide unique hedging opportunities in illiquid markets.

“We have had a clear strategy for several years to deliver the entire portfolio of the bank in offering hedging capabilities,” said Louise Kitchen, global head of Deutsche Bank’s commodities business based in London. “The strategy particularly paid off this year as we were able to offer a liquidity supply to clients that they wouldn’t necessarily find in other areas.”

Banks and their clients faced a very different commodities market in 2012 – one that was less directional than years past and characterised by generally low volatility, leaving clients with less incentive to hedge. But even without the general consistent bullish or bearish trends of previous years, Deutsche was able to offer innovative solutions and investment opportunities to its clients.

For example, the bank solved a major hedging issue for gas distribution companies in Central and Eastern Europe. Those companies were buying gas based on oil indices, and therefore needed to hedge both the possibility that oil and gas prices would diverge, as well as the foreign exchange risk associated with buying gas denominated in euros and selling to clients in US dollars.

In conjunction with the foreign exchange derivatives desk, the firm began offering forward contracts on oil indices denominated in both euros and US dollars, the first bank to do so. The strategy paid off for clients early in the year when Iran threatened to close the Strait of Hormuz and oil prices spiked while gas prices stayed level, necessitating an oil versus gas price hedge that could be denominated in both currencies. The bank has since created an offering for forward transactions denominated in Eastern European currencies too.

The North American gas business did not lag far behind. Deutsche executed 2.5bn cubic feet of gas trades per day through the year and the client-facing business increased by 24% year-on-year, even as volumes across the market declined.

Going long

The bank also excelled in providing long-dated hedges in electricity markets, a sector where banks shy away from entering purchase agreements maturing in more than five years due to a lack of liquidity. Not Kitchen’s team, though, which was able to combine strong relationships with European industrials and an ability to find investors who were searching for an efficient way to hold emissions-based risk to provide an innovative hedge, serving two different client bases at the same time.

Deutsche executed several deals with European industrials to purchase electricity for longer than five years in advance and subsequently packaged the emissions risk into a “carry trading” note for its investor clients.

Part of the bank’s success in the power and electricity market came from hiring six new traders, giving it the biggest continental European trading team in the industry and allowing it to execute trades seven days a week, 24 hours a day. That attracted the attention of small to mid-size consumers and producers that began outsourcing some of their off-hour trading responsibilities to the German dealer.

“For us, it’s not so much about competing on price on every single trade,” said Simon Grenfell, head of metal sales and origination. “It’s about fostering the loyalty of major clients who know that we have the capability to address multiple facets of their hedging needs and that we will always be there to provide liquidity, as we were through the US dollar funding crisis this year.”

And in a year when many banks cut their roster to come in line with increasing capital requirements, while top talent was exiting for hedge funds and private equity firms, the bank’s commitment to growth was impressive, as it made significant hires in Asia and Latin America.

“The idea has been to keep all aspects of the marketplace involved at all times,” said Kitchen. “The clients of one asset class are viewed as clients of the entire bank.”

The firm also built out its freight management business, a decision in 2011 that paid off in spades in 2012. According to the firm, it regularly completes 10,000 days of clients’ business in a single month and is now ranked number one in freight derivatives trading.

The strong performance of the freight team subsequently leaked into its investor product business, where it completed a US$60m Capesize Cal 2012 trade for an institutional investor looking to go long freight, believed by the bank to be one of the largest freight trades ever put on by an institutional investor.

Structured product boost

The firm’s structured products business excelled as well. Assets under management increased by approximately US$540m to US$17bn in 2012 as most banks experienced outflows.

Its Optimum Yield Balanced Index strategy was the top performing general commodity index in 2012, returning 8.3% in the year to mid-November, compared to 3.8% on the benchmark Dow Jones-UBS Commodity Index and 4.91% on the S&P Goldman Sachs Commodity Index.

And in the midst of a troubling trading environment for investors and corporate hedgers, regulatory changes added another layer of concern. But Deutsche’s commodities team provided regular client updates and conference calls aimed at engendering trust and keeping clients in the know.

“What we’ve been seeing is a lot of banks focusing inwards over the past two years with respect to regulation,” said Grenfell. “We decided that while regulation impacts us more directly than clients, we are a client-focused commodities business and they need to be along on the ride with us.”

One of the few blemishes on the firm’s record was a fine of US$1.5m levied by the US Federal Energy Regulatory Commission for allegedly manipulating power prices in the California market. The firm is disputing the accusation, stating that the bank “did not intentionally trade against its [own] interests”, according to a regulatory filing.

But it was not alone. FERC fined Barclays for the same manipulation in the same market for significantly more cash, US$470m. The UK-based bank is also disputing the allegation.

Expansion against the odds