Caught in the crossfire

IFR Derivatives 2008
9 min read

Although a strong case can be made that the commodity cycle is not over, there is an undeniable weakness permeating most commodities sectors. Meanwhile, the problems of the financial firms, along with the other manifestations of the credit crunch, are putting pressure on commodities. Jean Haggerty reports.

UBS, which built up its commodities trading division in the wake of Enron’s collapse, earlier this month announced its exit from commodities businesses other than precious metals. The move is aimed at bringing the bank’s cost base down to a more sustainable level. “The ongoing crisis in the financial markets and dramatically changed industry dynamics require us to recalibrate our business,” explained Jerker Johansson, chairman and CEO of UBS Investment Bank.

UBS was not among the banks that companies in Asia, Europe and the US disclosed active over-the-counter (OTC) commodity derivatives relationships with, according to Greenwich Associates 2008 Global Commodities Research Study, published in May. Neither was now defunct Lehman Brothers, which recently saw its US commodities operation become part of Barclays Capital.

Companies responding to the Greenwich study cited Goldman Sachs, Morgan Stanley, Barclays Capital, JPMorgan, Citi, Deutsche Bank and Societe Generale as active OTC commodity derivatives counterparties. Goldmans dominated the business among financial investors in OTC commodity derivatives, with nearly 60% – including pension funds, retail banks and hedge funds – indicating they trade with the firm.

Morgan Stanley ranked second, both for market penetration and quality ratings. Both firms have had a longstanding commitment to trading OTC commodity derivatives, and both have relatively long histories in energy commodities. This established presence and the credibility it gave – along with the sheer sizes of their respective franchises – helped attract investors and companies seeking to hedge commodity exposures.

Around the world, commodities investors are most active in index swaps and plain vanilla non-index commodity swaps. Nearly 45% of investors participating in a Greenwich Associates survey this spring said that they invest in index swaps and 39% said that they use plain vanilla non-index commodity swaps. About a quarter reported using OTC commodity options and 21% said that they use structured notes with commodity underlyings. "In general, fund managers and pension funds are more likely to invest in index options, while banks are more likely to use single-commodity swaps and structured notes," Greenwich Associates consultant Woody Canaday said.

A Barclays survey of institutional investors revealed a trend towards mixing passive and active management when investing in commodities. Only 5% of survey respondents said they expect to be investing in commodities via passive long-only indices over the next three years, compared to 12% indicating they currently invest this way. These same respondents said their structured commodities product investment, which they pegged at 43% of their commodities investment in March, will probably come in at about 31% of their investment in commodities three years from now.

But growing concerns about counterparty credit risk are also driving changes in investors’ priorities. Limiting the concentration of exposure with a single counterparty is the most common method of reducing counterparty credit risk. Submitting transactions to an OTC clearing service is another approach being embraced by market participants. Total CME Group ClearPort futures and options volumes came in at 9.1m last month – 43% higher than September 2007. While ClearPort futures volumes were up 71% over the same period last year, options volumes on ClearPort were up just over 7%. Among other things, ClearPort lets market participants conduct transactions off-exchange, negotiate their own prices and take advantage of exchange clearing. The New York Mercantile Exchange launched ClearPort before it became part of CME Group.

Life after Bear

Since Bear Stearns’s collapse, many banks have tightened the margin and collateral requirements imposed on their trading clients. In general, clients have underestimated the costs of collateral to maintain hedges. The fact that more of clients' money can be tied up in larger collateral and margin requirements presents a new cash management challenge.

As many corporate clients still have real hedging needs which have not gone away, they have accepted the need for higher collateral requirements. However, there is a corresponding flight to quality, and clients are actively looking to trade with houses with strong balance sheets. “Credit worthiness has become a key criteria for clients. While trading volumes may be smaller overall, there is a distinct concentration of trading to a smaller population,” said David Silbert, global head of commodities at Deutsche Bank.

This year’s violent commodities price volatility meant many dealers spent a lot of time restructuring client books. For clients, the situation is complicated by increases in the cost of capital. "However, where an organisation [like Deutsche Bank] can really help is that clients with real assets and a need for capital can raise that capital through us through creative collateral management programmes," said Silbert.

The Chicago Board Options Exchange’s new crude oil volatility index (OVX) hit an intraday high level of 66.54 on October 7. The OVX or "Oil VIX” measures the market's expectation of 30-day volatility of crude oil prices. It applies the CBOE’s volatility index (VIX) methodology to options on the United States Oil Fund (USO), an exchange traded fund tracking the spot price of West Texas Intermediate light, sweet crude oil, less USO expenses.

In response to member concerns about heightened volatility in commodity futures markets, the International Organization of Securities Commissions earlier this month established a commodities market task force to explore the changing nature of commodities futures markets. The task force is being led by US Commodities and Futures Trading Commission (CFTC) and the UK Financial Services Authority. It will examine whether supervisory approaches are keeping pace with developments and if regulators are cooperating sufficiently to deal with the increasing globalization of the markets.

For its part, the CFTC last month released a series of recommendations aimed at increasing transparency and improving controls in the marketplace. The report was based on a survey of swap dealers and index traders that aimed to quantify key components of the OTC swap and commodity index markets. If the recommendations put forward in the report are put into place, dealers active in the US OTC energy market will face more onerous reporting requirements.

The CFTC report also contradicted the theory that huge sums of investor money have pushed energy prices higher. In its report, the CFTC found that during the first six months of this year crude oil prices rose 46%, but the number of futures contracts that would profit from higher oil prices held by index traders declined by 11%.

Lawmakers, most notably those in the US, have not taken these findings on board. US lawmakers have been busy trying to pass legislation to quell commodities volatility. Invariably, these efforts have been predicated on the idea that speculators have been driving up commodity prices.

Meanwhile, while commodity prices are still up for the year, price forecasts have been declining in many sectors.

Room for growth

“[Institutional investors’] level of knowledge has gone up so much that comfort [with the asset class] remains, no matter how the asset class is performing,” said Martin Woodhams, managing director and head of commodity investor solutions at Barclays Capital in London.

Over the next three years, 34% of respondents, surveyed at Barclays Capital’s annual commodities investor conference in March, said they expect to have more than 10% of their portfolios in commodities. Two years earlier, only 19% of attendees held that view.

Their reasons for investing in commodities have been relatively stable since Barclays started surveying commodities investors: the 2008 survey revealed that market participants view portfolio diversification as the most attractive aspect of investing in commodities. For 11% of attendees the key appeal of commodities was their inflation hedging qualities. The absolute performance of commodities was valued most by 30% of attendees.

For much of this year, high price levels have weighed heavily on market participants’ minds. About 65% of commodities investors surveyed at Barclays’ conference cited high price levels as their top concern when investing in commodities. A year earlier, only 43% held this view. Other issues – including capacity/liquidity (20%), transparency (10%) and the absence of roll yield (5%) – were mentioned as major concerns.

Commodities are an immature market relative to equities and bonds. In light of this, on the structuring side, dealers are focused on spreading into commodities sub-asset classes like carbon emissions credits.

Market participants are also looking past more traditional commodities sectors, such as energy and metals, for returns. Indeed, this shift was evident earlier this year. About 53% of commodities investors at Barclays’ conference said that they expect the agriculture commodities sector to produce the highest returns this year.