29.3.2011

By Sean Carnahan

Market watchers would be forgiven for thinking that commodities have broken out from the traditional wisdom of cyclical markets and are heading for the heavens. Anyone remember some guy called Gordon Brown taking a similar view on ending boom and bust market activity. Anyone remember him?

Investors and hedgers have bought into the received wisdom that commodity prices are only going in one direction – up – as part of a super cycle but with inclusive peaks and troughs.

But is a commodities super cycle really underway or are we actually in a normal cycle? And in which case, is the received wisdom wrong and could commodities prices start to fall in the short to medium term?

If markets are in a normal cycle as opposed to a super cycle, it is not inconceivable that commodities prices could start falling by the end of 2011. That scenario would have a major impact on any investor or corporates with an exposure to commodities.

Danske Bank analyst Christin Tuxen describes a super cycle as “the idea that scarcity of commodities combined with rising demand from emerging economies drive a cycle that supersedes the ordinary business cycle”.

The theory is based on the concept that emerging industrial superpowers such as China and India would drive an unprecedented bull market in commodities, which would last for years.

However, if commodities are indeed operating in a normal cycle, given the shallow nature of the recovery, it remains entirely possible that the market could be close to topping out.

One thing is for certain: there is clearly a level of speculative froth that has quickly reformed following the recent financial crisis. That can be explained by the investor’s mindset and need to generate returns from speculative trading.

With the global recovery anaemic at best, why is it that both commodity and energy prices recovered so swiftly? And what if concern about the long-term value of all currencies is effectively pushing investment into everything else, with commodities like gold, oil and other minerals in the front line?

It seems unthinkable, but then so do many investment scenarios until they actually happen. And what about the flip side that a commodities bubble has been created which could even derail the fragile recovery?

Analogous to the early noughties dotcom bubble and the notion that house prices would always go up, the super cycle theory for commodities started to weaken when prices fell off a cliff in late 2008.

By December of that year they were at decade-lows. Indeed, closer examination reveals that the fall in the price of metals such as zinc and copper was greater than the slump during the late 1920s/early 1930s.

But, as is the case with the cycle, since then commodity prices have once again started to hit the high notes, with the S&P spot commodities index up 30 per cent on the year. Oil was about 40 per cent of the weight in the S&P index and drove the broad pattern. The commodity price index rose very sharply with the trading volume of the commodity derivatives market and peaked in July 2008 when oil prices peaked.

It then fell sharply through the second half of 2008 while gold was much less volatile, with no unusual rise in the trading volume of gold derivatives. The commodity price index and trading volume of commodity derivatives then grew rapidly, while the trading volume of gold derivatives was relatively flat, and the commodity price index started falling ten weeks before the Lehman bankruptcy.

Billions of new customers
The super cycle theory is partially based on the narrative that billions of additional consumers from China and India have joined the global market over the past two decades and this is a massive pressure on world resources.

This is a macro economic outlook. It would be hard to argue with this point, were it not for the lessons of history and the ebb and flow of market forces, which have caught investors out time and
time again.

All eyes now remain on China and the dramatic growth taking place across Asia and emerging markets. The sheer size and scale of everything China produces and consumes is spearheading the emerging markets boom, while strong trade data from the region is boosting optimism about the global economy.

Experience tells us that commodity prices are inherently cyclical.
Firstly, governments and firms rather have a tendency to plan poorly and underinvest in mining and production when commodity prices are low. This leads to prices spiking disproportionately when demand does pick up, then falling away again when supply outstrips demand.

Those looking to hedge commodity prices need to be more creative than submitting to a linear price lock-in. Buyers need to ‘create the space’ to benefit from future falls in commodity prices.

And we do mean ‘falls’ because, as already discussed, the super cycle or economic cycle commodity prices rise at the start and then fall as production exceeds demand. This requires a combination of skill and access to the right tools and instruments to create that space and hedge effectively.

What does this mean when managing commodity risk?
For investors who are long, beware. This isn’t a one-way street and they should think about locking in some protection. Corporates who supply commodities need to think about locking in current prices and lengthening the terms of their hedges choices.

For corporates who buy commodities, start to transition from linear hedges to strategies that give you protection against future price rises but also allow you to benefit from falling prices. We believe the option premium will be worth it over time.

According to a recent survey of manufacturers, over 80 per cent of senior executives said commodity price risk is important to a company’s financial performance, adding that commodity risk was not managed well during the past two years.

Companies try with varying levels of success to apply margin management, procurement strategies and hedging solutions to help them manage commodity price risk and their exposures.

Investing professionals and corporations need to focus on ensuring they have calibrated tools and pricing mechanisms to manage their exposures and risk associated with handling these instruments.

The key to managing exposure and risk within the commodities super cycle is to employ the optimum tools, data and analytical capabilities to manage both the spot instruments and related hedging instruments, such as OTC derivatives based on commodities.

Commodity risk management
SuperDerivatives is one of a number of suppliers offering an independent suite of tools and independent data to manage commodities risk through pricing, revaluation and distribution of OTC commodities data and pricing.

The system is based on a unique methodology which covers over 80 instruments across more than 100 underlying assets, ranging from oil and refined products and natural gas to electricity, agriculture, precious metals, base metals, emissions, livestock and freight.

This includes a range of analytical capabilities including real-time volatility surfaces allowing one-click pricing, advanced charting tools, a full historical database for market closing prices, sophisticated graphing tools, single- and multi-leg solvers and term structure for up to ten years.

This means that users can correlate commodities vs commodities and currencies vs commodities and use these correlations to price, analyse and re-use options on baskets of commodities.

The company also delivers a number of unique features, including an intuitive custom-strategy builder, automated creation of customisable trade idea term-sheets, hedging-oriented simplified display-mode, easy permission-based sharing of structures and portfolios, and seamless integration of client market data.

Whichever strategy company uses, it is important to remember that even within a supercycle that you do not get caught out by the troughs and peaks of the marketplace.

Case study: Airlines
Trading institutions have effectively contributed to the upward pricing of crude commensurate with the depreciation of the US dollar in order to offset the erosion of the currency.

This large price hike has disadvantaged US buyers in this cycle relatively more than their foreign counterparts since the relative strength of their currencies has cushioned them partially from the dollar increase in crude oil prices.

Beyond the price of crude oil, the price of jet fuel has also risen sharply. This means that airlines have to make effective financial risk management a primary concern.

Airlines need to closely examine their risk management techniques to protect their bottom-line profitability. Deploying an effective hedging programme that helps stabilise costs for an airline and at no time is this more critical than at the inflexion point of a cycle.

Risk management should be treated as a dedicated operation combining all of the company’s exposures.

So what is an airline to do in this profit-eating jet fuel price environment? The answer is to hedge effectively and to manage the process with precision using tailored tools, namely OTC derivatives.

Given the strong historical relationship in price movements between WTI and Jet Fuel Los Angeles, the implication is that jet fuel prices will also remain at these high
price levels.

If prices were to rise further, then the cost of hedging for the airline would be even greater. The impact of higher prices on volatility and the deteriorating creditworthiness of the airline as a counterparty would make hedging more expensive than today.

There are a number of instruments which airlines can use to hedge their jet
fuel exposure.

The benefit of executing OTC-traded instruments in particular is that they are both easier to tailor to the airline in question and can be more cost-effective to employ.

Swaps protect the airline from price fluctuations. However, should the spot price decline during the contract period, the airline risks paying more for its supply since the swap contract precludes it from participating in downward price movement.

Meanwhile, call options allow an airline to protect itself against a market price increase. However, firms must pay an initial premium to use such a strategy. Firms must also consider the market volatility levels when choosing to buy caps.

Collars, like caps, protect the airline from an increase in jet fuel prices. However, the airline cannot benefit from price declines below the minimum purchase price. Collars can be structured so that the payment of an upfront initial premium is not required. A collar can also be undertaken as a cost transaction.

Basis options and basis swaps can also be used as part of the hedging. Airlines hedging fuel prices are exposed to spread risk as there are no exchange traded jet fuel contracts.

This means that airlines tend to use a proxy as the underlying for their hedge of jet fuel. Oil contracts are well known to be correlated with jet fuel prices. To avoid exposure to spread risk, airlines are using more tailor-made, OTC instruments such as basis swaps and basis options.