London, 1 September 2010

After a period of explosive growth in the past decade, the market for commodity derivatives is starting to look increasing mature, and set to expand much more slowly in the next few years. It is unlikely futures and options markets for oil and gas, as well as industrial metals such as copper and aluminium, will experience significant growth in the next 2-3 years.

Existing opportunities for expanding the use of derivatives as a tool for risk management and investment appear to have been fully exploited in oil and gas for the time being. Lack of volatility will limit interest in hedging and investment to existing market users among producers, consumers and pension funds, rather than favouring expansion to new participants.

Environmental markets also face a period of hibernation. Prospects for a nationwide cap-and-trade system in the United States have essentially died after Congress declined to take them up this year, and will recede further if the Republican Party makes significant gains in November's midterm elections.

Popular support for state-level initiatives is running into resistance as a result of the weakened health of the economy. Even existing programmes such as the Regional Greenhouse Gas Initiative (RGGI) and the long-established federal acid rain programme are struggling to overcome recent setbacks.

Internationally, efforts to negotiate binding emissions caps have stalled, and slow recoveries in the advanced economies have cut demand (and prices) for carbon dioxide and sulphur dioxide permits below projected levels and below the levels needed to make these markets attractive to either hedgers or investors.

For the next 2-3 years, growth will be concentrated in two sets of "frontier" markets:

(1) Niche commodities that do not correlate closely with macroeconomic variables and continue to offer diversification and opportunities for using specialist knowledge (livestock, grains, softs, minor metals).

(2) Bulk commodities where spot trading and derivatives are only just being developed (iron ore, alumina, freight).

MORE CONSOLIDATION

Slower growth points to further rationalisation among banks and dealing houses. There has already been some consolidation with the disappearance of commodity trading components of Bear Stearns (absorbed into JP Morgan), Lehman Brothers (absorbed into Barclays), and parts of Sempra Commodities (absorbed into JP Morgan). Several brokerages have recently announced plans to scale back or eliminate emissions desks.

Commodity dealing is now dominated by five major banks (Goldman Sachs, Morgan Stanley, Barclays Capital, JP Morgan, and Deutsche), as well as some second-tier houses, independent dealers (Cargill, Koch) and energy firms (BP, Shell, Centrica). Consolidation has lessened competition in some areas and enabled surviving players to lift margins during the recession.

But high-frequency trading (HFT) is making inroads in more liquid markets such as gas and oil and will inevitably compress dealing margins. In a slow growing market competition for vanilla trading business will intensify. Some further reduction in the number of major dealers and staffing levels is likely.

Slowing growth in the oil and gas businesses will mean a shift in emphasis away from the main energy desks towards those specialising in agriculture, minor metals, bulks and transport, where the returns from marketmaking and specialist knowledge are still much higher.

Until now, when most investors spoke about commodities, they really meant oil and natga. In future, trading and investing is likely to involve a more diversified range of contracts and raw materials, with a bigger emphasis on formerly neglected markets for food, construction products, transport and niche metals.

IT WAS QUITE A PARTY

Between 2000 and 2008, the number of actively traded futures contracts registered with the U.S. Commodity Futures Trading Commission (CFTC) rose five-fold from 266 to 1,521, while the volume of futures traded also increased five-fold from 580 million to 3.4 trillion, according to the CFTC.

Not all growth was linked to commodities; the CFTC also regulates derivatives on financial products such as foreign exchange. But commodity trading has also been growing outside the United States and the five-fold increase is probably a fair estimate for the growth in the commodity derivatives business worldwide in the eight years leading up to the crisis.

In one published study, the CFTC showed open interest in the flagship NYMEX light sweet oil contract growing from an average of 580,000 contracts in 2000 to 975,000 contracts by 2004 and a staggering 2.7 million by H1 2008 (Charts 1 andf 2 - download below).

Heightened interest in commodity derivatives was accompanied by more use of long-dated contracts and increased interest from non-traditional, financial players (hedge funds, banks and pension funds) as well as traditional users (producers, consumers and merchants).

Banks and dealers successfully matched energy producers and consumers fearful about rising and volatile energy prices with pension funds seeking to diversify equity-heavy portfolios and hedge inflation risks, and hedge funds seeking to take on exposure to a volatile asset class.

SLOWER GROWTH AHEAD

But it would be a mistake to assume commodity derivatives can continue to grow at the same pace over the next 2-3 years, at least in the case of the more mature markets such as crude and gas:

(1) Oil and gas prices have been lower and more stable over the last 12 months. Few if any analysts and companies now expect large price swings for the next 2-3 years ahead, as the supply situation is expected to remain comfortable. Pressure to hedge against sudden price variations has been reduced.

(2) Correlations between equity markets, crude oil and many other mainstream industrial commodities have risen sharply since 2008. Financialisation has reduced the usefulness of at least some commodity derivatives as a means of diversification.

(3) Demand for hedging and risk management may have reached its natural limits for now. The typical maturity profile of crude oil contracts lengthened from around 3 months to as much as a year between 2000 and 2008, but the increase in the maturity profile has ground to a halt since 2007-2008 (Chart 3).

While some analysts stress the importance of encouraging even more speculation to provide greater liquidity for long-term hedging, it is not clear whether there really is an "unmet need" for long-term price protection. Most hedging requirements are short-term (operational hedges against inventory or fixed-price sales) and do not need a maturity much above 12 months.

Longer term hedges may be needed for some investment projects (such as new mines located high on the cost curve). But few producers or consumers show much interest in multi-year hedging beyond 2-3 years forward. The financial cost is prohibitive and the opportunity costs of locking in at the wrong price too high.

In practice, demand for price risk management in the more mature commodity markets such as oil and natural gas looks like it is fully satisfied (Chart 4). Unmet demand is concentrated in smaller and less liquid markets for transport, bulk commodities and some agricultural and other niche markets. Formerly niche markets also offer much greater diversification for investors, so they look set to experience fast growth in the next 2-3 years.

In the longer term, commodity trading businesses are cyclical. Hedging and investment demand will eventually pick up as the economic and capacity cycle turns and price volatility picks up.

Large untapped markets will also gradually open up in China and elsewhere as state-controlled power and gas prices are liberalised.

In the meantime, though, commodity derivatives markets will adjust to a period of slower growth, one less focused on energy and more focused on other raw materials.

Ends --

By John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.

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