London, 9 March 2010

Plans to develop volatility indices for contracts such as U.S. crude oil, corn and gold, announced last week by the CME and CBOE, illustrate how quickly commodity markets are changing in response to investor demands for more sophisticated and effective strategies that avoid directional strategies and roll losses. No one ever made money consistently from directional trading -- especially the long-only, buy-and-hold approach recommended to institutional investors using well-known commodity benchmarks such as the Standard and Poor's- Goldman Sachs Commodity Index and Dow Jones-UBS Index.

For some years, it has been clear first generation investment strategies such as passive indices would not make money in the long term. So the industry has been preparing second-generation strategies (repositioning investors further along the curve and allowing them to take positions in the spreads) as well as third-generation products (allowing customers to trade volatility rather than take directional positions).

Well-publicised investment losses caused by the persistent contango in oil and many other commodity markets over the last four years have accelerated the deployment of these more complex and sophisticated strategies. The new CME/CBOE tradable volatility benchmarks are merely one example of a broader trend as investors move away from the passive long-only approach that has dominated since 2004.

Losing Money

The basic problems bedevilling directional strategies, especially long-and-hold, are familiar, but worth restating: (1) Commodity futures do not produce an income stream for their owners. Investors do not automatically receive a yield for being long -- unlike the dividends, coupons and interest paid to owners of equities, bonds and loans. In fact, the yield is generally negative as futures owners pay to avoid the cost of storage and financing the physical commodity.

(2) Some researchers have suggested index investors can capture a "risk premium" embedded in futures contracts. But if there was ever such a premium, it has long since evaporated as the indices have become increasingly popular and the trade has become more crowded.

(3) Commodity prices exhibit strongly cyclicality and, over long periods, tend to be mean-reverting after adjusting for inflation. Price movements over the past century indicate there is no natural tendency to appreciate in real terms. Investors do not automatically gain from a passive position on the long side of the market. Paraphrasing the Book of Ecclesiastes, there is a time to be long and a time to be short.

(4) Predicting prices is notoriously difficult. Even the most skilled forecasters have a mixed track record. Periodic successes have been punctuated by notable failures. There is some evidence that trend-following strategies accompanied by strict filters can produce positive returns above the yield on "risk-free" Treasury bills. But most of those returns are captured by the fund managers in the form of management and success fees, according to research, leaving little or nothing for the investors who provided the capital in the first place.

No one ever saw a poor bookmaker, but placing sporting bets is not generally recommended as a way of making a living, unless you have inside information. For other investors, the challenge is to become more like the bookmaker and capture some of his profits.

Making Money

The betting analogy is apt. Substantial profits reported in recent years by commodity traders such as Goldman Sachs, Morgan Stanley and Barclays Capital demonstrate there is plenty of money to be made in commodities. But little of that is derived from directional trading. Most is earned from providing ancillary services (brokerage, trade execution, market-making, and storage) and comes in the form of fees, commissions, bid-ask spreads, option premiums, interest on embedded loans, and playing the contango to benefit from access to cheap storage and financing.

It is little wonder that big banks and trading companies are now rushing to acquire warehousing, storage and logistics businesses, confirming just how profitable these ancillary services can be.

Goldman Sachs last month announced plans to acquire the U.S.-based warehouse and logistics firm Metro International Trade Services. Commodity trader Trafigura this month acquired LME warehousing company NEMS. Warehousing company Henry Bath is one of the most profitable and attractive components of the Sempra Commodities businesses being bought by JP Morgan.

Goldman and Morgan Stanley already have substantial physical and logistics businesses. According to its filings with the SEC, Morgan Stanley engages in production, storage, transportation, marketing and trading of several commodities including industrial metals, farm products, crude oil and refined products, natural gas, electricity, coal, freight and LNG.

And in the United States, investing in Master Limited Partnerships (MLPs) owning gas and oil transportation pipelines and storage facilities has become increasingly popular,

attracting more than $150 billion worth of funds, generally paying high yields, averaging 7-8 percent per annum, according to one promoter.

None of these is a directional strategy (at least not directly). The smart money is not betting on whether the price of oil or copper rises or falls by $20 or even $50 (which is too hard and too unreliable to be a good way of making money). Instead, these institutions are positioning themselves in the general flow of funds from producers, consumers (hedgers) and investors (speculators), and skimming some of it off by facilitating trading and storage.

New Strategies

To have any chance of making money in the long run, investors need to adopt something of the same approach. The most basic strategy enhancement, used by providers such as the Deutsche Bank Liquid Commodity Index, has been to offer index investors are more dynamic roll procedure that adapts to changes in the structure of forward prices to maximise the benefit from rolling in backwardation while minimising the cost of rolling in contango.

More profound changes give investors some degree of "active" management by taking long positions only in selected commodities, or even becoming fully active and taking both long and short positions, to benefit from differences in cyclical behaviour or market structure.

SummerHaven Investment Management, which numbers among its senior staff pioneers of the passive commodity index movement, has now launched a dynamic index reweighted each month, picking 14 commodity futures from a basket of 27

MLPs and investments in oilfield and mining services companies are an increasingly attractive and common approach to benefiting from the commodity sector without taking a short-term directional position on prices.

Third Generation

New volatility benchmarks planned by CME and CBOE, modelled on the VIX benchmark for volatility in the S&P 500 equity index, take this evolution further, bringing the market into the realm of third generation commodity products. They will allow investors to buy and sell volatility itself rather than take a directional position.

A significant part of investment bank earnings in commodities comes from buying and selling volatility in exchange for option premiums. Planned new benchmarks will allow ordinary investors to participate in these markets directly (at least to a limited extent) as well as allowing the banks to lay off positions more easily.

The proliferation of dynamic roll strategies, mixed longshort funds, and now the launch of volatility indices, suggests commodity markets are maturing. They offer investors a more attractive suite of options for participating.

But it will also have a profound impact on the way markets trade. The old long-and-hold approach created an upward ratchet effect on commodity prices. The wider range of strategies now being marketed holds out the promise of adding to market liquidity and depth without creating the same distortions.

Ends --

John Kemp, Reuters columnist - for Commodities Now

The views expressed are his own