London, 2 September 2010

As investors focus on frontier commodity markets in the search for superior returns, the explosive rise and sudden collapse in cocoa prices this summer should serve as a warning about the problem of managing large positions in markets with limited liquidity.

While there are still two weeks to run until the September cocoa contract expires on NYSE Liffe, fears of a shortage have vanished after putting an enormous premium into nearby prices just a few weeks ago.

In the space of six weeks, prices for the September contract have fallen 17 percent, or 394 pounds per tonne. For the first time yesterday, front-month September cocoa moved to a small discount (3 pounds) to next-to-deliver December.

Six weeks ago, September was trading at a premium of almost 170 pounds . For the first time since May, the cocoa market yesterday moved into a contango structure throughout the length of the forward curve.

Favourable weather conditions in West Africa and prospects for a good crop, as well as lingering concerns about regulatory intervention following complaints by cocoa processors, have caused the former tightness to evaporate as quickly as it began [Download chart below].

GREATER LIQUIDITY RISKS

Niche markets such as cocoa, wheat, coal and freight have become increasingly attractive to both hedge funds and pension funds. While most markets show a marked increase in correlation with equities over the last three to four years, their correlation levels remain far below those observed for crude oil. Frontier and niche markets are less driven by financial investment and offer investors more exposure to commodity-specific uncorrelated returns.

But diversification comes at a price. Most of these markets remain small and the amount of liquidity is limited. For them to offer useful diversification, hedge funds and pension funds need to take on substantial exposures running into tens of millions, if not hundreds of millions of dollars.

In some cases, that may lead to a position that is a substantial fraction of the total market or to the position holder essentially becoming the market itself. Past experience has repeatedly shown that participants with a large position find it difficult to adjust or extricate without moving prices against themselves -- as Metallgesselschaft Refining and Marketing (MGRM) found when it effectively became the oil market in 1993 (and announced losses of $1.5 billion) and JP Morgan found earlier this year with reported losses in coal.

Becoming the market can be phenomenally profitable for a while if a genuine physical shortage or surplus then provides a convenient way to liquidate the accumulated stock of physical and futures positions. But it is perilous if expected conditions fail to materialise -- what one leading trader recently described as a "rookie" error.

SHORTER PRICE CYCLES

Markets for grains, livestock and softs are also more exposed to short-term volatility resulting from the weather and have much shorter lead times for bringing on new production than the energy and mining sectors.

The ability to time entry and exit precisely and obtain enough liquidity to minimise slippage are therefore critical. Slippage is usually defined as the difference between the price at which a trader starts to liquidate (or accumulate) a position and the average price at which all the orders are executed. It can be a measure of how much the trader moves the market against himself.

The tremendous performance of futures contracts for grains (wheat, soy and corn) and livestock (cattle and hogs) during June and July, driven by drought conditions and poor harvests around the Black Sea and other regions, plus hopes for longer-term gains linked to growing global consumption, and BHP Billiton's related bid for Potash Corp of Saskatchewan, will keep investor interest in the grains and livestock sectors high.

But the setback in cocoa prices and spreads should serve as a warning that price cycles for agricultural markets and some other niche commodities can be short and violent, tripping up even experienced traders. Picking the right time to get out and take profits is just as important as spotting potential shortages, even more so than in the bigger markets such as oil.

For early entrants, frontier commodities offer superior returns but also more volatility and greater liquidity risk.

Ends --

By John Kemp, Reuters market analyst - for Commodities Now

The views expressed are his own.

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