London, 29 September 2011: Reuters

The LME industrial metals are currently showing their "wild" side, registering huge intraday movement and historically high levels of volatility. This is not new, as my colleague John Kemp has pointed out. Commodity markets have always been prone to sudden shifts from well-behaved volatility to a "wild" state and back, to coin the expression used by French mathematician Benoit Mandelbrot. Indeed, with the benefit of that most useful of analytical tools, hindsight, the current bout of wildness can be at least partially explained both in terms of trigger and mechanics.

The problem is that investor strategies are shifting to accommodate this volatility, a development that risks bringing with it ever more frequent bouts of wildness.

A ONE-DIMENSIONAL NARRATIVE

As ever with the LME industrial metals it is copper that offers the greatest insight into what has changed since the current rout started last Thursday. Prior to then, three-month copper had been trading sideways around the $9,000 per tonne level. This, let us remind ourselves, is a very high price level by any historical yardstick.

Graphic on copper market volatility

The narrative constructed into that price was appealingly simple. It was predicated first and foremost on supply or rather, in copper's case, the lack of it. The well-documented combination of low ore grades at many of the world's biggest mines and systemic disruption due to labour unrest led most analysts to believe that global mine supply growth would be close to zero, maybe even negative, this year.

On that basis any demand-side growth, however sluggish, could mean only one thing, namely a deficit market, a drawdown on already low stocks and higher prices. The only issue was one of timing with China, the world's largest buyer of copper, stubbornly refusing to play to the script and aggressively de-stocking rather than sucking in more metal.

Bull believers were undeterred, arguing that after almost a year the de-stocking cycle was fast approaching an end, meaning previously hidden market deficit would become tangible deficit in the form of draws on visible exchange stocks. It was a one-sided narrative since by its nature it focused far more on the supply side than the demand side.

The upshot was a collective denial that slowing global growth could derail prices. Indeed, until very recently some analysts were bemoaning the macro "noise" that they felt was interfering with the supply-defined "bullish" narrative for copper.

Moreover, apparently forgetting what happened to the risk assets universe in the tail end of 2008, too few, if any, commentators factored in what renewed stress in the wholesale funding markets would mean. This is particularly relevant to the LME-traded metals.

Since the LME is not cash-cleared but rather structured as a forwards market, it is as much about credit as metals. Copper demand may be partly immunised from renewed recession in the euro zone just as long as China keeps growing but trading the stuff on the LME is directly affected by the credit market stress caused by the prospect of eurozone default.

WARNING SIGNS

What triggered the collapse in copper and other base metals was the steady accumulation of negative macro "noise" to the point that the previous bull narrative collapsed. And there were warning signs that if it did, it was always going to be a wild affair.

One of the little-noted features of the copper market in recent months was the emergence of a volatility "skew" in the options market. In essence the options market was placing a premium on downside exposure (puts), reflecting the steady accumulation of open interest on options such as the December $8,000 strike (10,495 lots).

It was a signal of market-maker nervousness about the likely ramifications of a sudden dramatic downside move. Those $8,000 put options, for example, were safely "out of the money" when copper was trading at $9,000. But as the price fell towards that level, selling by options delta hedgers added to the downside momentum.

Incidentally, that options-derived momentum works both ways. If copper were to accelerate back up to the $8,000 level, options players will unload their delta cover, again exacerbating the underlying move.

Another warning sign came from the collective positioning of the "black box" CTA traders, who feed off technical signals, most pertinently momentum. Fund-watchers on the LME estimate the systematic community went from collective long to collective neutral some time in early August.

It then started to shift into collective short territory around the middle of last month, meaning that it was poised to capitalise on any downside acceleration. Collective CTA selling on last Thursday's break lower fuelled market momentum, which in turn triggered more selling from the momentum-trackers.

Over the course of the last week the CTA systematic community has lifted its short exposure from around 50 percent of effective capacity to somewhere close to 100 percent. In tonnage terms that's equivalent to around 700,000 tonnes of sales. In other words wildness created more wildness, both from options delta-hedging and from systematic momentum trackers.

MORE WILDNESS PLEASE?

Both parts of the wildness mechanics are "known knowns" in the LME market-place, although they are both easy to forget when the market is being "well behaved". What is a "known unknown" is to what extent other bigger investors are now also seeking to exploit bouts of market wildness.

At last week's S&P GSCI Commodities Seminar speaker after speaker lined up to argue that passive investment in commodities has run its course. A new generation of indexes with enhanced roll strategies may have helped eliminate some of the negative roll problems that have undermined index performance in recent years.

But that doesn't address the two bigger issues facing institutional investors with passive long exposure. Negative correlation with other asset classes, a foundation stone of the whole commodities-as-investment-class theory, has been conspicuously absent in recent months.

And being passively long doesn't do the investor much good when commodity prices stop rising and start falling. As analysts at Barclays Capital noted in their September issue of "Commodity Cross Currents", passive indexes performed well last year, when commodities were generally rising across the board.

But they have been the worst sector performers this year, which has been characterised by increased volatility and high degrees of divergence between individual components of the indexes.

Barclays' advice to institutional investors is to get more active, incorporating strategies that try and exploit movements in spreads, the shape of forward curves and indeed outright direction. It is not alone. Other big investment banks are urging the same, layering active management over passive positions, or, to use the fund industry's terminology, mixing alpha with beta strategies.

Panellists at last week's seminar, most of them from the asset management side of the banking business, mused on whether a natural progression for commodity markets would be to use some of the tool-kit available in other asset classes such as momentum and volatility strategies.

Which starts to sound a lot like the way the systematic CTA community views market "wildness" as a way of generating profits. If the previously passive investment sector decides to take a walk on the wild side, it will do so with huge fire-power.

BarCap estimates total index investment in commodities at the end of June totaled $157 billion. The clear danger is that such weight of money becoming active will only accentuate commodities' existing "wild" side.

Ends --

By Andy Home, Reuters market analyst – for Commodities Now.

The views expressed here are his own.