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“Intelligent Commodity Trading and Risk Management” A Presentation Co-sponsored by PRMIA-Chicago, CAIA-Chicago, and the Arditti Center for Risk Management, DePaul University June 30, 2011 Ms. Hilary Till, Principal, Premia Capital Management, LLC; Fellow, Arditti Center for Risk Management, DePaul University; Research Associate, EDHEC-Risk Institute; Steering Committee Member, PRMIA-Chicago; and Member of the Commodities & CTAs Curriculum Committee, CAIA Association Disclaimers • This presentation is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities or other financial instruments. • The opinions expressed during this presentation are the personal 1929 stock certificate for crude-oil-development company in Alberta, opinions of Hilary Till and do not Canada. necessarily reflect those of other organizations with which Ms. Till is affiliated. • Any (inadvertent) errors and omissions are the responsibility of Ms. Till alone. 2 Commodity Futures Trading & Risk Management * I. Commodity Speculation II. Risk Management III. Commodity Product Innovations * For an article based on this presentation, please see: Till, H., 2011, “Intelligent Commodity Trading & Risk Management,” Commodities Now, http://www.commodities -now.com, March, pp. 63-68. Icon above is based on the statue in the Chicago Board of Trade plaza. 3 I. Commodity Speculation A. Historical View B. CFTC Data C. Prices and Futures Positions D. Comparison to Fundamental Factors 4 A. Historical View Holbrook Working’s Four Conditions for a Futures Market to Survive and Prosper 1. The contract terms and commission charges must be such as to attract appreciable use of the futures contract for merchandising purposes. 2. There must exist a possibility of attracting enough speculation to provide at least a reasonably fluid market. Source: Working (1970). 5 A. Historical View Holbrook Working 3. Handlers of the commodity must have reason to make substantial use of the futures contracts as temporary substitutes for merchandising contracts that they will make later. 4. There must exist adequate public recognition of the economic usefulness of the futures market. Source: Working (1970). 6 A. Historical View University of Illinois Research: Is There Excessive Speculation in the Agricultural Futures Markets? • While the increase in long-only speculation has received the most publicity, the increase in the size of short hedging positions is equally interesting. • Agricultural futures contracts have not had a historically high level of speculative (vs. hedging) activity, based on Working’s Speculative T index. Source: Sanders et al. (2008). 7 B. CFTC Data Disaggregated Commitments of Traders Report • The T index is a traditional metric for evaluating the balance of speculation-versus-hedging in a futures market. • With the 2009 release of additional CFTC data, one can calculate the T index for the U.S. oil exchange-traded futures-and-options markets. • One can examine the historical agricultural This EDHEC‐Risk Position Paper on Excessive Speculation is available futures markets as a guide to the typical balance at: http://www.edhec‐risk.com. of hedging-versus-speculation over many decades. Source: Till (2009a). 8 B. CFTC Data US Oil Futures Markets • Based on this traditional speculative metric, the balance of outright speculators in the NYMEX oil futures markets does not appear excessive relative to commercial hedging needs. Source: Till (2009b). • See next slides for other related research. Source: Till (2009a). 9 C. Prices and Futures Positions Managed Money and Swap Dealer Positions Oil Prices and Futures Positions Weekly Data, June 2006 through October 2009, Positions are for Managed Money and Swap Dealers, Futures Plus Options 250,000 $160 $140 Oil Prices 200,000 Net Positions $120 Price in $ per Barrel $100 150,000 Contracts $80 100,000 $60 $40 50,000 $20 - $- Jun-06 Jun-07 Jun-08 Jun-09 Managed Money and Sw ap Dealer Futures-and-Options Positions Front-Month NYMEX Oil Futures Price Graph Based on Ribeiro et al. (2009), Chart 1. Source: Ribeiro et al. (2009). 10 C. Prices and Futures Positions Oil Prices: The True Role of Speculation • “… we would say that alert futures traders, who noted that both the heating-oil crack spread and the Baltic [shipping] indices were successively peaking in the late-May-to-late-July period, had a number of warning signs that a fundamental source of demand for oil appeared to be diminishing in short order.” Source: Amenc et al. (2008). This EDHEC-Risk Position Paper on Speculation is available at: http://www.edhec-risk.com. Source: Till (2008b). 11 C. Prices and Futures Positions Oil Prices: The Actual Impact of Speculation Hypothesized Direction of Causality Price Changes lead Position Position Changes lead Price • “[T]hese tests are consistent Trader Classification Changes Changes Direction Significant? P Value Direction Significant? P Value with the view that current oil All Commercials (includes Manufacturers, Commercial + Yes .000 - No .418 Dealers, Producers, Other prices are being driven by Commercial Traders, and Swap Dealers) fundamental supply and Manufacturers Commercial Dealers + + Yes Yes .000 .000 - - No No .225 .130 demand factors.” Producers Other Commercial + - Yes No .036 .623 - - No No .160 .918 Traders Swap Dealer - Yes .001 - No .582 All Non-Commercials (includes Hedge Funds, - Yes .000 - No .451 Floor Brokers & Traders) Hedge Funds - Yes .000 - No .510 Floor Brokers & - No .683 - No .351 Traders Non-Registered - No .873 - No .575 Participants All Non-Commercials combined with Swap - Yes .000 - No .251 Dealers Source: Buyuksahin, B. and J. Harris, 2008, “Do Speculators Move Crude Oil Prices?”, CFTC‐Office of the Chief Economist, Working Paper, Fall. The study uses daily data from January 2003 to October 2008. Source: ITF (2009). 12 D. Fundamental Factors Aggregate Demand Growth • When “analyzing two very distinct commodities – crude oil and fine wine …” • … two International Monetary Fund researchers find that there are common macroeconomic factors, which “are the main determinants of commodity prices.” • “Although supply constraints have the expected effect, aggregate demand growth is the key factor.” [Italics added.] Source: Cevik and Sedik (2011) as cited in Till (2011). 13 D. Fundamental Factors Aggregate Demand Growth • For both crude oil and fine wine, “… advanced economies account for more than half of global consumption [while] emerging economies make up the bulk of the incremental change in demand, thereby having a greater weight in commodity price formation,” which in turn “is a recent phenomenon.” • That said, “global excess liquidity … is likely to have magnified the price pressures stemming from supply/demand imbalances.” • See next slide. Source: Cevik and Sedik (2011) as cited in Till (2011). 14 D. Fundamental Factors Crude Oil and Fine Wine Prices Nominal Prices (Jan 1998 to Jun 2010) (Index, December 2003=100) 500 450 400 350 300 250 200 150 100 50 0 Jan-98 Jan-02 Jan-06 Jan-10 Monthly Data Oil prices Wine prices Data: Spot price of crude is measured by the monthly average price of Brent and West Texas Intermediate. Monthly Fine Wine prices are measured by the Liv-ex Fine Wine Investable Index. Graph Based on Cevik and Sedik (2011), Figure 1. 15 II. Risk Management A. Institutional Risk Management B. Proprietary Trading Risk Management C. Hedge Fund Risk Management D. Fund-of-Hedge-Funds Diversification E. Market Risk Management F. Due Diligence G. FCM Monitoring Based on Till (2008a). 16 A. Institutional Risk Management Case Study Lessons • Establish clear-cut compliance and ethics programs, not just for the trading staff but also for senior management. • Always get your marks from large, legitimate, established brokers, publishers, or exchanges. • Ensure that one’s trading activity is diversified across more than one broker. • Impose strict position limits in all electronic trading systems. Source: Till (2008a). 17 B. Proprietary Trading Risk Management Types of Risks • The risk of personal bankruptcy is sufficiently large that a complex system of controls and incentives becomes a moot point. • The main risks are structural breaks in empirical regularities. Rembrandt’s Storm on the Sea of Galilee, Isabella Stewart Gardner Museum, Boston, and Cover of Against the Gods: The Remarkable Story of Risk by P. Bernstein, (New York: John Wiley & Sons), 1996. Source: Till (2008a). 18 C. Hedge Fund Risk Management Types of Risks • Hedge funds are a hybrid of an institutional asset-management firm and a proprietary trading firm, depending on how much of the principals’ wealth is at risk. • For large-scale hedge funds, operational risk issues are what is paramount. Source: Till (2008a). 19 D. Fund-of-Hedge-Funds Diversification Diversification of Idiosyncratic Risks A fund-of-funds can potentially dampen the sharp peaks-and-troughs in profitability of individual managers, as demonstrated in Akey (2007). • Even with this in mind, each individual manager should take steps to keep their market risk within well- understood bounds. Source: Till (2008a). 20 E. Market Risk Management Elements of Commodity Risk Management • Trade construction • Sizing • Exit strategy • Scenario analyses This EDHEC‐Risk Position Paper on • Choice of leverage level Amaranth is available at: http://www.edhec‐risk.com. Source: Till (2008a). 21 F. Due Diligence Business Risk • Business Inexperience • Loss of Information Edge • Unverifiable Track Record • Fraud Source: Akey et al. (2006). 22 G. FCM Monitoring FCM Financial Monitoring • The CFTC monitors financial data for FCMs and provides this information on their website. Financial Data for Futures Commissions Merchants Futures commission merchants (FCMs) must file monthly financial reports with the CFTC's Division of Clearing and Intermediary Oversight within 17 business days after the end of the month. Selected financial information from these reports is published below. The most recent month-end information generally is added within 12 business days after FCMs file their reports, but occasionally may be added later. For example: The 17th business day filing “due date" for February 28, 2009 financial reports was March 24, 2009. The 12 business day target for posting these data was April 9, 2009. Once posted, the CFTC does not revise this information to reflect any amended financial information subsequently received. Description of Report Data Fields 2009 November 30, 2009 PDF Excel October 31, 2010 PDF Excel September 30, 2009 PDF Excel August 30, 2009 PDF Excel Historical FCM Reports Source: http://www.cftc.gov. 23 III. Product Innovations A. Commodity Indices B. Commodity Structures C. Commodity Investor Concerns 24 A. Commodity Indices Enhancement of Traditional Indices • Commodity-index providers have created next-generation indexes, which attempt to methodically provide exposure to spot commodity prices while minimizing the carrying costs of such investments, particularly in the energy sector. Source: Till (2007). 25 A. Commodity Indices Beta • Choice of index: given that the driver of returns could be spot returns (and not roll returns), going forward. Backwardation: Contango: Crude Oil Curve February 2004 Crude Oil Curve February 2007 Crude Oil Price Curve: February 2004 Crude Oil Price Curve: February 2007 37 65.5 65 35 64.5 64 33 63.5 63 P rice 31 Price 62.5 62 29 61.5 61 27 60.5 60 25 59.5 59 Se 4 S e 05 S e 06 Se 7 Se 8 Se 9 S e 10 M 4 M 5 M 6 M 7 M 8 M 9 10 -0 -0 -0 -0 0 0 0 0 0 0 - - - p- p- p- p- p- p- p- ar ar ar ar ar ar ar 7 8 9 0 1 2 7 8 9 0 1 2 r- 0 r- 0 r- 0 r- 1 r- 1 r- 1 -0 -0 -0 -1 -1 -1 M ct ct ct ct ct ct Ap Ap Ap Ap Ap Ap O O O O O O Date Date Source of Data: The Bloomberg. 26 [Price is in dollars per barrel.] B. Commodity Structures Commodity-Linked Notes • The SEC website, EDGAR, shows the latest commodity-linked notes issued by the money-center banks. [EDGAR stands for the “Electronic Data Gathering, Analysis and Retrieval” system.] Source: EDGAR [http://www.sec.gov/edgar.shtml]. 27 B. Commodity Structures Exchange-Traded Funds (ETFs) • Last year, for example, the first U.S. platinum and palladium ETFs were launched, giving US investors easier access to these metals for large-scale direct investment. (Reuters, 1/7/10) 28 C. Commodity Investor Concerns Proxies for Oil Investment (12/31/08 to 12/31/09): • Canadian dollar vs. US dollar: +15.72% • Norwegian Krone vs. US dollar: +20.03% • S&P GSCI All Crude Index Total Return: +13.15% • Rolling Front-Month Crude Oil Futures Contract: +77.94% • Exxon Mobile Corporation Total Return (Dividends Reinvested): -12.60% Source of Data: The Bloomberg. 29 C. Commodity Investor Concerns Proxies for Oil Investment (12/31/09 to 5/31/11): • Canadian dollar vs. US dollar: +8.75% • Norwegian Krone vs. US dollar: +4.90% • S&P GSCI All Crude Index Total Return: +18.25% • Rolling Front-Month Crude Oil Futures Contract: +29.41% • Exxon Mobile Corporation Total Return (Dividends Reinvested): +27.17% … BP Total Return: -17.53% Source of Data: The Bloomberg. 30 C. Commodity Investor Concerns Proxy for Commodities: Canadian Dollar • Using quarterly data, “As regards the most recent appreciation of the Canadian dollar between 2002 and 2007, the two common factors [i.e., commodity prices and the relative fiscal position of Canada and the U.S.] together explain more than 60 percent of the appreciation in the Canada-U.S. exchange rate. • “Of this rise, the U.S. [debt-related] factor … explains about 50 percent, while commodities explain the other half.” Source: Cayen et al. (2010) as cited in Till (2011). 31 C. Commodity Investor Concerns Proxy for Commodities: Canadian Dollar Debt-to-GDP Ratios: Relative to the United States Quarterly Data 1970 to 2008 40 30 20 10 0 -10 1970q1 1973q2 1976q3 1979q4 1983q1 1986q2 1989q3 1992q4 1996q1 1999q2 2002q3 2005q4 Canada Graph Based on Cayen et al. (2010), Figure 5. 32 Conclusion Outlook • Barclays Capital noted that the reasons to still be constructive on commodities were as follows: – The historically positive Inflows into Commodities impact of negative real (in Billions of US Dollars) interest rates on 80 70 Medium-term notes commodity prices; 60 50 Exchange traded products Index sw aps – The long-run 40 30 diversification benefits of 20 commodities, and 10 0 -10 – The potential of -20 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 geopolitical risks to skew Graph Based on Norrish and Sen (2011), Figure 1. commodity prices to the upside. Source: Barclays (2010). 33 Conclusion Outlook • Deutsche Bank notes that the commodity sector’s appeal reflects investor appetite… – to gain exposure to emerging markets, – to hedge against tail events, and – to hedge against possible higher inflation ahead. Source: Lewis (2011). 34 Conclusion Performance Update Across Diverse Commodity Indices & Strategies SPGSCI: S&P 500 Goldman Sachs Commodity Commodity Index Returns Quarter to Date Index DBLCI-MR: Deutsche Bank Liquid Commodity 10 8.9 Index – Mean Reversion 8 Total returns % 6 DBLCI-OY: Deutsche Bank Liquid Commodity 3.9 Index – Optimal Yield 4 1.3 2 DJUBS: Dow Jones UBS (Commodity Index) 0 DBLCI – MRE: Deutsche Bank Liquid Commodity -2 -2.4 Index – Mean Reversion Enhanced -4 -4.1 -4.0 -3.6 -6 -5.1 DBLCI Apex: Deutsche Bank Liquid Commodity Index Apex. This index “is a risk weighted S combination of three strategies of mean RE R Y CI st x UB m I-O pe I-M GS e I-M tu reversion, carry and momentum” rv IA DJ LC LC SP en Ha LC LC DB DB om DB DB DB DB Harvest: A Deutsche Bank commodity futures M DB spread strategy DB Momentum: A Deutsche Bank commodity Sources of Data: Deutsche Bank, Bloomberg Finance LP (Data up to June 15, 2011). momentum strategy Graph Based on Lewis et al. (2011b), p. 1. 35 Conclusion Outlook • As of 6/17/11, the front-month WTI crude oil futures contract price was priced at $93.01 per barrel. • In gold terms, the price of crude oil is near its long- term average level. See next slide. 36 Conclusion Outlook Oil in Gold Terms Cost of 1 Ounce of Gold in Barrels of Oil Based on Rolling Front-Month Com ex Gold and NYMEX WTI Oil Futures Contracts (Monthly Data: 3/83 to 5/11) Long-Term Average: 15.71 Barrels 35 30 25 Barrels of Oil 20 15 10 5 0 3 5 7 9 1 3 5 7 9 1 3 5 7 9 1 -8 -8 -8 -8 -9 -9 -9 -9 -9 -0 -0 -0 -0 -0 -1 ar ar ar ar ar ar ar ar ar ar ar ar ar ar ar M M M M M M M M M M M M M M M Month-End Source of Data: Bloomberg. 37 Conclusion Outlook Spare Capacity Cushion in Question OPEC Spare Capacity Scenarios Libya crude oil production Algeria crude oil production 6.0 5.0 4.0 Million Bb/Day ` 3.0 2.0 1.0 0.0 1994 1996 1998 2000 2002 2004 2006 2008 2010 Graph Based on Lewis et al. (2011a). 38 References Akey, R., H. Till, and A. Kins, 2006, “Natural Resources Fund-of- Funds: Active Management, Risk Management, and Due Diligence,” a chapter in Fund of Hedge Funds: Performance, Assessment, Diversification and Statistical Properties (Edited by G. Gregoriou), Oxford: Elsevier Finance, pp. 383-399. Akey, R., 2007, “Alpha, Beta, and Commodities: Can a Commodities Investment be Both a High-Risk-Adjusted Return Source and a Portfolio Hedge?”, a chapter in Intelligent Commodity Investing (Edited by H. Till and J. Eagleeye), London: Risk Books, pp. 377-417; and in Journal of Wealth Management, Fall 2006, pp. 63–82. Amenc, N., B. Maffei, and H. Till, “Oil Prices: The True Role of Speculation,” EDHEC-Risk Publication, November 2008. Barclays Wealth Americas, 2010, “Commodities Macroeconomic Backdrop,” Barclays Wealth Americas in partnership with Barclays Capital presentation, November. Cayen, J-P., D. Coletti, R. Lalonde, and P. Maier, 2010, “What Drives Degas, Edgar, “The Cotton Exchange at New Orleans,” 1873, Exchange Rates? New Evidence from a Panel of US Dollar Bilateral Musée Municipal, Pau, France. Exchange Rates,” Bank of Canada Working Paper, May. For an article on the historical parallels between 1873 and Cevik, S. and T. Sedik, 2011, “A Barrel of Oil or a Bottle of Wine: How now, as seen when looking into the distant mirror of Degas’ Do Global Growth Dynamics Affect Commodity Prices?”, International painting, please see: Till, H., 2011, “Cotton Through a Distant Monetary Fund Working Paper, January. Mirror,” Commodities Now, http://www.commodities-now.com, March, pp. 28-29. 39 References [ITF] Interagency Task Force on Commodity Markets, 2009, “Special Report on Commodity Markets,” Draft, January 5th. This report was not formally released, but was accessed by the Wall Street Journal through a Freedom of Information Act request, as reported in Lynch (2010). The task force was chaired by Commodity Futures Trading Commission (CFTC) staff. Lewis, M., 2011, “Commodities Outlook,” Deutsche Bank Global Markets Research, January 11. Lewis, M., D. Brebner, M. Hsueh, X. Fu, A. Sieminski, S. Choi, M-C., Lewis, and I. Curien, 2011a, “Commodities Weekly,” Deutsche Bank Global Markets Research, February 25. Lewis, M., M. Hsueh, X. Fu, A. Sieminski, S. Choi, M-C., Lewis, and I. Curien, 2011b, “Commodities Weekly,” Deutsche Bank Global Markets Research, June 17. Lynch, S., 2010, “CFTC Documents Reveal Internal Debate on Position Limits,” Wall Street Journal, May 14. Norrish, K., and A. Sen, 2011, “Commodity Cross Currents,” Barclays Capital Commodities Research, March 22. Ribeiro, R., L. Eagles, and N. von Solodkoff, 2009, “Commodity Prices and Futures Positions,” J.P. Morgan Global Asset Allocation & Alternative Investments, December 16. Sanders, D.R., S.H. Irwin, and R.P. Merrin, 2008, “The Adequacy of Speculation in Agricultural Futures Markets: Too Much of a Good Thing?” Marketing and Outlook Research Report 2008-02, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign, June. Tang, F., 2010, “U.S. Platinum, Palladium ETFs Set to Trade on Friday,” Reuters, January 7. Till, H., 2007, “Value Investing in Commodity Futures,” The Price Report, August 21. Till, H. (2008a), “Case Studies and Risk Management Lessons in Commodity Derivatives Trading,” a chapter in Risk Management in Commodity Markets: From Shipping to Agriculturals and Energy (Edited by H. Geman), Chichester (UK): John Wiley & Sons Ltd., pp. 255-291. 40 References Till, H., (2008b), “The Oil Markets: Let the Data Speak for Itself,” EDHEC-Risk Publication, October. Till, H., 2009a, “Has There Been Excessive Speculation in the US Oil Futures Markets? What Can We (Carefully) Conclude from New CFTC Data?”, EDHEC-Risk Publication, November. Till, H., 2009b, “Speculation in Oil Futures,” Financial Times, December 7. Till, H., 2011, "Trade-Offs Between Commodity Futures and Other Proxies for Commodity Investment," Presentation at the EDHEC-Risk Alternative Investments Days Conference, The Tower (Tower Hill)-London, April 6. Working, H., 1970, “Economic Functions of Futures Markets,” a chapter in Futures Trading in Livestock – Origins and Concepts (Edited by H. Bakken), Chicago Mercantile Exchange. Presentation Prepared By Katherine Farren, CAIA, Premia Capital Management, LLC, http://www.premiacap.com. ® The logo and “Premia Capital” are registered in the U.S. Patent and Trademark Office. 41 Intelligent Commodity Investing Link to “Intelligent Commodity Investing”: www.riskbooks.com/intelligentcommodity http://www.prmia.org/Chapter_Pages/Chicago/RB07_ICI_LETTER-1.pdf 42
"“Intelligent Commodity Trading and Risk Management”"