By Shelley Goldberg
Profiting from commodity trading often requires a combination of market knowledge, luck and most importantly, strong risk management. But over the years, the number of commodity trading houses has dwindled, and the institutional, pure-play commodity hedge funds that remain, and actually make money, can be counted on two hands.
Amid the mayhem, banks held tightly to their commodity desks in the belief that there was money to be made in this dynamic sector. The trend continued until the implementation of the Volcker rule, part of the Dodd-Frank Act, which went into effect April 2014 and disallowed shortterm proprietary trading of securities, derivatives, commodity futures and options for banks’ own accounts. As a result, banks pared down their commodity desks, but maintained the business.
Last week, however, Goldman Sachs Chief Executive Lloyd Blankfein, one of many bank heads who started out in the commodity space, announced that Goldman was reviewing the business after a multiyear slump and yet another quarter of weak commodity prices.
In the 1990s boom years, commodity bid-ask spreads were so wide you could drive a freight truck through them. Volatility came and went; but when it came, it was with a vengeance and traders made and lost fortunes. Commodity portfolios could be up or down about 20 percent within months, if not weeks. Although advanced trading technologies and greater access to information have played a role in the narrowing of spreads, there are other reasons specific to the commodities market driving the decision to exit. Here are the main culprits:
Gold bounces between $1,200 and $1,300 an ounce, WTI crude straddles $45 to $50 per barrel and corn is wedged between $3.25 and $4 a bushel. Volatility is what traders live and breathe by, and the good old days of 60 percent and 80 percent are now hard to come by. Greater efficiency in commodity production and consumption, better logistics, substitutes and advancements in recycling have reduced the concern about global shortages. Previously, commodity curves could swing from a steep contango (normal curve) to a steep backwardation (inverted curve) overnight, and with seasonality added to the mix, curves resembled spaghetti.
Commodities have long been considered a good portfolio diversifier given their non-correlated returns with traditional asset classes. Yet today there’s greater evidence of positive correlations between equities and crude oil and Treasuries and gold.
These are positions that attract a large number of investors, typically in the same direction. Large commodity funds are known to hold huge positions, even if these only represent a small percent of their overall portfolio. And a decision to reverse the trade in unison can wipe out businesses. In efforts to eke out market inefficiencies, more sophisticated traders will structure complex derivatives with multiple legs (futures, options, swaps) requiring high-level expertise.
Margin requirements for commodities are much lower than for equities, meaning the potential for losses (and profits) is much greater in commodities.
Some commodities lack liquidity, particularly when traded further out along the curve, to the extent there may be little to no volume in certain contracts. Futures exchanges will bootstrap contract values when the markets close, resulting in valuations that may not reflect physical markets and grossly swing the valuations on marked-to-market portfolios. Additionally, investment managers are restricted from exceeding a percentage of a contract’s open interest, meaning large funds are unable to trade the more niche commodities such as tin or cotton.
Price control is not only a fact in crude oil, with prices influenced by the Organization of Petroleum Exporting Countries but with other, more loosely defined cartels that perpetuate in markets such as diamonds and potash.
It’s Downright Difficult
Why was copper termed “the beast” of commodities, a name later applied to natural gas? Because it’s seriously challenging to make money trading commodities. For one, their idiosyncratic characteristics can make price forecasting practically impossible. Weather events such as hurricanes and droughts, and their ramifications, are difficult to predict. Unanticipated government policy, such as currency devaluation and the implementation of tariffs and quotas, can cause huge commodity price swings. And labor movements, particularly strikes, can turn an industry on its head. Finally, unlike equity prices, which tend to trend up gradually like a hot air balloon but face steep declines, commodities have the reverse effect -prices typically descend gradually but surge when there’s a sudden supply shortage.