By James Williams – Commodity hedge funds have been in the doldrums somewhat, as the macroeconomic climate continues to make life difficult for managers. Performance, in effect, just hasn’t stacked up, leading to some institutional investors heading for the exit. As the Financial Times reported on 6 February 2013, industry executives estimate that overall AUM in the commodity hedge fund sector has fallen “by at least 20 per cent in the past year, and perhaps by more than a third”.
Stalwarts of the industry, such as Michael Coleman’s Singapore-based Merchant Commodity fund, had, by last summer, lost two thirds of its AUM over a bruising 18-month period, but vowed to press on. Others last year chose not to, most notably high-profile natural gas trader John Arnold who closed the Centaurus Energy Master Fund to “pursue other interests”, wrote Bloomberg.
Looking at historical returns in the Newedge Commodity Trading Index, between December 2002 and December 2005 returns averaged 28.03 per cent. Between December 2006 and December 2009 that figure dropped to 10.8 per cent. More worryingly, between December 2010 and December 2012, the average is just 1.3 per cent.
Nevertheless, there have been plenty of managers who have managed to keep their heads down and deliver solid, if not spectacular returns.
“Last year was a tricky one. Quite a few of the big well-known commodity funds had a tough time. We ended 2012 up 4.3 per cent but we think we can improve on last year’s performance significantly going forward,” comments Jaakko Ahmala, who co-manages the Galena Energy Fund with Mark Heath in Geneva.
Galena Asset Management is part of Trafigura, the multinational commodity trading firm and third largest oil and metals trader after Vitol and Glencore, but operates completely independently. The firm runs eight different funds with an aggregate AUM of approximately USD2.4billion. The Galena Energy Fund currently runs USD220million in assets.
Within the energy complex, the S&P GSCI Brent Crude Index has delivered 1-year annualised returns of 7.40 per cent. By comparison, the S&P GSCI Unleaded Gasoline Index has returned 29.71 per cent.
For asset managers, knowing when and where to build positions across the energy complex is crucial. Galena does this by taking a purely fundamental approach. It is, says Ahmala, “the edge that we believe we have over the competition. Whether it be volatility, flat price, refining margins, how we express those fundamental views depends on where we see the most compelling opportunities at any given time.”
Adds Heath: “Ours is not a high-octane investment strategy. It’s a co-ordinated approach that aims to achieve double-digit returns in a controlled way. The underlying theme to the trades that we put on the book boils down to the fundamental view of how the hydrocarbon planet looks in terms of supply and demand. We’ll either be skewed towards looking at long products versus crude, or short products versus crude. Those themes will tend to underlie the book over a period of months rather than days.”
The fund trades a number of energy futures and swap/options and over the long-term holds a market neutral position. If a constructive fundamental view emerges in the short term it will adjust the book to a net long or net short position accordingly, but the approach taken by Galena is measured, controlled. It’s not looking to shoot out the lights, performance-wise.
David Donora is the co-manager of the Threadneedle Enhanced Commodities Fund alongside Nicolas Robin, an actively managed long-only fund with around USD1.1billion in AUM. Compared to many of its hedge fund counterparts, and indeed the DJUBSCI Index against which it is benchmarked, the fund delivered strong results for 2012, returning xxxx per cent. Since it launched in June 2010, TECF has generated cumulative net returns of 30.79 per cent, compared to 13.79 per cent for the benchmark.
Unlike the Galena Energy Fund, TECR invests across the entire commodities complex. Through November the portfolio held 9.37 per cent in Brent crude oil relative to 1.51 per cent in crude oil. It remained bearish on the US oil physical markets given that crude oil production in North America increased by 800,000 barrels a day in 2012, but continued backwardation in the Brent curve supported the WTI/Brent carry trade.
Donora says the fund continues to be positive on the energy complex, confirming: “Our current view is that we will stay underweight natural gas against gasoline, and if the economic conditions are favourable 2013 might allow for some increase in the price rationing for crude oil.” That the average price for Brent crude was USD111 in 2011 and USD112 in 2012 suggests that prices are already high; for them to go higher, evidential global economic growth would be necessary.
According to the firm’s December newsletter, its natural gas/gasoline was a key performer for the fund in November. The overweight position in gasoline provided 33 basis points of outperformance relative to the index thanks to on-going refining tightness in the US Northeast, while its underweight position in natural gas earned 53 basis points on the back of warmer weather forecasts for November and December.
While crude oil has little spare capacity, other commodities such as grains – wheat and corn – are far more readily capable of reacting to supply constraints. Yes, the US suffered record droughts last year causing corn prices to spike at USD8.49/bushel on 10 August, and according to the US Department of Agriculture’s (USDA) forecasts released last month, corn inventories in the country will fall to 602million bushels by the end of the current season – the lowest in 17 years.
But places like Australia and South America are increasing acreage, applying fertilizers and manifestly increasing production with Donora noting: “It is possible that in the next 60 days we’ll see record crops in South America. Right now, our position in grains is pretty neutral because there’s a lot of volatility and the price action is highly weather dependant. This is not an area where we have strong conviction within the portfolio. The one crop we’re watching closely in the US right now is the wheat crop, particularly in Oklahoma, Kansas and Texas where there are still extreme drought conditions and the wheat crop is under considerable risk.”
The oil product markets were some of the most interesting in 2012 says Ahmala and lay at the core of the strategy. Ultimately it was where the fund derived most of its returns and was helped “by the fact that we have an understanding across all parts of the barrel. We didn’t really avoid anything within the energy complex per se. We saw opportunities in coal, natural gas. We are comfortable trading in multiple sectors.”
Heath stresses, however, that they’ve avoided trading the Brent/WTI spread. “Rather, we tend to trade more aggressively the individual spreads of both contracts because then you’re effectively trading like for like.”
“Looking at 2013, we’re constructive towards the energy complex. In a macroeconomic environment where year-on-year both the Chinese and US economies look better we’re generally positive from a refined products perspective.”
One innovative fund that launched this year is the Diapason Relative Value Petroleum Industry Fund. Essentially an arbitrage fund, it trades the spreads between commodity contracts – that is crude oil and refined products – by looking at the microeconomics of a refinery, rather than just looking at fundamental price. The team uses a proprietary model to track the relationship between crude and refined products, and trades on any arbitrage opportunities that arise.
Edouard Mouton, head of quantitative research at Swiss-based Diapason Commodities Management, explains: “The strategy aims to provide absolute returns by anticipating the rational and predictable behaviour of refiners. By looking in detail at the way refiners manage their industrial assets on a daily basis we are able to understand the price relationship between refinery inputs and outputs and to implement arbitrage position based on their behaviour.
“Based on any divergence from what should be the theoritical relationship between crude and refined products our model generates long and/or short positions on refinery margins.”
The strategy is barrel-neutral (or quantity neutral) when building positions between the input and output of a refinery – that is, between crude oil and refined products. By mimicking the behaviour of an oil refinery this is one of the first funds of its kind.
Currently, the strategy invests in six futures contracts: “ICE Brent Crude Oil, ICE Gasoil, NYMEX RBOB Gasoline, NYMEX Heating Oil, DME Oman Crude Oil, and NYMEX WTI Crude Oil.
“The investment process will consider the refinery profitability of the major hubs in the world where markets prices are determined and take positions based on the analysis of those economics,” says Mouton, adding that based on past figures “we would expect the fund to deliver 10 per cent net annualised returns”. The three major refining hubs tracked by the model are the US Gulf Coast, Singapore, and North Western Europe.
This is a distinct strategy, and one that stands out from the way most energy-focused commodity funds currently operate. And the early signs are that investors are intrigued by the opportunity to earn a new source of return. As Mouton confirms: “People understand the fund’s value-add and the innovation behind it. We’ve received good feedback from private banks, family office and FoHFs.”
As for precious metals, Threadneedle’s Donora confirms that whilst the gold market might continue to be interesting in 2013 the fund remains market weight in precious metals relative to the benchmark. The fund’s biggest overweight position is in oil-based energy as well as a significant overweight position in lead and nickel.
“We’ve got a market weight position in aluminium and zinc. Currently, in base metals we’re underweight. Around 4 per cent of the fund is overweight in lead, and 3 per cent in nickel. We look at fundamentals as well as market structure and a few technical factors such as seasonality when looking at individual commodities. Take aluminium for example: that’s a basic fundamental story where China has improved its production capabilities significantly in the last few years, and are able to ramp up production if there were a price signal. So there’s no supply constraint,” says Donora.
Contrast that to lead, however, which is more supply-constrained. It’s environmentally challenging, relies a lot on recycling. Factor in that car numbers are increasing globally, and there’s more of a demand dynamic at play.
Since June 2012, the lead spot price has increased from USD0.8/lb to USD1.0902/lb at the time of writing.
“In general commodity markets are supply-constrained. If we do have a pick up in global growth we will see tighter commodity markets, which will result in higher commodity prices. We see that as the key driver of commodities in 2013,” notes Donora.
