Commodities & the Volatility Epoch28/02/2023
As volatility continues in the sector, it’s now more important than ever for commodity houses to employ experts, not generalists and to remain nimble in their ability to move with the rapidly changing market.
A McKinsey article from January this year focused on this point, making the case that commodity traders need new business models in order to exploit volatility in the market.
This is particularly pronounced with the energy transition well underway, increasing structural volatility and disrupting trade flows. Index funds and commodity trading pools have doubled in AuM, putting pressure on forward curves in often small markets and general de-globalisation and the perceived need to repatriate critical materials is opening new arbitrages.
Geopolitics and the rise of ‘one-off’ events
From a macro perspective ‘one-off’ events seem to be happening rather more frequently than before. Whether that’s Russia’s invasion of Ukraine or the outbreak of Covid, sovereign countries are having to reassess their ability to source critical materials.
This has led to a concerted effort to be able to secure materials more regionally. European refiners have increased US imports to off-set the loss of Russian Oil with the US set to become a net exporter of crude (something that has not been the case since World War II). Rare Earths and other materials that are critical in the production of iPhones and batteries are still predominantly produced in China (80% of rare earths imports in 2019). The US has set aside a large portion of the $2trn infrastructure spend attempting to counteract the Chinese dominance.
“It’s absolutely correct there is a cornering of the market with Lithium and other rare earths” – said Biden’s climate envoy, John Kerry on CNBC
Traditional trade routes have also been affected with now longer, less efficient shipping lanes in use, which avoids unfriendly nations, but increases costs and delivery times.
These supply chain issues and trade disruptions look set to continue alongside general de-globalisation and self-protectionism. The offshoot being the potential opening of new arbitrages and unique opportunities for commodity traders to exploit.
Estimated annual investment in hydrocarbons has fallen 50% in the last 10 years. However, according to McKinsey, the level of funds committed to energy transition – approximately $700bn in 2021 – is about 1/3rd of the $2trn required in 2022. This will not likely be sufficient to prevent the emergence of sustained bottlenecks.
Since the financial crisis of 2008 global miners have been spending very little cash in the ground, preferring dividend increase and share buy-backs (see BHP Billiton, Rio Tinto, etc). This has pleased shareholders. However, the reality is that should the demand for metals and rare earths associated with the green push come to fruition, we simply don’t have enough mines either producing or in development. You can’t simply turn on a commodity tap…it takes years to develop a mine. This will create spikes and increase volatility across the market.
The increase in volatility across commodities has resulted in a significant tightening of collateral requirements and increased the frequency of margin calls, which has in turn increased capital requirements. Coupled with the stance of central banks (rising interest rates), the cost of financing the movement of raw materials has increased substantially. This has led to large challenges for smaller trading houses and players.
According to McKinsey, commodity trading value pools have close to doubled in size since 2018 ($27bn - $52bn in 2021). The increase in volumes across commodity markets can easily been seen across passive ETF’s and Risk Premia funds. These ‘long only’ strategies are mandated to roll positions forward, as they can’t take physical delivery. This often equates to a very large amount of pressure on the forward curve as and when they roll forward. The nimble trader is able to position themselves to take advantage of huge rolls across relatively small markets, with the providers methodology/positioning made publicly available.
The outcome of all of the above points suggests that volatility is here to stay, at least in the short to medium term. And a ‘long only’ perspective in commodities is possibly not the most efficient way to exploit the space.
Within the market a commodity traders’ success or failure will be based upon their ability to navigate this new norm.
Important information: This document is issued by Arion Investment Management Limited (“Arion”) which is authorised and regulated by the UK Financial Conduct Authority (the “FCA”). It is intended for the use of clients of Arion only. This document is intended for institutional investors and professional clients. It is not to be distributed to or relied upon by retail investors in any circumstances.
The information and opinions in this document are believed to be current and accurate in all material aspects as at the date of its release and to compiled or arrived at based upon information obtained from sources believed to be reliable and accurate. Arion makes no representation or warranty as to the accuracy or completeness of this document and accepts no liability for any inaccuracy or omission. Information obtained from third parties has not been independently verified by Arion. Arion does not accept any responsibility to update this document or any opinions expressed in it based on any information obtained after the date of its release.
This document is for informational purposes only. All comments, opinions and content contained in this document are of a general nature and do not take into account the personal investment aims, financial situation or requirements of any investor or potential investor.
The information in this document does not constitute an offer to sell or the solicitation of an offer to purchase any investment product or service. The value of investments and the income derived from them can fall as well as rise. Investors may not get back the amount originally invested. Past performance is not an indicator of future returns or results. Before acting upon anything associated with this document Arion recommends that specific investment advice is taken.
This document is a marketing communication and has not been prepared in accordance with the requirements of any jurisdiction designed to promote the independence of investment research. It is not subject to any prohibition on dealing ahead of the dissemination of investment research.
About Arion: Arion is a commodity focused investment adviser and manager with offices in London. Arion is authorised and regulated by the FCA (registered no. 742037), is registered with the U.S. Commodity Futures Trading Commission (CFTC) as a Commodity Pool Operator and Commodity Trading Advisor and is member of the National Futures Association (NFA).