Funds in commodity markets are 'here to stay': Standard

While the various fund players in the commodity markets all have different rationales and approaches, the funds are "here to stay," said Michael Skinner of Standard Bank base metals and sales. Speaking at the Platts Aluminum Symposium in Scottsdale, Arizona, in late January, Skinner said as a result of this investment, commodities in general would remain "stronger for longer."

Skinner said the funds were still awash with money, but the various categories of funds - including hedge funds, commodity trading advisors, index funds and pension funds - all had differing strategies and approaches to commodity markets. He said like pension funds, the index funds also had a long-term approach. "And while index funds do rebase, as we have seen recently, they have longer-term horizons," he said, adding that hedge funds tended to have a short-term outlook.

Skinner said the advantages of fund involvement included increased liquidity, a greater number of participants in the market and heightened investor awareness in the commodity market. He said with the forward curve being flatter, due to fund involvement, it was more economical for the market to hedge forward.

"There has been a parallel shift in the forward curve; funds are playing further down the curve, providing liquidity further forward," he said. He noted that with higher nearby prices, bargain hunting started happening further down the curve;"so we get a flattening" due to this passive money coming in.

But he said fund involvement was a disadvantage for the market in that it resulted in increased volatility, prices tended to overshoot - resulting in amplified peaks and troughs - and price distortion occurred.

Skinner said looking to the future, a shift from passive-to-direct investment was expected with "cherry-picking," and funds getting involved in more specific commodities. He said there would also be a shift from new money to old money, with pension funds moving in to the market. He said in the future, market players would be looking to get involved further down the curve, resulting in a change to long-term strategies from short-term views.

Skinner said that the rapid growth of the investment community had resulted in a dislocation of the price and fundamentals "at times." He added that, while stocks had decreased, it was not to the extent that the price should be as high as it is;"volatility of funds has caused that."

Asked by Platts to comment on the factors contributing to the large backwardation in the aluminum market, which was just over $100/mt on an official cash-to-three-months basis on the LME February 9, Skinner said there was "no smoke without fire" and with the illusive nature of funds, it was not surprising that speculation had arisen as to who was behind the backwardation. Skinner said there had been an attempt to get the outright price up in December, but the strategy had been unsuccessful.

"This year they are dipping their toes into the physical market and accumulating stock," he said, adding too that a "huge backwardation" usually attracted metal in to warehouses, rather than resulting in draws. He suggested this implied that one or more large players were holding the metal. He said while everyone was entitled to their own opinion, the nearby long dominant aluminum position, worth about $1.8 billion, coupled with large option positions at $2,900/mt and $3,100/mt "is definitely a play to move the prices on the upside."

Skinner said the backwardation was expected to remain in place at least until March. He suggested that if the option strikes were not reached, the position was likely to be rolled to March.

Meanwhile, Craig Tuckman, managing director of Merrill Lynch Commodities, told the Symposium that aluminum and other base metal markets are seeing a growing number of traditional and non-traditional players using complex trading and hedging strategies for their international investors. Those strategies, as well as the growing number of "new" players, are likely to result in more price volatility.

In addition to trend-following funds such as Commodity Trading Advisors, index funds - with more than $150 billion invested in commodities - and private equity funds are using increasingly complex strategies to generate returns for investors. Other new players include investment banks managing risks for their investors and investor funds doing fundraising for mining equities, he said.

"Understand that this is going to have an impact on day-to-day liquidity," Tuckman said.

Other examples of non-traditional players and activity include global diversified miners, who may look to extend the life of a particular mine by locking in margins on lower-grade ore recoveries, and precious metals producers who have hedged a significant amount of their base metals production to monetize value at relatively high costs, he said.

If these players holding warrants were to liquidate their positions, "it could create greater cash flow volatility...and could impact the [US] Midwest [Platts Transaction] premium," Tuckman said. "There's less metal available, which could create spikes in the premium."

The aluminum market would also be affected if trading went completely electronic, Tuckman said. "We could see aluminum go the way of foreign currency exchange, with a 24-hour trading cycle using electronic trading systems that banks provide," he said.

The number of "new" players using complex trading strategies is likely to create not only greater trading price volatility but also increased trading outside of traditional futures. "We could see investors investing in not only cash and three-months [contracts] but also spreads and options. It can distort the fundamental equation in the market a lot," Tuckman said.

Created: February 17, 2007

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