Commodity hedge funds look forward to robust rally

Weathering the storm

The sudden reversals in commodity and energy prices in May and June caught many hedge fund managers by surprise.

Some of the biggest commodity hedge funds, including Clive Capital, Touradji Capital Management and BlueGold Capital Management, which together manage close to $10 billion, are nursing double-digit losses for the first half of the year after high conviction bets on rising oil prices turned against them, according to investors familiar with the funds.

Commodity hedge funds suffered large losses on May 5 when the price of crude oil dropped 8%, the steepest single day loss in two years. London-based Clive Capital, which is reported to have lost $400 million in the collapse, struggled to explain the sudden reversal in a letter to investors, describing it as “a five standard ­deviation move”.

Oil rallied off its lows in early June, but what many hedge funds did not see coming was a further 5% drop on June 23 when the International Energy Agency (IEA) unexpectedly announced it would release 60 million barrels of oil from its ­emergency reserves.

The back-to-back monthly losses have many investors questioning the investment philosophy and risk management discipline of the big commodity hedge funds.

“We think discretionary commodity managers have a real edge in terms of their ability to analyse supply and demand fundamentals at the micro level but what we saw in May and June is that they can get hurt by sudden changes in macro sentiment, technical indicators and investor flows,” says Ben Funk, head of research at Liongate Capital Management, which runs a fund of commodity hedge funds.

The recent volatility in oil prices “had nothing to do with fundamentals,” says Tony Hall, chief investment officer (CIO) of the Duet Commodities Fund, which has bucked the recent trend of losses among commodity hedge funds. Hall says Duet was able to anticipate the reversal in oil prices because the investment team pays close attention to macro and technical indicators as well as fundamentals.

“The macro environment and the financial fundamentals are having a growing influence on the commodity markets. The impact of margin calls, positioning and liquidity is more significant now than it has ever been,” says Hall.

Duet looks for scenarios “where the technicals and macro line up with the fundamentals,” he says.

First indicators
In May, technical indicators led the investment team at Duet to conclude that something was awry in the commodity markets. The first sign of trouble was when silver prices dropped 17% from April 28 to May 4 after Comex increased margin requirements for futures contracts. Oil was the next to drop and the liquidation quickly spread through the entire commodity complex.

“The sell-off was purely financial and flow driven,” says Hall. “A lot of hedge funds were long crude coming into May because the physical fundamentals were tight. We thought the financial world had gotten ahead of itself and positioned for a ­retrenchment.”

The Duet Commodities Fund, a long/short energy and metals fund, returned 3.7% and 6.45% in May and June respectively and was up 29% for the first half of the year, according to investors.

The challenge for commodity traders lies in adapting to an environment where macroeconomic and technical factors have a disproportionately large impact on commodity prices relative to fundamentals.

“The fundamentals are secondary right now,” says Cedric Chone, a portfolio manager at Galena Asset Management, a division of Trafigura which runs $1.7 billion in a range of commodity strategies. “We’re seeing crude oil being linked to the job figures in the US when there is no fundamental correlation between the two. The markets are nervous, so economic data can have a big impact on ­commodity prices.”

Correction or downturn?
The question many discretionary commodity managers are asking themselves is whether the recent retrenchment in prices reflects a bull-market correction or the beginning of a pronounced downtrend.

Richard Bornhoft, a founder and CIO of Equinox Fund Management, who has been investing in commodity funds since 1983, says most managers are leaning towards the former. “We have seen a theme over the past couple of months of discretionary managers taking short positions in those commodity markets that appear overextended,” he says. “But over the intermediate to long-term, most discretionary commodity managers are very bullish.”

Fund managers that weathered the recent storm stress the importance of active risk management when investing in commodities.

“These markets can be very volatile. The managers that have the ability to cut losses and create opportunity in the pullbacks are the ones that are going to provide alpha in the long run,” says a manager at one hedge fund that is positive for the year. “A significant portion of a commodity hedge fund’s alpha comes from active and prudent risk management,” he says.

He advocates “credible stops, liquid positions and building some optionality into the portfolio to help during periods of duress.”

 

The trading environment is expected to remain challenging through August and September. “There is a conflict between incredibly strong fundamentals for many commodities and a terrible macro environment. That’s causing the market to stutter, and trading a stuttering market is incredibly challenging,” says Chris Brodie, founder and portfolio manager at Krom River Trading.

“This is not the environment to have high-conviction directional trades in the portfolio,” says Brodie. “You have to be careful, keep positions sizes small and make sure you are not exposed to macro changes.”

Krom River employs a combination of fundamental and macro research to generate investment ideas, while technical analysis is used to determine timing. The portfolio typically contains a mix of directional, relative value and volatility trades, which helps to dampen downside volatility.

“The relative value positions soak up some of the exposure and the directional trades are offset by the long volatility book,” Brodie explains. “It means when we get it right, the long volatility positions will accentuate the returns, but when we get it wrong, it will cushion the losses.”

Scaling down
Commodity funds have on the whole scaled down their exposures and taken directional bets off the table, says Liongate’s Funk. “They are licking their wounds, looking at their losses and trying to eke out smaller returns in relative value and spread trades,” he says.

The levelling off of liquidity in the financial system following the US Federal Reserve’s decision to end its second round of quantitative easing (QE2) on schedule in June could mean “the return of relative value trading opportunities,” says Galena’s Chone.

The widening spread between Brent and West Texas Intermediate (WTI) oil futures contracts is being closely watched by hedge funds, as is the relationship between base metals such as copper, aluminium, lead and zinc.

Hall recently increased the Duet Commodities Fund’s allocation to relative value trades to 40%, up from a typical level of 30%. However, he says this is a temporary measure in response to the current uncertainty in commodity markets. “We think relative value could work well in the third quarter while the market is rebalancing, but over the longer term we’re looking to be in more directional trades,” he says.

Fundamental reassertion
There is a high degree of conviction among hedge fund managers that the fundamentals will reassert themselves and push commodity prices higher by the end of the year.

The case for higher oil prices is particularly compelling. The fundamentals point to a structural supply deficit for crude oil whereby demand from emerging markets is growing at a faster rate than supply can match. Western countries may seek to dampen prices through moves such as the IEA release in June, but commodity bulls argue these interventions are “completely ineffective” in the long run and ultimately fail to address the structural supply and demand problems.

The outlook for agricultural commodities also appears strong for similar reasons. The price of grains such as corn, wheat and rice is expected to rise due to reduced inventories and rapidly increasing demand from emerging markets. Surging demand for pork in China represents another interesting opportunity for traders.

Brodie blames the recent decline in corn prices on “transportation pipeline disruptions” that have made inventories appear larger than they truly are. He expects prices to move higher as it becomes clear that inventories are more depleted than market participants currently believe.

Funk says he expects commodity funds to begin increasing exposures in the near future. “We expect to see more buying later this year on the back of this very tight supply and demand picture, especially in energy and agricultural commodities,” says Funk.

Krom River’s Brodie says commodities are due “a strong rally” in the next one to three years, though he warns investors to expect a bumpy ride.

His thesis is that commodities are likely to rally later this year as China’s tightening cycle comes to an end and fundamentals reassert themselves. However, he warns that prices could drop sharply if the sovereign debt crisis in Europe sparks a currency crisis and a severe recession in the continent. These problems will likely be a drag on the US economy, forcing the Federal Reserve to print more money which will weaken the US dollar and spur another rally in commodities.