Commodity derivatives house of the year - JP Morgan


Last year was never supposed to be one of growth and innovation. As the financial crisis intensified following the demise of Lehman Brothers in September 2008, analysts predicted the theme of the next 18 months would be damage limitation.

What the soothsayers did not allow for was the potential for well-capitalised firms to pounce on opportunities as they emerged while the rest of the market battened down the hatches to wait out the storm. JP Morgan was one such institution, and 2009 has seen it transformed from mere also-ran into a major player in global commodities markets.

JP Morgan’s acquisition of Bear Stearns in March 2008 handed it Bear Energy, one of most highly prized energy businesses in North America, as well as the firm’s sizeable precious metals franchise.

Meanwhile, the collapse of Lehman Brothers triggered fears over the health of the remaining Wall Street investment banks, Goldman Sachs and Morgan Stanley. In the commodity world, the shock caused by the perceived fragility of these two commodity titans was aggravated by an announcement by UBS in October 2008 that it intended to sell its Canadian and agricultural commodities arms.

Those two UBS units were ultimately purchased by JP Morgan in a deal that closed on February 2, giving the firm a foothold in the soft commodities world and, perhaps more significantly, access to the major oil markets of Canada to complement its existing US business.

Along with these three acquisitions in 2009, market participants report that JP Morgan has distinguished itself from its competitors for its consistency of pricing and execution, and for continuing to make markets even through the very worst of the crisis.

“JP Morgan has consistently performed in all the markets we trade. We rely on them for liquidity, information and research – whether that be in crude, natural gas or European gas and power. Other commodities desks were far less consistent and moved in and out of the market throughout 2009. We have done a few quite sizeable trades and JP Morgan is very good at pushing liquidity for us and accommodating the size of our positions,” says Rich Ritholz, a commodities trader at hedge fund Elliott Associates in New York.

One of the most notable changes for JP Morgan over the past year has been its move into physical commodities trading, an area in which the firm previously had limited experience.

“We only received approval to trade physical commodities in September 2008, so everything we have done in the physical space is brand new for 2009. We’re now active in the US crude markets with physical oil and refined products, and active in Canadian crude markets with significant storage capabilities in Alberta through the UBS acquisition,” explains Jeff Frase, head of global oil trading in New York. “Beyond North America, we have floating refined product storage in Asia and Europe through vessels off the coasts of Singapore, northern Europe and in the Mediterranean. Combined with considerable organic growth in these areas, our sheer footprint in the commodities business has expanded greatly in the past 12 months.”

Trading physical commodities presents a number of operational and logistical challenges. Production facilities need to be insured, traders with the relevant experience have to be hired, and the bank needs to account for the unique credit and operational risks posed by trades that commonly take weeks to settle. Nonetheless, JP Morgan has gone from having no physical presence in the North American power and gas markets to what it considers to be a leading position in just 16 months.

“JP Morgan is trading gas and power in every market in North America. On the power side, we actually own power plants and we have several 15-year-plus tolling arrangements. We have 7,000 megawatts (MW) of generation under management and we act as agent for 1,200MW of generation for co-operatives in the south-eastern US,” says Paul Posoli, global head of gas, power and environmental markets in Houston. “In liquefied natural gas (LNG), we’re selling around four billion cubic feet (bcf) a day. To put that in perspective, the entire North American physical LNG market is around 60bcf a day, so we have a big presence. We also have about 40bcf of storage, so as far as financial institutions go, we are unmatched in scope and scale.”

Unmatched or not, the firm does not intend to stop there. In the oil space, JP Morgan is looking for strategic partnerships in refinery activity in North America, for more storage opportunities globally and to expand its 12-strong oil desk in Singapore as part of an effort to grow its presence in Asia. 

In LNG, the desk is on course to increase its liquefaction capacity by about 35% in the next 18 months and has engaged in marketing partnerships to sell LNG in new regions. In one such marketing arrangement with Cheniere Energy, a Houston-based LNG producer, JP Morgan has rights to sell natural gas in the US on its behalf. In another similar deal, the bank has the rights to market LNG cargoes in the UK for a major oil company.

While expansion in energy has been a cornerstone of JP Morgan’s commodities strategy in 2009, the $210 million acquisition of EcoSecurities, a Dublin-based carbon credit origination and distribution platform, which closed in November, signals the bank’s intention to be at the forefront of the carbon-trading revolution.

The deal marks the second major carbon business the firm has acquired in the past two years, following the purchase of Oxford-based carbon emissions reduction firm ClimateCare just a week after the Bear Stearns acquisition in March 2008.

Acquiring EcoSecurities represents a major investment for JP Morgan, involving 250 staff in 30 different offices across 23 countries. The firm’s compliance-orientated emissions credit origination business is also a significant departure from the voluntary carbon reduction activities of ClimateCare, which focuses on intermediation of credits rather than origination.

“EcoSecurities will be a huge part of the business. It is already the biggest carbon originator and aggregator in the world, and relative to what JP Morgan does today it’s a huge increment, giving us around 70 million tonnes of carbon, either contracted or under option,” explains Blythe Masters, global head of commodities in New York. “The acquisition will make us one of the largest holders of emission reduction credits in the world, which will differentiate JP Morgan from other commodities houses that simply intermediate for entities like EcoSecurities in the market.”

Despite the push into new markets, JP Morgan has continued to build in more traditional areas. Clients praise the bank for the quality of its research and for taking the time to adapt and customise investment products.

“We worked with JP Morgan on a long/short strategy retail product. We felt its index offerings weren’t a good fit for us, so we met the team in New York to come up with a tailored solution. There are only a handful of long-only commodity funds available to most mutual fund investors, so their ability to provide long/short strategies for retail investors is very unique in the industry,” says Kevin McGovern, managing director of mutual funds at Rydex Investments in Rockville, Maryland.

In addition to customised investor products, the bank has also created mass-market investments that enable clients to gain direct commodity exposure, while recognising that counterparty credit risk concerns have driven many investors away from bank-issued products and into exchange-traded alternatives.

According to JP Morgan, approximately $35 billion in investor money poured into exchange-traded funds in the year to December 2009. In particular, investors have sought exposure to gold as spot prices soared from $811.70 per ounce on January 14 to $1,215.70 by December 2. The bank has sought to capitalise on those flows by designing a buy/write strategy that combines a long physical position in gold with the sale of call options on gold by the investor to JP Morgan.

“Gold was trading about $900 per ounce at the end of the first quarter and volatility levels were at all-time highs, so it was a good time to be a seller of volatility by selling calls,” explains Tim Owens, head of currency and commodity solutions at JP Morgan in London. “In this strategy, the investor committed to sell calls every month struck 10% out-of-the-money. Historically, we’ve rarely seen moves of 10% per month, so selling those calls effectively gave the seller a discount of 10% and they ended up paying $810 an ounce for physical exposure to gold.”

Elsewhere, JP Morgan plans to build out its capabilities in base metals in the near future – particularly ferrous metals such as steel and iron ore. Developments in the spot markets are raising expectations that producers may soon begin to investigate their hedging options, and JP Morgan says it is poised to be ready to service those needs once they arise.

Ultimately, 2009 was a balancing act for JP Morgan in commodities: integrating new acquisitions, adjusting to the realities of trading physicals and developing new products for both individual clients and the general investor market, while at the same time focusing on maintaining liquidity, research and hedging support to investors and producers alike. Despite accomplishing it all, Masters is the first to admit that luck played a part.     

“Clients were narrowing down their counterparties in 2009, while being more exacting about the calibre of houses they dealt with and we were very lucky – not just smart – to be able to take advantage. If it had happened a year earlier, we would not have been able to capitalise upon that trend, as we would not have been able to trade physical or have had the capability to take on board anywhere near the number of clients we have. There are many things we were able to do in 2009 that we would not have been able to do just 12 short months previously, but right now we’re in a pretty enviable position,” she says.

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