Index buyers warping Brent Crude's price curve a boon for opportunists

Commodity indices dubbed the 'gorilla in the corner' of oil market

While hedge funds have been blamed by some for stoking Brent Crude prices, experts say the emergence of commodity indices is bending the curve between spot and forward prices, and opening up trading opportunities in the process.

Russell Newton, principal at Global Advisors, a London-based CTA that trades industrial commodities, says Brent Crude's spot is at $45 and the back of the curve sits at $40. Usually the curve between the two points will slope gently, but index money is changing that, he adds.

"The index is the gorilla in the corner. It's selling its spot position every month and buying the second month (out). So, right now, you have a curve that's more like $44.5, (then) $45, $44.4, $44. That's an opportunity," Newton says.

"Passive speculators are having to pay to roll a long position every month in a market where backwardation, by its very nature, is saying we need oil today, we don't really want oil tomorrow. At the front, that's being overshadowed by the gorilla in the corner." This creates opportunities for fund managers who are used to exploiting statistical arbitrage, such as forex players.

Newton sees statistical arbitrage and global macro as some of the main beneficiaries of the world's commodity market growth in 2005.

"Quite a few hedge funds are trying to buy proprietary traders from the commodities markets. Clearly, it's a good market for commodities at the moment; therefore it's a good market for commodities traders. But it's hard to tempt someone from a well-paid job in a proprietary shop to a hedge fund, without paying them a lot of money. Unless you don't get the best guy," he says.

However, not all investors lack reservations about commodities' rude health of late.

While excited by sustained high performance in recent months, some are increasingly worried investing now is buying at the market's peak, according to Karmal Naqvi, a precious metals analyst at Barclays Capital in London.

Naqvi says such fears are understandable - given that several commodities are at multi-year highs but are ultimately misplaced. The results from a survey of 150 institutional investors - mainly pension funds - at a recent Barclays Capital-hosted commodities conference in London add to the many sources that support his view.

Most said they had no exposure to commodities, but 64% planned to increase exposure to 6% or more within three years, with diversification the main attraction for 64% of respondents.

In contrast to the optimism of the commodities team at Barclays Capital, Tony Coote, director at London's Jaguar Investments, believes commodity markets will remain volatile and continue to provide excellent investment opportunities, with sensitive issues to be resolved through the year including IMF gold sales, political stability in Iraq, OPEC meetings, China's economy and supply-side developments in the metals markets.

Jaguar Investments is a systematic hedge fund specialising in commodities investments and, since 70-80% of the cumulative experience of its two managers is in metals, it has approximately 50% of the portfolio in this area, investing in copper, aluminium, zinc, gold and silver, supplemented by Brent Crude, natural gas and agriculturals picked for their diversity and relative liquidity.

Weightings to each commodity were designed to ensure that each has a roughly equal impact on the portfolio.

"We're not particularly bearish, we're fairly neutral on a short-term basis at the markets' current levels," says Colin O'Neill, director at Jaguar. "In the short term, we think prices have probably run their course; although if we see renewed dollar weakness and the current account deficit continues to grow, that might give commodities the next push higher."

He says that a euro worth $1.45 to $1.50 should lead to increased diversification of assets into commodities. "China is probably an old story for the moment," he adds.

Managers agree there has been a long-term shift in the price of some commodities, especially oil, but they are not agreed what the new trading band and volatility is likely to be.

Coote says Crude will probably fluctuate around $40-$50/bbl in the short-term, while Newton says the band will be wider at $35-$70.

key points

Index money is changing the shape of the spot-to-forward price curve in Brent Crude, producing trading opportunities

Some investors feel commodities are at a peak before a decline in the market

IMF gold sales, stability in Iraq and China's economic future remain unresolved issues for global commodity markets