Investing in commodities
Of mice and markets
A surge in speculation is making commodity markets more volatile
A GAME of cat and mouse appears to be taking place in the oil market. The felines are big producers who want prices to go higher, the rodents speculators betting that they will fall.
Twice this year, in the first quarter and the third, hedge funds and others have taken out record short positions on futures of West Texas Intermediate (WTI), an American crude-oil benchmark, only to be mauled by (so far empty) talk among members of the OPEC oil cartel and Russia of a production freeze. The resulting scramble by funds to unwind their short positions has fanned a rally in spot oil prices (see left-hand chart).
This reminds Ole Hansen, head of commodities research at Denmark’s Saxo Bank, of currency intervention by central banks. It often works best, he says, when speculators are positioned heavily in the opposite direction. He mischievously pictures Saudi Arabia’s deputy crown prince, Muhammad bin Salman, watching a screen on his desk each week when America’s Commodity Futures Trading Commission (CFTC) reports speculative positions, poised to pounce.
Not long ago there were fewer mice to catch: in 2012-14 volumes in commodity futures and options markets as a whole were relatively muted, as China’s economy slowed and prices of materials from copper to coal tumbled. Now volumes have bounced back. The Chicago-based CME says the volume of energy futures and options traded on its exchanges has risen by 21%, year on year, in 2016. Those of metals are also up strongly. Barclays, a bank, says that inflows into commodity-based exchange-traded products (ETPs), index funds and other investments have surged too. Led by gold and oil, this year they are at their highest for seven years (see right-hand chart).
The last time investment flowed heavily into commodities was at the tail end of the China-led supercycle, in 2009-12. But back then, says Erik Norland of the CME, the pattern was different.
Commodity markets were dominated by investors making one-way bets that prices would rally.
Moreover, producers saw no need to hedge their exposures because prices (and hence their profits) were rising.
Lately, however, markets have become harder to read. In oil, for instance, the heightened volatility appears to have attracted hedge funds, which for the first time have been the most active investors in futures markets all year, according to CFTC data. Kevin Norrish, head of commodities research at Barclays, describes today’s investors as more tactical than strategic.
They are not investing out of confidence in the asset class as a whole. One example is their enthusiasm for gold, considered a safe-haven asset amid concerns about Brexit and America’s presidential election.
Saxo’s Mr Hansen reckons the low yields offered elsewhere in financial markets are also piquing interest in commodities. The cost of buying a tonne of copper and storing it for sale, for example, is less daunting when interest rates are negative.
The low-yield world may also be driving brave, or foolhardy, retail investors into commodity ETPs. The biggest beneficiaries this year have been gold funds. In America almost $12 billion has poured into one exchange-traded fund, State Street Global Advisors’ SPDR Gold Shares; the total invested in all such oil funds is just $1 billion. Yet oil has also attracted some devil-may-care day traders prepared to risk everything for a quick buck. Mr Hansen points out that a particularly hair-raising ETP, the family of so-called 3X, or triple-leverage, notes linked to WTI prices, has surged in popularity this year, even though the fund is designed to multiply losses as well as gains. Investors in that are probably chasing volatility, rather than thinking about the boring details of supply and demand.
Such bets may be adding to the choppiness of markets. During the commodities boom, speculators were often wrongly blamed for pushing food and energy prices to stratospheric heights, when the true cause was China’s thirst for scarce raw materials. Since then, the new mines, oil wells and fields of grain carpeting the planet to meet that demand have started to produce goods just when the appetite for them has dulled, pushing down prices. But speculators are jumping on anything that may suggest large changes in supply, which may cause exaggerated price swings. For instance, they have placed big wagers on rising coffee prices this year, because of weather-related crop damage in Vietnam, Indonesia and Brazil. Prices of robusta and arabica coffee are near 18-month highs.
Some believe inflows into commodities have already peaked. The pattern in recent years has been to divest in the autumn. But with the presidential election looming and uncertainty about American interest rates high, further volatility may be in store. Moreover, Saudi and Russian officials are again talking about stabilising oil markets as they prepare for a meeting later this month, which could make waves. The choppier markets are, the more speculative money they may attract.