Professional Documents
Culture Documents
Modity Investing and Trading
Modity Investing and Trading
Modity Investing and Trading
Contributors include:
Michael Haigh Socit Gnrale,
Kamal Naqvi Credit Suisse,
Mark Hooker State Street Global Advisors,
Carlos Blanco NQuantX, LLC and
Wang Xueqin Zhengzhou Commodity Exchange.
Commodity markets are an indelible
element of financial markets and of society.
For thousands of years they have shown
themselves to be the most efficient way to
assign the elemental resources
necessary to advance. This fundamental
quality has not changed.
What has changed is the breadth,
depth and complexity of markets.
Commodity
Investing
and Trading
EDITED BY STINSON GIBNER
PEFC Certified
This book has been
produced entirely from
sustainable papers that
are accredited as PEFC
compliant.
www.pefc.org
01/10/2013 15:36
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Contents
ix
xi
xvii
25
65
75
113
133
165
Coal
Jay Gottlieb
207
Farmland as an Investment
Greyson S. Colvin and T. Marc Schober
Colvin & Co. LLP
10 Agriculture Trading
Patrick OHern
Sugar Creek Investment Management
11 Quantitative Approaches to Capturing Commodity Risk
Premiums
Mark Hooker and Paul Lucek
State Street Global Advisors and SSARIS Advisors
229
249
295
307
337
vi
371
CONTENTS
389
409
439
vii
ix
Michael Haigh is managing director and global head of commodities research for Socit Gnrale, based in New York City, managing
a team of commodity analysts in Singapore, Paris, London and New
York City. Prior to joining Socit Gnrale, he was global head of
commodities research at Standard Chartered Bank in Singapore.
Michael has also held the position of managing director at K2
Advisors, and spent several years as the associate chief economist at
the US Commodity Futures Trading Commission and as a tenured
associate professor of economics at the University of Maryland. He
holds a PhD in economics with a minor in statistics from North
Carolina State University.
Mark Hooker was most recently senior managing director of State
Street Global Advisors and head of its Advanced Research Center,
where he was responsible for the worldwide development and
enhancement of SSgAs quantitative investment models. Prior to
joining SSgA in 2000, Mark was a financial economist with the
Federal Reserve Board in Washington, and before that an assistant
professor of economics at Dartmouth College. He earned a PhD in
economics from Stanford University and a bachelors degree with a
dual concentration in economics and mathematics from the
University of California at Santa Barbara.
Paul D. Kaplan is director of research for Morningstar Canada and a
senior member of Morningstars global research team, as well as a
qualified CFA. He is responsible for many of the quantitative
methodologies behind Morningstars fund analysis, indexes, advisor
tools and other services. Pauls research has appeared in many
professional publications, including his book, Frontiers of Modern
Asset Allocation. He received his bachelors degree from New York
University and his masters and doctorate in economics from
Northwestern University.
Paul R. Lucek is the chief investment officer, Hedge Fund Group,
and a member of the Hedge Fund Investment Committee at SSARIS
Advisors. Prior to joining SSARIS, he developed quantitative algorithms for trading stock index futures, and in 1996 he co-founded
SITE Capital Management. He made the transition to money
management from the MD/PhD programme at Columbia
xiii
xiv
INTRODUCTION
xv
xvi
Introduction
Stinson Gibner
Whiteside Energy
INTRODUCTION
xx
Part I
Commodity Market
Fundamentals
roughly 10% each of Brents price movements). The Lehman bankruptcy changed this, with fundamentals explanatory power
dropping to the 3040% range, on average. Since 2013, we have seen
Brents fundamentals progressively giving up explanatory power to
the macro influences as inventories increase, alleviating concerns of a
shortage (see Figure 1.2). The dollars influence has latterly been
practically irrelevant in determining the price path for Brent.
Figure 1.1 Non-fundamentals influence on Brent experienced a structural break
in 2008, jumping from 2030% to over 80%
Macro
Dollar
Liquidity
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
Jan-13
Jul-12
Jan-12
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
Jan-09
Jan-08
Jul-08
0.00
Figure 1.2 In late 2012 and early 2013 the macro influences had taken away
from Brents fundamentals
Mar-13
Sep-12
Mar-10
Sep-10
Mar-09
Sep-09
Mar-08
Sep-08
Mar-07
Sep-07
Mar-06
Sep-06
Mar-05
Sep-05
Mar-04
Sep-04
Mar-03
Sep-03
Mar-02
Sep-02
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Sep-11
Liquidity
Mar-12
Dollar
Mar-11
Macro
Base
Prior to the Lehman crisis, the bulk of the explanatory power relating
to base metals price movement was explained by fundamentals (for
both copper and aluminium (not shown)), followed by movements
in the dollar. The role of fundamentals diminished post-Lehman
with more explanatory power coming from the macro factors and
much less from the dollar (see Figure 1.3). Copper is the one base
metal that is very exposed to the macro outlook, especially as price
levels have become significantly higher than the marginal cost of
production. Not surprisingly, prices can be significantly influenced
by other factors. In late 2012, the role of macro dropped in its
explanatory power (Figure 1.4).
Precious
The gold market remains an outlier among commodities (not
surprisingly), with the influence from non-fundamentals still coming
from the dollar, and liquidity and macro factors jostling for second
place in terms of explanatory. Since Lehman (Figure 1.5), liquidity
has improved in terms of extra explanatory power of gold price
movements. Since late 2012, the outside influences have diminished (see Figure 1.6), coinciding with gold prices plummeting in
early April 2013.
Figure 1.3 Copper the dollar has taken a back seat to macro since Lehman
Macro
Dollar
Liquidity
0.8
0.7
0.6
0.5
0.4
0.3
0.2
Mar-13
Mar-12
Sep-12
Mar-11
Sep-11
Mar-10
Sep-10
Mar-09
Sep-09
Mar-08
Sep-08
Mar-07
Sep-07
Mar-06
Sep-06
Mar-05
Sep-05
Mar-04
Sep-04
Mar-03
Sep-03
Mar-02
Sep-02
0.1
Figure 1.4 The role of macro has deteriorated since late 2012
Macro
Dollar
Liquidity
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
Jan-13
Jul-12
Jan-12
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
Jan-09
Jan-08
Jul-08
Mar-13
Mar-12
Sep-12
Mar-11
Sep-11
Mar-10
Sep-10
Mar-09
Sep-09
Mar-08
Liquidity
Sep-08
Mar-07
Sep-07
Mar-06
Dollar
Sep-06
Mar-05
Sep-05
Mar-04
Sep-04
Mar-03
Sep-03
Mar-02
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Sep-02
Macro
Agriculture
The markets fundamentals (here represented by soybeans)
accounted for approximately 7095% of price volatility prior to
Lehman (see Figure 1.7). The remainder of the price movement was
captured mainly by the dollar (after the early 2000 recession).
Nevertheless, soybeans could not avoid the influence of the Lehman
7
Figure 1.6 Outside influences on gold have become irrelevant since late 2012
Macro
Dollar
Liquidity
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
Jan -13
Jan -12
Jan -11
Jan -10
Jan -09
Jan -08
0.0
Mar-13
Mar-12
Sep-12
Mar-11
Sep-11
Mar-10
Sep-10
Mar-09
Sep-09
Mar-08
Liquidity
Sep-08
Mar-07
Sep-07
Mar-06
Dollar
Sep-06
Mar-05
Sep-05
Mar-04
Sep-04
Mar-03
Sep-03
Mar-02
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
Sep-02
Macro
Figure 1.8 The drought of 2012 brings more explanatory power from soybean
fundamentals on price movement
Macro
Dollar
Liquidity
-1
2
-1
Ja
n
Ju
l
-1
Ja
n
Ju
l-1
1
n11
Ja
0
-1
l-1
Ju
9
Ja
n
9
-0
l-0
Ju
8
Ja
n
l-0
Ju
Ja
n
-0
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
Sentiment Indicator
0.015
Risk seeking
0.8
0.01
0.6
0.005
0.4
0.2
-0.005
Risk averse
0.0
Feb-12
-0.01
Mar-12
Apr-12
10
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Figure 1.10 Impulse response: a one standard deviation drop in sentiment drags
down the DJUBS to its lowest level after five days
Std. Dev
0.2
0
-0.2
10
-0.4
-0.6
-0.8
-1
-1.2
Source: SG Cross Asset Research
11
Figure 1.11 But a one standard deviation drop in the DJUBS does not influence
sentiment
Std. Dev
0.1
0.08
0.06
Reaction of sentiment to a drop in DJUBS over 10 days
0.04
0.02
0
1
10
2
12
-Ju
l-1
1
12
-O
ct
-1
11
Ja
n12
-
-1
0
12
-
Ap
r
9
12
-Ju
l-0
8
ct
-0
12
-O
08
nJa
12
-
pr
-0
6
-0
Ju
l
12
-A
12
-
-0.1
12
-
ct
-0
5
13
2
l-1
12
-J u
12
-O
ct
-1
11
-Ja
n12
12
-A
pr
-1
9
12
-Ju
l-0
8
12
-O
ct
-0
08
12
-Ja
n-
7
-A
pr
-0
l-0
-Ju
12
12
-0.1
12
-O
ct
-0
1
12
-Ju
l-1
-1
-O
ct
12
n11
-Ja
12
-A
pr
-1
0
l-0
-Ju
12
12
8
ct
-O
12
12
-Ja
n-
-0
08
7
-0
pr
-A
-Ju
l-0
12
12
-0.1
12
-O
ct
-0
12
-Ju
l-1
1
ct
-1
Ja
n11
12
-O
12
12
-
-A
p
r-1
9
12
-Ju
l-0
ct
-0
8
12
-O
12
-Ja
n08
r-0
7
12
-A
p
12
-Ju
-0.1
l-0
6
-0.2
-Ju
l-1
2
12
1
ct
-1
-O
12
-A
p
12
12
-Ja
n11
0
r-1
9
12
-Ju
l-0
-0
8
-O
ct
12
n08
12
-Ja
r-0
7
12
-A
p
6
l-0
12
-Ju
12
-O
ct
-0
5
-0.3
-0.2
16
2
12
-Ju
l-1
-1
1
12
-O
ct
n11
12
-Ja
pr
-1
0
12
-A
l-0
9
12
-Ju
ct
-0
8
-O
12
-Ja
n08
12
7
r-0
-Ju
-A
p
12
12
-O
-0.1
12
ct
-0
l-0
6
0.5
0.4
0.3
0.2
0.1
12-Jul-12
12-Oct-11
12-Jan-11
12-Apr-10
12-Jul-09
12-Oct-08
12-Jan-08
12-Apr-07
12-Jul-06
12-Oct-05
12
-Ju
l-1
ct
-1
12
-O
n1
0
pr
-1
12
-A
12
-Ja
9
-Ju
l-0
12
ct
-O
12
12
-Ja
n-
-0
08
7
12
-A
pr
-0
l-0
6
12
-Ju
5
ct
-0
-O
12
-0.05
17
to sentiment and are still part of global benchmark indexes, but sentiments influence on them is certainly lower.
Last, we present a couple of examples of markets that did not
change after Lehman. US natural gas (a domestic rather than global
market) is the distinct outlier in that its correlation pattern did not
change at all with the structural change in 2008 (see Figure 1.20). Its
average correlation remained at 0.06, precisely the same value it had
before the crisis in 2008. Lean hogs is also independent of sentiment,
having a very similar correlation value pre- and post-Lehman (0.06
and 0.05). Its correlation can occasionally go negative (Figure 1.21).
Figure 1.20 DCC between US natural gas and sentiment
0.6
0.5
0.4
0.3
0.2
0.1
2
l-1
-Ju
12
12
-O
ct
-1
1
12
-Ja
n1
-1
0
pr
12
-A
-Ju
l-0
9
8
12
-
-Ja
12
12
r-0
Ap
12
-
O
ct
-0
n08
6
l-0
-Ju
12
-O
-0.1
12
ct
-0
5
-0.2
-0.3
18
2
l-1
12
-Ju
ct
-1
1
12
-O
11
12
-
Ja
n-
0
12
-
Ap
r
-1
9
Ju
l-0
12
-
ct
-0
8
O
n-Ja
12
-0.2
12
-
08
7
-0
6
l-0
12
-A
pr
12
-O
-0.1
12
-Ju
ct
-0
5
Post-Lehman
Risk
off
Risk
neutral
Risk
on
Risk
off
Risk
neutral
Risk
on
Zinc
Silver
Aluminium
Copper
Cotton
Brent
Copper
Nickel
Heating oil
WTI
Aluminium
RBOB
Gold
14
18
Zinc
Corn
Nickel
WTI
10
10
Silver
10
RBOB
10
Soybean oil
10
10
Brent
11
12
11
Soybeans
11
11
11
Coffee
12
Coffee
12
12
12
Soybean oil
13
18
15
Cotton
13
13
13
Soybeans
14
16
16
Wheat
14
14
14
Sugar
15
17
12
Corn
15
16
16
Natural gas
16
13
14
Gold
16
15
15
Heating oil
17
15
17
Live cattle
17
17
17
Lean hogs
18
11
13
Sugar
18
18
18
Live cattle
19
20
20
Natural gas
19
19
19
Wheat
20
19
19
Lean hogs
20
20
20
19
a longer-term view
h a risk switch that
52-day sentiment is
or falls below 20%
e set to zero (again,
roducts (alpha), for
his is an arbitrary
nvestors risk tolers is that, if there is
ue to a crisis (for
21
example), the investor sits on the sidelines until long-term sentiment improves (ie, passes through 20% to the upside), at which
point the risk-tilting mechanism kicks in once more.
Importantly, while we have isolated the commodities most affected
by sentiment as the ones to remove in risk off versus capture in
risk on, even the less-sensitive commodities are positively correlated with sentiment. Therefore, one could argue to completely
remove all commodity exposure in risk off, but here we choose to
remain invested instead of having extended periods of time sitting
on the sidelines. Performance is clearly better overlaying the sentiment (see Figure 1.22), a function of re-weighting and overlaying
with an extra layer of insurance (the 252-day window). Focusing
purely on the September 2008 onwards (47 months), the number of
positive months increases from 27 to 32 and average annualised
return rises from 13.34% investing in the DJUBS (about 3.52%
annualised) to 74.08% (about 15% average annualised) investing in
the DJUBS, weight-tilted 100-day sentiment indicator with the 252day overlay. Ignoring the 252-day overlay (from sentiment) results in
a return of 32%. Therefore, most reward from using the sentiment
indicator comes from the performance attributed from shifting
weights based on the 100-day indicator (about 45% over the DJUBS),
although the overlay (insurance) adds almost the same amount. The
number of times the portfolio is re-weighted because of a change in
sentiment is approximately 25 times per annum. With the 30-day
sentiment indicator applied (instead of the 100-day), the number of
times is 46 hence higher trading costs.
SUMMARY
It is clear that outside influences on commodities have picked up
since 2008. The role of macro, dollar and liquidity vary across
commodities and across time. Sentiment has made a substantial
impact on the commodities markets since 2008. Here, we have documented the causal relationship (from sentiment to commodities) and
reported that some commodities are more affected by sentiment than
others. A ranking was established. We applied our research results
by overlaying the DJUBS with the sentiment indicator signals, utilising the rankings of the sensitive commodities by re-weighting in
risk-off and risk-on environments. The re-weighting alone
22
200
Incremental return since 2008: overlaying with 252 day Sentiment Indicator: 42%
180
140
120
100
80
60
40
DJUBS
20
0
Sep -06
Sep -07
Sep -08
Sep -09
Sep -10
Sep -11
Sep -12
23
160
Figure 1.22 DJUBS versus DJUBS-with-weight-tilt (based on 100-day sentiment) and 252-day sentiment indicator overlay
24
when gas burn rises. Injections and withdrawals from storage facilities are surveyed and reported by the Energy Information
Administration (EIA), part of the US Department of Energy (DOE),
providing a closely watched weekly monitor of supply/demand
balance.
The natural gas transported through long-haul pipelines is
primarily methane with a mixture of some ethane and smaller
amounts of heavier hydrocarbon gases, and may contain a small
percentage mixture of nitrogen and carbon dioxide. The average
heating value of gas consumed in the US is now about 1,025 Btu per
cubic foot or 1.025 million Btu (MMBtu) per thousand cubic feet
(Mcf). This leads to an often-used rule of thumb conversion factor
that 1 Mcf approximately equals 1 MMBtu. Pipelines have specifications for the range of gas quality acceptable for receipt. The heating
value of the gas accepted must typically lie within a range of, for
example, ~9701,100 Btu per cubic foot. Some of the most common
natural gas units of measure and conversions are given in Table 2.1.
GAS MARKETS
Before the 1990s, natural gas purchases and sales were predominantly handled by long-term contracts for physical natural gas.
Natural gas can still be traded by the purchase or sale of physical gas
where the seller delivers and the buyer receives the molecules, and
there is also a liquid market where gas can be traded purely finanTable 2.1 Common units of measure and conversions
Common units of measure
MMBtu
Mcf
Bcf
Tcf
Bcm
MMT
MMBOE
Million Btu
Thousand cubic feet
Billion cubic feet (1,000 Mcf)
Trillion cubic feet (1,000 Bcf)
Billion cubic meters
Million tonnes
Million barrels of oil equivalent
Conversions
1
1
1
1
26
27
US$40.00
Industrial use (Bcf/day)
23
US$36.00
US$4.00
14
US$0.00
Source: EIA
28
20
0
20
12
15
20
11
US$8.00
20
10
16
20
09
US$12.00
20
08
17
20
07
US$16.00
20
06
18
20
05
US$20.00
20
04
19
20
03
US$24.00
20
20
02
US$28.00
20
00
21
19
99
US$32.00
19
98
22
19
97
from 1998 to 2006, there was declining use in every significant sector
except food and non-metallic minerals. The largest losses in use were
in chemicals manufacturing (down 2.59 Bcf/day), primary metals
(down 0.82 Bcf/day) and refining (down 0.43 Bcf/day). Within the
chemical sector, nitrogenous fertilisers alone accounted for almost
0.75 Bcf/day loss of demand over this time period due to production
moving offshore. Imports of anhydrous ammonia grew by 4.4 million
short tons, equating to 0.45 Bcf/day of domestic gas demand loss.
Since 2006, industrial use of gas has begun to grow again. Of
course, the deep recession between late 2008 and early 2010 created a
loss of demand of around 1.5 Bcf/day in 2009. However, growth of
industrial demand has started to accelerate due to low natural gas
prices, which looks to continue into the future, driven by a resurgence in the chemical and refining sectors. Domestic ammonia
7.0
6.0
Bcf/day
5.0
4.0
3.0
2.0
1.0
s
al
et
er
al
in
ed
m
Fa
br
ic
at
c
al
li
et
m
th
Pa
pe
r
N
on
or
ie
er
ca
te
g
m
et
a
ar
y
im
ls
g
in
re
fin
Fo
o
Pr
Pe
tro
le
um
Ch
em
ic
al
s
0.0
Source: EIA
29
00
-2
0
00
3
Ju
04
l-2
00
4
Ja
n20
05
Ju
l-2
00
5
Ja
n20
06
Ju
l-2
00
6
Ja
n20
07
Ju
l-2
00
7
Ja
n20
08
Ju
l-2
00
8
Ja
n20
09
Ju
l-2
00
9
Ja
n20
10
Ju
l-2
01
0
Ja
n20
11
Ju
l-2
01
1
Ja
n20
12
Ja
n
00
3
l-2
Ju
Ja
n2
-2
00
02
n20
Ju
l
Ja
31
THE NORTH AMERICAN NATURAL GAS MARKET
Source: EIA
1
20
01
Ju
l-2
Ja
n-
35
30
25
20
15
10
Figure 2.3 Monthly average gas use for electric generation (Bcf/day)
Million gigawatthours
4.15
4.10
4.05
4.00
3.95
3.90
3.85
3.80
3.75
3.70
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Source: EIA
50.0%
40.0%
Natural gas
30.0%
Nuclear
20.0%
All other
10.0%
0.0%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: EIA
1990s and early 2000s, fuel oil was sometimes economically competitive with natural gas, so during times of high gas prices there could
be an economic incentive to turn on oil-fired generation which, in
turn, liberated gas for higher value heating use. With the advent of
oil prices near US$100+/bbl, natural gas has remained much less
expensive and oil use for generation has fallen from the already low
level of 2% of total generation in 2002 to 0.3% in 2012.
32
Figure 2.6 Natural gas and coal generation capacity and gas average heat rate
450
Capacity (gigawatts)
400
11.5
11.0
10.5
350
10.0
9.5
300
9.0
8.5
250
8.0
7.5
200
12.0
NG summer capacity (GW)
Coal summer capacity (GW)
Average heat rate
7.0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: EIA
20
0
n10
Source: EIA
35
THE NORTH AMERICAN NATURAL GAS MARKET
Ju
l
1
-2
00
1
Ja
n20
02
Ju
l-2
00
2
Ja
n20
03
Ju
l-2
00
3
Ja
n20
04
Ju
l-2
00
4
Ja
n20
05
Ju
l-2
00
5
Ja
n20
06
Ju
l-2
00
6
Ja
n20
07
Ju
l-2
00
7
Ja
n20
08
Ju
l-2
00
8
Ja
n20
09
Ju
l-2
00
9
Ja
n20
10
Ju
l-2
01
0
Ja
n20
11
Ju
l-2
01
1
Ja
n20
12
Ja
Bcf / Day
60
50
40
30
20
Figure 2.7 Residential and commercial gas demand (monthly average in Bcf/day)
55
50
Gustav & Ike
45
Katrina & Rita
37
THE NORTH AMERICAN NATURAL GAS MARKET
Source: EIA
19
94
Ja
n19
95
Ja
n19
96
Ja
n19
97
Ja
n19
98
Ja
n19
99
Ja
n20
00
Ja
n20
01
Ja
n20
02
Ja
n20
03
Ja
n20
04
Ja
n20
05
Ja
n20
06
Ja
n20
07
Ja
n20
08
Ja
n20
09
Ja
n20
10
Ja
n20
11
Ja
n20
12
Ja
n20
13
19
9
n-
Ja
n-
Ja
(Bcf / day)
75
70
65
60
TX Cold
Bakken (ND)
Eagle Ford (TX)
Bcf/day
20
15
Woodford (OK)
Fayetteville (AR)
10
Barnett (TX)
Antrim (MI, IN, and OH)
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: EIA
38
16
1600
Natural gas price
14
12
1200
Rigs
US$/mmbtu
10
800
400
Source: EIA
n13
Ja
-1
2
Ja
n
n11
Ja
10
nJa
09
nJa
-0
Ja
n
n07
Ja
n06
Ja
Ja
n05
04
nJa
n03
Ja
n02
Ja
00
n01
Ja
99
Ja
n-
nJa
98
nJa
n97
Ja
n96
Ja
n-
95
Ja
Ja
n-
94
39
Figure 2.10 Count of rigs drilling for oil and gas in the US
Forecast
Tight gas
Non-associated offshore
60
Coalbed methane
Associated with oil
Non-associated onshore
50
40
30
20
10
0
1990
1995
2000
2005
2010
2015
2020
2025
2030
40
70
4,500
4,000
3,500
3,000
Bcf
2,500
2,000
Range 2004-2010
1,000
2011
2012
500
Apr
Source: EIA
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
45
1,500
Table 2.2 US production and estimated net exports, demand and imports
State or region
Texas
Louisiana
Oklahoma
Gulf of Mexico, Federal Offshore
Arkansas
Rockies (NM, CO, UT, WY)
Marcellus (Northeast States)
Midwestern States
California
Florida
Southeast
Production
(Bcf/d)
Exports
20
8
6
4
3
15
7
1
1
11
5
4
4
2
13
Demand
Imports
12
12
6
3
7
4
11
5
3
6
46
Figure 2.13 NG price (average of front 12 months) and storage levels relative to five-year trailing average (right axis)
Production declining
Production growing
US$14
2,000
Recession +
mild summer
US$12
1,600
Cold Jan-Mar
Coal to gas
switching
1,200
US$8
800
US$6
400
Bcf
US$/mmbtu
US$4
Mild Jan
US$2
(400)
Mild summer '03
Cold winter '02-'03
US$0
Jan-02
Apr-02
Jul-02
Oct-02
Jan-03
Apr-03
Jul-03
Oct-03
Jan-04
Apr-04
Jul-04
Oct-04
Jan-05
Apr-05
Jul-05
Oct-05
Jan-06
Apr-06
Jul-06
Oct-06
Jan-07
Apr-07
Jul-07
Oct-07
Jan-08
Apr-08
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11
Jul-11
Oct-11
Jan-12
Apr-12
Jul-12
Oct-12
Jan-13
Apr-13
(800)
48
US$10
49
50
-5
Jan-13
Jul-12
Jan-12
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
US$/mmbtu
Prompt Futures
15
1 Year Contango
10
0
8
4
2009
2010
2
2011
2012
2013
51
THE NORTH AMERICAN NATURAL GAS MARKET
Mar-02
Jul-02
Nov-02
Mar-03
Jul-03
Nov-03
Mar-04
Jul-04
Nov-04
Mar-05
Jul-05
Nov-05
Mar-06
Jul-06
Nov-06
Mar-07
Jul-07
Nov-07
Mar-08
Jul-08
Nov-08
Mar-09
Jul-09
Nov-09
Mar-10
Jul-10
Nov-10
Mar-11
Jul-11
Nov-11
Mar-12
Jul-12
Nov-12
Mar-13
Jul-13
Nov-13
Mar-14
Jul-14
Nov-14
Mar-15
Jul-15
Nov-15
Mar-16
Jul-16
Nov-16
Mar-17
Jul-17
Nov-17
Mar-18
US$/mmbtu
12
10
2002
2003
2004
2005
2006
2007
2008
Figure 2.15 The annual evolution of the natural gas futures curve
GLOBAL LNG
Rita D'Ecclesia
Sapienza University of Rome
Global LNG flows reached over 200 MMT in 2012, the equivalent of
almost 10 Tcf of gas or about 8% of world gas production. This panel will
discuss major exporters and importers and possible trends going forward.
Exports
By 2012, LNG exports represented about 30% of international gas flows.
Global LNG exports grew from 117 MMT in 2005 to 203 MMT by 2012,
an average annual increase of 10%. Table 2.3 shows the LNG exports for
the 10 largest exporters since 2005 including Canada scheduled to be a
major player by 2020.
The biggest LNG exporters in 2005 were Indonesia (17%), Malaysia
(15%), Algeria (14%) and Qatar (14%), accounting for 60% of world
exports. By 2012, the balance had shifted and four countries Qatar
(39%), Malaysia (13%), Australia (11%) and Indonesia (10%) accounted
for 73% of the total exports, with Algeria having heavily reduced its share.
During this period LNG exports grew by 56 MMT. In terms of
geographic distribution the Middle East was the fastest growing exporter,
growing from 38 MMT (28% of total) in 2005 to 85 MMT (43% of total) in
2012, while the Atlantic Basin reduced its exports from 44 MMT in 2005
to 37 MMT in 2012.
Exports are tied to the liquefaction capacity of each country, therefore
we need to look at the existing plants and those planned for the next
decade. In Table 2.4, the evolution of liquefaction capacity between 2000
and 2012, and an estimate for 2020, is provided. The list of exporters with
more than 10 million metric tonne per annum (MMTPA) of liquefaction
capacity is short and rapidly changing. There are 20 countries exporting
LNG and five major re-exporters (Belgium, Brazil, Mexico, Spain and the
US). Liquefaction capacity utilisation around the world averages 90%, and
so its growth is critical to expanding volumes, whereas global utilisation of
regasification is only 35%.
In 2001, the US was expected to become a major importer of LNG, but
by 2012 a resurgence in US gas production lead to the prospect of the US
becoming a major exporter once liquefaction trains become operational,
expected to begin around 2016.
Because of the high infrastructure costs of creating and delivering LNG,
most projects require long-term contracts that lock in the destination of
LNG produced. An estimated 25% of these flows are now short-term
contracts (less than four years in duration), and an increasing amount of
LNG flows are in the hands of international oil and gas companies (IOCs
see Table 2.4) with more destination flexibility.
From 2008 to 2012, IOCs increased their share of export capacity by 45
54
Algeria
Egypt
Nigeria
Oman
Qatar
Australia
USA
Indonesia
Malaysia
Russia
Canada
World total
2005
2008
2009
2010
2011
2012 D(20122005)
2015
15.9
4.3
8.0
5.7
16.8
9.2
1.1
19.5
17.6
15.9
10.6
16.7
8.6
30.0
15.0
0.8
20.1
22.1
15.7
10.2
11.6
8.1
36.9
17.9
0.6
19.3
22.3
5.0
14.3
7.1
17.9
8.6
56.2
18.8
0.6
23.5
23.2
9.9
12.5
6.3
18.9
8.1
75.4
19.5
0.3
21.9
24.9
10.6
11.2
4.7
19.6
8.2
76.4
20.9
0.2
19.0
24.9
10.9
4.7
0.5
11.6
2.4
59.6
11.7
1.0
0.5
7.3
10.9
19.3
4.9
14.2
8.3
75.3
21.7
9.9
13.6
25.9
9.6
8.1
0.1
5.4
0.2
1.1
0.8
9.7
5.4
1.0
1.3
19.3
4.9
14.2
8.3
75.3
77.3
80.8
15.1
25.9
9.6
16.9
0.0
0.0
0.0
0.0
0.0
55.6
70.9
1.5
0.0
0.0
0
195.9
56.0
202.6
22.6
347.5
144.9
117.0 139.8
D(20122005)
D(20152012)*
D(20202015)*
57.2
41%
64.5
44%
75.3
42%
76.9
44%
75.6
39%
18.4
70.7
35%
4.6
144.8
42%
Middle East
% of total
38.6
28%
45.0
31%
64.8
36%
83.5
48%
84.5
43%
45.9
83.7
41%
18.9
83.7
24%
44.0
31%
38.0
26%
39.9
22%
38.0
22%
35.7
18%
8.3
48
24%
119
34%
* Estimates by GIIGNL.
74.0
70.9
55
Major exporters
billion cubic meters per annum (bcm/a) from 85 to 130 bcm/a, led by
Shell, Exxon Mobil, Total, ConocoPhillips, Woodside and Chevron.
National oil and gas companies (NOCs) increased by 74 bcm/a, from 137
to 211 bcm/a. Trading houses, LNG importers, financial institutions and
local companies represent the balance, 33 bcm/a in 2008 and 48 bcm/a
by 2012. NOCs have an obligation to satisfy domestic demand, therefore
Russia, Nigeria and Indonesia are increasingly focused on the price gap
between their domestic market and export prices. In general, IOCs are
more responsive to market conditions, and bring advantages in terms of
integrated project development. European utilities with considerable LNG
strategies include GDF-Suez, EdF, E.ON and RWE.
In 2012, Qatar dominated global export capacity with a 39% market
share and 84 MMTPA of liquefaction (see Table 2.5). The other Middle
East exporters, including Abu Dhabi, Oman and Yemen, have no reported
plans to expand their liquefaction capacities. Qatar is a true swing
exporter and, in the period 200812, sent on average 35% to Europe, 5%
to the Americas and the rest to Asia (of which 33% was to Japan, 25% to
each of India and South Korea, 10% to Taiwan and 7% to China). Asian
demand growth is impressive (see Table 2.6). China has grown from
nothing in 2005 to 5 MMT in 2012, India from 6 to 10 MMT, Japan from 8
to 16 MMT and Taiwan from 1 to 6 MMT. South Korea is the only stagnant
Asian importer, with 9 MMT in 2005 and 11 MMT in 2012. Most of the
LNG from Abu Dhabi, Oman and Yemen flows to Asia.
The Pacific Basin liquefaction capacity stands at 92 MMTPA, representing 38% of the world total. It is expected to increase by 2020 as many
large Australian and Canadian projects come online, and Australia is
expected to tie with Qatars liquefaction capacity. Indonesia has been
experiencing domestic production outages, and is therefore planning to
expand its liquefaction capacity to send out 40% of production to the
domestic market. In addition, adding new liquefaction capacity in 2014,
Indonesia is converting two ageing liquefaction plants to regasification.
Malaysia has had a series of outages on liquefaction maintenance and has
minor plans for floating liquefaction in the future.
Australia and Canada are positioned to be key exporters in this basin. In
the period 200512, Australia added 24 of the 26 MMTPA Pacific Basin
liquefaction increase. According to planned new liquefaction plants,
Australia will increase its capacity by 60 MMTPA, and Canada is expected
to build 17 MMTPA of liquefaction capacity by 2020, estimated as 50% of
the 34 MMT of filed projects.
The major Atlantic Basin exporters hold 23% of liquefaction capacity.
From 2005, Algerian capacity has remained unchanged at 19 MMTPA,
still recovering from the 2004 explosion at Skikda that kept capacity
offline in the 200812 period. New capacity additions for Algeria have
been quoted at US$1,000/MT capital costs. Egypt started as an exporter in
2004 and has 12 MMTPA of capacity. Its economic growth has created
more domestic demand, and it is planning to build regas capacity. By
56
Country
Basin
2000
2005
2008
2009
2010
2011
Algeria
Egypt
Nigeria
Oman
Qatar
Australia 1
USA2
Indonesia
Malaysis
Russia
Canada3
Atlantic
Atlantic
Atlantic
Middle East
Middle East
Pacific
Atlantic
Pacific
Pacific
Pacific
Pacific
19.4
0
9.6
7.1
16.1
0
1.4
26.5
15.9
19.4
12.2
9.6
7.1
25.5
12.1
1.4
26.5
22.7
19.4
12.2
21.8
10.7
36.9
19.8
1.4
26.5
22.7
19.4
12.2
21.8
10.7
60.3
19.8
1.4
34.1
22.7
9.55
19.4
12.2
21.8
10.7
75.9
19.8
1.4
34.1
24.2
9.55
19.4
12.2
21.8
10.7
83.7
19.8
1.4
34.1
24.2
9.55
2012
19.4
12.2
21.8
10.7
83.7
24.1
1.4
34.1
24.2
9.55
2015
8%
5%
9%
4%
35%
10%
1%
14%
10%
4%
24.1
12.2
21.8
10.7
83.7
24.1
10.4
33.95
26.07
9.55
100%
TOTAL
96.0
136.5
Capacity change
212.0
229.1
236.9
241.2
40.5
34.9
and percentage
share
40.55
17.1
7.8
4.3
9%
5%
8%
4%
33%
9%
4%
13%
10%
4%
24.1
12.2
21.8
10.7
83.7
85.9
85
37.75
26.07
9.55
16.9
100%
256.6
413.7
201512
202015
15.42
157.1
6%
3%
5%
3%
20%
21%
21%
9%
6%
2%
4%
100%
Capacity by area
2000
2005
2008
2009
2010
2011
2012
20122005
2015*
20152010
2020*
20202015
42.4
45%
23.2
24%
30.4
31%
61.3
40%
32.6
28%
42.6
32%
69
41%
47.6
33%
54.8
26%
86.15
38%
71
38%
54.8
24%
87.65
37%
86.6
40%
54.8
23%
87.65
38%
94.4
39%
54.8
23%
91.95
37%
94.4
37%
54.8
27%
26.35
93.67
43%
94.4
23%
68.5
35%
1.72
176.17
82.5
94.4
13.7
143.1
74.6
1
2
57
54
12.2
200500
171.4
2020
2000
2005 2008
2009
2010
4
7
2
4
7
2
4
7
2
4
11
5
4
11
5
19
3
34
22
3
9
47
27
6
11
57
27
6
24
77
Europe
34
47
59
USA
Americas
China
India
Japan
South Korea
Taiwan
Asia
2011 2012
* Estimates by GIIGNL.
58
2020*
27
6
24
77
4
11
5
5
27
6
24
82
4
11
5
5
27
6
24
82
9
20
16
15
27
6
24
117
10
22
27
20
27
10
27
143
77
77
84
88
125
150
46
53
78
83
83
50
60
100
110
112
104
44
4
5
108
55
4
8
5
115
55
4
10
6
115
55
7
10
8
116
55
7
12
8
117
55
7
14
8
118
55
7
152
168
175
177
178
179
207
Middle East
Total
2015*
4
189
223
284
314
355
373
411
term supply choice. Coastal India is another big importer, where GDP is
crimped by a lack of energy, and rolling brown-outs are common.
Asia more than doubled imports in the period 200512, with Indonesia
and Taiwan starting to import in 2005, with Japan, China and South Korea
also increasing their volumes. Europe and the Americas reduced their
LNG imports in 201012, despite increasing between 2005 and 2010
(Table 2.6), due to factors such as price, the economic downturn and
increasing US domestic production.
Asia is the largest importing region, with almost 65% of total world
imports. In 200812, Asia imported an average of 136 MMT (63% of
world total imports). Of these, 55% was delivered to Japan, 22% to South
Korea, 6% to China and the remaining 17% to India, Taiwan and
Indonesia. Imports in Asia have staged a recovery after a contraction in
2009 (7%, see Table 2.7).
European imports increased by 70% during 200512. In 2012, they
accounted for 21% of global imports. The largest importer is Spain (31% in
2012), followed by France (15%), the UK (21%), Turkey (11%), Italy
2008
2009
2010
2011
2012
D(20122005)
3
7
5
1
15
5
10
47
1
1
4
1
2
2
10
19
Belgium
France
Italy
Netherlands
Spain
Turkey
UK
Big 7 Total
2
8
2
2
9
1
5
10
2
5
10
7
14
3
0
28
22
4
1
40
20
4
7
48
21
6
14
62
5
11
6
1
17
5
19
63
Europe
30
42
52
65
65
49
20
USA
11
10
Americas
12
11
16
21
19
18
China
India
Japan
South Korea
Taiwan
3.7
47.2
18.8
5.9
3
8
69
29
9
6
9
66
21
9
10
12
72
28
11
13
12
78
35
12
15
13
87
37
13
15
9
40
18
7
Asia
75.7
118
113
132
153
166
90
117.7
195
181
220
241
236
119
Middle East
TOTAL
59
Big 7 Europe
40%
22%
29%
0%
25%
Europe
43%
23%
25%
0%
24%
Americas
2%
37%
33%
8%
5%
119%
45%
53%
54%
56%
68%
13%
4%
27%
3%
4%
70%
35%
9%
32%
21%
17%
37%
1%
9%
26%
9%
16%
13%
5%
12%
4%
8%
9%
67%
7%
21%
9%
2%
China
India
Japan
South Korea
Taiwan
Asia
Total
(10%), Belgium (6%) and the Netherlands (1%). These six countries
account for the lions share of demand (96%).
Imports by the Americas accounted for an average 17 MMT over 2005
12, and in 2012 were a mere 7% of world LNG imports. The US
accounted for 44% of the volume followed by Mexico (19%), Argentina
and Chile (9% each), and 6% for Brazil and Canada.
Two countries in the Middle East (Kuwait and Dubai) started to import
LNG in 2009 and in 2012 were an insignificant 1% of global imports.
Imports of LNG are linked to the regasification capacity of the various
importing countries (see Table 2.8). In 2012, there were 93 LNG regasification terminals operating in the world including 11 floating facilities.
There are two possibilities for significant regasification capacity growth
around the world. Both China and India have considerable plans to
expand LNG imports. The GIIGNL 2012 Annual Report lists eight projects
under development in China that are expected to add some 15 MMT of
regas capacity. This would double Chinese import capacity. By 2020,
China could be importing as much as South Korea. India similarly lists
12.5 MMT of capacity under construction, likely to continue to be
hampered by logistical issues, and also lists a variety of terminal and distribution projects. This would more than double Indian import capacity into
the early 2020s.
Regasification in Europe is mainly concentrated in the seven largest
European importers which have 82 of the total 88 MMTPA of regasification capacity. The utilisation rates swing depending on the LNG price. For
example, Spain imported 22 MMT in 2008 and only 15 MMT in 2012. The
flexibility of imports in Europe is a reflection of its market maturity and efficiency. The LNG demand in Europe has been growing at a fast pace over
200510, with an annual average growth of 19% to 2011, and declined
60
2009
2010
2011
2012
2015*
2020*
Belgium
France
Italy
Netherlands
Spain
Turkey
UK
56
132
72
121
89
42
112
96
130
95
96
93
75
73
30
76
100
60
73
68
98
10
56
98
44
95
96
93
81
70
7
115
97
122
13
62
85
79
70
85
44
70
85
44
Big 7 total
Europe
70
71
63
68
81
76
57
56
69
69
USA
16
18
11
11
11
107
164
74
66
186
82
157
64
54
171
82
157
64
54
171
Asia
80
85
90
Middle East
72
75
80
Total
35
40
40
Americas
China
India
Japan
South Korea
Taiwan
16
41
154
60
52
211
56
155
57
38
130
95
157
62
50
158
110
156
67
64
172
heavily in 2012 (25%, partly due to relative price and partly economy
shrinkage). The large reduction of LNG demand is in line with the heavy
reduction of natural gas demand in 201112 in Europe. In the period
200508, virtually every European country, from Lithuania to Ireland,
added regas capacity.
In the US during 200508, a lot of regas capacity was built, but subsequently was not needed, so US utilisation rates are abysmal.
Regasification global usage is only 35%, but capacity utilisation varies
widely by region. Regas capacity can provide flexibility and security of
supply. Utilisation rates change as capacity is added and as other energy
flows dictate. For example, between Spain and France energy may flow as
gas or be wheeled as electricity.
Table 2.9 lists regasification capacity utilisation rates. Italys data is difficult to follow, with listed additions apparently running earlier than official
openings. India suffers from the same problem. Russia and China do run at
excess of nameplate capacity. Taiwans import data is suspect. All figures
come from GIIGNL.
61
Table 2.9 European natural gas supply and demand in the European Union (bcm)
Production
2000
2005
2008
2009
2010
23193
21198
19328
17426
average (200812)
49613
49729
46512
average (200812)
Russian pipeline imports
19390
15128
18099
16429
average (200812)
1447
13288
12302
12657
average (200812)
Excess demand in LNG equivalent (MmT)
average (200812)
Excess demand (BCM)
2012
1706
44029
Consumption
2011
1070
9833
9103
9366
10269
8626
8016
908
62
The order book was 78 vessels at the end of 2012 and 27 new orders
were added in the year, of which 23 were LNG carriers ranging from
150,000172,000 m3, two FSRUs, one regasification vessel (RV) and one
floating liquefied natural gas (FLNG) carrier (210,000 m3). ICIS Heren has
forecasted that additional expansion is needed for the fleet in order to
retire older ships in 201520.
What may be more important for estimating future shipping flows is the
ever-increasing share of flows to the Pacific basin, rather than the Atlantic
basin, lengthening tonne miles. The future growth of European demand,
on the other hand, depends mostly on building storage and distribution
assets, where environmental and other compliance issues will be considerably more expensive than in emerging or frontier markets. Concerns
over emissions seem to be curtailing European demand for LNG and
compressed natural gas (CNG) as a truck fuel.
Future LNG flow considerations
Liquefaction plant build costs in the early 2000s (such as Egypts US$250
350/MMTPA and Omans US$200/MMTPA) were comparatively low.
Qatar RasGas II and III build costs were around US$350/MMTPA, while
Qatargas IV was close to US$750. Australian Pluto was estimated at
US$800 and the Russian Sakhalin capacity got deferred on an estimated
US$1,000. Geography, climate and political risks drive construction
costs. An ever-increasing amount of gas trying to come to market from
emerging countries (Equatorial Guinea, Yemen, Peru, Angola, PNG, Libya
and Iran) will not help lower costs of future liquefaction capacity addition.
This will make it increasingly easier for an IOC to get involved, compared
to an NOC.
More generally, domestic gas demand is growing in many producing
countries for generating power and water, fuels and petrochemical
production, as well as reinjection to oilfields.
In terms of major exporters, we note that Qatar, who have paused liquefaction at current levels, actually have approvals in place to expand
liquefaction up to 105 MMT. This represents an opportunity. Nigeria still
has considerable waste between gas field and liquefaction, and an uncertain future for further developing gas pipelines within Africa. The US has a
major opportunity to capture export market share, but energy exports have
no great historical precedent within the worlds largest energy consumer.
Russia will inevitably add more LNG capacity for Asia.
Europe has experienced a reduction in natural gas production since
2000, from 232 bcm in 2000 to 150 bcm in 2012 (see Table 2.9). The
demand for natural gas reached a high of over 500 bcm in 2010, but by
2012 was back near the 2000 level of 440 bcm. Russian natural gas
pipeline exports to Europe have declined since 2000 bringing an increase
in other import demand from 14.5 bcm in 2000 to 108 bcm by 2012. This
equates to a European LNG demand of 80 MMT in 2012.
63
2012
D(20122008)
D%
IOCs
Shell
BP
BG
ExxonMobil
Total
ENI
Repsol/Gas Natural
ConocoPhillips
Marathon
Woodside
Chevron
19.3
15.3
9.7
9.3
7.9
6.3
4.7
4.0
3.4
2.7
2.7
27.4
17.3
9.7
20.8
14.6
7.3
5.9
7.2
3.4
9.6
6.3
8.1
2.0
0.0
11.5
6.7
1.0
1.2
3.2
0.0
6.9
3.6
42
13
0
124
85
16
26
80
0
256
133
TOTAL
85.3
129.5
44.2
52
NOCs
Pertamina (Indonesia)
Qatar Petroleum
Sonatrach (Algeria)
Petronas (Malaysia)
NNPC (Nigeria)
StatoilHydro (Norway)
Gazprom
39.6
27.8
27.8
25.4
14.8
1.9
0.0
39.6
84.0
33.9
26.5
14.8
1.9
10.0
0.0
56.2
6.1
1.1
0.0
0.0
10.0
0
202
22
4
0
0
10+
TOTAL
137.3
210.7
73.4
53
Algeria
Egypt
Nigeria
Oman
Qatar
Australia
USA
Indonesia
Malaysia
Russia
Canada
2008
2009
2010
2011
2012
2015
2020
82%
87%
77%
81%
81%
76%
56%
76%
97%
0%
81%
83%
53%
76%
61%
90%
43%
57%
98%
53%
74%
58%
82%
81%
74%
95%
44%
69%
96%
103%
64%
52%
87%
76%
90%
98%
21%
64%
103%
111%
58%
39%
90%
76%
91%
87%
12%
56%
103%
114%
80%
40%
65%
78%
90%
90%
95%
40%
99%
100%
100%
80%
40%
65%
78%
90%
90%
95%
40%
99%
100%
100%
100%
100%
Total
Source: Authors estimate
64
This chapter will offer insight into the role of a commodity meteorologist and how they aid our understanding of risk within commodity
markets. Primary sources of information, methods of interpretation
and strategy considerations are given from the perspective of an
energy trading firm. Weather linkages in other commodity markets
are also briefly discussed.
Weather drives daily volatility demand for natural gas. Weather
influences residential, commercial and electrical power end users,
natural gas is burned in the winter for heating and electrical generation requirements in summer. Regional demand differences and
seasonality ultimately affects natural gas futures pricing and
regional basis hubs. In natural gas markets, cold weather can force
peak day demand events where price-induced curtailments may
occur to non-temperature sensitive clients (ie, reduction of industrial
load) in order to ensure that needed gas is available to residential and
commercial consumers. Residential and commercial sectors requirements peak during the heating season, and gas must be stored to
meet the winter demand.
Weather is a constant source of short term volatility in natural gas
demand and price expectations. Therefore, a solid understanding of
the relationship between weather and natural-gas fundamentals is
imperative.
65
the American model does not show it for the same time period. So,
there is no middle ground here and a forecast must be made. Does
the Midwest have a cold event or not? Therefore, the in-house
meteorologist has to react with a highly accurate, timely response
and be prepared to accommodate many information requests from
traders.
An important process after having a forecast view of the incoming
weather pattern is anticipating how or when the forecasts from
various sources may change. This task is called "forecast the forecast". Overall, agreement or disagreement with the forecast's output
from various sources serves as a confidence level barometer for
traders. Situations arise when the Nymex price moves strongly due
to forecasts of impending cold or warm events, and traders can put
immense pressure onto the in-house meteorologist to either change
the internal forecast or to precisely time when the forecasts will
change. Therefore, it is the meteorologists job to make such information both accessible and easy to understand, and to be clear and
concise about the risks from a challenging forecast.
Following Keynes advice that Wordly wisdom teaches that it is
better for the reputation to fail conventionally than to succeed unconventionally, the easiest way out is to agree with the general weather
view of the markets, and when the pattern surprisingly changes,
then point to the fact that global weather models were wrong. To
provide true value to the firm, however, the meteorologist must
make the best possible assessment of forecasting the forecast revision
and communicate that opinion along with the relevant risks to the
trading desks. The meteorologist should not get overly bogged
down in details but focus on the importance of getting the weather
pattern right first, and then worry about the details. Simpler is better.
After the early morning weather operations are finalised, several
weather updates will arrive during regular trading hours. As the
numerical models update, any significant change in the weather
pattern compared to early morning weather information could cause
price volatility. The NAM is the first one to update, although this
weather model only provides forecasts up to 3.5 days ahead. The
GFS is the first global weather model to update the 16-day forecasts.
The GFS is immediately followed by its ensembles, a package of forecasts that show the level of stability or instability of the current
solution. Then, the ECMWF updates after the American models are
69
analyse all the forecasts available and, of course, forecast the forecast
of the official tropical NHC advisory. The time between a tropical
cyclone developing off the coast of Africa and reaching the Gulf of
Mexico can take nearly ten days. High volatility of energy prices
comes packaged with these systems and persists over the lifetime of
these tropical cyclones.
OTHER WEATHER IMPACTS
Weather updates during regular trading hours provide energy
traders with significant demand change expectations for North
America down to a regional and individual city level. In the summer,
power traders are the most sensitive to small changes in temperature, cloud cover, precipitation and wind. Sea breezes or
thunderstorms over downtown cities create rapid and significant
changes in electricity demand. Therefore, meteorologists providing
information to power traders have to be in tune with radar and satellite images on a constant basis during the trading day.
Agriculture
Reuters, May 2013: After a cold and wet spring in most of the US
crop belt, farmers have seeded 28% of their intended corn acres, up
from 12% a week earlier but far behind the five-year average of 65%,
Chicago Board of Trade corn and soybean futures were trading
higher on Tuesday, due in part to the slow planting pace that threatened to trim 2013 production prospects.
October 9, 2012, the Financial Times reported that hopes for bountiful
crops in South America fell after forecasts reduced the likelihood of
El Nio conditions developing, reducing the probability of abovenormal rains during the growing season.
Bloomberg reported on May 2, 2013, Oklahoma wheat production,
already expected to decline 45% from a year earlier, may fall further
as freezing weather tonight threatens crops.
September 12, 2012, The New York Times story, US Lowers Forecast
of Crop Yields for a 3rd Time as Record Heat Lingers, reported that
the USDA lowered forecast corn and soybean yields as record heat
added to drought damage.
The normal daily meteorological operations used in the energy business can be extrapolated to other commodity markets for which
weather changes/influences the supply or demand for a commodity.
The most obvious are the agriculture markets. The planting season
72
Drought conditions in the Midwest and Ohio Valley can affect the
river levels at the Mississippi and Ohio rivers. Coal and agricultural
barges might be restricted from travelling across the low levels of
these rivers. Supply of coal and agricultural goods could be affected
on a regional basis due to transportation restrictions. Even nuclear
power plants can be affected by drought conditions: nuclear facilities
need large amounts of water for cooling purposes. After the water
has been utilised in the plant, it is discharged back to a nearby body
of water at a higher temperature. State and federal regulations
prohibit nuclear plants from continuing operations once the water
temperature reaches a certain threshold. There is a two-fold issue
here: it compromises the reactor safety and affects aquatic life.
Livestock
January 2013, Bloomberg reported, Hogs futures climb as US cold
may hinder supply, noting that Northern temperatures of 1015F
might disrupt the movement of animals to market.
May 2, 2013, Farmers Weekly reported that UK livestock deaths
exceeded 100,000 because of March blizzards and extreme freezing
weather.
73
Coffee futures can become quite volatile if strong cold events affect
Southern Brazil. Brazil is the largest coffee producer and the only one
threatened by frosts. The coffee plant cannot tolerate frost. Depending
on frost intensity, the flowers get killed or the entire tree can die. If the
plant dies, then new plants need to be planted and it can take around
three years for them to bear coffee cherries. Vietnam is another large
producer of coffee but the main weather threat to coffee production is
the landfall of typhoons into that country. Cocoa futures have their
main weather risk in droughts. Western Africa, especially Ivory Coast
and Ghana, are the largest producers of cocoa in the world. Lack of
sufficient moisture causes the budding pods to wither.
CONCLUSION
The basic tools of operational weather forecasting for the commodity
markets are essential as an invaluable source of information for
traders. All these operations can be reduced to one goal: the best
weather fundamentals for forecasting supply and demand changes.
74
In this chapter, the conversation on crude oil will be broken into two
main parts. The first section will cover the basics and mechanics of
the current global market, while the second will address historical
price perspective and why the state of the price exists as it does. In
the first section, the basic fundamental and seasonal price drivers of
the new global marketplace for crude oil will be examined.
Subsequently, the chapter identifies the tendencies of crude oil
pricing based upon supply and demand processes that effectuate
seasonal price movements. Some details on the characteristics of
crude oil that can drive price, including quality, grade, location and
transportation, will be next. Finally, the section will conclude with a
discussion of pricing and trading.
The second part will discuss price perspective. It will address how
a US$17/bbl commodity in 2002 could become a US$147/bbl
commodity by only 2008. It will question why the globe always
seems to be running out of oil, while, so far, that fate has yet to be
realised.
WHY OIL?
Critical fuel and elasticity
What can you use crude oil for? This question has a strange, somewhat counterintuitive, answer: not much! However, when crude oil
is delivered to and processed through a refinery, this answer
becomes very different.
75
Crude oil and its products are critical fuels to the world economy
and have huge effects on our daily life. Whether you are using a
plastic cup, filling up your car, heating your home during a cold
winter, or fuelling farm equipment to plant, harvest and bring crops
to market, petroleum plays an important role. The uses of petroleum
products are generally linked to essential modern human needs, and
the demand for crude oil is generally inelastic.
Examples can be too real for those who were waiting in queues in
the aftermath of Hurricane Sandy on the East Coast of the US in
October 2012. Having unfortunately been affected first hand, the
return of 2+ hour queues to fill your car or electric generator,
rationing and police presence at stations resoundingly begs the
inevitable question why dont we just use something else?
Certainly those in New Jersey and New York City would have
instantly shed their place in the queue for a readily available and
cost-beating alternative, but they could not.
There are many reasons for this, most of which point to the factors
of inexpensive cost and infrastructure. Crude oil and its products
have been the least-expensive source of energy across many areas of
the economy for decades. This fact has led to an explosion of
petroleum-related infrastructure that services most daily needs
without a reliable inexpensive alternative. Tankers, refineries,
pipelines, trucks, stations and home furnaces point to a petroleum
infrastructure that makes our society reliant on them while offering
no credible alternative.
These issues infrastructure, price and convenience have caused
a generally limited elasticity of downside demand, which is
supported by the data. As Figure 4.1 shows, the drop-off in
Organisation for Economic Co-operation and Development (OECD)
demand in 200809 was large in absolute terms, but less impressive
in percentage terms: only a 6% decline during the worst recession
since the 1930s. Furthermore, the West Texas Intermediate (WTI) oil
price could barely get back to 2004 levels of approximately
US$50/bbl on a quarterly average basis. This was a level that had
actually not been seen prior to 2004. Such an effect points to a generally increasing price trajectory since the early 2000s. The elasticity of
demand is roughly a 0.3 ratio to the change in GDP in OECD countries. Essentially, if the OECD GDP increases by 1%, the demand for
crude should increase by approximately 0.3%.
76
Figure 4.1 OECD liquid fuels consumption and WTI crude oil price
Percent change (year-on-year)
6
100
50
-2
-4
-6
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Non-OECD GDP
77
78
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
3.5
Mexico Maya
Saudi Arabia Arab Heavy
3.0
Kuwait Kuwait
2.5
UAE Dubai
2.0
1.5
1.0
Ecuador Oriente
North Sea Brent
Libya Es Sider
United States WTI
0.5
Sweet
0.0
20
25
30
35
40
API gravity (a measure of crude oil density)
Algeria Sahara
Blend
Malaysia Tapis
45
50
Heavy
Light
Date
Company
Commodity
Entry port
State of entry
Origin
August 2012
August 2012
August 2012
August 2012
August 2012
August 2012
Chevron USA
Chevron USA
Chevron USA
Chevron USA
Chevron USA
Chevron USA
Crude oil
Crude oil
Crude oil
Crude oil
Crude oil
Crude oil
El Segundo, CA
El Segundo, CA
El Segundo, CA
El Segundo, CA
El Segundo, CA
El Segundo, CA
California
California
California
California
California
California
Ecuador
Ecuador
Ecuador
Ecuador
Ecuador
Ecuador
BBLS SULPHUR
(000s)
324
326
328
353
371
374
1
1
1
2.01
1
1
API
23.7
23.4
23.5
19.4
23.9
24
82
As we can see in Figures 4.6 and 4.7, production from the Middle
East has historically been sent to the refining areas of the Gulf Coast
of the US, as well as many other refining regions across the world.
However, in response to refining capacity additions and subtractions
by region, oil trade flows have changed. The ability of western
nations to continue to compete globally on refining has become
suspect. The US and Western Europe found their great refining
centres under tremendous duress in 2011. Atlantic Basin crude oil
prices, generally indexed to Brent and imported, were being used as
feedstock to produce higher and higher quality (lower sulphur
content) products. These product specifications were mandated by
the EU and US governments. In addition, these refiners faced evermore stringent quality standards on petroleum products while
having to combat a reduction in petroleum product demand since
2008. Furthermore, higher fuel efficiency and the greater acceptance
of clean technologies have also cut into demand.
The business case for continuing to produce petroleum products
in these two jurisdictions if a refinery was lower on the Nelson
Complexity scale and its refining power was generally simple was
becoming increasingly unprofitable. Examples of victims of these
two simultaneously negative phenomena were PetroPlus, the largest
independent refinery in Western Europe, Sunoco, the biggest
refining presence on the US East Coast, and ConocoPhillips, who
divested its downstream business and spun it off into Phillips 66
Figure 4.6 World oil production by region (millions of barrels per day)
Asia Pacific, 8.1
North America
14.3
Africa, 8.8
South & Central
America, 7.4
84
(with this last case probably augmenting efficiencies in management). The replacements for these refineries were generally Indian,
Chinese and Middle Eastern refining capacity additions. With fewer
regulations for start-up, cheaper labour (none or fewer union labour
constraints) and closer proximity to the source of crude oil, the
trends depicted in Figure 4.7 are not only set to continue, but to be
accentuated in the coming years. After all, no major refineries have
been built in the US since 1976. Capacity grew solely through
upgrades and increases in complexity. Meanwhile, Asian refiners,
less hindered by regulation and clean air rules, have been building
brand new, more efficient refineries that can actually fill the gaps left
by those archaic, decommissioned refineries of the west.
However, as this all seemed to be speeding out of control in the US
and Western Europe, a new technological breakthrough came along
just in time to give at least a temporary reprieve for many US East
Coast refineries. Domestic crude oil, produced through techniques of
hydraulic fracturing from the interior of the US, has made its way
across the country to the refining centres in a cost-efficient way. This
trend has given some of these refineries hope. We will talk more
about the phenomenon later in this chapter but, with the Carlyle
Group purchasing part of the Girard Point refinery from Sunoco and
Delta Airlines purchasing the Conoco Phillips Trainer, PA refinery,
the progression of this global change in regional refinery economics
24.21%
3.80%
31.33%
22.99%
7.09%
7.49%
3.57%
8.09%
30.19%
8.61%
North America
Middle East
Africa
Asia Pacifc
26.42%
85
seems to have been stayed. Additionally, the US Gulf Coast has been
importing less and less crude to run its refineries, and within 23
years the region should not need to import crude oil at all.1
The future trajectories of production, refining and storage are
beginning to change the market and may slowly change how crude
oil and petroleum are priced. Despite the extraordinary growth in US
production, there is little risk to the status of the Middle East and
former Soviet Union (FSU) as major producers. The inclusion of
Iraqs huge reserves under a market-oriented and ambitious regime
provides optimism for the continued strength of Middle Eastern
crude oil production. With Brazil and Russia having gained in
economic prominence, these countries will also have the ability to
marshal larger resources toward oil exploration and production
(E&P) for increasing contributions in the global crude oil supply mix.
Also, new technology and high prices have encouraged a renaissance in US oil production.
The real issues that have arisen from this sea change are logistical.
How does the crude get from production areas to the refiners, and
what are the risks along these routes? The flow of crude oil from
Middle Eastern countries to jurisdictions East of Suez has been
growing for decades. However, with more and more of global oil
production heading in this direction, the world oil transit choke-
Millions of barrels/day
20302035
20252030
20202025
20152020
20112015
US &
Canada
Latin
America
Africa
86
Europe
FSU
Middle
East
China
Other
Asia
87
Table 4.2 Volume of crude oil and petroleum products transported through world
chokepoints (200711)
Location
2007
2008
2009
2010
2011
Bab el Mandeb
Turkish Straits
Danish Straits
Strait of Hormuz
Panama Canal
Crude oil
Petroleum products
Suez Canal and SUMED Pipeline
Suez Crude Oil
Suez Petroleum Products
SUMED Crude Oil
4.6
2.7
3.2
16.7
0.7
0.1
0.6
4.7
1.3
1.1
2.4
4.5
2.7
2.8
17.5
0.7
0.2
0.6
4.6
1.2
1.3
2.1
2.9
2.8
3.0
15.7
0.8
0.2
0.6
3.0
0.6
1.3
1.2
2.7
2.9
3.0
15.9
0.7
0.1
0.6
3.1
0.7
1.3
1.1
3.4
N/A
N/A
17.0
0.8
0.1
0.6
3.8
0.8
1.4
1.7
Notes: All estimates are in million barrels per day. N/A is not available. The table does not
include a breakout of crude oil and petroleum products for most chokepoints because only the
Panama Canal and Suez Canal have official data to confirm breakout numbers. Adding crude
oil and petroleum products may be different than the total because of rounding. Data for
Panama Canal is by fiscal year.
Source: EIA estimates based on APEX Tanker Data (Lloyds Maritime Intelligence Unit);
Panama Canal Authority and Suez Canal Authority, converted with EIA conversion factors
Let us talk about the granddaddy of them all at first, the Strait of
Hormuz, which is located between Oman and Iran and connects the
Persian Gulf with the Arabian Sea. Here, roughly 35% of all seaborne
traded oil and 20% of all oil traded worldwide passes through on a
daily basis. More than 85% of these crude oil exports go to Asian
markets such as Japan, India, South Korea and China. At the
narrowest point, the Strait is 21 miles wide and the width of the shipping lane in either direction is only two miles, separated by a
two-mile buffer zone. The alternatives are woefully inadequate.
Pipeline replacement capacity currently only offers 45 million
barrels a day of unused capacity, and trucking would add only a
maximum of a few hundred thousand barrels per day. Most tankers
going through the Strait of Hormuz run greater than 150,000 deadweight tonnage (DWT) these are very large tankers. A block of the
Strait of Hormuz would result in a shortfall of undelivered crude oil
of perhaps up to 12 million barrels a day.
The Strait of Malacca is the other main strategic point. It is
located between Indonesia, Malaysia and Singapore (where the big
Pulau Bukom 500,000 barrel-a-day Shell refinery operates), and
links the Indian Ocean with the South China Sea and Pacific Ocean.
88
This is the key chokepoint in Asia. With 13.8 million barrels per day
(mbpd) flowing in 2007, the Strait had ratcheted flows up to an estimated 15.2 mbpd in 2011. At the narrowest point, in the Phillips
Channel of the Singapore Strait, Malacca is only 1.7 miles wide. If
the Strait was blocked, nearly half of the worlds fleet would have
to reroute around Indonesia. With so much crude flowing through
this waterway, it would not go undelivered as in the case of a
blockage of the Strait of Hormuz; it would just have to be rerouted
at greater costs and time to market.
The rest have their strategic interests too. The Turkish Straits are
important for western pricing because it is a main thoroughfare that
transports Russian crude exports, as well as exports from Azerbaijan
and Kazakhstan, to Western European refineries. Weather often
impacts transit in winter, forcing additional transit time of up to
weeks in some cases. Finally, a Bab el Mandeb closure could keep
Persian Gulf tankers from reaching the Suez Canal as it is located
between Yemen, Djibouti and Eritrea, and connects the Red Sea with
the Gulf of Aden and the Arabian Sea. Most transit goes north to
destinations in Europe, US and Asia. If impassible, it would redirect
3.4 mbpd around the southern tip of Africa, a significant addition of
transit time.
Crude pricing and trading
Not all crude oil that is produced and delivered goes directly into the
refinery for processing. The crude that awaits refining in any timeframe is held in storage. Storage is the most significant statistic of
over- or under-supply in the crude oil market.
Most notable has been the effects of storage levels and capacity in
Cushing, OK, the delivery point of the CME/Nymex WTI crude oil
futures contract. Being a landlocked area with limited capacity and
limited transit to and from the storage tanks, the Cushing phenomenon played a major role in the term structure of the Nymex futures
contract through 2010. As one can see from Figure 4.10, a significant
amount of storage capacity has been added to Cushing inventories
since the third quarter of 2010. This fact has alleviated some of the
risks of storage congestion and stock-out phenomenon that has
plagued this storage area, and therefore the Nymex pricing of
prompt/term spread relationships.
When storage levels approached high percentages of capacity, the
89
Million barrels
70
60
50
40
Working
storage
capacity
Inventories
30
20
10
0
Sep 30, 2010
Enbridge pipeline into the Cushing area. Outflows had been going to
the only consumers on the block, the local refineries. Other pipeline
capacity is in full swing, such as the Seaway pipeline reversal (it used
to bring crude up from the US Gulf Coast to the PADD II refineries
until domestic Bakken and Southern Canadian production exploded),
alleviating most bottlenecks. The consuming pipelines name the
destination. BP is flowing towards Chicago (or, more specifically,
Whiting, Indiana) to its 410,000 bbl/day Whiting refinery. Likewise,
the Ponca line heads to the Phillips 66, Ponca City refinery (at 195,000
barrels/day) and the Ozark pipeline takes off to St Louis area to
supply the Phillips 66 (formerly Conoco Phillips) Wood River
Refinery at (300,000+ barrels/day). Also worth noting is CVR
Energys 115,000 barrels/day Coffeyville, KS refinery, which has its
own line coming from the Oil Hub. Then there are other inputs, such
as the Enbridge Spearhead pipeline that delivers more Canadian
crude to Cushing.
Furthermore, Figure 4.11 shows existing and proposed pipeline
expansions, which continue to address transport issues of crude oil
Figure 4.11 North American oil pipelines
91
from production areas in the north to the refining centres in the Gulf
Coast.
Finally, Figure 4.12 points out the more important figures for
pricing the WTI near term structure. Two very different states of the
world existed for prompt second-month WTI spreads in September
2008, and then quite the exact opposite in January 2009. On
September 13, 2008, the 110 mph Hurricane Ike crashed into the
Houston Gulf Coast, delaying crude oil imports and disrupting
infrastructure up the Houston Ship Channel and the Loop, to the
point that Cushing inventories plummeted and the spike in
prompt/second WTI spread blew out to US$29/bbl on expiration
(See Figure 4.14). Then, only four months later, the opposite was
true. Crude oil inventories were approaching a limit at 80% of then
storage capacity at Cushing, Oklahoma, and global inventories were
dramatically swelling. With capacity at just under 40 million barrels
in early 2009, the inventories ballooned to just under 35 million
A M J J A S O N D J F MA M J J A S O N D J F MA M J J A S O N D J F MA M J J A S O N D J F MA M J J A S O N D J F MA M J J A S O N D J F MA
Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08 Q1 09 Q2 09 Q3 09 Q4 09 Q1 10 Q2 10 Q3 10 Q4 10 Q1 11 Q2 11 Q3 11 Q4 11 Q1 12 Q2 12 Q3 12 Q4 12 Q1 13
92
USD
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7/13/200712/18/2012 (LON)
Price
USD
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3
2
1
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-1
-2
-3
-4
-5
-6
-7
-8
-9
-10
-11
-12
-13
-14
-15
-16
-17
-18
-19
-20
-21
-22
-23
-24
-25
-26
-27
.12
Q4
2007
Q1
Q2
Q3
Q4
Q1
2007
Q2
Q3
2009
Q4 Q1
Q2
Q3
2010
Q4
Q1
Q2
Q3
2011
Q4
Q1
Q2
Q3
Q4
2012
outlet for the Seaway pipeline only boasts 2.6 million barrels of
storage and has limited the ability of Seaway to move all of its
400,000 bbls/day capacity to the Gulf. These constraints had
prevented a resolution of the spread relationships.
With many alternatives for crude transport unavailable, the
markets turned to an old school form of crude oil transportation: railroads. Rail loadings of oil have been soaring and the economics make
sense. With many new terminals being built to handle much of the
throughput, the transport of crude via rail has been able to alleviate
some of the issues. This solution has changed the equation enough to
rationalise the economics of two East Coast refineries. With the hope
of getting Midwest crude oil, the business case has changed from an
unprofitable venture such as those in Europe to big opportunities for
those including Monroe Refining (a division of Delta Airlines) and
the Carlyle Group. Both investors have bought two main East Coast
refineries previously set for closure because of poor economics. The
ability to receive shale crude oil as feedstock has helped to make the
business case to keep these refineries open. Furthermore, in Monroe
Energys case, their supply chain of jet fuel in the New York market
and ability to supply competitors makes it a sound investment, with
some personnel who used to work at the refinery already being part
of the Monroe team.
2009
2010
96
2011
36,544
26,247
16,789
11,389
11,324
10,843
8,583
6,784
3,395
2,650
2,832
2,498
2,860
51,482
64,663
2012
Ecuador - Oriente
Malaysia - Tapis
- Iran Heavy
Kuwait - Kuwait IranIran
- Iran Light
Saudi Aradia - Arab
UAE - Dubai
Heavy
Oman - Oman
Saudi Aradia - Arab
Light
100
Figure 4.18 Oil disruptions, OPEC spare capacity and crude prices
25%
Threatened oil supply
Disrupted oil supply
Spare capacity (EIA)
Crude oil price (RHS)
US$120
Iran
15%
US$80
US$60
10%
US$40
IranIraq war
5%
Iran
revolution
US$20
Gulf war II
US$0
0%
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
20
12
VZ 0203, Iraq 03, Nigeria 03>, Libya 10>, and others
102
US$100
Current US$ per barrel
20%
Market fears of
an Iran-related
Hormuz
disruption
faded after
April
12
United
States
10
Saudi
Arabia
8
6
Russia
4
Iran
0
1960
1970
1980
1990
2000
The era of finding onshore super-giant oil fields was gone. The
new cost of finding fields and extracting was increasingly being
focused on deep-water offshore finds that were expensive and risky
to excavate. With very large fields such as Mexicos Cantarell in
decline, and the West feeling the pinch of the fall-off in production
from the Hugo Chavez regime in Venezuela, there was great concern
in the race for the marginal barrel. Areas such as the North Sea had
begun a decline that continues to the present day. The one major
bright spot that Figure 4.19 does not point out is the upswing in US
production that now boasts greater than 7 mbpd, reversing the
downward trend which was intact since 1970.
Let us now look at Figure 4.20, which illustrates the growth in
consumption of the largest driver of the decade, China. Amazingly,
since China became a net importer of crude oil, its shortfall has
grown substantially to make it the second largest consumer of crude
oil after the US. This rapid growth and migration of the populace to a
middle class that is a global consumer of crude oil products has had
a profound effect on price and excess capacity (as shown in Table 3).
According to EIA projections, this trend will continue going
forward through to 2035. With much of the future growth in liquids
consumption coming from China, India, other non-OECD Asia and
the Middle East, much of the supply growth will have to come from
somewhere. Interestingly, OPEC is showing a growth in market
share from about 40% to 42%. Therefore, the promise of Iraqi growth
may have some lasting effects on keeping OPEC share growing.
Meanwhile, as shown in Table 4.4, with the production declines in
the OECD countries, the lone shining star is the US thanks to the
shale production boom that may even supercede the estimates which
may crowd out some OPEC production growth. The IEA claims that
the US will be the worlds largest oil producer by 2017. This implies a
staggering growth rate, which may be difficult to achieve given the
typically high decline rates for most new wells in the Bakken and
Eagle Ford shales.
There are a few things to note based upon the overall trends.
Looking once again at Figure 4.18, the tightness of the supply
demand balance that ushered in this new era of prices largely took
effect when the excess OPEC capacity shrank back below 3% of
global production (about 2.7 mbpd). At the same time, there was a
second stage ramp-up in Chinese demand (as shown in Figure 4.20)
106
Forecast
12,000
10,000
Consumption
8,000
Net imports
6,000
4,000
Production
2,000
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
at the acceleration point around 2003. Thus, the new price regime
entered the markets. With similar shortages during the first Gulf
war, the nominal price reached US$41 in late 1990. Contrast that time
with early 2009, in an oversupplied environment of having 6%+
excess capacity the price was only able to fall to US$32/bbl. This
price action speaks to a new price regime.
Note the price assumptions listed by the EIA in Table 4.4. These
price assumptions show a steady growth. The answer is sensible. As
excess capacity continues to be very low, price needs to ration the
markets demand. To get 109.50 million barrels of oil out of the
ground in 2035, many new fields, unprofitable at todays prices,
would require the ability to contribute to the global liquids production mix. Before the great recession that collapsed the markets in
2008, price raced towards US$147/bbl, an incredible feat for a
commodity that hit a low of around US$17/bbl in 2002. There was
the push of Chinese demand, the faster decline in Mexican, North
Sea and US production, and a dwindling of excess capacity to a point
where only 800,000 bbls/day was projected to stand between easily
functioning markets and an aggregate stock-out.
107
Table 4.3 International liquids supply and disposition summary (million barrels per
day)
2009
2010
2015
2020
2025
2030
2035
Annual
growth (%)
201035
OECD
US 50 states
US territories
Canada
Mexico and Chile
OECD Europe
Japan
South Korea
Australia and NZ
18.81 19.17
0.27 0.28
2.16 2.21
2.35 2.34
14.66 14.58
4.39 4.45
2.15 2.24
1.16 1.13
19.1
0.31
2.15
2.39
14.14
4.51
2.25
1.11
19.02
0.32
2.21
2.43
14.43
4.6
2.35
1.14
19.2 19.47
0.34 0.36
2.25 2.29
2.5
2.6
14.65 14.76
4.62 4.51
2.46 2.53
1.17 1.21
19.9
0.36
2.35
2.68
14.74
4.42
2.56
1.23
0.10
1.00
0.20
0.50
0.00
0.00
0.50
0.20
TOTAL OECD
45.94 46.4
45.95
46.5
47.19 47.72
48.24
0.20
2.94
2.97
0.10
2.45 2.55
16.03 17.65
5.4
5.79
8.85 9.4
8.16 8.98
3.57 3.8
3.15 3.47
2.63
18.5
5.8
9.89
9.49
4.09
3.8
0.90
2.80
2.40
1.50
1.00
0.80
1.50
4.05
4.09
1.70
54.32 58.62
61.26
1.70
Liquids consumption
NON-OECD
Russia
Other Europe and
Eurasia
China
India
Other non-OECD Asia
Middle East
Africa
Brazil
Other Central and
South America
2.73
2.93
3.02
2.94
2.15
8.33
3.11
6.43
6.84
3.23
2.52
2.08
9.19
3.18
6.73
7.35
3.34
2.65
2.3
12.1
3.7
7.28
7.78
3.3
2.84
2.35
14.36
4.58
7.95
7.69
3.37
2.94
3.07
3.19
3.49
3.66
Total non-OECD
consumption
38.41 40.65
45.82
49.83
Total liquids
consumption
84.35 87.05
91.76
0.90
33.34 34.58
51.01 52.47
10.25 10.53
37.3
54.46
11.11
39.23
57.1
12.6
41.91 44.05
59.6 62.3
13.94 14.85
45.89
63.61
15.54
1.10
0.80
1.60
39.5
40.7
40.7
41.3
41.9
OPEC Production
Non-OPEC production
New Eurasia exports
OPEC market share
(percent)
39.7
2.91
3.81
41.4
2010
2015
2020
2025
2030
2035
Growth
(%)
62.37
59.72
144.98
132.95
2.40
2.30
61.65
59.04
229.55
210.51
4.30
4.20
22.3
3.92
4.16
2.43
23.43
3.89
4.45
2.29
25.46
3.62
5.09
2.13
27.16
3.42
5.35
1.97
29.77
3.37
5.4
1.92
32.07
3.31
5.31
1.79
33.94 1.50
3.27 0.70
5.26 0.70
1.72 1.10
32.8
34.05
36.3
37.91
40.46
42.48
44.19
1.00
8.79
1.91
2.98
4.36
0.13
0.62
18.8
9.82
1.79
2.65
3.7
0.14
0.55
18.65
10.73
1.82
1.97
3.33
0.15
0.54
18.54
10.53
1.82
1.58
3.15
0.15
0.54
17.78
10.57
1.81
1.65
3
0.15
0.53
17.72
10.15
1.78
1.68
2.83
0.16
0.53
17.14
0.60
0.30
2.30
1.70
0.70
0.60
0.40
10.14
3.22
4.27
3.77
1.58
2.41
2.19
2.01
10.04
3.67
4.29
3.79
1.43
2.4
2.72
2.29
10.54
4.01
4.46
3.55
1.31
2.54
3.34
2.32
11.06
4.37
4.79
3.38
1.18
2.68
3.87
2.47
11.62
4.52
4.93
3.17
1.06
2.7
4.21
2.67
12.16 0.70
4.54 1.40
4.7
0.40
3
0.90
0.97 1.90
2.68 0.40
4.45 2.90
2.65 1.10
Non-OPEC
OECD
US
8.27
Canada
1.96
Mexico and Chile
3
OECD EUROPE
4.7
Japan
0.13
Aust and NZ
0.65
TOT OECD PROD
18.71
Non-OECD
Russia
9.93
Other EUR AND EURASIA
3.12
China
3.99
Other Asia
3.67
Middle East
1.56
Africa
2.44
Brazil
2.08
Other Central and South American 1.9
Total non-OECD prod
28.69
29.59
30.63
32.07
33.8
34.88
35.15
0.70
80.21
82.44
85.58
88.52
92.04
95.08
96.47
0.60
0.75
1.69
0.22
0.01
0.21
1.14
0.12
0.9
1.93
0.22
0.01
0.21
1.2
0.13
1.05
2.51
0.23
0.17
0.28
1.78
0.16
1.34
3.08
0.24
0.21
0.37
2.31
0.28
1.62
3.75
0.26
0.24
0.38
2.61
0.61
2.08
4.46
0.27
0.24
0.39
2.9
0.92
4.14
4.61
6.18
7.82
9.47
11.27
84.35
87.05
91.76
Total production
2.59 4.30
5.16 4.00
0.28 1.00
0.24 14.50
0.4
2.60
3.17 3.90
1.18 9.10
13.02
109.5
4.20
0.90
109
came the recession, and one can see in the consumption numbers in
Table 4.3 that very little (if any) growth is expected between 2008 and
2015. The shale revolution coming from the US and southern Canada
then appeared. At US$50/bbl, these technologies are not financially
viable, but, at US$7080/bbl, they are profitable. Once again, the
peak oil whispers have faded because of technology and may stay
quiet for a while if this technology becomes a universally accepted
means of production. However, our new pricing regime is in place.
The price assumptions made by the EIA exist so that the market stays
balanced. This theme is an important one. As we move from one
price regime to another, the effects of the market pricing is to ration
demand (as it has already done in many OECD countries since 2008)
and to price in new technologies for production that become financially viable at higher price points.
CONCLUSION
In summary, the global landscape of the market for crude oil has
many intricate influences, stemming from grade, location, politics
and its reception from its downstream counterparts at the refinery
level. The growth in emerging economies have shaken the stability of
the existing supply/demand balances, but have also ushered in a
new era boasting new methods of combating the continuous struggle
for the globe to be well supplied with crude oil. However, even as
Hubbert had predicted back in 1956, the decline of crude oil as our
main source of energy has been wildly overestimated. The cost and
the technological breakthroughs continue to preserve this
commodity as a large part of our daily lives.
1 International Energy Agency, 2012, Oil Market Report, November.
2 US Energy Information Administration, 2012, World Oil Transit Chokepoints, August 22.
3 Platts, 2011, Dated Brent: The Pricing Benchmark for AsiaPacific Sweet Crude Oil, May.
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Carlson, M., Z. Khokher and S. Titman, 2007, Equilibrium Exhaustible Resource Price
Dynamics, Journal of Finance, American Finance Association.
Evans, L. and G. Guthrie, 2009, How Options Provided by Storage Affect Electricity
Prices, Southern Economic Journal, 75(3), January, pp 681702.
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Hubbert, M. King, 1956, Nuclear Energy and the Fossil Fuels, Shell Development
Company, Publication Number 95, presented before the Spring Meeting of the Southern
District, American Petroleum Institute, San Antonio, Texas, March.
Kaldor, N., 1939, Speculation and Economic Stability, The Review of Economic Studies.
Oliver, M., C. Mason and D. Finnoff, 2012, Pipeline Congestion and Natural Gas Basis
Differentials: Theory and Evidence, University of Wyoming.
Samuelson, P., 1965, Proof that Properly Anticipated Prices Fluctuate Randomly
Industrial Management Review, 6.
Working, H., 1948, Theory of the Inverse Carrying Charge in Futures Markets, Journal of
Farm Economics, 30, pp 128.
Working, H. 1949, The Theory of Price of Storage, American Economic Review, 39, pp
1,25462.
111
used for other commodity markets. Nobody ever talks about crude
oil market design in a regulatory sense. Complications such as
freight costs and quality standards are left up to the market participants to sort out for themselves.
Part of the challenge in electricity market design is getting the
balance right between the role of the market and that of government
and regulators. Policymakers continue to struggle with this challenge, even in the most mature electricity markets. Indeed, there is an
observable cycle backwards and forward between more regulated
and more market-based policy frameworks.
Where can functioning wholesale markets be found?
At the time of writing, there are several functioning and reasonably
liquid wholesale markets that perform the central tasks of price
discovery, offer hedging opportunities and give signals to market
participants for efficient operational and investment decisions.
Liquid wholesale power markets exist to a greater or lesser extent in
several areas of the European Union, in parts of North and South
America, and in Australia and New Zealand. Traded electricity
markets are also coming into existence in other countries. This
chapter will concentrate on the development of wholesale power
markets in Europe, particularly in Germany and Britain (GB).
HOW POWER IS TRADED THE CHARACTERISTICS OF
EUROPEAN ENERGY MARKETS
European market design principles: The importance of the
balancing regime
European market design is based on self-dispatch rather than
centralised dispatch of power production unlike, for example, most
North American markets. It is therefore a bilateral two-sided market
in that generators sell into, and retailers buy from, wholesale markets.
As discussed, this means that the system operators role is
restricted to dealing with residual imbalances in the system as a
whole and resolving any locational constraints. This takes place after
gate closure, which is normally one hour before real time operation. However, in reality, system operators sometimes have to begin
to take some action before gate closure if plant expected to be used
for balancing or re-dispatch needs to be ramped up or warmed in
advance.
118
Market participants on both the generation and the retail side have
to balance at gate closure across a so-called settlement period of
either 30 minutes or 15 minutes. Those market participants whose
actual measured injections do not match their consumption are said
to be out of balance and are subject to imbalance charges. They
have to pay the system operator for the actions required to balance
the system. This payment is governed by the national regulator in the
country concerned. It is usually based on the costs to the TSO of
resolving imbalances, although the formula used varies in each
country. Balancing arrangements are increasingly market-based,
with the settlement price based on bids and offers from those generators with spare capacity, or alternatively demand-side offers.
An important consequence of this market design is that trading of
electricity and also price formation is strongly driven by the desire of
market participants to avoid the consequences of being out of
balance. If a company goes into gate closure with a short position,
they are potentially exposed to very high imbalance prices at particular times. Likewise, being long at gate closure is not without risks
either, particularly if imbalance prices can go negative, which is a
possible outcome. The balancing mechanism is therefore at the heart
of European market design.
Day ahead and intraday markets
The other main reference price in European markets comes from the
day-ahead markets. These are largely two-sided cleared auctions
operated by dedicated market operators. For example, in Germany
and France the auction is run by EPEX Spot (a joint venture between
EEX and Powernext). Meanwhile, day-ahead auctions in GB and in
Nordic markets are operated by Nord Pool Spot. The Dutch dayahead auction is operated by APX-ENDEX (now a subsidiary of
ICE), who also operates a day-ahead market in GB.
Day-ahead exchanges are not usually compulsory marketplaces.
However, there is a strong regulatory push to ensure these markets
are liquid. In the draft European network code on capacity allocation
and congestion management (CACM), it is envisaged that these dayahead exchanges will play a central role in allocation of cross-border
transmission capacity. This process is known as market coupling.
The CACM network code was slated to become binding European
legislation in 2014.
119
their exposures. They may have some kind of target hedge path in
terms of what proportion of their consumers needs should be
covered by a certain date eg, that X% should be bought by Y
months before consumption.
Likewise, generators will also sell the bulk of their generation
capabilities in forward markets in order to allow for effective business management. For example, the generation business will need to
know in advance how much revenue they are likely to collect in a
particular year. They will then be able to decide on a maintenance
timetable and other budgeting decisions. However, they will not
necessarily sell all potential volumes into forward markets since this
implies a risk in the event of a generation failure.
In essence, price formation in forward markets, and therefore
customers bills, is the consequence of how these decisions are taken
about how, and when, to buy and sell. For example, the more that the
supplydemand position is expected to be tight, the more that
retailers will tend to try and manage their exposure to short-term
markets and seek to hedge earlier, pushing up forward prices.
Conversely, if there is expected to be large margins of spare generation capacity, retailers may be more content to delay buying volumes
and wait for prices to fall. Similarly, generators may have to accept
selling at lower spreads if they see a lot of spare generation capacity
around and there is little prospect of prices increasing in spot markets.
HISTORICAL PRICE PERSPECTIVE
Germany
Figures 5.1 and 5.2 show the main trends in electricity prices in
Germany. The German electricity market is the most liquid in
Europe, if not the world. Trading is based on a single Germany/
Austria day-ahead reference price.
Initially, market opening between 2000 and 2005 led to significant
reductions in wholesale market prices as more competition was
introduced and trading became established. Prices gradually
increased between 2005 and 2008, bringing considerable new investment in generation. Some 10GW of new conventional plant began
operation in the period 201013. However, the financial crisis and
reductions in industrial demand have bought about significant price
reductions. This was only partly reversed by the enforced closure of
all German nuclear plants in 2011 after the Fukushima disaster.
122
Peakload
120
EUR/MWh
100
80
60
40
20
0
03
05
20
/
1
/0
/
03
/2
01
6
00
2
1/
/0
3
0
7
00
03
8
00
/2
1
/0
/
03
/2
01
9
00
03
1/
/0
10
20
0
/
01
3/
11
20
0
0
/2
01
3/
12
/
03
/2
01
3
01
10
3
01
/0
1
/2
01
12
1/
20
/0
01
01
/0
1/
2
01
1
10
1/
20
/0
01
01
/2
0
8
01
/
01
/0
1/
20
0
07
1/
20
6
01
/0
00
/2
/0
1
01
/2
00
01
/0
1
-10
09
EUR/MWh
20
-20
-30
Baseload clean dark spread
Peakload
100
/MWh
80
60
40
20
0
/
01
0
/2
01
05
01
6
00
/2
1
/0
00
/2
01
/
1
7
/
01
0
/2
01
08
01
1/
/0
09
20
0
0
/2
01
1/
10
01
1/
/0
11
20
/
01
/2
01
2
01
0
/
01
1/
1
20
Peakload
30
/MWh
25
20
15
10
5
13
20
1/
/0
01
/0
1/
2
01
2
11
01
20
1/
01
/0
01
0
01
/
01
/2
09
08
20
1/
01
/0
20
1/
1/
01
/0
01
/0
20
07
6
00
1/
2
01
/0
01
/0
1/
20
05
125
time of writing do not show much sign of recovery despite the anticipated closure of some 1015GW of generation capacity up to around
2017.
Renewable production has not yet reached the same level of penetration as in Germany and its impact will continue to grow.
However, a key difference in the GB market is that renewable
producers are, and will continue to be, responsible for selling their
own power and, other than the smallest facilities, are balanceresponsible. This may prevent the impact on prices being of the same
magnitude. The subsidies for solar production and the extent of takeup, in particular, are markedly less generous.
Compared to total peak demand of some 60GW, there is around
12GW of renewable production, a much lower percentage than in
Germany. Only around 1GW of solar photovoltaics has so far been
installed in the GB market.
Wider relationships between European markets
European markets are becoming increasingly correlated, especially
as interconnection between EU countries increases and the existing
infrastructure is managed more efficiently via market coupling.
However, there are still major locational issues and associated basis
risk that affects them.
The main locational features of European power supply is that,
due to hydroelectricity resources, the Nordic countries usually have
a year-round surplus of generation (unless there is a very cold
winter, preceded by very dry conditions). This often leads to
comparatively low wholesale prices in the Nordic system.
Both France and Belgium have high shares of nuclear power and
these countries have traditionally had low wholesale prices.
However, the high level of peak heating demand increasingly means
that these countries now import in the winter. During 200912, the
price differential between Germany and France closed and has
reversed to an extent that in France, prices are higher than those in
Germany. Both GB and the Netherlands electricity prices are typically driven by gas prices, and a locational spread with Germany will
emerge if gas and coal prices deviate. Italy has typically had the
highest wholesale electricity prices in the EU.
Differences between these regions are maintained as a consequence of constraints in the overall European transmission network.
126
131
120
100
80
60
40
20
0
0
10
12
14
16
Weeks of consumption
Weeks of consumption
(2012)
1.5
2.1
3.1
6.0
6.0
8.0
11.0
16.6
40.0
60.0
400.0
700.0
Inventory levels are not only the primary driver for price levels
and change, but also for forward pricing, which will be discussed
later in the chapter.
DEMAND
Metals demand is strongly linked to economic growth. However,
while the level of global GDP is a reasonable proxy for living stan135
2002
2004
2006
136
2008
2010
2012
80s
90s
00s
10s*
Steel
Copper
Aluminium
12%
Oil (rhs)
45%
11%
40%
10%
35%
9%
30%
25%
8%
20%
7%
15%
6%
10%
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Figure 6.5 World copper mine production has grown very slowly since the
1990s, but this could change in 201314
Mine supply (without disruption), kt
Mine supply, kt
Increase, % (rhs)
22000
20000
10
8
2015
2013
2014
2011
2012
2010
2009
2008
2006
2007
2005
2003
-2
2004
10000
2001
2002
12000
2000
1999
14000
1998
1996
16000
1997
1995
18000
138
PRICES
As discussed earlier, the key to fundamentally driven commodity
pricing is the relationship between inventories and price. The actual
or estimated level of inventories, best measured in terms of
consumption, and the expected change in inventories, known as the
market balance, are the core drivers for the price level, the volatility
of prices and the shape of the forward price curve.
The metals markets tend to have long price cycles due to the long
lead times in mined supply. Figure 6.8 depicts a long-term time
3,000
2,500
2,000
1,500
1,000
500
0
20,000
Production (kt/a)
40,000
Figure 6.7 Copper mine costs of production: sharp rises in consumable and
labour costs
4000
3500
3000
Services & other
2500
Stores
2000
Fuel
1500
Electricity
1000
Labour
500
0
1990
1995
2000
2005
2010
2012
139
series for base metals showing how long the price cycle tends to be
and also, interestingly, that current prices for base metals are not
significantly high in real terms. This is despite the fact that since 2002,
the prices of all metals have risen significantly, with gold and iron
ore reaching all time highs in 2012, as shown in Figure 6.9.
The rise of electronic access to commodity markets and growth in
high-speed trading technology has, in our view, changed short-term
commodity pricing dynamics not necessarily for the better or
worse, just changed. A standard technical analysis for copper, for
instance, has become a new challenge for traditional commodity
Figure 6.8 Average real base metal prices
8
Principal component
7.5
7.0
4
20 years!
24 years!
12 6.5
years
so far..! 6.0
17 years!
19 years!
2
0
23 years!
19 years!
5.5
-2
5.0
-4
4.5
-6
-8
1850
4.0
1870
1890
1910
1930
1950
1970
1990
2010
Figure 6.9 Gold, oil, iron ore and copper remain expensive relative to history
250%
200%
150%
100%
50%
0%
-50%
-100%
Aluminium Wheat
Corn
Zinc
T. Coal
Nickel
Tin
Lead
140
Copper
Iron Ore
Brent
Crude
Gold
USD
AUD
JPY
600
500
400
300
200
100
0
1971
1981
1991
2001
2011
141
-3.0
-2.0
US 5 year TIPS, %
(scale inverted)
$1,500
-1.0
$1,250
0.0
$1,000
1.0
$750
2.0
$500
3.0
$250
Jan-07
4.0
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
-2.0
$1,750
-1.0
$1,500
0.0
$1,250
1.0
$1,000
2.0
$750
Gold, $/oz (LHS)
3.0
$500
US 5 year TIPS, % (scale inverted)
$250
Jan-09
4.0
Jan-10
Jan-11
Jan-12
142
Jan-13
from which all market price points are determined. However, when
trading the metals markets, much discussion revolves around the
point of the forward price curve that needs to be traded and to what
degree that point does or does not reflect the expectations already
priced-in to the market.
For example, in Figure 6.13, the iron ore market curve changed
significantly in both shape and level over several months reflecting
how changes in market expectations, the demand from physical
consumers for immediate delivery of metal and the flow of business
across the various points of the curve can shift and reshape the
forward prices.
Commodities with relatively low levels of available inventory
tend to be in backwardation, with nearer-dated futures contracts at
higher prices than the futures contracts further out the curve,
reflecting the premium that the consumer is willing to pay to secure
metal. If the contrary is true, and the market is perceived to be in
ample or over-supply, then the futures curve tends to be upward
sloping, and the market is said to be in contango.
Metals tend to have a somewhat more consistent contango
compared to energy due to the relative ease of storing metals. Gold is
the extreme example of this, with storage of gold being a tiny fraction
of its cost and, therefore, gold tends to trade in perpetual contango
Figure 6.13 Iron ore market curve
Iron ore 62% China (TSI) swaps : NYM : last price : 6/4/2013
Iron ore 62% China (TSI) swaps : NYM : last price : 12/5/2012
Iron ore 62% China (TSI) swaps : NYM : last price : 5/3/2013
125
115
USD/metric tonne
120
110
Dec 2014
Oct 2014
Aug 2014
May 2014
Mar 2014
Dec 2013
Oct 2013
Jul 2013
May 2013
Feb 2013
Dec 2012
105
143
with forward prices driven by the US interest rates minus the storage
or leasing rate. For other metals, such as aluminium, there is also a
tendency towards contango as inventory tends to be built and held
for large consumers, such as car manufacturers. Operators with their
own storage facilities and/or access to cheaper finance can sometimes buy and hold physical metal against an offsetting paper
position for a (largely) risk-free return.
BASE METALS
The base metals, also known as industrial metals or non-ferrous
metals, are aluminium, copper, zinc, lead, nickel and tin. The worlds
benchmark contracts are listed on the London Metal Exchange
(LME). However, other key contacts include the Comex Copper and
Shanghai Futures Exchange (SHFE) copper contracts.
The LME has an idiosyncratic trading system. The most active
daily price is known as the three months price, literally a trading
Figure 6.14 Structure of LME futures
Daily prompt dates
Cash
3 months
6 months
LME Mini
12
Tin
PP, LLDPE
& Steel
144
15
Aluminium
(alloy) &
NASAAC
27
63
Lead,
nickel
& zinc
Aluminium
(Primary
copper)
123
against industry benchmark indexes that are based upon spot physical deliveries.
Due to the magnitude of the flow and the relative high costs of
freight as a percentage of the final price, both iron ore and thermal
coal can be quoted by including the cost of freight to the consumer
port price (CFR). This is typical for iron ore, or from the port of the
producing country before the freight on board (FOB) price, which
tends to be more common for thermal coal.
PRECIOUS METALS
Precious metals, particularly gold, are among the most actively
traded commodity markets, with gold having the widest number of
trading participants of any commodity, including oil. The precious
metals that are actively traded are gold, silver, platinum and palladium. All of these have liquid OTC and exchange-traded markets.
Unlike other commodities, they also have a very large physically
traded wholesale market, of which London is generally seen as the
global centre, although there is a wide range of important local
markets across the world.
The term precious relates partly to their relative scarcity and
partly as they are often used as a store of value rather than for direct
consumption although both gold and silver are commonly used as
miniature decorations on top of Indian sweets, and hence are
genuinely consumed! The precious metals markets are also distinctive in having traditional banking elements that is, gold can be
deposited, on an allocated or unallocated basis, and therefore also
borrowed or leased, much like classic money.
The precious metals, and particularly gold, have probably more
trading centres than any other commodity, despite being globally
homogenous. As mentioned, while the global central point for the
precious metals market remains London, there are a wide range of
very important physical gold markets, including Zurich, Mumbai
and Dubai. However, increased market share and overall liquidity
lies in the listed exchanges, in particular the New York Mercantile
Exchange (Nymex), the Shanghai Futures Exchange (SHFE), the
Multi Commodity Exchange (MCX), the Tokyo Commodity
Exchange (TOCOM) and the Dubai Mercantile Exchange (DME).
Unlike other commodities, a large fraction of all the precious
metals mined in history still exist and can be considered, at least
146
Demand surge:
Chinese;
emerging markets; and
moderate growth across the rest of the world.
Supply constraints and costs explosion:
falling ore grades;
labour shortages and disruption;
technical problems (mines and refineries);
infrastructure bottlenecks, delays and disruptions;
resource nationalisation;
environmental and social legislation;
reduced availability of scrap; and
shift to underground mining.
Inventory declines:
falling visible exchange inventories; and
off-exchange inventories either falling or not being made
available.
Investor buying:
Investor buying:
index inflows;
structured product buying; and
exchange-traded product demand (ETFs, etc).
Hedge fund buying:
commodity specialist fund buying on constructive S&D;
macro hedge funds buying on a China play and/or US dollar
weakness; and
technical traders buying due to signals and momentum.
Corporate flows:
consumer forward buying due to concerns over price rises;
and
producer reductions of existing hedge books ie, net buying.
Looking forward, many of these factors are, or are likely to be,
much less positive; indeed, they may become negative influences on
price over the next few years. Generally, we still expect nominal and
real prices to hold in a higher range compared to history, but we also
expect to see greater variation in individual metals. The winners are
likely to be those where we see little likelihood of sustained increases
in supply such as zinc, lead, platinum, palladium and copper.
148
Machinery &
equipment, 8%
Construction, 19%
Consumer goods,
9%
Packaging, 13%
Transport, 32%
Electrical, 15%
Demand by country
50%
2003
45%
2012
45%
40%
35%
30%
27%
24%
25%
20%
19%
18%
17%
15%
15%
14%
10%
3% 3%
5%
3%
2%
2% 2%
2% 1%
1% 1%
Middle East
Africa
Oceania
0%
China
Europe
Asia
North
America
Latin
America
Russia
Cost curve
3,000
90% minus
premium:
US$1,812
US$/t
2,500
90%:
US$2,072
92%
80%
Current LME
Cash: US$1,893
1,500
1,000
149
Energy, 39%
Supply by country
50%
46%
2003
2012
45%
40%
35%
30%
25%
20%
20%
20%
18%
14%
15%
10%
10%
10%
9%
8%
5%
5%
8%
8%
5%
4% 4%
4%
5%
3%
0%
China
North
America
Russia
Europe
Middle East
Oceania
Asia
Latin
America
Stage 1
refining
Alumina refining
Stage 2
smelting
Recycling
Aluminium smelting
Processing
Extrusion
Rolling
Casting
150
Africa
Electrical/electronics,
34%
Transportation, 14%
Construction, 30%
Demand by country
40
37.7
35
30
25
19.8
20
15
12.2
9.4
10
8.6
8.9
6.6
5.1
5.7
4.5
1.9
3.2
4.4
3.0
4.1
2.9
1.3 1.9
2.2 1.9
Taiwan
Russia
Brazil
0
China
USA
Germany Japan
South
Korea
India
Italy
Cost curve
10000
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
0
5,000
10,000
15,000
151
Labour, 25%
Electricity, 13%
Stores, 32%
Fuel, 8%
Supply by country
50%
45%
2003
44%
43%
2012
40%
35%
30%
25%
20%
15%
13%
15%
9%
10%
4%
5%
9%
9%
7%
7%
9%
6% 6%
6%
4%
5%
1% 2%
0%
Latin
America
North
America
China
Africa
Russia
Oceania
Europe
Asia
Middle East
Condensate
Raffinate
Oxygen
Thickener
Copper
concentrate
Pressure oxidation
Wash
water
Atmospheric leach
(optional)
Limestone
Neutralisation
To pressure
oxidation
Residue washing
(counter current
decantation)
Wash
water
Filtration
Solvent extraction
Filtration
Electrowinning
Leach residue
(to gold plant)
152
Gypsum
(to tailings)
Copper cathode
(to market)
16%
12%
10%
8%
5%
4%
0%
0%
-5%
-4%
-10%
-8%
-12%
19
8
19 6
8
19 7
8
19 8
8
19 9
9
19 0
9
19 1
92
19
9
19 3
9
19 4
9
19 5
9
19 6
9
19 7
9
19 8
9
20 9
00
20
0
20 1
0
20 2
0
20 3
0
20 4
0
20 5
06
20
0
20 7
0
20 8
0
20 9
10
-15%
Demand by country
USA
10%
Other
28%
China
33%
Germany
7%
Taiwan
5%
Korea
6%
Japan
11%
Cost curve
25,000
Ramp-ups, NPI
and tocantins
92.7%
LME cash
US$/tonne
15,000
Median:
US$10,136
10,000
5,000
0
-5,000
90%:
US$15,945
-10,000
153
Sulphides
Laterites
1200
1000
800
600
400
200
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Demand by application
Tubular products 10%
Other 7%
154
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Demand by country
Latin America 5%
Oceania 2%
Africa 1%
Japan 4%
China
41%
North America
10%
Europe
19%
Cost curve
90%:
US$1,524
2,500
2,000
US$/tonne
1,500
US$120/tonne premium
99.1%
LME cash
price: US$1,847
1,000
95.9%
Median:
US$965
500
0
-500
-1,000
155
Russian Fed.
2%
Europe
6%
China
30%
Other Asia
7%
N. America
12%
Australia
12%
L. America
22%
Rolled &
extruded
products
7%
Oxides &
chemicals
8%
Galvanising
57%
Decasting
alloys
11%
Demand by application
Industrial
machinery
7%
Consumer
products
8%
Infrastructure
13%
Transport
23%
Construction
49%
156
190
170
US$/t
150
130
110
90
70
50
2009
2010
2011
2012
2013
2014
140
Spot Price
120
100
Consensus
CS price forecast
80
60
40
20
0
0
100
200
300
400
500
600
700
800
900
BHP.AX
CLF
FMG.AX
KIOJ.J
RIO.AX VALE.N
China
Other
157
HIGH
USES
% OF WORLD RESERVES
Lignite
17%
Hard coal
53%
Sub-bituminous
30%
Bituminous
52%
Thermal
Steam coal
Largely power
generation
Power generation
Cement manufacture
Industrial uses
Anthracite
-1%
Metallurgical
Coking coal
Domestic/
industrial
including
smokeless fuel
50
RoW
China
40
30
20
10
0
-10
2011
2012
2013
2014
2015
40
RoW
Indonesia
35
30
25
20
15
10
5
0
2011
2012
2013
2014
158
2015
50,000
Tonnes
40,000
30,000
20,000
Far from
market
10,000
0
2000
2002
2004
2006
2008
2010
2012
Demand by sector
Bar coin retail
investment
26%
Dental
1%
Jewellery
57%
Industrial
11%
Cost curve
1800
C3 costs (real)
1600
$/oz Au
1400
1200
1000
800
600
400
200
1980
1985
1990
1995
2000
2005
2010
Source: Credit Suisse, Wood Mackenzie, GFMS, Thomson Reuters, World Gold
Council, Bloomberg Professional Service
159
Old gold
scrap
39%
Mine
production
60%
Official sector
sales, 1%
8, 1
9,000
34
8,000
7,000
160
06
3,7
80
Belgium
Australia
Canada
Other
280
228
Austria
287
282
Spain
Lebanon
445
310
UK
Turkey
366
323
Venezuela
Saudi Arabia
424
383
Taiwan
Portugal
558
502
ECB
Netherlands
India
765
613
Russia
IMF
2012A Mine
Germany
United
1,000
Japan
1, 0
996
Switzerland
40
03
54
China
2, 3
2,000
1,0
2012A
52
35
2,4
2,4
Italy
3,000
France
14
2,8
17
4,000
2, 8
91
5,000
3, 3
Tonnes
6,000
Scrap
20%
Mine
production
77%
Government sales
3%
Primary silver
28%
Silver scrap
Zero growth
5.0% growth rate
1,200
1,200
1,000
1,000
800
800
600
600
400
400
200
200
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
161
Photography
900
800
700
600
500
400
300
200
100
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Demand by sector
Coins & medals
8%
Jewellery &
silverware
26%
Photography
13%
Industrial applications
53%
ETP demand
500
iShares
ETF Securities
30
450
Mln ounces
400
350
25
20
300
250
15
200
150
100
10
5
50
Ap
r
Ju -06
n
Au -06
g
O -06
c
D t-0
ec 6
Fe -06
b
Ap -07
r
Ju -07
n
Au -07
g
O -07
c
D t-0
ec 7
Fe -07
b
Ap -08
r
Ju -08
n
Au -08
g
O -08
c
D t-0
ec 8
Fe -08
b
Ap -09
r
Ju -09
n
Au -09
g
O -09
c
D t-0
ec 9
Fe -09
b
Ap -10
r
Ju -10
n
Au -10
g
O -10
c
D t-1
ec 0
-1
0
162
Others
Zimbabwe
North America
Russia
South Africa
8,000
'000 ounces
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Others
Zimbabwe
North America
Russia
South Africa
8,000
'000 ounces
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Other
Petroleum
Glass
Electrical
Chemical
Jewellery
Autocatalyst
Investment
'000 ounces
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
-1,000
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
163
10,000
Chemical
Autocatalyst
Jewellery
Investment
Dental
9,000
8,000
'000 ounces
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
-1,000
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
$2,250
Plat. Ldn
Bskt Ldn
Plat. ZKB
Pt other
Plat. US
Plat. Swiss
ABSA
Plat, spot
$2,000
1,750
$1,750
Thousands oz
1,500
1,250
$1,500
1,000
$1,250
750
$1,000
500
$750
Apr-13
Jan-13
Oct-12
Jul-12
Apr-12
Jan-12
Oct-11
Jul-11
Apr-11
Jan-11
Oct-10
Jul-10
Apr-10
Jan-10
Oct-09
250
$500
Pall. Ldn
Bskt Ldn
Pall. ZKB
Pall. US
Pall. Swiss
Pall, spot
Pd Other
$900
$800
2,000
Thousands oz
$700
$600
1,500
$500
1,000
$400
$300
500
164
Apr-13
Jan-13
Oct-12
Jul-12
Apr-12
Jan-12
Oct-11
Jul-11
Apr-11
Jan-11
Oct-10
Jul-10
Apr-10
Jan-10
Oct-09
Jul-09
Jan-09
Apr-09
$200
$100
Grains and oilseeds were the first commodities, the staple of our diet
and the basic building blocks for meat and fish (through aquaculture).
In developed economies, food represents some 10% of GDP, higher in
developing economies. Around 20% of people around the world
receive government-subsidised food. This chapter will examine these
crops for each of the major producers and consumers around the
world, analysing how the meat and fish protein markets impact
grains, and the worlds ability to rotate and adjust crop plantings in
the face of a changing demand profile. Likely trends are also noted.
Once the domain of the big grain companies, these commodities
have been a major asset class for investors since the early 2000s, and
this chapter will take a bottom-up approach to analysing the most
relevant information for the various investment themes and their critical drivers for the years ahead. The traditional power players in the
agricultural markets, both originators and exporters, are the US, the
EU, Brazil and Argentina, and this dominance has been dramatically
affected by the increasing importance in price formation of nontraditional spheres of influence. Investment themes here have been
greatly influenced by a number of factors, such as the emergence of
China as the worlds largest grain economy while US grain
consumption as ethanol has made it a significantly less important
player for global grains biofuels in general, urbanisation and its
attendant social changes, dramatic changes in food consumption and
rapidly changing agricultural and environmental policy around the
globe.
Surprises that have led to a tightness in these markets include the
165
(member states of
ndependent States
c of South Africa
or producers (see
, EU-27, Morocco,
and
167
460 MMT of rice comes from four major producers (see Table 7.7)
Brazil, Thailand, China and India.
Of the soft oilseed total of 350 MMT:
250 MMTof soybeans are from four major producers (see Table
7.9a) US, Argentina, Brazil and Paraguay;
60 MMT of rapeseed are from four major producers (see Table
7.9b) Canada, EU-27, China and India; and
40 MMT of sunseed are from three major producers (see Table
7.9c) Canada, EU-27 and CIS/FSU.
Hard oils (palm oil production) are dominated by Malaysia and
Indonesia at 38MMT (see Table 7.2).
Each major producer has a substantial grain economy for each
grain, and many interact since feedgrains are often combined with
oilseed meals for example, to make complete animal diets. Each of
these economies is different and evolving. There are few clean lines,
with many feedgrains also being foodgrains, and feedgrains being a
major feedstock for biofuels (primarily ethanol, but also sugar cane),
as is vegetable oil (primarily biodiesel).
In Table 7.1 and subsequent tables we compare the last three-year
average of 2010, 2011 and 2012 (201012) to the previous three-year
averages of five years ago (200507), 10 years ago (200002), 15 years
ago (199597) and 20 years ago (199092), to avoid blips in individual
years. We see from this summary that, although the grains area
appears remarkably stable over time (3% 20-year growth), the
oilseeds area has expanded by more than 75%. For combined grains
and oilseeds, the 20-year yield growth has been 24% on an overall
hectare expansion of 13%, leading to a production increase of 40%.
For total arable land, the last five-years production growth came
evenly from area (5%) and yield (6%).
Additionally, we must remember that in this period the US took
around 160,000 km2 or 18.1 MHa (equal to 40 million acres, MAc) out
of production through its Conservation Reserve Program (CRP).
Also, in this period the EU ran its Cereal Set-aside programme. Setaside became compulsory in 1992, primarily as a means of reducing
the grain mountain as part of the Common Agricultural Policy. It
was originally set at 15%, before being reduced to 10% in 1996 and
then abandoned in September 2007.
168
Table 7.1 Grain and oilseed 20-year AYP progression comparing three-year averages of 201012 (absolute values) and percentage
growth from 200507 (5-year growth), 200002 (10-year growth), 199597 (15-year growth) and 199092 (20-year growth); MHa,
Mt/Ha and MMT
Crop
Grains
Oilseeds
Total arable
635
164
799
Yield Y
Prdn P
3.400
2.200
3.200
2170* 2%
355 15%
2525
5%
200507
200002
AYP % growth
8%
3%
6%
10%
18%
11%
199597
AYP % growth
6%
34%
11%
16%
8%
13%
23%
45%
26%
199092
AYP % growth
2%
52%
9%
23%
20%
20%
25%
82%
31%
AYP % growth
3%
78%
13%
28% 31%**
27% 125%
24% 40%
Source: Adapted from Informa; * 635/3.40/2,170 means grains area is 635 MHa, world average yield is 3.40 Mt/HA and world production is 2,150
MMT; ** 3%/28%/31% means grains area has grown 3% in 20 years, yield has grown 28% and production by 31%
169
Table 7.2 Major exporters and major importers, by grain or vegetable protein
Corn/Maize
100 MMT
Top 10 Exporters
1 US
2 Argentina
3 Ukraine
4 Brazil
5 India
6 Russia
7 RSA
8 Paraguay
9 Canada
10 EU-27
Corn/Maize
Wheat
130 MMT
Soybeans/Meal/Oil
93/55/8 MMT
Rapeseed
11MMT
Palm Oil
38 MMT 70%
of the 54 MMT
of global veg
oil
US
Australia
Canada
EU-27
Russia
Argentina
India
Ukraine
Kazakhstan
Turkey
US/Arg/Arg
Brz/Brz/Brz
Arg/US/US
Paraguay/India
Canada/China/
Canada
Australia
Ukraine
Indonesia (19.0)
Malaysia (18.7)
Wheat
Soybeans/Meal/Oil
Rapeseed
Palm Oil
China/EU/China
EU27/Indonesia/
India
Mexico/Vietnam/
Iran
Taiwan/Thailand/
Bangladesh
Japan/Japan/
Venezuela
Thailand/Philipp/
Peru
Indonesia/Iran/
Algeria
Egypt/South Korea/
Egypt
US/Mexico/South
Korea
South Korea/Canada
& Colombia/
Morocco & RSA
EU-27
India
Japan
China
China
EU27
Mexico
Pakistan
US
Singapore
Canada
Egypt
Top 10 Importers
1 US EtOH
Egypt
2 Japan
Brazil
3 EU-27
Indonesia
4 Mexico
Japan
5 South Korea
Algeria
6 Egypt
South Korea
7 Iran
Mexico
8 Taiwan
Iraq
9 Colombia
Morocco
10 Algeria
Nigeria/Philipp.
US
Bangladesh
CIS/FSU
Iran, Vietnam
& Japan
FEEDGRAINS
There are three major feedgrains in the world corn, sorghum and
barley the production of which amounts to 1,045 MMT. However,
we must add significant volumes of feed wheat consumed in China
(1012 MMT), the EU (4957 MMT in 200712), Russia (13 MMT) and
170
Table 7.3a Maize 5-, 10-, 15- and 20-year AYP progression (comparing 201012 with 200507, 200002, 199597 and 199092).
After each country name the % of world area devoted to this crop in 2012 and 1992 are given
Maize / Corn
US
Argentina
Brazil
Mexico
France
EU 27
CIS/FSU
South Africa
Thailand
China
World total
35% 21%
3%
2%
8% 10%
2%
5%
2%
1%
7%
3%
3%
2%
1%
3%
1%
1%
23% 16%
100% 100%
34.1
3.7
14.4
6.5
1.6
8.6
5.9
3.1
1.0
33.3
168.6
8.834
6.625
4.526
3.087
9.347
6.870
4.734
3.953
4.248
5.779
5.061
Prdn P
301
24
66
20
15
59
28
12
4
193
853
20052007
AYP % growth
9%
28%
4%
8%
6%
1%
58%
13%
1%
19%
11%
6%
1%
25%
1%
4%
11%
31%
20%
13%
10%
5%
2%
26%
30%
8%
10%
9%
110%
34%
12%
30%
16%
20002002
AYP % growth
20%
44%
15%
11%
13%
6%
120%
11%
13%
39%
23%
5%
12%
41%
18%
5%
14%
66%
48%
11%
22%
16%
26%
62%
62%
5%
8%
7%
269%
33%
3%
69%
43%
19951997
AYP % growth
20%
19%
11%
16%
7%
24%
130%
18%
11%
41%
22%
15%
35%
79%
34%
12%
0%
64%
61%
28%
19%
24%
38%
59%
100%
13%
3%
35%
271%
32%
15%
68%
52%
19901992
AYP % growth
22%
63%
9%
7%
8%
97%
108%
8%
22%
56%
29%
18%
59%
114%
38%
32%
3%
51%
82%
55%
27%
32%
43%
158%
133%
27%
21%
89%
216%
68%
20%
99%
69%
% Of world
yield
178%
133%
90%
63%
188%
138%
95%
80%
85%
115%
100%
Table 7.3b Barley 5-, 10-, 15- and 20-Year AYP Progression (comparing 2010-12 with 2005-07, 2000-02, 1995-97 and 1990-92).
After each country name the % of world area devoted to this crop in 2012 and 1992 are given
Last 3 year average
20102012
Area A
Yield Y
Barley
Canada
EU27
CIS/FSU
World total
5%
5%
25% 20%
27% 37%
100% 100%
2.5
12.5
13.5
49.5
3.125
4.250
2.000
2.625
Prdn P
8
53
27
129
20052007
AYP % growth
30%
11%
18%
12%
5%
6%
7%
8%
27%
5%
12%
5%
20002002
AYP % growth
37%
12%
17%
10%
20%
0%
2%
5%
25%
12%
16%
6%
19951997
AYP % growth
46%
17%
42%
26%
4%
3%
39%
16%
44%
15%
18%
14%
19901992
AYP % growth
40%
15%
50%
33%
9%
4%
10%
13%
35%
12%
45%
25%
% Of world
yield
119%
162%
76%
100%
Table 7.3c Sorghum 5-, 10-, 15- and 20-Year AYP Progression (comparing 2010-12 with 2005-07, 2000-02, 1995-97 and 1990-92).
After each country name the % of world area devoted to this crop in 2012 and 1992 are given
Last 3 year average
20102012
Area A
Yield Y
Sorghum
US
Argentina
Australia
World total
5% 10%
3%
2%
2%
1%
100% 100%
1.9
1.1
0.7
38.5
3.713
4.367
3.181
1.527
Prdn P
7
5
2
59
20052007
AYP % growth
21%
87%
12%
8%
10%
7%
11%
4%
30%
74%
7%
4%
20002002
AYP % growth
41%
4%
93% 12%
11% 36%
5%
3%
39%
70%
20%
3%
19951997
AYP % growth
53%
53%
20%
9%
8%
11%
33%
5%
57%
67%
59%
4%
19901992
AYP % growth
56%
52%
46%
3%
9%
18%
64%
5%
60%
78%
133%
2%
% Of world
yield
243%
286%
208%
100%
172
For many animals, grains are a simple supplement for their diet
(eg, beef cattle that consume mainly forage), while dairy cows, pigs
and poultry require a considerable amount of protein to be added to
their diet since they perform optimally with a 2025% protein feed,
almost twice that of any cereal grain. This implies a 75:25 grain:meal
combination. Therefore, major feedgrain consumers must also
produce or import their protein needs, making the EU a major
importer of softseed proteins. Although it may seem very straightforward, the Pearson Square formulation works surprisingly well for
estimating diets for forecasting animal or aquaculture needs, and is
easily found with a web-search.
Biosystems, of which one is the stomach, are complex and a series
of associative effects can be observed. We do not digest equally meat
and potatoes that are eaten separately, as compared to eating combinations in various proportions. The cooking method and previous
meal also influence digestion. We do not similarly digest meat and
rice in the same way as meat and potatoes. This leads to feed conversion efficiency (FCE), a metric which is the first step towards
metabolisability, the rate at which we actually use the nutrients we
have ingested. FCE is normally expressed as kilograms (kg) of dry
matter output per Kg of DM feed.
In principle, as we allocate raw materials, feedgrains should only
go to those processes that efficiently transform them into human
food. For example, this means that we would not feed grains to cattle
other than what is required to optimise their ability to digest cellulosic feeds. If this were the case, and we were simply economic
actors, we would have more than enough to feed the world
however, this would have the effect of large parts of the common diet
disappearing around the world. We prefer to eat as we please,
dependent on prevailing price and income.
Associative effects include the reality of optimised nutrition,
combining carbs, proteins and fats to get the optimal feed conversion. Diets have been balanced at the commercial level based on the
least-cost formulation since the 1960s, and it remains a simple linear
programming exercise. Animal nutrition has advanced much faster
than human nutrition, not least because we can isolate genetics and
enforce diets for animals, before butchering them to measure the
output much more easily than with humans. Optimising nutrition is
scientifically easy but socially complex, and we can imagine very
173
Table 7.4 True US corn (maize) annual S&D (MMT), using 1990/91 crop year alcohol as base: a 20-year perspective (September
August crop)
Crop year
1995/96
2000/01
2005/06
2010/11
2011/12
2012/13
27.1
7.44
26.4
7.12
29.3
8.59
30.4
9.29
33.0
9.59
34.0
9.24
35.5
7.67
34.2
34.2
201.5
201.5
0.1
235.8
235.8
39.6
38.8
188.0
186.8
0.4
228.0
226.8
43.6
42.8
251.9
244.8
0.2
295.7
288.6
53.7
51.9
282.3
250.5
0.2
336.2
304.4
43.4
37.0
316.2
197.6
0.7
360.2
241.6
28.6
21.7
313.9
195.5
0.7
343.3
224.9
25.1
18.1
272.4
164.5
3.2
300.7
192.8
Use
Feed & Residual
117.1
% Adj Tot Supply
50%
Food/Seed/Ind
36.2
Ethanol FSI
8.9
Fuel FSI
0.0
Non Fuel FSI
36.2
Total FSI as % total supply
15%
Non fuel FSI as % total supply
15%
Adj domestic use (ex fuel)
153.3
Exports
43.9
Exports as % adj total supply
19%
Exports as % adj domestic use
29%
Adj total use
197.1
Carryout
38.6
Adj Carryout (ex 20 days 'fuel as corn') 38.2
Adj C/O as % adj domestic use 25%
119.4
53%
41.4
10.1
1.2
40.2
18%
18%
159.6
56.4
25%
35%
215.9
10.8
10.3
6%
147.9
51%
50.2
16.0
7.1
43.1
17%
15%
191.0
49.3
17%
26%
240.3
48.2
47.4
25%
155.3
51%
76.7
40.7
31.8
44.9
23%
15%
200.2
54.2
18%
27%
254.4
50.0
47.7
24%
121.7
50%
163.3
127.5
118.6
44.7
45%
18%
166.4
46.6
19%
28%
213.0
28.6
21.7
13%
115.5
51%
163.5
127.3
118.4
45.1
48%
20%
160.6
39.2
17%
24%
199.8
25.1
18.1
11%
109.2
57%
153.0
116.8
107.9
45.1
51%
23%
154.4
25.4
13%
16%
179.8
13.0
6.6
4%
0.6
0.9
2.2
7.0
7.0
6.4
US (September/August)
Harvested Area (MHa)
Yield (MT/Ha)
Carryin
Carryin less 20 days 'fuel as corn'
Production
Production less EtOH
Imports
Total supply
Adj total supply (ex fuel)
0.5
175
Source: Agrimax
Note: In each step the traditional USDA format is improved by deducting maize produced for fuel EtOH and the appropriate stocks deducted.
1990/91
(DDGS). The carbon dioxide released from the process is also utilised
to carbonate beverages and in the manufacturing of dry ice. Ethanol
yield is constantly rising and water use efficiency improving. The
initial assumption that biofuels were good for the environment
because they had a smaller carbon footprint is debatable regarding
the contention that the production of grain alcohol, and therefore
E15, may actually have a greater environmental impact than fossil
fuels.
US non-fuel FSI averaged 15% of production across the 20-year
period, amounting to some 42 MMT. In theory, this all comes from
wet milling, a process which takes the corn grain and steeps it in a
dilute combination of sulphuric acid and water for 2448 hours in
order to separate the grain into many components. The slurry mix
then goes through a series of grinders to separate out the corn germ.
This process is the backbone of industrial processing for the production of fructose, glucose, dextrose, starch, potable alcohol and
industrial alcohols. These figures are typical of an industrial maize
economy found all over the world with the exception of highfructose corn syrup (HFCS) and fuel ethanol, which are US-specific.
In 20 years, US production of HFCS increased by 33%, glucose and
dextrose by 54%, starch by 14%, potable alcohol was unchanged and
cereal consumption increased by 64%, largely driven by the USDA
food pyramid. The growth is predictable since the plants are
announced and take time to build. This industrial demand is largely
non-switchable. For example, it was affected by a 2006 agreement
(which became effective in 2008) to allow sweeteners to flow from
the US to Mexico without tariffs.
HFCS is produced by wet milling corn to produce corn starch,
then processing that starch to yield corn syrup, which is almost
entirely glucose, and then adding enzymes that change some of the
glucose into fructose. The resulting syrup (after enzyme conversion)
contains naturally 42% fructose, and is consequently called HFCS 42.
Some of the 42% fructose is then purified to 90% fructose (HFCS 90).
To make HFCS 55, the HFCS 90 is mixed with HFCS 42, and this
increased fructose percentage gives it the same sweetness taste as
sugar (which is why it is called high fructose corn syrup).
A system of sugar tariffs and sugar quotas imposed in 1977 in the
US significantly increased the cost of imported sugar, and US manufacturers therefore sought cheaper sources. HFCS, as it is derived
179
Beef and
veal
Pork
57.3
12.0
8.1
9.1
1.4
2.8
5.6
103.2
10.2
23.0
3.2
1.9
51.1
China
EU 27
US
Brazil
Russia
Vietnam
Canada
Japan
Philippines
Mexico
Poultry
Meat
76.0
16.5
9.0
12.3
2.3
2.6
12.5
236.5
38.7
40.1
24.6
5.7
5.5
69.2
US
China
Brazil
EU 27
Mexico
India
Russia
Argentina
Iran
Thailand
China
India
Peru
Indonesia
US
Japan
Chile
Vietnam
Thailand
Russia
Commercial catch
of world &
aquaculture
Total
meat
%Meat
protein
%of world
in diet
fish
142.0
4.9
6.4
0.5
3.5
7.5
47.5
100%
16%
17%
10%
2%
2%
29%
615.0
82.3
86.6
49.7
14.8
18.4
185.8
38%
47%
46%
49%
38%
30%
37%
100%
3%
5%
0%
2%
5%
33%
180
World
US
EU-27
Brazil
Russia
India
China
Table 7.5 FAO estimates of world 2010 animal protein consumption by type major economies (MMT)
Table 7.6 Wheat five-, 10-, 15- and 20-year AYP progression (comparing 201012 with 200507, 200002, 199597 and 199092).
After each country name the % of world area devoted to this crop in 2012 and 1992 are given
US
Canada
Argentina
Brazil
EU 27
Morocco
CIS/FSU
Turkey
China
India
Australia
World total
11%
6%
2%
1%
8%
1%
21%
4%
14%
10%
4%
100%
19.0
9.0
4.0
2.0
25.5
3.0
49.0
8.0
24.0
29.0
13.5
220.5
3.000
2.875
3.625
2.500
5.250
1.625
1.875
2.125
4.875
3.000
2.000
3.000
59
4%
25
5%
15 29%
5
6%
135
3%
5
4%
92
5%
17
6%
118
4%
87
8%
26
11%
668
2%
13%
12%
29%
41%
4%
28%
2%
6%
8%
13%
45%
7%
9%
7%
8%
48%
7%
29%
3%
0%
12%
22%
60%
10%
200002
AYP % growth
3%
13%
37%
21%
2%
10%
9%
9%
3%
11%
14%
2%
16%
39%
59%
72%
7%
58%
0%
12%
29%
8%
24%
13%
12%
20%
0%
107%
4%
75%
9%
2%
24%
20%
40%
15%
199597
AYP % growth
24%
24%
29%
44%
10%
22%
4%
8%
18%
14%
31%
2%
22%
7%
27%
4%
60%
14%
60% 128%
12%
24%
38%
51%
29%
35%
17%
8%
28%
5%
16%
33%
3%
35%
19% 16%
199092
% of world
AYP % growth
yield
25% 21% 10% 100%
37% 29% 19%
96%
16% 70% 46% 121%
15% 100% 78%
83%
35% 2% 32% 175%
19% 21% 39%
54%
4%
0%
4%
63%
11% 20%
7%
71%
21% 51% 19% 163%
23% 32% 63% 100%
60% 19% 90%
67%
2% 21% 18% 100%
182
Wheat
China and Turkey) to see what they can contribute. The Ukraine crop
dipped from 18.0 to 14.0 MMT, and they drew stocks to maintain
exports at 3.5 MMT, down 3.0 on the previous year. Russia agitated for
a Ukraine export ban. Kazakhstan exports surged from 4.0 to 8.0 MMT
on a decent crop and a stock draw. India, however, who can be a 5.0
MMT exporter, was coming off two disappointing crops and had low
stocks. So, not only were they absent from the export market in
CY2006/07, but in fact imported almost 7.0 MMT. Chinas production
rose 11.0 MMT yoy, but they were already in stock-building mode and
withdrawing from the export market strategically. China therefore
barely exported 1.0 MMT more than the previous year. Turkey was
down to bare minimum stocks and had a sufficiently reduced crop in
CY2006/07 to be absent from the export market. In fact, across the
minor exporters there was a significant increase in imports yoy,
primarily lead by India and indicating the structural shift in the two
most populous countries in the world; China is now a structural
importer, and while India may come and go as both exporter and
importer, it will inevitably follow China to the structural importer
category.
Among the major importers, Egypt built stocks by 1 MMT in
2006/07 and increased imports yoy, Brazil increased imports by 1
MMT, Japan maintained imports, Indonesia raised imports and
Algeria cut theirs by an offsetting amount. South Korea, Nigeria,
the Philippines and Morocco cut imports modestly, while Iraq
imports took a big downturn and Mexico was unchanged. Overall,
major importer demand dipped by only 2.0 MMT in the face of a
30.0 MMT dip in major exporter production, pinpointing the very
staple nature of wheat demand and its insensitivity to price. It
should be clear to the reader that every large market player has
access to the shipping fixtures, or grain movements, by loadport
and discharge port.
We then entered the major bull run. Any problems in the 2007
growing season would cause a major disruption, and the hedging
pressure and speculative pressure increased to intense levels. US
production rebounded by 6.5 MMT in CY2007/08 and another 12.0
MMT in CY2008/09, but only after drawing stocks to a low 8.0 MMT.
Disastrously, the EU had more problems in 2007/08 and production
dipped another 5.0 MMT, and stocks hit a near record low. By
CY2008/09, a world-saving rebound of 31 MMT would be
190
Table 7.7 Rice 5-,10-, 15- and 20-year AYP progression (comparing 201012 with 200507, 200002, 199597 and 199092). After
each country name the % of world area devoted to this crop in 2012 and 1992 are given
Rice
Brazil
Thailand
China
India
World total
3%
6%
22%
29%
100%
2.5
11.0
30.0
43.5
158.5
3.250
1.875
4.750
2.250
2.875
8 12%
20
4%
141
4%
100
1%
461
3%
18%
5%
6%
7%
6%
5%
9%
10%
6%
9%
200002
AYP % growth
18%
7%
5%
0%
6%
44%
10%
6%
20%
11%
199597
AYP % growth
18%
18%
12%
20%
18%
27%
15%
4%
1%
6%
77%
22%
8%
22%
15%
199092
% of world
AYP % growth
yield
30% 41% 106%
41%
21% 34%
4%
8% 17%
23%
2% 32%
21%
8% 21%
22% 113%
61%
65%
8% 165%
35%
78%
30% 100%
191
harvested, but not until the market had gyrated wildly. Adding to
the woes in 2007, Canadian wheat production dipped 5.0 MMT, and
they too drew stocks heavily to record a low of barely 4.0 MMT.
Australian production recovered, by a mere 2.8 MMT, to a sub-14.0
MMT crop. Argentinian and Russian crop production increased
slightly, and the major exporters saw their total production increase
by 6 MMT and stocks draw another 7.0 MMT on top of the previous
years 20.0 MMT decline. Collectively, their production would surge
by more than 66.0 MMT in CY200809 to end the bull market. Minor
exporters had a domestic production rebound of 8.0 MMT but
reduced their exports yoy, and while they cut their imports in half
they were also building stocks. Although there was some variance
between major importers, stock were built modestly and imports
rose modestly.
Wheat exhibited the classic volatility of a market with inelastic
demand and whose price-solving mechanism is to scale a steep
marginal supply curve to increase production at the expense of
competing crops. This occurred at the same time as crude oil price
was increasing dramatically and maize demand for ethanol surged
in the US. As in Table 7.6, the wheat supply from 200507 to 201012
would only increase in area by 2%, yield would rise 7% and production by 10%. Production increases were 20% in the EU, 18% in China,
14% in CIS/FSU, 13% in India and 9% in the US.
As a foodgrain, rice provides the most widely consumed staple
food of over half the worlds population (see Table 7.7), especially in
Asia and the West Indies. It is the seed of the monocot plants Oryza
sativa (Asian rice) or Oryza glaberrima (African rice). It is the predominant dietary energy source for 17 countries in Asia and the Pacific,
nine countries in North and South America and eight countries in
Africa.
Rice provides 20% of the worlds dietary energy supply, while
wheat supplies 19% and maize 5%. It is the grain with the secondhighest worldwide production after maize, but since a large portion
of maize crops are grown for purposes other than human consumption, rice is the most important grain for human nutrition and caloric
intake, providing more than one fifth of the calories consumed
worldwide by the human species. There are many varieties of rice
and culinary preferences vary regionally. In the Far East, there is a
preference for softer and stickier varieties.
192
ood-expenditures.
million people are
consumer base of
example, has the
UK grocery market
GDP, and employs
uring sector in the
K manufacturing.
ufacturing in the
. This is roughly a
, for example, has
193
US
Argentina
Brazil
Paraguay
China
India
World Total
42%
9%
18%
2%
14%
5%
100%
30.5
18.5
25.5
3.0
8.0
10.0
105.0
2.750
2.625
2.875
2.125
1.750
1.125
2.500
85
49
74
6
14
11
258
8%
16%
18%
19%
15%
22%
13%
2%
7%
7%
8%
10%
10%
1%
5%
9%
27%
28%
6%
34%
15%
200002
AYP % growth
4%
62%
57%
105%
14%
73%
33%
8%
2%
6%
18%
4%
27%
5%
12%
60%
66%
68%
11%
120%
39%
199597
AYP % growth
17%
191%
114%
155%
1%
96%
63%
11%
20%
25%
6%
3%
18%
15%
30%
248%
166%
139%
2%
132%
87%
199092
% of world
AYP % growth
yield
31%
286%
154%
222%
8%
223%
89%
18%
12%
53%
39%
26%
21%
25%
54% 110%
333% 105%
288% 115%
348%
85%
36%
70%
294%
45%
135% 100%
Table 7.8(b) Rapeseed 5-,10-, 15- and 20-year AYP progression (comparing 201012 with 200507, 200002, 199597 and 1990
92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given.
Rapeseed
Canada
China
India
EU 27
World total
15%
31%
31%
15%
100%
7.5
7.0
7.0
6.5
34.0
1.750
1.750
1.000
3.000
1.750
14
13
7
20
61
38%
15%
6%
17%
25%
5%
1%
5%
1%
2%
45%
14%
11%
17%
28%
200002
AYP % growth
88%
2%
44%
57%
47%
32%
16%
15%
1%
16%
143%
18%
65%
56%
70%
199597
AYP % growth
69%
10%
4%
58%
47%
199092
% of world
AYP % growth
yield
Soybeans
194
Table 7.8(a) Soybean 5-,10-, 15- and 20-year AYP progression (comparing 201012 with 200507, 200002, 199597 and 1990
92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given.
Table 7.8(c) Sunseed 5-,10-, 15- and 20-year AYP progression (comparing 201012 with 200507, 200002, 199597 and 1990
92). After each country name the % of world area devoted to this crop in 2012 and 1992 are given.
Sunseed
US
Argentina
EU 27
CIS/FSU
World total
6%
15%
24%
26%
100%
0.5
1.5
4.0
13.0
24.5
1.625
2.125
1.875
1.375
1.500
1 19%
4 27%
7
12%
18
32%
37
9%
2%
25%
15%
15%
16%
19%
9%
28%
51%
26%
200002
AYP % growth
30%
16%
15%
84%
23%
5%
23%
26%
42%
28%
35%
3%
45%
160%
57%
199597
AYP % growth
40%
44%
31%
106%
23%
199092
% of world
AYP % growth
yield
8% 35% 22%
18% 34% 29%
96%
48%
3%
43% 195% 179%
23% 52% 44%
195
to 2.28 MT/Ha, Argentina from 2.82 to 2.36 and Brazil from 2.82 to
2.37. In 2002, Argentina and Brazil out-yielded the US for the first
time, and their combined production matched US. For the first time,
not only did global soybean production not grow, it dipped by some
10 MMT. This sparked an unprecedented rally which had long-term
effects on how the markets traded, who dominated them and how
the Chinese thought about their soybean strategy. In the authors
opinion, this drop may be partly attributed to the illegal spread of
GM seeds in Latin America at a time when the technology was new
and certainly undeveloped for Latin American conditions. Critically,
it demonstrated that yield advancements came with increasing yield
variability and unexpectedly large sensitivity to weather variations.
The US saw 0.5 standard deviation changes in GDDs give far bigger
swings in yield than history would have lead us to expect.
For those who follow freight markets, part of Chinas soybean
importing strategy has been to add Chinese tonnage to the global dry
bulk market, since they are structurally short, causing a sharp downward correction in freight prices.
HOW ROTATION CONVERGES THE GRAINS
As a major source of income for trading companies and hedge funds
alike (see Appendix 7.1), and definable by excellent fundamental
analysis, we can arbitrage maize, wheat and soybean prices. In the
short run, one can reasonably expect these three commodities to
change price relative to each other, to reallocate or switch hectares
between crops and hemispheres. We can always bring more land
into production, but in Brazil, for example, that involves a year of
land clearance of indigenous plants before a year of growing rice and
clearing the land, and then a serious commercial crop can be started
in the third year. Table 7.9 shows an interesting view of the major
crop economies in a side-by-side comparison of total arable land flexibility and individual crop flexibility. The major opportunities with
existing resources, in terms of area, are all within Table 7.9. The
serious student should understand this one table representation of
flexibility in both percentages and individual crops as well as the
yield gaps presented in the various tables for the major crops, by
country.
The US and the EU-27 are the most economically responsive areas
or rational actors to relative price, by which we mean per-hectare
201
Table 7.9 Rotation flexibility by major grain economy in 20 years (total arable area and min/max percentages by major crop)
Swingable hectares is total area times (max minus min); current percentage devoted to each crop is given by country and world
Barley
Min
Max
90
60
30
45
105
90
85
32%
9%
9%
28%
22%
41%
17%
17%
46%
33%
2%
9%
Swingable hectares
US
EU-27
Argentina
Brazil
China
India
CIS/FSU
Theoretical total
Min
Max
21%
34%
16%
Sorghum
Rice
Min
Max
Min
Max
2%
6%
2%
5%
22%
40%
11%
3%
23%
31%
53%
34%
46%
38%
11%
31%
34%
64%
38%
7.9
4.8
2.2
8.3
12.4
0.0
5.3
41
Wheat
0.0
8.1
0.0
0.0
0.0
0.0
18.6
27
3.5
0.0
0.9
0.0
0.0
0.0
0.0
4
Soybeans
Min
5%
29%
48%
Max
15%
34%
57%
10.9
3.8
7.9
3.2
8.5
2.7
9.6
47
Min
Max
28%
38%
31%
32%
7%
3%
68%
59%
10%
12%
0.0
0.0
0.0
4.5
4.7
8.7
0.0
18
Rapeseed
Sunseed
Min
Max
Min
Max
6%
12%
6%
6%
15%
19%
6%
6%
8%
9%
5%
17%
8.8
0.0
11.3
12.4
3.6
7.6
0.0
44
0.0
3.8
0.0
0.0
2.7
2.7
0.0
9
0.0
5.2
4.0
0.0
0.0
0.0
9.6
19
Current %
US
EU-27
Argentina
Brazil
China
India
CIS/FSU
Maize
40%
16%
12%
31%
33%
0%
9%
Barley
0%
22%
0%
0%
0%
0%
17%
Sorghum
2%
0%
4%
0%
0%
0%
0%
Wheat
22%
44%
11%
4%
23%
33%
59%
Rice
0%
0%
0%
5%
29%
48%
0%
Soybeans
35%
0%
66%
59%
7%
12%
0%
Rapeseed
0%
11%
0%
0%
7%
8%
0%
Sunseed
1%
7%
6%
0%
0%
0%
15%
Current % world
21%
6%
5%
28%
20%
13%
4%
3%
Source: Agrimax.
202
Maize
MHa
US
EU-27
Argentina
Brazil
China
India
CIS/FSU
Area
income. Since the early 1990s the US has planted as little as 32% and
as much as 41% of its 90.0 MHa of arable land to maize, 26% to
sorghum, 2234% to wheat and 2838% to soybeans. At the last
count, the US were at maximum on maize, 35% on soybeans and
minimum on wheat. This trend will continue with more ethanol
(maize) produced and less land available for wheat and soybeans.
Wheat area is the most switchable, and surged 3.0 MHa in 2003.
Soybean hectares surged almost 2.5 MHa in 1997 in response to the
Freedom to Farm Act. Over the 20 years, total land area only
increased by 6 MHa. With the threat (or reality) of E15, it is expected
there will be more maize at the expense of wheat.
By contrast, the EU-27 has 60.0 MHa in grains and oilseeds up by
almost 20.0 MHa's in 20 years, with maize swinging between 9% and
17%, wheat between 40% and 46%, barley between 21% and 34%,
rapeseed between 6% and 12% and sunseed between 6% and 14%. At
the last count, the EU-27 was close to maximum on wheat and rapeseed, average on sunseed and close to bottom on barley.
Argentina and Brazil till some 30 MHa and 46 MHa, respectively,
with each having grown from 15.5 and 30.5 since the early 1990s.
Argentina is more rotationally complex, with 1017% maize, 25%
sorghum, 1138% wheat, 3168% soybeans and 619% sunseed.
Brazil is 2846% maize, 311% wheat, 515% rice and 3259%
soybeans. Latterly, Argentina has been in the middle on maize, at the
high end for sorghum, at the bottom end for wheat and all the way to
max on soybeans and at minimum for sunseed. Brazil was close to
minimum for maize, bottom end for wheat and rice and, like
Argentina, at max for soybeans.
China, with 103 MHa under tillage, is almost unchanged in area
since the early 1990s (+5 MHa), and can swing 2233% on maize, 23
32% on wheat, 2934% on rice, 711% on soybeans and 58% on
rapeseed. At the last count, it was max on maize (to blend with
imported soybeans), minimum on wheat, rice and soybeans and
close to max on rapeseed. The main China growth story is meat
production pork and chicken with high FCE. A high FCE requires
a singular focus on maize-plus-soymeal diets, for physical flowability or product handling as well as nutrition.
India, with more than 90 MHa in tillage, swings only 3134%
wheat, 4857% rice, 412% soybeans and 69% rapeseed. Food security points to more wheat over time but much of this is going to go to
203
If there is a second thing that has also changed the grain markets
completely during this period, it is the manner and rate at which
CPGs are growing to dominate our increasingly urbanised food
consumption. At the time of writing, Chinas Shuanghui
International has just bought Smithfield Foods, the huge US-based
but globally active pork and meat company, for US$4.7 billion. The
need for modern food processing safety, branding and packaging,
and all the required supply chain management skills, has rendered it
more cost effective to buy it rather than build it.
If there is a third thing that must happen over the next few years, it
is the intensification of agriculture for the cost of bringing more
area into production has become much more expensive than most
had anticipated.
Since maize combined with soybean meal is the cornerstone of
modern animal (and soymeal for aquaculture) nutrition, much more
grain will be consumed in Brazil and exported as meat. China and
the US have some 34 MHa under maize, and both will increase area.
Also, Chinese yield will move towards the US (there is a 3 MT/Ha
gap, see Table 7.3), just as China did with the EU in wheat (see Table
7.6). The maize market into the 2020s will remain fundamentally
tight and expensive. E15 will take more corn to the fuel tank,
although there are some real costs being discussed at the retail petrol
station level where the retail supplier is pushing hard to stay at E10
or go to E15, but not carry both. This would require adding pumps,
tanks, trucks and re-branding all expensive items. Brazil will export
more maize than the US consistently. The only two things that can
cause maize demand to break to the downside are a dramatic u-turn
in US energy policy (1:100) or a breakthrough in cellulosic ethanol
(1:50). Even a dramatic fall in crude oil prices would only stimulate
maize demand for the gasoline pool as it worsens the economics for
cellulosic ethanol. Economics says Brazilian ethanol should continue
to flow in ever-greater quantities to the US, but it may not become a
political reality.
It is ironic that the CIS/FSU has a higher barley than wheat yield,
something almost impossible in terms of modern farming. The
CIS/FSU has the greatest potential to increase yield through intensification and plant breeding, and has some 49 and 14 MHa under
wheat and barley, respectively. Any area reductions will be offset by
increased commercialism of these two markets inside Russia, from
205
Coal
Jay Gottlieb
Coal has driven global development since the British industrial revolution, beginning in the 18th Century with the harnessing of
increasing amounts of coal-fired steam power for transportation and
steel production. The role of coal-fired steam in transportation and
manufacturing along with the use of coking coals in the production
of steel is familiar. While other fossils remain a big part of peoples
daily lives petrol for cars and natural gas for home heating and
cooking coal has largely receded from view. It works away quietly
in the industrial background. While coal is no longer used locally for
transportation or building heat, it is still consumed as a key component in steel and cement production and fuels around 40% of the
worlds electric power generation.
Coal is found abundantly around the world, is relatively easy to
produce with existing mining technologies and can be transported
through a wide variety of modes, such as conveyor belt directly from
mine to power plant, or through combinations of truck, rail, barge
and ocean-going freighter. As transportation infrastructure developed around the world since the 1960s, prices for bulk transportation
declined and coal changed from a commodity with only a local
regional reach and economics to one that is traded similarly to other
higher-value energy commodities, flowing around the world from
production areas to wherever it commands the highest value in
consumption. Along with the explosion of transportation options,
coal consumers have become much more sophisticated in managing
their power plants to run on a greater variety of coals, adjusting for
physical and chemical differences in coals from divergent sources.
The major exporters of coal are Indonesia, Australia, South Africa,
Colombia, US and Russia. China and Europe are the major
importers. While the exact numbers will of course change from year
to year, the major participants will not.
CHARACTERISTICS OF COAL
So, let us return to the question, what is coal? It is an energy-rich
source of carbon that is relatively easy to find, mine and transport,
but is also bulky and heavy relative to its energy value. Also, coal
208
COAL
Brown coal
Lignite
Sub-bituminous
Bituminous
Anthracite
209
COAL
residual ash (slag). The coals most suitable for producing coke
command the highest prices on the world market.
Sulphur content is always undesirable. Creating air pollution
when the coal is burned, sulphur emissions must be controlled with
expensive technologies. Laboratory analysis of sulphur content as
percentage of total weight of coal is typically adjusted for the heat
content of a ton of the coal for pricing purposes, as regulatory standards are based on how much sulphur is emitted per ton of coal
burned.
High-rank coals are high in carbon and therefore heat value, but
low in hydrogen and oxygen. Low-rank coals are low in carbon but
high in hydrogen and oxygen content.
Transportation
More than any other energy commodity, transportation costs are a
major component of the cost of fuel delivered to the end-user. This is
a simple result of coals high bulk and weight relative to its value.
The high cost of transportation and rigidities in the transport infrastructure impact the markets for coal. Coals are typically priced
either free on board (FOB) at mine origin, or cost, insurance and
freight (CIF) at the consumers destination, with either the consumer
or producer responsible for arranging and paying for transportation
from or to that point. There are no intermediate collection points and
few wholesale marketing points. Train shipments are difficult, if not
impossible, to re-schedule and re-direct, so there is very little trading
of physical coal once it is en route to an ultimate destination, unlike
the vast amount of trading of oil tankers. Seaborne coal markets are
where the most active trading occurs, because of the greater flexibility and relative low cost of moving a bulky item across the water
versus across land.
Coal mines are either surface (open pit) or underground.
Transportation from the mine can be done through a number of
modes, but again the low value-to-weight ratio makes minimising
the physical handling of coal the key to cost efficiency in transportation. Depending on distance and mode of transport, transport costs
for delivered coal range from 2070% of delivered price to the ultimate consumer, a major component of the total cost of coal
procurement.
Coal can be moved directly from source to end-user via truck for
211
distances of less than 100 miles. For longer distances, rail or waterborne transport is typically used. Coal can also be trans-shipped
from rail or truck into river barges or ocean-going vessels. For other
than international export, no more than two trans-shipments would
be used, as it is important that transportation mode changes add as
little cost as possible. Therefore, coal goes from mine to end-user
with few intermediate transactions.
Historically, coal sold under long-term supply contracts with less
trading than other commodities due to high capital costs mirrored
on both the production side (mine and transportation development)
and the use side (power plant construction). Since many of the
mines, transportation networks and generation plants have been put
in place and their capital costs are amortised, the economics allows
for shorter deals. In addition, consumers have learned to be much
more flexible in sourcing, which enables coals to compete among
each other and against other fuels. Consequently, markets have
become more dynamic. Trading and risk management tools have
also grown to match that flexibility. An increasing proportion of coal
is sold on the spot market and priced off of indexes. This is what has
stimulated the growth of derivatives trading.
Cheaply mined and having relatively low heat content (and also
low sulphur content), Powder River Basin coals are shipped by rail
from Wyoming to west coast ports and then on to Asia. Eastern US
coals can change modes several times, from mine by rail or truck to
river barges and then out to Europe through loading on ocean-going
vessels in the New Orleans area, or directly by rail to ports on the east
coast. Once sea-borne, coals from Australia and South Africa
compete with the US coals for markets in Europe and Asia. The
consumer purchases the coal based on a limited number of heat
content and quality variables against the price delivered to their
power plant. Thermal coal has become for the first time a truly world
commodity, a fact that is reflected in the growth of derivatives
trading.
Bituminous coal is typically much more expensive to mine, has up
to 50% greater heat content and thus significantly lower transportation costs, and can be environmentally friendly, commanding higher
price at the mine. As mentioned above, sub-bituminous coal, such as
from US Powder River Basin, has lower heat content and transportation costs as much as 50% greater with long, overland rail
212
COAL
214
COAL
215
Indonesia
Australia
Russia
United States
Colombia
South Africa
250,000
200,000
150,000
100,000
50,000
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
216
COAL
tries outside the US have increased by around 200% since the late
2000s. These dramatic rises in cost vary across production areas and
are due to a wide variety of reasons. The main impact has been to
increase the integration of worldwide coal markets as producers look
for more extensive markets and consumers search for competitive
purchasing opportunities.
Figure 8.1 shows the changing landscape of the top global coal
exporters. Almost half of Australias exported coal goes to metallurgical use, mainly in Asia and Europe, with Japan, India, China and
South Korea being the main Asian importers. Japan is also the largest
buyer of Australian thermal coal. The US and Canada export significant quantities of metallurgical coal, but thermal coal comprises
most of Indonesias rapidly growing export volumes. China,
South Korea, India and Japan are the largest importers of US coal.
Figure 8.2 shows the distribution of recoverable reserves for coal
globally, while Figure 8.3 displays the trends for the largest
importing countries.
Consumption
While there are other important trends in coal demand, such as
continued growth in Indias consumption and imports, China alone
has dominated global consumption and demand growth. Again
Figure 8.2 World recoverable coal reserves (861 million tons)
Other
26%
US
28%
Indonesia
6%
Australia
9%
China
13%
Russian Federation
18%
217
Figure 8.3 Largest coal importers annual imports (thousand short tons)
250,000
200,000
150,000
100,000
50,000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Japan
India
China
Taiwan
South Korea
Figure 8.4 EIA historical and forecast annual coal consumption (quadrillion Btu)
100
90
80
70
60
50
China
United States
OECD Europe
India
OECD Asia
Rest of World
40
30
20
10
0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Source: EIA, international energy statistics database (as of November 2012), and EIA Annual Energy Outlook 2013 (base case).
COAL
219
glut of natural gas in the US in 2012 drove natural gas prices to a level
where, in July 2012, for the first time in history US electricity production from gas-fired plants was equal to that of coal-fired plants.
Contrast this with the early 1990s, when coal represented more than
50% while gas represented roughly 5%. At prices above US$3.50/
MMBtu for gas, coal becomes competitive again. Gas-fired power
displaced US coal in the international markets, where the cheap coal
significantly increased European coal-fired generation at the expense
of their natural gas plants.
Chinas consumption growth comes largely from increasing
power generation. China has large domestic coal reserves, but it will
always take advantage of low import prices and significantly
increase imports appropriately. Since US demand has been down
due to the explosion of inexpensive supplies of natural gas, China
has imported US and other coals while reducing domestic production. When demand and prices increase in the US domestic markets,
China will rely on its own production again.
220
COAL
221
CONCLUSION
Typical production cost increases in the major exporting countries
other than the US have increased by about 200% since the late 2000s,
resulting in the integration of worldwide coal markets.
Different coals compete with each other through a sometimescomplex value optimisation, combining quality, suitability, location
and cost of transport. Quality differentials continue to play a bigger
role in import decisions for coking coal because they play a bigger role
in the suitability for various steel plants. This contrasts with steam
coal, which is basically just heat and is very interchangeable. There
are sufficient known and accessible reserves of met-quality coal;
however, due to the increases in production costs, prices have to rise
to bring them to market. Therefore, if demand for steel production is
sufficient, met coal prices will rise to meet the input demand.
Demand drivers are factors that move electricity demand such as
weather, economic growth and, to some extent, the price of
competing fuels including natural gas. Met coal demand depends
directly on steel production.
Multi-year coal contracts have been in a long process of evolution
since the early 1990s. It used to be fairly easy to describe typical terms
and conditions, but this is no longer the case as there are many types
differing within countries and from country to country.
Coal remains the single most important fuel for generating electricity worldwide. Traditionally, coal has been by far the cheapest fuel
for generating electricity. The other cheaper form is hydropower,
which is strictly limited by geography and annual weather conditions.
However, due to technological improvements in extracting natural
gas, that fuel has become consistently competitive to coal on price.
Furthermore, natural gas is less carbon-intensive than coal, its
burning produces fewer undesirable emissions and the capital costs
of building natural gas-fired generation are much less than for coal.
Therefore, coal has lost significant ground to natural gas. Due to its
abundance and the high level of installed generating capacity,
however, coal will continue to play a significant role in electricity
generation.
Since the beginning of the industrial revolution, coal has been and
continues to be the workhorse of the energy world. The coal
marketing chain from production to final consumer is typically much
less diverse and complex than other commodities. Coal also has a
222
COAL
much lower value per weight than other commodities. Also, industrial organisations are the exclusive end-user consumers for coal. The
high proportion of transportation costs and less-diverse end-users
result in few transactions from mine-mouth to final consumer.
Therefore, among the major energy commodities, coal markets have
been the slowest to adopt financial derivatives. However, coal has
become a full member of the energy risk management jigsaw.
APPENDIX 8.13
Coal conversion statistics and terminology
Basis of analysis
Definitions:
To obtain:
Air dry
Dry basis
As received
multiply
ar by:
ad by:
100/(100 IM%)
db by:
(100 IM%)/100
(100 TM%)/100
Example:
ar
ad
db
daf
TM
11.0
IM
2.0
2.0
Ash
12.0
13.2
13.5
VM
30.0
33.0
33.7
39.0
FC
47.0
51.8
52.8
61.0
Sulphur
1.0
1.1
1.12
223
MASS
Units:
Metric ton (t) = tonne = 1,000 kilograms (= 2,204.6 lb);
Imperial or long ton (lt) = 1,016.05 kilograms (= 2,240 lb); and
Short (US) ton (st) = 907.19 kilograms (= 2,000 lb).
Conversions:
From long ton to metric ton, multiply by 1.016;
From short ton to metric ton, multiply by 0.9072;
Mt million tonnes;
Mtce million tonnes of coal equivalent (= 0.697 Mtoe); and
Mtoe million tonnes of oil equivalent.
Calorific values (CV)
Units:
kcal/kg Kilocalories per kilogram;
MJ/kg* Megajoules per kilogram; and
Btu/lb British thermal units per pound.
* MJ/kg = 1 Gigajoule/tonne (GJ/t)
COAL
1.09 MJ/kg
470 Btu/lb
Power generation:
1 MWh = 3600 MJ;
1 MW = 1 MJ/s;
1 MW (thermal power) [MWth] = approx 1,000 kg steam/hour;
th/3.
1 Aaron Blake, Washington Post, June 25, 2013: Obama science adviser calls for war on coal.
2 BP, 2013, Statistical Review of World Energy, June.
3 Source: World Coal Association website: http://www.worldcoal.org/resources/coalstatistics/coal-conversion-statistics/.
4 Ultimate analysis determines the amount of carbon, hydrogen, oxygen, nitrogen and
sulphur.
225
Part II
Farmland as an Investment
Greyson S. Colvin and T. Marc Schober
Colvin & Co. LLP
2.
3.
For our purposes, we will generally focus on arable land or row crop
farmland that produces grains planted in rows harvested each year,
including corn, soybeans and wheat. These are the grains that are
(and will be) needed to feed the worlds growing population. We
will also look at farmland located in the US, since it has some of the
best producing farmland in the world, as well as the most advanced
farmers and farming technology, the most developed infrastructure
and uses the most leading technologies.
According to the Natural Resource Conservation Service (NRCS),
there are 12 recognised types of soil in the world. Of these, the most
naturally fertile are mollisols, which is suitable or very suitable farmland. Mollisols are generally found in only four places: in the Pampas
Region of Argentina, the Steppes of Ukraine and Russia, areas of
Northeast China and the Grain Belt of America. Mollisols make up
only 7% of the ice-free land in the world and are the best soils for
farming because they contain large quantities of organic matter.
Mollisols found in the Midwestern US are the best for agriculture
due to the grasslands formed thousands of years ago. These prairies
produced strong and fertile soils because each year the grasses (and
animals) would break down, with nutrients in the organic matter
decomposing into the ground. Once the Wisconsin Glacier retracted
from Illinois and Iowa, great dust storms blew fertile silt on top of the
young land, making it ideal for crop production.
However, in terms of percentage of land area, not very much of
the planet is actually appropriate for farming. Once you remove
places that are too cold or too wet, the deserts, the forests, the bad
soils and every other strange place that cannot host a decent haul of
crops, there is not much left over. However, while America has 5% of
the worlds population, half of its land is suitable for cultivating and
growing crops. In comparison, China has 20% of the worlds population but only 7% farmable land, according to the FAO.
Under the rule of law, US farmland cannot be hijacked by a totalitarian government or organised crime (yes, organised gangsters do
terrorise and control some farms in the Ukraine and Russia), and the
US Midwest Corn Belt sits in the optimum climate for production.
When coupled with modern technology, the US farmers work ethic,
excellent soil and infrastructure for transporting crops, the US is
unsurpassed for production.
All farmland is not created equal and no two properties are the
230
FARMLAND AS AN INVESTMENT
same. The ability of the land to produce profitable crops is part art
and part science; however, at the end of the day, so is analysing and
valuing farmland. This chapter will therefore cover the following
factors that drive the fundamental investment rationale for farmland
investments.
Land scarcity: there are approximately 3.5 billion acres of arable
ng a mere 5% over
for proteins will
231
FARMLAND AS AN INVESTMENT
Cropland
Prime farmland
Timber
Tree crops
High risk
High returns
Own/hold
Cash rent
Crop share
Custom farm
Joint venture
Operate
3%
5%
7%
10%
12%
12%+
233
landowner from taking on crop or credit risk from the farmer. The
landowner does not have to worry about drought or the rate of crop
growth. Land across the Midwest is typically leased at 45% of the
market value of the land; target farmland for investment that can be
leased for 5% or greater is recommended. Farmland in other regions
of the US can have lower lease rates as a percentage of value due to
the commodities produced and other factors affecting the value,
such as potential development.
Farmland as an investment
Farmland has a proven record it has been one of the top performing
investments over the last 100 years. In the 20th century, farmland
only decreased in value three times: during the Great Depression, the
inflation crisis of the early 1980s and in the housing crisis of 2008/09.
The US farm sector has a healthy balance sheet and, as mentioned,
debt-to-asset ratios are low. Unsurprisingly, farmers historically
have been the main buyers of US farmland and do not buy intending
to flip for profit but rather to hold for decades or generations,
keeping the land in the family. Farmland is the most valuable asset a
farmer can own, which leads most to reinvest a significant part of
their crop and livestock revenue back into the purchase of additional
farmland to expand their operations.
It is also important to understand that farmland values per acre
are essentially a function of revenues generated per acre. Revenues
are mainly dictated by two variables: price of the commodity and
yield per acre. In the 20th century, grain prices were fairly stable
while production increased a few percentage points per year, on
average. The increase in production allowed farmland to become one
of the most stable and consistent asset classes.
Despite three downturns over the last 100 years, farmland returns
in the US are historically one of the best investment vehicles,
comparing favourably with more traditional assets such as stocks
and bonds. Table 9.1 clearly shows the stability of farmland. Bear in
mind, this includes crop years and/or regions that were wiped out
or suffered severely diminished yields due to drought, flood and
other disasters.
In 2012, the Federal Reserve Bank of Chicago reported that farmland values grew by 16%, the third largest increase in the previous 35
years. Despite the worst drought in over 55 years, high commodity
234
FARMLAND AS AN INVESTMENT
1 year
(%)
5 years
(%)
10 years
(%)
20 years
(%)
22.8
22.8
33.5
26.5
23.9
7.4
10.9
12.0
16.2
18.4
14.1
13.1
3.7
5.8
11.8
14.1
13.5
11.8
12.8
7.4
8.3
8.1
9.7
8.7
7.3
8.5
8.5
6.9
4.6
4.9
4.6
4.2
4.1
4.7
4.5
prices and record farm incomes drove demand for agricultural land.
Survey respondents anticipated that the momentum would continue
over the next 12 months based on the record income expectations for
2013. Iowa farmland values led the pack, with a 20% return in 2012,
followed by Illinois and Michigan with an 18% annual return. This
was during a time many considered recessionary.
One of the most attractive attributes of farmland is income
realised from rental. Since 1967, rural cash rents have yielded
roughly 5.7%, according to the USDA (this was calculated by the
authors using historical data from: http://usda.mannlib.cornell.
edu/MannUsda/viewDocumentInfo.do?documentID=1446). This
compares very favourably to Treasury bonds and other incomeproducing assets. The cash rental contract is typically prepaid, so the
investor does not have to take operational or credit risk from the
farmer. Society will undoubtedly be drastically different by the mid21st century, but the US farmer will still be leasing farmland to raise
livestock and crops.
Farmland also provides investors with the chance to diversify
from traditional investments, which makes it an excellent asset to
balance a portfolio and offset financial and commercial real estate
market volatility. Farmland has always shown a positive correlation
to the Consumer Price Index (CPI), exceeding stocks, bonds and nonfarm real estate.
Farmland is frequently compared to investing in gold because of
its characteristic as an inflation hedge. However, unlike gold, farmland also produces a stable income stream, and as a consequence it
has been described as gold with yield. Gold does not stock-split or
235
-0.50
-0.25
Positive
+0.23
+0.28
+0.30
+0.36
+0.25
+0.50
Source: NCREIF, Ibbotson & Associates, Morningstar, Western Spectator (June 2010)
pay dividends; you just hang on to it, pass it down or sell it. It can
also be seen as similar to non-dividend paying equities. Eventually,
the only way these stocks bring value to you or your family is when
you sell them. However, farmland will bring returns to you and
generations of your family as long as they continue to own and
manage the land.
RENEWABLES AND THEIR IMPACT
Renewable fuels impact on the farm
Social and political concerns regarding climate change and fossil-fuel
dependency have led to a significant focus on renewable fuels, such
as ethanol, as a replacement for petroleum-based fuel sources.
Ethanol is primarily manufactured from crops such as corn, wheat
and sugar cane. According to the USDA, ethanol production in the
US increased from less than three billion gallons in 2003 to over six
billion gallons in 2007, and is estimated to exceed 12 billion gallons
by 2020. The Renewable Fuel Standard from the 2007 Energy
Independence and Security Act calls for total renewable fuel to reach
36 billion gallons by 2022.
Ethanol, no matter how viable or controversial, is mandated as a
renewable source of energy. At its most basic, ethanol is grain
alcohol, produced primarily from corn and sugar cane. The USDA
estimates that more than 40% of US corn production was used to
produce ethanol in 2011. In January 2011, the US Environmental
Protection Agency (EPA) approved the use of E15 gasoline for vehi236
FARMLAND AS AN INVESTMENT
FARMLAND AS AN INVESTMENT
1986
1992
1998
2004
2010
Source: ERS/USDA
1970
1980
1990
2000
2010
Source: ERS/USDA
239
240
FARMLAND AS AN INVESTMENT
Acres (2013)
Europe
US
Brazil
Other Latin America countries
Indonesia
Russia
Ukraine
World total
94,294
173,158
66,500
59,290
37,500
123,368
33,333
1,553,689
Additional acres
% of world total
1,000
12,950
106,000
76,000
102,000
10,397
1,120
309,467
20%
FARMLAND AS AN INVESTMENT
Production (1000MT)
180,000
140,000
100,000
60,000
20,000
80/81
Total production
90/91
Total consumption
00/01
10/11
Ending stocks
243
FARMLAND AS AN INVESTMENT
1970
1990
2010
2030
2050
is still the tip of the iceberg. Most agriculture investors are attracted
to the sector because of the wealth creation due to the transfer to a
protein-based diet in emerging markets. China is expected to
increase corn imports from 1 million tons in 2010 to 15 million tons
by 2014. The biggest demand for grain by the emerging markets has
not even occurred yet. The basic supply and demand is in place for
farmland to continue its bullish trends in the long term.
Although the amount of farmland is limited in the US, farmable
corn-producing land is expanding into areas with great soil but
heretofore slightly unsuitable climates in the Midwest, primarily due
to biotech seeds. Large seed and agrichemical companies have
focused years of research on higher performing varieties and hybrids
of important food and feed crops. The next generation of biotech
traits focus on greater productivity, improved nutrient use, disease
resistance, plant density and drought and cold tolerance.
While GMOs may bring a degree of controversy, they also
generate much-needed crop acreage and yield. And with people
always looking for safe places to invest, this can translate to a great
investment upside through increased commodity production.
Although farmers make up the majority, people from many
different walks of life own farmland, and outside investors have
always had a minority interest. However, outside investor interest
has grown latterly and will keep growing as farmland continues to
feed the worlds growing population. Almost 200 investment firms
are expected to invest US$30 billion in farmland by 2015, according
to Michael Kugelman of the Woodrow Wilson International Center
for Scholars. Worldwide media coverage now includes farmland on
a daily basis and the expansion of farmland as an asset class
continues to occur.
The average age of the US farmer is steadily increasing. The 2007
Census of Agriculture reported their average age had increased from
50.3 in 1978 to 57.1 in 2007. The ageing farmer may provide an opportunity for the non-farmer investor to get into this commodityproducing market. There was a time when the family farm went to
the son when the father retired or passed on. However, societal
trends have seen people selling the family farm and getting out of the
family business.
Demand is growing for farmland as the worlds population and
global needs for food increase. What many do not realise is that the
246
FARMLAND AS AN INVESTMENT
247
10
Agriculture Trading
Patrick OHern
Sugar Creek Investment Management
Commercial trading activity has grown to become more sophisticated over time, as businesses have dedicated more capital to build
out trading desks by instituting structured commodity marketing
and risk-mitigating hedging plans for themselves and their
customers.
Figure 10.1 illustrates the growth in commercial participant
volumes traded across agriculture markets since the year 2000. The
expansion among the commercial trading community is viewed as
imperative as the globalisation of agriculture commodities has
increased the volatility in profit margins for all types of physical
commodity businesses. The increased volatility in profit margins has
driven commercials to put more emphasis on managing margin risk.
For instance, consider a large livestock feeding operation that takes
part in purchasing, feeding and selling the stock. The focus for this
operation is not only on hedging or marketing the sale price, but also
the purchase price and the input costs, including feed and energy
usage. Profit margins can vary greatly over the ownership period
due to changes in the price of input costs that can create enormous
business risks for the producer. For non-commercial traders, it has
become increasingly important to understand the behaviour and
underlying economics of these commercial trading entities, as the
business risk imbedded within participants such as the livestock
feeder are just as crucial as the supply and demand of the commodity
itself.
Figure 10.1 also illustrates the difference in the level of participation between commercial and non-commercial participants. This
difference highlights the importance for non-commercial participants to be more aware of the business and economic decisions being
made by commercial market participants, as they generally account
for 5060% of the aggregate trading volume and total open interest
across agriculture markets. In commodities, open interest is the total
number of futures and/or options contracts in a contract month,
while total open interest accounts for the total amount of contracts
across the forward curve per commodity.
Generally speaking, the non-commercial participation ranges
around 4060% of the commercial participation. As seen in Figure
10.2, CME Feeder Cattle non-commercial volumes are larger than
that of commercial volumes. This is due to an unusual amount of
commercial hedging activity falling into the non-reportable category,
250
Figure 10.1 Growth in commercial and non-commercial trading across agriculture markets
CBT wheat, KCBT wheat, corn, MGE wheat, oats, soybeans, soybean oil, soybean meal, cotton, rough rice, orange juice, milk, lean hogs,
live cattle, feeder cattle cocoa, sugar and arabic
7,000,000
Contracts
6,000,000
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
0
1/4/2000
1/4/2001
1/4/2002
1/4/2003
1/4/2004
1/4/2005
1/4/2006
1/4/2007
1/4/2008
1/4/2009
1/4/2010
1/4/2011
1/4/2012
251
s
O
at
rn
Co
Co
co
So
a
yb
ea
Cl
n
o
as
s i il
ii
m
Su
ga ilk
rn
o.
11
Fe
ed
er
ca
Le ttle
an
ho
W
gs
Li
he
ve
at
ca
ttl
cb
e
ot
+k
c
Ro bo
t
ug
h
O
ric
ra
e
ng
e
ju
Co
ic
e
tto
n
no
So . 2
yb
So
ea
yb
ns
ea
Ar n m
ab
ea
ic
l
a
co
ffe
e
0.0%
thus being exempt from reporting. This occurs in all markets, but is
more pronounced in the livestock complex in general. The traditional commercials in live and feeder cattle are the feed yards, most
of which hedge their exposure in the live cattle. While cow/calf and
stocker operators utilise the feeder cattle market for hedging
purposes, the majority of their position sizes fall below the reporting
requirements.
Understanding the economics of physical commodity businesses
requires a strong knowledge of the individual components that
determine profit margins. This analysis of market fundamentals can
give traders an edge in generating opportunities and determining
the best types of trading strategy to implement. By understanding
the nuances of producer and merchant margins, non-commercial
traders can better assess buy-side and sell-side hedging activity that
takes place in the futures market. The most margin-sensitive hedgers
are active on both the buy- and sell-side; those include merchandisers, livestock feeders and processors. More traditional sell-side
hedgers include producers who have less market-related margin
risk, as their input costs are more tied to the operational overhead
and productivity. For instance, consider a grain farming operation:
in advance of each growing season, the producer must decide which
crop to plant by assessing a variety of important factors such as the
projected profitability per acre and the soil conditions across the
acreage in which the crop will be planted on. While the price of the
252
AGRICULTURE TRADING
Corn
1,800,000
Contracts
1,400,000
1,200,000
Sugar No. 11
1,000,000
800,000
600,000
Soybeans
400,000
200,000
0
1/4/2000
Wheat CBOT
7/4/2001
Corn
1/4/2003
Soybeans
7/4/2004
Cotton No. 2
1/4/2006
Lean Hogs
7/4/2007
Live Cattle
1/4/2009
Cocoa
Sugar No. 11
7/4/2010
1/4/2012
Arabica Coffee
254
1,600,000
AGRICULTURE TRADING
FSI
6,000
5,000
4,000
Exports
3,000
2,000
1,000
Carry out
0
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12*
255
12
01
/2
0
04
/
01
1
04
/0
1/
2
10
1/
20
/0
04
1/
20
09
/0
04
00
8
01
/2
/0
1
04
04
/
/2
00
06
04
/0
1/
20
5
/2
00
04
/0
1
00
4
/2
/0
1
04
1/
20
03
/0
04
/2
00
2
04
/0
1
00
/0
1/
2
04
04
/0
1/
2
00
0.00%
257
AGRICULTURE TRADING
260
AGRICULTURE TRADING
425.00
US$1,800.00
375.00
US$1,600.00
325.00
US$1,400.00
275.00
US$1,200.00
225.00
US$1,000.00
175.00
US$800.00
125.00
US$600.00
US$400.00
75.00
US$200.00
25.00
Soybeans cents/bushel
1
01
09
12
/0
6
/2
20
6/
/0
/0
12
12
6/
20
20
6/
/0
12
/2
/0
6
12
07
05
3
00
01
/0
6/
20
263
AGRICULTURE TRADING
12
12
/
06
/1
97
19
/0
6/
12
6/
/0
12
/1
/0
6
12
19
9
99
3
1
12
/0
6/
1
99
9
98
6/
1
/0
12
99
9
-25.00
5
US$0.00
/2
0
03
6/
11
09
20
6/
20
12
/0
/0
12
07
6/
20
/0
12
06
/0
6/
20
05
12
12
/
00
/1
99
/0
6/
2
/0
6
40.00
10
35.00
8.75
30.00
7.5
25.00
6.25
20.00
5
15.00
3.75
10.00
2.5
5.00
1.25
0.00
0
264
12
12
99
5
/1
99
/0
6
12
/1
99
/1
/0
6
91
89
/1
9
/1
9
06
/0
6
12
12
12
/
12
/0
6
AGRICULTURE TRADING
Description
#1 Directional
#2 Calendar spreads
#4 Crush spreads
Example
Table 10.2 provides daily correlations across individual agriculture commodities and comparative to energy and metals
commodities. The correlations in this table also show the distinct de-
266
CC
KC
SB
FC
LH
LC
SM
BO
CT
RR
CL
HO
NG
HG
SI
Cocoa (CC)
Arabica coffee (KC)
72.86
69.13
47.75
29.38
54.30
3.81
29.79
23.70
48.38
49.96
6.60
38.31
89.06
51.96
Corn (C)
25.84
46.29
0.49
16.58
63.64
30.97
47.38
23.57
32.39
43.55
9.07
32.20
57.21
Soybeans (S)
4.69
9.04
7.37
19.07
36.71
13.70
69.23
61.29
14.21
36.58
23.40
20.08
23.46
9.78
50.74
55.22
94.10
50.93
61.83
40.09
2.71
36.19
11.30
69.97
44.28
55.30
25.37
83.91
72.27
53.60
51.97
0.69
37.89
23.22
41.66
0.66
20.02
55.57
0.87
19.63
12.57
20.24
32.41
30.09
44.74
6.38
33.36
22.20
34.07
25.90
2.08
31.11
17.89
43.36
30.28
49.29
38.81
10.17
10.66
5.29
50.28
25.00
9.47
11.22
33.30
22.32
67.18
61.20
76.27
59.52
15.80
23.82
5.90
52.91
0.38
35.96
81.16
79.97
72.04
61.03
74.30
1.03
59.59
16.69
41.39
12.04
28.39
33.90
69.12
1.17
15.42
25.36
Copper (HG)
80.12
63.62
67.44
38.82
5.94
34.09
30.69
43.83
17.80
5.54
72.08
77.27
3.11
29.91
11.48
59.89
Silver (SI)
36.77
72.67
13.51
20.42
59.34
35.01
60.95
2.32
15.17
11.59
67.59
34.22
42.24
55.74
71.68
29.83
47.29
Gold (GC)
49.45
1.92
34.87
72.60
43.93
76.59
29.81
41.90
7.06
1.77
6.71
56.82
59.29
27.02
66.97
46.53
37.45
47.76
267
AGRICULTURE TRADING
63.37
/2
20
24
/1
0
/0
9/
24
01
1
24
/1
1/
20
11
24
/1
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11
/2
269
AGRICULTURE TRADING
24
/0
7
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6/
01
5/
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20
1
4/
24
/0
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/0
01
3/
2
/2
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11
20
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-40.00%
24
/2
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12
12
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12
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/0
7
/0
6
24
/0
5
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/2
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11
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0/
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/1
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9/
20
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/2
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01
/2
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5/
20
/0
4
/0
3
01
/2
2/
20
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24
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/0
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01
24
/
40.00%
45.00%
30.00%
35.00%
25.00%
15.00%
20.00%
10.00%
5.00%
0.00%
AGRICULTURE TRADING
271
272
24
24
24
24
24
24
24
/0
7
/0
6
/0
5
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4
/0
3
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9
/0
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3
/0
2
/0
1
/0
1
24
24
24
24
24
24
24
24
24
24
24
24
Figure 10.10 90-day rolling correlation between corn and crude oil
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
AGRICULTURE TRADING
Figure 10.11 Lean hog February versus October spread (10-year seasonal)-1.5250
22.5000
20.0000
17.5000
15.0000
12.5000
2012
10.0000
2013
7.5000
4.9850
5.0000
3.3350
2.6750
2.5000
-0.1750
-0.9500
-1.5250
-2.4850
-3.1500
0
-2.5000
-5.0000
-7.5000
-7.5000
-10.0000
-12.5000
-14.1600
-15.0000
2008
-17.5000
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12
Jan-13
Feb-13
Mar-13
274
13.5900
AGRICULTURE TRADING
275
NASS
April
May
June
July
August
September
October
November
80%
2010
Condition year
2008
2008
2009
2010
2011
2012
2009
2011
70%
60%
50%
40%
30%
2012
20%
Nov 25
100%
Condition (percent)
80%
Condition type
Excellent
Good
Fair
Poor
Very poor
60%
40%
20%
0%
100%
Doughing
80%
Progress (percent)
Emerged
Dented
60%
Silking
Mature
40%
Planted
Harvested
20%
0%
April
May
June
Progress year(s)
July
2012
August
2011
September
October
November
20072011
AGRICULTURE TRADING
US$800.00
US$750.00
US$700.00
!
!
!
!
2012: drought inspired rally
US$650.00
US$600.00
US$550.00
US$500.00
US$450.00
US$400.00
1/6/12
2/6/12
3/6/12
4/6/12
5/6/12
6/6/12
7/6/12
8/6/12
AGRICULTURE TRADING
RSI indicator has fallen below the overbought level; just below this
price level, if the price weakness can be sustained, the price will be
able to drop below both the 20- and 100-day moving averages. This
confluence of signals can help confirm a potential entry point for the
bearish directional strategy. Using this methodology helps in adding
discipline, as it forces traders to adhere to the price action relative to
the technical signals, which can often indicate future longer-term
price movements before actual fundamental developments can be
realised. This is an important filter that can temper traders expectations behind their fundamental conviction about a commodity
market, and helps them to be patient in expressing strong convictions. Overall, there are a variety of technical indicators that can be
used in assessing the agriculture markets and, most importantly,
they offer a non-biased overlay to discretionary decision-making.
Figure 10.16 illustrates a combination of technical indicators that
can be used to signal a trading opportunity. Note, the moving
average cross as the 20-day crosses over the 100-day to the downside.
Additionally, in advance of this cross the RSI had been testing overbought territory, which indicates that the market maybe reaching a
top. In the case of this illustration, this was true and the moving
average cross provided a confirmation and a sell signal. Figure 10.17
illustrates a combination of Fibonacci retracement and moving
average cross that can be used to signal a trading opportunity and
provide the trader with a back drop in which to balance expectations.
STRATEGIES AT PLAY IN THE AGRICULTURE MARKETS
The previous section provided a general description of the types,
behaviour and objectives of traders in the agriculture markets. This
section will categorise the specific types of strategies being employed
by those participants, along with their risks and management of such
strategies. There are five main strategy types covered: directional,
calendar spreads, geographical arbitrage, crush spreads and options
volatility. Methodologies used in trading strategies involve the
research and analysis of seasonality, forward curve structure and
fundamental factors. Using those factors, traders are then tasked
with choosing the most suitable strategy that aligns with their fundamental thesis or return objective.
279
0.00
Jun-11
Jul-11
Aug-11
Sep-11
Oct-11
Nov-11
Dec-11
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
280
300.00
290.00
280.00
270.00
260.00
250.00
240.00
230.00
220.00
210.00
200.00
190.00
180.00
170.85
170.00
160.00
150.00
140.00
Price falling below both the 20- and 100-day moving averages
%
Relative strength index (RSI) indicating near overbought values
Figure 10.17 Use of Fibonacci retracement and moving average cross to identify a trading opportunity
2.40
November 2013 soybeans to December 2013 corn ratio
2.34 (100.0%) 2.35
2.30
2.25
2.20 (61.8%)
2.20
2.16
2.16 (50.0%)
2.15
2.11 (38.2%)
2.10
2.07
2.06 (23.6%)
2.05
2.02
2.00
1.97 (0.0%)
1.95
100% retracement from highs
Jul-11
Aug-11
Sep-11
Oct-11
Nov-11
Dec-11
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
281
AGRICULTURE TRADING
Jun-11
Directional
Directional trading strategies are a very common style of trade
employed by both commercial and non-commercial trading participants. Commercial traders using this strategy will utilise flat price
trades to market or hedge production or commodity risk. In its
simplest form, this can be implemented as a flat price futures buy or
sell or as a hedge against an underlying physical commodity exposure. For non-commercial traders, the flat price exposure is a source
of beta that compliments their speculative ideas on future price
direction. Flat price trades among the non-commercial and commercial trading community can be expressed in many different forms.
Different style of directional bets include options spreads, risk reversals such as owning a call and selling a put against the same
underlying contract month, and synthetic options that involve
trading futures and options in the same contract month.
Prior to entering a directional trade, traders must evaluate a
variety of riskreward factors such as selecting the appropriate
contract month across the forward curve and choosing the expected
time horizons for the trade, while also establishing risk allocation,
profit targets and stop/loss level(s). Experienced traders looking to
place a directional bet in an agriculture market are always aware of
the calendar as seasonality plays a large role in the risk profile of a
directional trade. After taking into account seasonal factors, the
trader will determine which contract month can best express their
ideas on fundamental price movements. Since many commodities
futures in the agriculture sector span multiple crop years, traders
have to make sure their fundamental thesis ties to the appropriate
time horizon in which they are trading.
For example, during the month of May, an oilseed trader becomes
bearish and decides to sell the US soybean market on expectations
for an above-average new crop production, but sells the old crop July
contract in order to express their bearishness; while being short is the
correct directional position, in this case it is not the correct contract
month or season to be short based on the fundamental thesis. This
trader is taking significant risk by holding a short position in an old
crop contract that may be trading off of different supply and demand
fundamentals. Additionally, the riskreward expectation for such a
trade could greatly underperform due to muted trade duration as
the July contract will have expired before new crop production is
282
AGRICULTURE TRADING
Wheat
Jan
Feb
March
Apr
May
June
July
Aug
Sep
Oct
Nov
Dec
US Winter
Harvests
WH
KWH
US Spring
WN
KWK
KWN
Plants
MWH
Canada
WU
WZ
KWU
KWZ
MWU
MWZ
Harvests
MWK
MWN
Plants
Harvests
France
Milling Wheat (PM)
Plants
WK
Harvests
PMF
PMH
PMK
Plants
PMQ
PMX
Germany
Harvests
Plants
UK
Harvests
Plants
Ukraine
Harvests
Turkey
Harvests
Egypt
Plants
Harvests
Russia Winter
Plants
Harvests
Russia Spring
Plants
Iran
Harvests
Pakistan
China
Plants
Harvests
Kazakhistan
India
Plants
Plants
Harvests
Plants
Harvests
Plants
Harvests
Plants
Harvests
Plants
284
Plants
Brazil
Soybeans
Jan
Feb
March
Apr
Harvests
Plants
SF
SH
China
Jan
Feb
March
Sep
Oct
Nov
Dec
Plants
Harvests
SK
SN
SQ
Apr
SX
Harvests
May
June
July
Aug
Sep
Oct
Nov
Dec
Plants
US
Plants
Corn (C)
CH
China (North)
Plants
Harvests
CK
CN
Plants
CU
CZ
Harvests
Plants
Harvests
France
Plants
Harvests
Harvests
Plants
Russia
Plants
India
Harvests
Plants
Harvests
Harvests
Plants
285
AGRICULTURE TRADING
Plants
Ukraine
South Africa
Aug
Harvests
Harvests
Spain
July
Plants
Argentina
China (South)
June
Plants
US
Brazil
May
Harvests
Harvests
Argentina
Corn
Harvests
Plants
Brazil
Soybeans (S)
Harvests
Plants
Argentina
Australia
/2
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24
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/0
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20
10
24
/0
8/
20
10
24
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3/
20
12
Cents/bushel
25
15
10
286
5/
20
1
24
/0
6
24
/0
Figure 10.18 20-day ATR: old versus new crop corn spread relative to outright contracts
7
20
6
5
1
AGRICULTURE TRADING
traders with a non-directional bias and the opportunity to trade relative fundamentals across the term structure of a commodity.
Non-directional reasons to trade calendar spreads can involve price
relationships regarding cash basis and seasonality.
From a directional standpoint, some traders may entertain trading
a calendar spread as a hedge against being directionally positioned
at different points on the futures curve or as a more conservative bet
on directional price expectations against one leg of the spread. There
are many possible fundamental and technical drivers for trading
calendar spreads. Some of the most compelling calendar spread
strategies can be seen in Table 10.4.
Geographical spread arbitrage
Geographical arbitrage is another form of inter-commodity spread in
which a trader buys and sells the same type of commodity produced
across different regions of the world. These commodity futures
contracts often exist on different exchanges and have different
quality or grade characteristics. An example of trading a geographical spread would be purchasing Arabica coffee and selling Robusta
coffee. Trading a geographical arbitrage strategy is mainly carried
out by fundamental specialists due to the high level of specific
knowledge needed to understand the pricing relationships. For technical traders, this type of commodity spread can have appeal from a
mean reverting standpoint, as the trader will seek opportunities
when the spread between the two related commodities reaches
extreme levels. Purely trading geographical arbitrage from a technical standpoint, however, does come with significant risk as the flat
price direction of an individual leg of the spread can move oppositely for sustained periods of time based on specific
micro-fundamental factors. Other inter-commodity spreads can
have strong quality-based and seasonal aspects, such as trading
lower-grade US soft red winter wheat versus higher-grade hard red
spring wheat.
See Table 10.5, which details fundamental drivers for trading
inter-commodity or geographical arbitrage. The same technical
drivers can apply for these types of spreads as that outlined for
calendar spreads.
Figure 10.19 shows how the soybean to corn ratio provides an
example of blending technical, seasonals and fundamentals while
287
Technical reasons
Geographical
spread arbitrage
Example using
futures
Crush spreads
Example using
futures
Example using
futures
Options volatility
Example
288
AGRICULTURE TRADING
Technical reasons
Geographical
spread arbitrage
Example using
futures
Crush spreads
Example using
futures
Example using
futures
Options volatility
Example
Crush spreads
A crush spread is a form of arbitrage predominately used by
commercial traders in order to manage production-related margin
risk. Typically, a crush spread includes two or three individual
components. Speculative participants with a keen understanding of
production margins often like to implement crush or reverse crush
spreads as a proxy as it allows them to participate synthetically in
289
2.80
2.62
2.60
2.51
2.46
2.40
2.35
2.25
2.20
2.09
2.02
2.00
1.89
1.80
1.60
Dec-11
Jan-12
Feb-12
Mar-12
Apr-12
May-12 Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Nov-12 Dec-12
Jan-13
Feb-13
Mar-13
290
3.01
3.00
AGRICULTURE TRADING
Technical reasons
Geographical
spread arbitrage
Example using
futures
Crush spreads
Example using
futures
Example using
futures
Options volatility
Example
291
purchase soybean meal and corn against the lean hog or live cattle
futures. Table 10.6 details the fundamental drivers for placing a
crush trade.
Options volatility
Trading of options volatility strategies offers traders with a wide
range of dynamic opportunities on a standalone basis, and also when
coupled with futures directional and relative value spreads. Trading
opportunities in options include individual commodity spreads and
direction or across commodities in the form of arbitrage.
Experienced relative value option specialists in agriculture are
frequently able to find attractive opportunities by trading differentials in volatility on an inter/intra commodity basis. Additional
strategies involve trading put versus call skews across one or more
contract months in one or multiple commodities.
Directional trading is also prominent in options by way of owning
net, absolute gamma or premium in any contract month. An example
of a net gamma options play would be to own a bull call spread in
which the trader purchases an at-the-money call and sells an out-ofthe money call against it at a slightly lesser value, resulting in a net
payment of premium and a net long volatility position. The number
of options strategies which can be expressed across agriculture
markets is seemingly endless, and they provide traders with unique
and niche opportunities to generate profitable returns. Table 10.7
details the three different types of options strategies that are often
traded across the agriculture space.
CONCLUSION
The speed of information flow and the sudden correlations across
markets from time to time can in some ways be attributed to the
success and growth of electronic trading, as a more diverse set of
speculative participants from around the world have virtual around
the clock access to trade and manage risk in most commodity
markets. In general, this new normal in price behaviour and
volatility offers more opportunities for multi-strategy and relative
value driven traders. Periods of high volatility and relatively wider
price ranges can frequently distort prices relative to perceived fundamentals, which can create unique opportunities. These types of price
environments are often associated with adverse market conditions;
292
AGRICULTURE TRADING
Relative volatility
Relative value
Example using
futures
Crush spreads
Example using
futures
Example using
futures
Options volatility
Example
those traders which can realise the difference between an event that
is normally anticipated (seasonal or fundamental data point) and one
that is rare and unexpected will find success in trading and
managing risk in agriculture markets.
The ability to recognise, filter, and accurately assess changing
market developments is critical in making trading decisions. With
293
294
11
295
CONVERGENT
DIVERGENT
CONVERGENT
|
-2
|
0
DIVERGENT
|
2
|
5
Source: SSARIS/SSgA
financial crisis (GFC) and the 2011 European debt crisis. During these
crisis events, fundamental and value-based strategies often have
significantly negative performance. When behavioural finance
concepts such as fear and greed drive market movements, asset
prices succumb to panic and overshoot their fair values. Convergent
approaches have great difficulty in this type of crisis environment
because, as an asset price drops due to panic and fear, the convergent
model suggests that the asset is an even more attractive buy. The
model will eventually be correct when the asset price hits a bottom
and the crisis passes, but trading positions taken along the way may
experience heavy losses. Unrealised losses in commodity futures
contracts force future commission merchants (FCMs) to issue margin
calls. If further capital is not produced, the managers positions are
liquidated and the losses are realised. This situation was aptly
described by a quote attributed to John Maynard Keynes: Markets
can remain irrational longer than you can remain solvent.
A prime example of crisis price dynamics is illustrated in Figure
11.2: the price of the December 2008 Nymex crude oil futures
contract. Within a span of 10 months, the contract rose from
US$84.62 per barrel to US$146.68, before sinking to US$49.62.
Somewhere within the range of a 73% run-up and a 66% decline was
an intrinsic value for crude oil, but the price had been driven far
beyond fair value in both directions.
During market dislocations, such large directional moves are
common. The most striking characteristic of these crisis events is an
increase in market volatility (almost, by definition, a crisis event
includes an increase in market volatility). A secondary effect is an
increase in magnitudes of correlations. Assets that previously exhibited low correlations tend to become correlated during a crisis. A
tertiary effect is the increase in serial price correlation or autocorrelation within individual markets. Table 11.1 shows these three effects
during the 200708 GFC: over 2007, the DJ-UBS index had an annualised volatility of 12%, average correlation of its components of 0.15
and near-zero autocorrelation of those components returns. During
2008, each of those statistics more than doubled, with serial correlation rising more than five-fold. When markets become driven
beyond fair value and fundamental convergent methodologies fail, it
is the divergent category of strategies that can capitalise on the
increase in market autocorrelation.
299
US$/barrel
125
105
85
65
2/
1
16 /08
/1
30 /08
/1
13 /08
/2
27 /08
/2
12 /08
/3
26 /08
/3
/
9/ 08
4/
23 08
/4
/
7/ 08
5
21 /08
/5
/
4 / 08
6
18 /08
/6
/
2/ 08
7
16 /08
/7
30 /08
/7
13 /08
/8
27 /08
/8
10 /08
/9
24 /08
/9
8/ /08
1
22 0/0
/1 8
0
5/ /08
11
19 /0
/1 8
1/
08
45
Table 11.1 DJ-UBS index trailing 52-week statistics, weekly data points
2/1/2008
31/12/2008
increase
Annualised
standard
deviation
Average
correlation of
components
Average
auto-correlation
within components
0.120
0.293
2.44
0.150
0.429
2.87
0.025
0.145
5.81
Table 11.2 Performance of divergent and convergent strategies versus the DJ-UBS
DJ-UBS
commodity index
total return
Annualised
return
Annualised
standard
deviation
Return/risk
ratio
Divergent
Convergent
momentum
backwardation &
strategy (15-27-55 regime switching
day lookbacks)
strategy
Combined
convergent &
divergent strategy
(50%/50%)*
0.048
0.053
0.106
0.083
0.167
0.077
0.203
0.132
0.289
0.681
0.523
0.626
Data based upon DJ-UBS Commodity Index returns (January 1996October 2012)
* The combined convergent/divergent strategy is rebalanced monthly
304
REFERENCES
Chung, S., M. Rosenberg and J. Tomeo, 2004, Hedge Fund of Fund Allocations Using a
Convergent and Divergent Strategy Approach, The Journal of Alternative Investments,
Summer.
Gorton, G., F. Hayashi and K. G. Rouwenhorst, 2007, The Fundamentals of Commodity
Futures Returns, Yale ICF Working Paper No. 0708.
Gorton, G. and K. G. Rouwenhorst, 2006, Facts and Fantasies about Commodity
Futures, Financial Analysts Journal, 62(2), March/April.
Ilmanen, A., 2011, Expected Returns: An Investors Guide to Harvesting Market Rewards
(Hoboken, NJ: Wiley).
Spurgin, R., 1999, A Benchmark for Commodity Trading Advisor Performance, Journal
of Alternative Investments, Fall.
305
12
reward for taking price risk from market participants ahead of the
market using the fact that commodity prices and inventories follow
persistent fundamental economic trends. In particular, roll returns
are closely linked to inventory cycles. Given that changes in inventories are the differences between supply and demand, momentum in
commodities is ultimately the result of persistence in inventory
levels and changes. As inventories build (or draw) slowly over time,
momentum generates alpha by identifying the commodity markets
that need to create incentives for market participants to balance
markets by moving physical commodities in and out of storage, or
incentivising changes in demand or supply.
Volatility strategies provide insurance to market participants and are
rewarded for taking price risk from market participants that are
unwilling to bear those risks. As in any other derivatives market,
implied volatility in commodity markets serves as the key parameter
for market participants eg, producers, consumers, processors and
investors to match supply and demand for options. However, there
is often a structural imbalance between buyers and sellers of options
in commodity markets. Market participants hedging needs cause
biases in the options markets, offering a source of market-neutral
alpha for investors.
CURVE PLACEMENT STRATEGIES
To understand how alpha can be generated by curve placement
strategies, we need to understand how commodity forward curves
are shaped and how different market participants segment themselves across the curves. Moreover, we need to be aware of when and
how these market participants position themselves throughout the
year and the trading flows associated with these positions.
Forward curves and the market value of storage
Commodity forward curves embed not just expectations about
future prices, but also the net costs of carrying physical commodities
over time. Hence, storage and financing costs largely explain the
shape of the curve in most commodity markets. A simple arbitrage
argument shows how the cost of physical storage should be equal to
the difference between forward and spot prices (see Figure 12.1). If
the net cost of physically storing a commodity is higher (lower) than
309
Figure 12.1 Storage economics determines the shape of the forward curve: cost
of financing plus storage costs
102
100
$/bbl
Risk premium: a producer would accept a lower
price than expected in exchange for locking-in his
margins: F0,T S0 = E0(ST) S0 Risk Premium
98
Actual future price, F0,T
96
Market expectation of
future prices, E0(ST).
How do we determine them?
94
92
90
88
22-Feb-11
22-May-11
22-Aug-11
22-Nov-11
the difference between spot and forward prices, owners of the physical commodity would rather sell (buy) the commodity on the spot
market and buy (sell) it forward than store it. This dynamic would
force spot prices down and forward prices up when the forward
curve is not steep enough to compensate for storage costs. Similarly,
it would force spot prices up and forward prices down if the forward
curve is too steep.
However, storage costs interact with market expectations and the
need of physical players to own the physical commodity. Depending
on market conditions, one of the factors may be more relevant than
the others. For commodities that are hard and expensive to store
such as natural gas, crude oil and lean hogs (a commonly used type
of pork that is traded in Chicago) the cost of storage tends to play
an important role in determining the slope of the forward curve, but
the shape of the forward curve can, at times, deviate widely from the
storage cost implied contango.
But what determines the curvature of the forward curve? That is,
what determines the difference between the 1M2M timespread and
the 3M4M timespread? Using the same physical arbitrage argument, it should be the cost of financing and storing a commodity for
a month starting in one month versus the cost of financing and
storing a commodity for a month starting three months from now.
310
7%
2.83
6%
5%
3 month forward
2.80
4%
2.53
3%
2%
1%
1.0%
2 month forward
1 month forward
Volatility
1.2%
1.4%
1.6%
1.8%
2.0%
2.2%
2.4%
311
the September contract (when the harvest starts coming in) during
the months of June, July and August, exerting some buying pressure
on the September contract during those months.
Risks of curve placement strategies
One of the characteristics of curve placement alpha is that it faces
headwinds when beta commodity investments perform well. It is a
stylised feature of commodity forward curves that spot prices tend to
tilt the forward curve into backwardation as they move higher. As
demand starts outpacing supply, the spot price tends to rise and
inventories tend to draw. Lower levels of inventories should
decrease storage costs, and push down forward prices relative to
spot prices. In fact, a backwardated curve is the markets way of
offering storage holders an incentive to supply the commodity into
the spot market. Therefore, when the market is tightening, spot
prices move up and the forward curve flattens or moves into backwardation.
This link between spot prices and the shape of the forward curve
is behind one of the most important characteristics of curve placement alpha: its negative correlation with the market. By being long
contracts with longer maturity and short the contracts on the front
end of the curve, curve placement alpha strategies tend to get hurt
when commodity prices rally. A common solution to this problem is
to use the monthly rebalancing of the curve alpha strategy to
neutralise its exposure to the market by having less notional exposure on the short leg than on the long leg. The result is a
beta-neutralised curve placement strategy. While beta neutralisation
is not a performance enhancement feature, it eliminates the negative
correlation between curve placement alpha and commodity beta. As
a result, investors are left with a purer alpha strategy that is not negatively impacted by commodity price rallies. Investors who are
looking for a more market-neutral strategy should neutralise their
beta exposure in their curve placement alpha strategies.
Another often proposed solution to this problem is the dynamic
allocation across maturities. If curve placement alpha suffers when
forward curves move into backwardation, then it may be better to
dynamically adjust the strategy according to the shape of the
forward curve. For instance, the investor may choose the position in
the forward curve that has the best-implied roll yield (ie, the
313
200
180
2%
Jan-06=100
2%
160
1%
140
120
1%
100
0%
80
-1%
60
-1%
40
-2%
20
0
-2%
06
07
08
314
09
DJUBSF5
10
11
DJUBS Roll Select
Statistically
insignificant at the
10% level
-4
-3
-2
-1
Jul-05 to Jul-10
Jul-00 to Jul-10
Figure 12.5 Degree of persistence on the shape of the forward curve (From
Jan-06 to Dec-10)
Gold
Silver
Coffee
Nickel
Zinc
Copper
Aluminium
Sugar
Heating oil
Cotton
Corn
Crude oil (WTI)
Gasoline
Natural gas
Lean hogs
Soybean
Soybean oil
Cocoa
Live cattle
Wheat
39.2
24.2
15.7
15.3
13.7
10.5
9.0
9.0
8.9
8.4
6.7
6.3
6.0
6.0
5.6
5.5
5.4
4.9
4.4
2.6
0
10
20
30
40
50
317
VOLATILITY STRATEGIES
Commodity volatility can also provide a powerful source of alpha
for investors. Just as in any other derivatives market, implied
volatility in commodity markets serves as the key parameter for
market participants such as producers, consumers, processors and
investors to match the supply and demand for options. However,
there is often a structural imbalance between buyers and sellers of
options in most commodity markets.
Market participants hedging needs cause persistent biases in the
commodity options markets, offering a source of market-neutral
alpha for investors. Commercial market participants are natural
buyers of insurance against large price swings ie, buyers of
volatility. Producers and consumers are willing to pay a premium to
protect their profit margins against large price movements. At the
same time, there are few natural sellers of volatility in the
commodity options markets apart from speculators.
Because of the relatively low participation of speculators in
commodity options markets, this imbalance between buyers and
sellers of volatility has helped to create structural alpha opportunities for investors. For market participants willing to take on price
risk, there is an opportunity to profit from this demand for insurance. Generally, there is high demand for long option positions
among commercial market participants, such as producers,
consumers and distributers.
Option sellers collect the premium of an option and often delta
hedge their exposure to the underlying contract. However, at inception, option sellers do not know whether the final profits of delta
hedging the position will be positive. The difference between the
option price change and the profit or loss of the underlying delta
hedge is the hedging error that affects the profit and loss (P&L) of
selling options and delta hedging. Hence, option market makers
need to be compensated for the risk of losing money on their delta
hedges.
This hedging risk is a function of the gamma of the option, as
well as the future realised price volatility of the underlying future.
As a result, option prices (and consequently implied volatility) need
to be high enough to compensate market makers for the risk of
volatility realising at high levels over the lifetime of the option. While
the high demand for options from commercial players pushes up
318
4%
3%
195
2%
175
1%
0%
155
-1%
135
-2%
-3%
115
-4%
-5%
Dec-02
95
Jun-04
Dec-05
Jun-07
Monthly returns
Dec-08
Jun-10
Dec-11
Jun-13
319
Figure 12.7 MLCXCVSB index with monthly returns (WTI crude oil 1M versus
3M variance swap calendar spreads)
5%
175
4%
165
3%
155
2%
145
1%
135
0%
125
-1%
115
-2%
105
-3%
-4%
Dec-02
95
Jun-04
Dec-05
Jun-07
Monthly returns
320
Dec-08
Jun-10
Dec-11
Jun-13
Returns
MIP: Maximum Information Ratio Portfolio
with weights adding to 100%
4.5%
4.0%
3.5%
3.0%
0.75%
0.95%
1.15%
1.35%
Targeted
volatility
323
Returns
MVP: Minimum-Variance Portfolio with
weights adding to 100%
4.5%
Efficient frontier
with unconstrained weights
4.0%
3.5%
3.0%
0.8%
1.0%
1.2%
1.4%
Targeted
volatility
products. Traditional approaches to representing pure beta exposures work well for stocks and bonds but not so well for the
commodities asset class. In fact, we argue that there is no such
thing as commodity beta. Moreover, we also assert that new passive
strategies that use a momentum-based long/short approach rather
than the long-only approach of the most common commodity
indexes are better benchmarks for active strategies.
NO SUCH THING AS COMMODITY BETA
For many asset classes, it is very easy to take a pure beta exposure.
Multiple asset class proxies are available, many of which are reasonable substitutes for each other. The Russell 3000, S&P 500 and Dow
Jones Wilshire 5000 indexes, for example, are representative of the
broad stock market and have similar performance characteristics,
just as the Citigroup Broad Investment-Grade (BIG), Barclays Capital
US Aggregate and Merrill Lynch US Domestic Master bond indexes
mirror the wider fixed income market and perform alike. However,
for commodities fewer choices and more disparity exist among the
index options.
NOT ALL INDEXES ARE ALIKE
Figure 12A.1 illustrates the similar risk and return characteristics of
the broad stock and bond indexes and the disparity among the three
traditional commodity indexes the S&P GSCITM Commodity
Index, Dow Jones UBS Commodity Index, and Reuters/Jefferies
CRB Index. When we plot standard deviation and compound annual
return for each index over a common time period (January 1991
September 2012), we see that the nearly identical risk and return
characteristics of both the stock and bond indexes place the plot
points on top of one another. The commodity indexes, however, do
not display the same level of consistency. Dramatic differences in
constituents and weighting schemes as well as rebalancing rules are
likely the cause of the performance differences in the commodities
indexes. The S&P GSCI index, for example, has about double the
weighting to the energy sector as the Dow Jones UBS Commodity
and Reuters/Jefferies CRB indexes and only one third of the
weighting to agriculture.
326
Figure 12A.1 Standard deviation versus compound annual returns for various
indexes
Compound
annual return %
Stock indexes
Reuters/Jefferies CRB
(inception: 02/01/1994)
Commodity indexes
BarCap US
agg. bond
Dow Jones UBS commodity
Standard
deviation %
Source: Morningstar
1.
2.
Contract price
Positive
roll yield
Contract price
0 (spot)
months to delivery
Negative
roll yield
0 (spot)
months to delivery
329
330
Soybean meal
Brent crude
WTI crude
Live cattle
Gasoline-oil-petroleum
Heating oil
Lean hogs
Soybean oil
Wheat, hard winter
Natural gas
Negative excess
return
Long-only
Long/flat
Long/short
Long/flat
Short-only
332
d
r
333
DOWNSIDE PROTECTION
While all long-only commodity indexes tend to provide strong
protection when the stock market is down and in inflationary environments, the Morningstar Long/Short Commodity index limits
downside risk while negotiating ups and downs in the commodity
markets themselves. The Long/Short indexs maximum drawdown
in the February 1991September 2012 period, as seen in Figure 12A.5,
was substantially lower than that of the S&P GSCI and Dow Jones
UBS Commodity indexes. We also compared maximum drawdowns
experienced by the listed indexes during five-year sub-periods
within that overall period, and the Morningstar Long/Short
Commodity index suffered much smaller drawdowns in all subperiods. Clearly, a long/short strategy is better equipped to tap into
334
335
13
! (r ! R )
RMSE =
/T
(13.1)
t=1
where rt and Rt are the returns for the tracking portfolio and the
index, respectively.
Second, except for the replication error, the return of the tracking
portfolio is also of interest. To this end, the mean excess return (ER) is
considered over the benchmark index, defined as follows:
T
ER = " ( rt ! Rt ) /T
(13.2)
t=1
Let Pit denote the price of stock i at time t, C the available capital and
xi the number of units bought of stock i. The complete formulation of
the objectives and constraints used to solve the index tracking
problem can then be expressed as follows:
Minimize: f = ! ! RMSE " (1! ! ) ! ER
Subject to:
(13.3)
!P
iT
xi = C
(13.4)
i=1
"i = 1,..., N
(13.5)
343
!z
(13.6)
!K
i=1
xi ! 0,
zi ! {0,1}
!i = 1,..., N
(13.7)
where 0 l 1 is a user-defined parameter that outlines the tradeoff between the two objectives (tracking error and excess return). In
the case l = 1, the tracking portfolio has as its objective to minimise
the tracking error (pure index tracking), whereas when l = 0, the
portfolios goal is to maximize the excess return. Constraint 13.4
guarantees that the value of the portfolio at the end of the in-sample
period is equal to the available capital C. This budgetary limitation
ensures that for all alternative tracking portfolios an identical
amount C is invested at the beginning of the out-of-sample period.
Constraint 13.5 associates a binary variable zi to each stock i, which
is used to consider whether stock i is included in the tracking portfolio (zi = 1) or not (zi = 0). The parameter e is used to impose a
lower bound on the proportion of the capital invested in each stock
(in this study e is equal to 0.01). Finally, constraint 13.6 defines the
maximum number of stocks K that can be included in the tracking
portfolio.
Evolutionary solution techniques
The optimisation model of equations 13.313.7 is a complex combinatorial problem that is difficult to solve with analytical techniques.
Thus, evolutionary algorithms have become particularly popular in
this context. Evolutionary algorithms were first used for addressing
the index-tracking problem by Goldberg (1989), who apply a genetic
algorithm for index replication. More recent applications of genetic
algorithms in index-tracking and portfolio optimisation can be found
in the works of Oh et al (2005), Chang et al (2009) and Soleimani et al
(2009). Beasley et al (2003) propose an evolutionary population
heuristic, accounting for transaction costs and the possibility for revision of the tracking portfolio. Their results indicate that deriving the
optimal portfolio directly from past data and not from the distribution of stock returns ultimately achieve better results. Maringer and
Oyewumi (2007) apply DE for tracking the Dow Jones Industrial
Average assuming different cardinality constraints in their selected
344
tively new phenomenon, more recent data are utilised to test the
proposed investment strategy. The indexs construction methodology is similar to that of the world-renowned CRB Spot Commodity
Index. The SEI is designed to offer a timely and accurate representation of a long-only investment in energy commodities using a
transparent and disciplined calculation.
Geometric averaging provides a broad-based exposure to the six
energy commodities, since no single commodity dominates the
index. It also helps increase the index diversification by giving even
the smallest commodity within the basket a reasonably significant
weight. Gordon (2006) finds that a geometrically weighted index is
preferred to alternative weighting schemes, because the daily rebalancing allows the index not to become over- or underweighted. This
avoids the risks that other types of indexes are subject to, such as
potential errors in data sources for production, consumption,
liquidity or other errors that could affect the component weights of
the index. Furthermore, through geometric averaging the SEI is
continuously rebalanced, which means that the index constantly
decreases (increases) its exposure to the commodity markets that
gain (decline) in value, thus avoiding the domination of extreme
price movements of individual commodities. As Erb and Harvey
(2006) point out, the indexes that rebalance annually eventually
become trend followers because commodity prices movements
constantly change the weightings, whereas those that rebalance daily
stay closer to the original intent of the index. In addition, Nathan
(2004) shows that the indexes that use geometric rebalancing, and
thus rebalance their weightings daily, generally exhibit lower
volatility.
The mathematical specification used to calculate the geometric
average SEI is the following:
1
" i Pi %n
P1 P 2
Pi
SEIt = $! ti ' ! 100 = n t1 ! t2 !! ti ! 100;i = 1, 2,,6;n = 6
i=1 P
P0 P0
P0
#
0 &
(13.8)
where, SEIi is the index for any given day, i represents each one of the
six commodities comprising the index, Pti is the price of each
commodity for any given day, and P0i is the price of each commodity
in the base period.
The SEI provides a stable benchmark structure for the index,
making SEI suitable for institutional investment strategies. The
347
under various assumptions by selecting the first year as the insample period and the last three years as the out-of-sample period.
The final five datasets have the following number of stocks: N = 41
(UK Filter), N = 53 (Bovespa Composite), N = 65 (Dow Jones
Composite Average), N = 77 (US Filter) and N = 97 (FTSE 100 index).
TRACKING THE SPOT ENERGY INDEX
The performance characteristics of the proposed strategy are examined. The stocks picked by both the DE and the GA are used to track
the performance of the SEI. The initial capital of the investment portfolio is set equal to C = US$100,000, where both the DE and the GA
converge at the end of the in-sample period. In the empirical
analysis, tracking portfolios consisting of maximum K stocks are
used with K = 10, 15 and 20. Three different trade-offs between
tracking error and excess return are also considered, with l = 0.6, 0.8
and 1, thus moving from maximising excess return to minimising
tracking error. The heuristic is then repeated 10 times with the same
set of parameters per run, from which the best solution is chosen.
Figure 13.1 displays the SEI against quarterly rebalanced portfolios selected from the DE and GA, respectively. The portfolios consist
of a maximum of 15 stocks, the FTSE 100, DJIA, Bovespa and UK
Filter and US Filter, respectively; results are shown for l = 1. Looking
at the figures, it is clear that during and towards the end of the recession period, the benchmark index can be best tracked with the
Bovespa baskets, followed by the UK Filter baskets; whereas, during
the last year (2010) it is the US Filter and DJIA baskets that perform
better. The portfolios comprised of optimally selected energy-related
stocks can successfully track the SEI, generating similar returns for
most of the out-of-sample period. The US Filter and UK Filter results
verify that, when energy-related stocks are selected, they can better
replicate the risk and return trade-off of the SEI. The same applies for
the Bovespa baskets, since the Brazilian stock exchange has a large
number of energy- and commodity-related listed companies that
would closely follow any developments in the international energy
markets. In addition, between the DE and GA selected portfolios,
from the graphs it seems that the latter ones can follow more closely
the performance of the SEI, achieving highest excess returns for the
final out-of-sample year.
Table 13.1 presents the RMSEs and the mean excess returns of
349
Figure 13.1 Out-of-sample tracking of the SEI with the Bovespa, DJIA, FTSE 100,
UK Filter and US Filter baskets respectively; = 0.8, with maximum 15 stocks in
the basket, rebalanced quarterly
100K Portfolios Q_reb K15L08 (DEA)
200000
180000
160000
140000
120000
100000
80000
60000
40000
20000
Feb-10
Feb-10
Oct-09
Dec-09
Oct-09
Aug-09
Dec-09
Jun-09
Aug-09
Jun-09
Apr-09
Apr-09
Feb-09
Dec-08
Oct-08
Aug-08
Jun-08
Feb-08
Apr-08
Dec-07
Oct-07
Aug-07
Jun-07
Apr-07
Feb-07
Bovespa
DJIA
FTSE
UK FILTER
Feb-09
Dec-08
Oct-08
Aug-08
Jun-08
Apr-08
Feb-08
Dec-07
Oct-07
Aug-07
Jun-07
Apr-07
Feb-07
US FILTER
SEI
the benchmark index when compared to the ones selected from the
DE.
Another interesting observation is that, although the RMSEs are
improved when rebalancing occurs, increasing the frequency from
quarterly to monthly has only a marginal effect. These results are
more profound for the portfolios selected by the DE, and align with
Dunis and Ho (2005), who find that, when comparing alternative
rebalancing frequencies, a quarterly portfolio update is preferable to
monthly, semi-annual or annual reallocations. In terms of their
excess returns, in most cases the portfolios selected by the GA tend to
outperform the ones selected by the DE. The UK Filter and US Filter
baskets, which also have the lowest tracking errors (see panels D and
E on Table 13.1), have excess returns that in some cases are positive,
indicating that the selected portfolios, on average over the out-ofsample period, outperform the SEI.
In the case of the US Filter baskets selected by the GA, the index is
constantly outperformed in terms of excess returns (8.10% for K = 20
and l = 0.6 under monthly rebalancing, and 6.14% for K = 15 and l =
0.6 under quarterly rebalancing); there is only one exception for both
rebalancing frequencies, in which l = 1 and K = 10 when the portfolios underperform the index. This is an indication that the trade-off
criterion does work, and leads to portfolios that compromise any
excess return over a better tracking performance as expressed by the
smaller RMSEs. Thus, taking into account the fact that commodity
indexes performed better compared to the financial indexes over the
three-year out-of-sample period (except the Bovespa Composite),
with the methodology employed the performance of the SEI is
closely replicated, and in the case of the energy-related stock portfolios, the benchmark index is even outperformed.
For Table 13.1, panels A, B, C, D and E report the out-of-sample
daily RMSE and mean daily percentage excess returns, as defined in
equations 13.9 and 13.10, respectively. Under both rebalancing
strategies, the weights of the tracking portfolios are estimated based
on the available data in the rolling window in-sample period (one
year) every month and quarter, respectively. Portfolios returns are
adjusted for transaction costs of 0.5% for each transaction.
In terms of the riskreturn trade-off (l), it is observed that results
are very similar among portfolios where l = 0.8 and 1. In most cases,
the riskreturn trade-off criterion tends to perform well, selecting
351
RMSE
(K)
()
Panel A: Bovespa
10
0.6
0.8
1
Monthly rebalance
Mean ER (%)
RMSE
Quarterly rebalance
Mean ER (%)
RMSE
Mean ER (%)
DE
GA
DE
GA
DE
GA
DE
GA
DE
GA
DE
GA
0.0346
0.0343
0.0343
0.0344
0.0359
0.0362
0.0136
0.0176
0.0189
0.0324
0.0347
0.0133
0.0331
0.0330
0.0330
0.0329
0.0326
0.0327
0.0432
0.0480
0.0545
0.0104
0.0471
0.0689
0.0333
0.0332
0.0333
0.0332
0.0329
0.0332
0.0389
0.0438
0.0472
0.0134
0.0416
0.0236
15
0.6
0.8
1
0.0345
0.0343
0.0343
0.0359
0.0361
0.0356
0.0161
0.0181
0.0180
0.0239
0.0334
0.0238
0.0331
0.0330
0.0330
0.0327
0.0327
0.0327
0.0427
0.0487
0.0533
0.0063
0.0298
0.0418
0.0333
0.0332
0.0332
0.0332
0.0331
0.0333
0.0411
0.0431
0.0442
0.0148
0.0280
0.0312
20
0.6
0.8
1
0.0345
0.0343
0.0343
0.0354
0.0358
0.0357
0.0148
0.0186
0.0164
0.0233
0.0329
0.0284
0.0331
0.0330
0.0330
0.0331
0.0327
0.0328
0.0436
0.0488
0.0541
0.0094
0.0052
0.0346
0.0333
0.0332
0.0333
0.0335
0.0333
0.0334
0.0417
0.0427
0.0461
0.0209
0.0000
0.0210
Panel B: DJIA
10
0.6
0.8
1
0.0319
0.0319
0.0319
0.0328
0.0330
0.0330
0.0232
0.0238
0.0249
0.0257
0.0210
0.0218
0.0318
0.0318
0.0318
0.0315
0.0316
0.0313
0.0479
0.0511
0.0522
0.0115
0.0312
0.0274
0.0319
0.0318
0.0319
0.0319
0.0318
0.0317
0.0302
0.0323
0.0314
0.0243
0.0273
0.0172
15
0.6
0.8
1
0.0320
0.0319
0.0319
0.0329
0.0330
0.0328
0.0244
0.0240
0.0246
0.0200
0.0250
0.0239
0.0319
0.0318
0.0318
0.0315
0.0314
0.0313
0.0503
0.0515
0.0515
0.0332
0.0244
0.0410
0.0319
0.0319
0.0319
0.0318
0.0319
0.0319
0.0297
0.0311
0.0314
0.0172
0.0192
0.0283
20
0.6
0.8
1
0.0319
0.0319
0.0319
0.0328
0.0329
0.0328
0.0228
0.0235
0.0253
0.0251
0.0289
0.0323
0.0319
0.0318
0.0318
0.0315
0.0315
0.0313
0.0514
0.0529
0.0505
0.0239
0.0300
0.0344
0.0319
0.0319
0.0319
0.0319
0.0318
0.0317
0.0313
0.0301
0.0308
0.0005
0.0332
0.0051
No rebalance
352
Table 13.1 Out-of-sample index tracking performance of the selected portfolios.
0.0315
0.0317
0.0316
0.0318
0.0316
0.0314
0.0450
0.0469
0.0495
0.0359
0.0246
0.0193
0.0309
0.0309
0.0310
0.0299
0.0302
0.0300
0.0597
0.0701
0.0735
0.0260
0.0416
0.0635
0.0308
0.0309
0.0310
0.0303
0.0305
0.0307
0.0438
0.0475
0.0461
0.0106
0.0255
0.0334
15
0.6
0.8
1
0.0315
0.0316
0.0316
0.0318
0.0313
0.0312
0.0512
0.0477
0.0490
0.0253
0.0220
0.0175
0.0309
0.0309
0.0310
0.0303
0.0302
0.0303
0.0674
0.0634
0.0699
0.0327
0.0449
0.0682
0.0308
0.0309
0.0310
0.0303
0.0306
0.0306
0.0468
0.0416
0.0456
0.0180
0.0127
0.0349
20
0.6
0.8
1
0.0315
0.0316
0.0316
0.0317
0.0313
0.0313
0.0507
0.0484
0.0492
0.0271
0.0297
0.0245
0.0309
0.0310
0.0310
0.0303
0.0303
0.0301
0.0705
0.0681
0.0679
0.0311
0.0656
0.0600
0.0308
0.0309
0.0310
0.0305
0.0305
0.0306
0.0442
0.0445
0.0449
0.0092
0.0145
0.0208
0.0318
0.0315
0.0317
0.0309
0.0312
0.0307
0.0900
0.0818
0.0809
0.0834
0.0834
0.0751
0.0299
0.0300
0.0300
0.0294
0.0290
0.0292
0.0712
0.0680
0.0713
0.0019
0.0725
0.1371
0.0300
0.0301
0.0301
0.0296
0.0296
0.0297
0.0681
0.0611
0.0632
0.0032
0.0412
0.1049
Panel D: UK Filter
10
0.6
0.8
1
15
0.6
0.8
1
0.0312
0.0313
0.0313
0.0309
0.0309
0.0308
0.0825
0.0847
0.0846
0.0519
0.0408
0.0531
0.0299
0.0300
0.0300
0.0294
0.0293
0.0293
0.0782
0.0720
0.0782
0.0427
0.0501
0.1083
0.0300
0.0300
0.0301
0.0298
0.0296
0.0297
0.0711
0.0707
0.0601
0.0341
0.0410
0.0459
20
0.6
0.8
1
0.0311
0.0311
0.0311
0.0305
0.0303
0.0304
0.0796
0.0858
0.0763
0.0586
0.0451
0.0516
0.0299
0.0299
0.0300
0.0297
0.0294
0.0295
0.0764
0.0752
0.0747
0.0508
0.0790
0.0794
0.0300
0.0300
0.0301
0.0299
0.0298
0.0296
0.0717
0.0697
0.0676
0.0446
0.0391
0.0494
0.0307
0.0308
0.0309
0.0329
0.0321
0.0318
0.0258
0.0265
0.0234
0.0442
0.0780
0.0314
0.0306
0.0309
0.0310
0.0297
0.0295
0.0294
0.0449
0.0603
0.0688
0.0710
0.0607
0.0278
0.0309
0.0310
0.0310
0.0307
0.0300
0.0298
0.0364
0.0345
0.0367
0.0249
0.0240
0.0172
Panel E: US Filter
10
0.6
0.8
1
0.6
0.8
1
0.0307
0.0308
0.0308
0.0321
0.0327
0.0322
0.0246
0.0244
0.0254
0.0581
0.0511
0.0566
0.0309
0.0309
0.0309
0.0306
0.0296
0.0295
0.0497
0.0575
0.0648
0.1241
0.0212
0.0027
0.0310
0.0310
0.0310
0.0308
0.0301
0.0302
0.0322
0.0336
0.0342
0.0614
0.0016
0.0204
20
0.6
0.8
1
0.0307
0.0308
0.0307
0.0327
0.0319
0.0311
0.0261
0.0251
0.0226
0.0668
0.0320
0.0649
0.0309
0.0309
0.0309
0.0301
0.0296
0.0294
0.0510
0.0603
0.0662
0.0810
0.0210
0.0071
0.0310
0.0310
0.0310
0.0308
0.0303
0.0301
0.0274
0.0329
0.0352
0.0345
0.0369
0.0126
353
15
(K)
()
Panel A: Bovespa
10
0.6
0.8
1
Skewness
Ex. Kurtosis
Correl.
Info Ratio
DE
GA
DE
GA
DE
GA
DE
GA
DE
GA
DE
GA
6.79
8.04
8.88
6.38
7.48
2.94
35.68
35.39
35.49
38.32
36.15
37.28
0.572
0.541
0.537
0.588
0.499
0.565
7.688
7.696
7.846
7.146
7.198
7.791
23.76
23.72
23.62
27.67
26.04
26.46
0.185
0.209
0.225
0.064
0.200
0.113
15
0.6
0.8
1
7.36
7.86
8.14
0.73
4.05
4.87
35.72
35.49
35.45
38.38
37.33
36.76
0.578
0.548
0.532
0.516
0.620
0.461
7.699
7.910
7.734
7.113
7.932
7.889
23.84
23.79
23.65
28.06
26.89
25.36
0.196
0.206
0.211
0.071
0.134
0.149
20
0.6
0.8
1
7.49
7.77
8.62
8.27
3.01
2.29
35.73
35.42
35.50
38.45
37.53
37.69
0.570
0.544
0.534
0.494
0.481
0.485
7.661
7.675
7.801
7.896
7.498
8.467
23.95
23.57
23.64
26.36
26.21
25.94
0.199
0.204
0.220
0.099
0.000
0.100
Panel B: DJIA
10
0.6
0.8
1
4.61
5.14
4.90
3.13
3.87
1.33
19.76
19.79
19.76
22.72
22.40
22.87
0.543
0.563
0.630
0.329
0.444
0.437
12.944
13.201
13.884
9.405
9.707
10.343
8.96
9.13
8.97
13.36
13.44
14.63
0.151
0.161
0.156
0.121
0.136
0.086
15
0.6
0.8
1
4.48
4.83
4.91
1.33
1.83
4.12
19.85
19.80
19.87
22.44
23.63
24.36
0.536
0.563
0.600
0.405
0.210
0.475
12.659
13.169
13.712
10.195
8.742
12.793
9.01
9.04
8.97
13.63
14.64
15.65
0.148
0.155
0.156
0.086
0.095
0.141
20
0.6
0.8
1
4.87
4.58
4.75
2.88
5.36
1.72
19.84
19.83
19.86
22.41
24.40
23.42
0.543
0.542
0.587
0.335
0.355
0.526
12.801
13.054
13.684
7.553
9.969
10.842
9.00
9.07
8.93
12.49
16.10
15.57
0.156
0.150
0.153
0.002
0.165
0.026
8.03
8.96
8.62
5.68
3.41
5.42
25.87
25.82
26.14
28.61
29.42
28.74
0.040
0.019
0.039
0.010
0.082
0.018
5.981
5.743
6.319
6.623
8.084
8.876
24.57
24.11
24.07
30.30
30.01
28.52
0.225
0.244
0.236
0.056
0.132
0.173
8.78
7.49
8.47
1.54
0.19
5.78
26.18
26.03
26.26
29.32
28.89
30.48
0.006
0.004
0.016
0.060
0.026
0.106
6.170
6.140
6.310
7.373
7.309
7.594
25.07
24.12
24.01
31.08
29.36
30.57
0.241
0.214
0.233
0.094
0.066
0.180
0.6
0.8
1
356
Table 13.2 Distributional statistics of portfolios daily returns under quarterly rebalancing
0.6
0.8
1
Panel D: UK Filter
10
0.6
0.8
1
8.12
8.22
8.32
0.68
0.64
2.24
26.12
26.12
26.17
29.30
29.07
29.43
0.033
0.023
0.037
0.091
0.076
0.068
6.108
6.140
6.138
7.646
7.321
7.613
25.00
24.23
23.62
29.88
30.02
29.92
0.228
0.229
0.230
0.048
0.075
0.108
14.16
12.40
12.91
2.21
7.37
23.42
18.43
18.40
18.47
23.56
23.53
22.11
1.545
1.540
1.506
0.908
1.322
1.353
11.532
11.741
11.692
5.806
8.974
9.453
22.81
22.59
22.38
29.94
30.14
28.14
0.360
0.323
0.333
0.017
0.221
0.560
15
0.6
0.8
1
14.91
14.81
12.13
5.58
7.32
8.57
18.45
18.57
18.59
23.98
23.19
24.84
1.556
1.602
1.560
0.908
1.126
0.947
11.403
12.077
11.759
4.967
6.813
5.099
23.06
22.93
22.40
28.91
30.08
30.45
0.376
0.373
0.317
0.181
0.220
0.245
20
0.6
0.8
1
15.06
14.55
14.03
8.22
6.86
9.44
18.38
18.38
18.48
24.71
24.85
23.93
1.595
1.600
1.611
1.115
0.995
1.037
11.618
11.910
11.846
6.180
5.192
6.240
22.97
22.74
22.36
29.35
30.23
30.48
0.379
0.368
0.357
0.237
0.209
0.265
6.16
5.70
6.23
9.29
9.06
1.33
20.51
20.64
20.68
26.77
24.56
24.22
0.303
0.246
0.289
0.650
0.018
0.217
28.721
27.642
29.105
16.322
6.268
7.641
17.51
16.95
17.55
26.39
28.30
29.06
0.187
0.177
0.188
0.129
0.127
0.091
Panel E: US Filter
10
0.6
0.8
1
15
0.6
0.8
1
5.12
5.47
5.62
18.48
3.41
8.15
20.57
20.63
20.73
26.87
25.42
24.86
0.252
0.200
0.194
0.104
0.165
0.000
28.952
28.577
28.466
5.516
8.188
6.699
17.48
17.38
17.42
25.97
28.33
27.10
0.165
0.172
0.175
0.317
0.008
0.107
20
0.6
0.8
1
3.91
5.27
5.87
11.69
12.30
6.19
20.58
20.65
20.84
27.18
26.32
26.44
0.289
0.206
0.235
0.154
0.287
0.371
28.874
28.549
28.229
5.360
7.590
11.545
17.46
17.31
17.32
26.41
27.99
29.28
0.141
0.168
0.180
0.178
0.193
0.067
Skewness
Ex. Kurtosis
Correl.
Info Ratio
0.094
0.026
0.053
0.009
0.162
0.166
0.189
2.283
4.875
4.636
5.374
5.999
1.102
2.099
20.09
12.90
24.34
14.51
43.83
44.02
0.185
0.191
0.182
0.235
0.477
0.192
357
Panel F: Indexes
SEI
Bovespa
DJIA
FTSE 100
S&P500
DJ UBS Energy-TR
Rogers Energy Commodity-TR
20
information available from the latest price data does make a difference in reducing the portfolios volatility, but the small return
improvement coupled with the rebalancing costs outweighs the
volatility benefits. Results are consistent for all cases for the risk
return trade-off l. Between monthly and quarterly rebalancing, the
differences are relatively small, but the information ratios are, in
most cases, higher for the quarterly rebalanced portfolios. Under the
buy-and-hold scenario, the best performance in terms of information
ratios is reported for the Bovespa portfolios, and under both monthly
and quarterly rebalancing this is reported for the US Filter portfolios.
In most cases, negative information ratios are reported, indicating
that these portfolios over the out-of-sample period underperform
against the benchmark, as they are associated with the lowest excess
returns.5 This observation can be explained by the fact that energy
markets, as represented by the SEI, have been resistant to the
economic recession, even although they have experienced one of the
most severe up-and-down trends in their history.
The relatively low correlations of the selected equity portfolios
with the SEI (between 9% and 31%) suggest that investors who want
to participate in the energy sector can still benefit from the addition
of the selected baskets. This observation aligns with the findings of
Buyuksahin et al (2010), that the correlation between equity and
commodity returns is not often greater than 30%. Also, correlation is
not the most appropriate performance measure, as it only measures
the degree to which the selected equity baskets and the SEI move in
tandem, and does not capture the magnitude of the returns and their
trajectories over time. Equity returns deviate from a normal distribution, displaying skewness and fat tails. The same is true for the
returns of the SEI that exhibit positive skewness and relatively high
excess kurtosis. Both futures commodity indexes have excess
kurtosis similar to the SEI, with their skewness, however, being
negative. Most equity portfolios selected by both the DE and GA
exhibit negative skewness, indicating that the equity portfolios have
more weight in the left tail of the distribution, in contrast with the
SEI, which has more weight in the right tail.
Finally, as a robustness check, a nave strategy of randomly
selected stocks has been tested, forming equally weighted portfolios
constituted of 10, 15 and 20 stocks. The stocks are selected from the
same five equity pools used by the EAs from a uniform distribution,
358
thus giving equal probability for all stocks chosen. The evidence
confirms that the strategy and methodology used in this chapter are
much more efficient and stable in achieving a good tracking performance (low RMSEs), and good returns relative to the SEI (positive or
very small negative ERs). Under the nave strategy, there is a large
dispersion of outcomes and no consistency.6
CONCLUSIONS
In this chapter, a geometric average Spot Energy Index is constructed
and then its performance is reproduced with stock portfolios. This is
achieved by investing in small baskets of equities selected from five
stock pools: the Dow Jones, FTSE 100, Bovespa Composite and the
UK and US Filters. The investment methodology used employs two
advanced evolutionary algorithms: the GA and the DE. Both algorithms are self-adaptive stochastic optimisation methods, superior to
other rival approaches when applied to the index-tracking problem.
To test the performance of the tracking baskets, three different rebalancing scenarios were examined, also taking transaction costs into
consideration: buy-and-hold; monthly rebalancing; and quarterly
rebalancing. For comparison reasons, the performance of a nave
investment strategy of randomly selected stocks forming equally
weighted portfolios was also reported.
It was found that energy commodities, as proxied by the SEI, can
have equity-like returns, since they can be effectively tracked with
stock portfolios selected by the investment methodology followed
here. Overall, during the three-year period examined, which reflects
a period before, during and towards the end of the global economic
recession, an investor would realise positive returns by investing in
commodities, as the SEI returns suggest. With the methodology
employed, that performance is closely replicated and, in the case of
the energy-related stock portfolios and those selected from the
Bovespa equity pool, the benchmark index is even outperformed. In
most cases, there seem to be no major differences between the DE
and GA selected portfolios, although the GA tends to select portfolios that have a lower tracking error. Both algorithms mostly do not
utilise the maximum number of stocks allowed to select, with the DE
being more stable in the number of stocks picked between the
various cases of the riskreturn trade-off; the GA tends to select portfolios quite different in terms of their composition.
359
360
APPENDIX
Differential evolution algorithm
DE is a population-based stochastic optimization algorithm that
employs mutation, recombination (crossover) and selection operators to evolve iteratively an initial set (population) of NP randomly
generated N-dimensional solutions. At each iteration (generation),
the algorithm applies the aforementioned evolutionary operators to
each one of the available solutions. In particular, let xiG denote the
solution vector i (i = 1, , NP) at a generation G, xijG be the jth element
of xiG, and x*G the best solution from generation G (specified
according to the problems objective function). Having xiG as the
starting basis, a new solution xiG+1 is constructed replacing xiG in the
next generation G + 1. The solution updating process is performed in
the following three steps:
1.
2.
3.
Crossover
solution
xi1
xi2
xi,l1
Parent solution
vi1, vi2, , viN
vil
vi,l+1
vi, j*1
xij*
xiN
2.
3.
DE
Population size:
Generations: 100
Crossover: arithmetic (80% probability)
Selection: tournament (size = 4)
Mutation: uniform (0.5% probability)
Population size:
Generations: 100
Mutation: rand-to-best/1 (F = 0.7)
Crossover: exponential (CR = 0.5)
Super-sector
Sector
Sub-sector
7000 Utilities
7500 Utilities
7530 Electricity
363
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Management, Financial Analyst Journal, 54(5), pp 1831.
Stopford, M., 2009, Maritime Economics (3e) (London: Routledge).
Storn, R. and K. Price, 1995, Differential Evolution: A Simple and Efficient Adaptive
Scheme for Global Optimization Over Continuous Spaces, Technical Report TR-95012,
International Computer Science Institute, Berkeley.
Storn, R. and K. Price, 1997, Differential Evolution, A Simple and Efficient Heuristic
Strategy for Global Optimization Over Continuous Spaces, Journal of Global Optimization,
11(4), pp 34159.
366
367
Part III
14
An example of best practices in the integration of risk management within the overall governance structure is the risk management
policy of BHP Billiton PLC, one of the largest diversified resources
companies in the world (see Panel 14.1).
PANEL 14.1: BHP BILLITON RISK MANAGEMENT POLICY2
BHP Billitons risk management policy (see below) defines the groups
approach to risk management, linkage to the corporate objective and integration into its business processes.
Risk will manifest itself in many forms and has the potential to impact
the health and safety, environment, community, reputation, regulatory, operational, market and financial performance of the group and,
thereby, the achievement of the corporate objective.
By understanding and managing risk we provide greater certainty and
confidence for our shareholders, employees, customers and
suppliers, and for the communities in which we operate.
Successful risk management can be a source of competitive
advantage.
Risks faced by the Group shall be managed on an enterprise-wide
basis. The natural diversification in the Groups portfolio of
commodities, geographies, currencies, assets and liabilities is a key
element in our risk management approach.
We will use our risk management capabilities to maximise the value
from our assets, projects and other business opportunities and to
assist us in encouraging enterprise and innovation.
Risk management will be embedded into our critical business activities, functions and processes. Risk understanding and our tolerance
for risk will be key considerations in our decision-making.
Risk issues will be identified, analysed and ranked in a consistent
manner. Common systems and methodologies will be used.
Risk controls will be designed and implemented to reasonably assure
the achievement of our corporate objective.
The effectiveness of these controls will be systematically reviewed
and, where necessary, improved.
Risk management performance will be monitored, reviewed and
reported. Oversight of the effectiveness of our risk management
processes will provide assurance to executive management, the
board and shareholders.
The effective management of risk is vital to the continued growth and
success of our Group.
Source: BHP Billiton
373
374
ntial variability of
Market scenarios
Mark to market/mark to model
Multiple time steps (periods)
Portfolio ageing and walk-forward analysis
Netting agreements
Collateral and margin clauses
Portfolio trading/hedging strategies
Counterparty default
Hedge effectiveness rules
Rating downgrade
Operational risks
Dynamic hedging strategy
Volumetric risks
VaR
Collateral at risk
(CaR) and CFaR
EaR
YES
YES
NO
NO
NO
NO
NO
NO
NO
NO
NO
NO
NO
YES
YES
YES
YES
YES
YES
YES
YES
NO
YES
YES
YES
YES
YES
YES
YES
YES
YES
YES
YES
YES
YES
YES
YES
YES
YES
Source: NQuantX
375
Collateral changes
(MtM-based, AR/AP,
premiums, downgrades)
Counterparty losses
(MtM-based, netting guarantees,
AR/AP, collateral)
376
CFaR
and
EaR
Figure 14.2 Potential future exposure and potential collateral requirement report
US$30,000,000
US$10,000,000
US$0
US$10,000,000
US$20,000,000
US$30,000,000
4/1/2010
5/1/2010
6/1/2010
7/1/2010
8/1/2010
2/1/2011
3/1/2011
4/1/2011
378
US$20,000,000
US$100,000
P&L (thousands)
US$50,000
US$0
-US$50,000
-US$100,000
-US$150,000
-US$200,000
-US$250,000
Power
Crude oil and products
Pr
%
ic
e
+2
Pr
5%
ic
e
Vo
+5
la
0%
til
i
t
Vo
y
-2
la
0%
til
ity
+2
0%
-2
5
Agricultural
ic
e
Pr
Pr
ic
e
-5
0%
-US$300,000
Agricultural
Metals
Gas
Power
Portfolio
379
Board of
directors
Senior
management
CFO/Treasury
Procurement/
logistics groups
Cost-at-risk; operating
cashflow reports.
Market risk
managers
Credit risk
managers
REFERENCES
Aragons, J. R., C. Blanco, K. Dowd and R. Mark, 2006, Market Risk Measurement and
Management for Energy Firms, in P. C. Fusaro (Ed), Professional Risk Managers Guide to
Energy and Environmental Markets (Wilmington, DE: PRMIA Publications): pp. 6982.
Blanco, C. and M. Pierce, 2012, Spot Price Process for Energy Risk Management, Energy
Risk, March.
Blanco, C. and M. Pierce, 2012, Multi-factor Forward Curve Models for Energy Risk
Management, Energy Risk, April.
Blanco, C. and R. Mark, 2004, ERM for Energy Trading Firms: ERM Starts with Risk
Literacy, Commodities Now, September, pp 7882.
Blanco, C., 2010, Collateral, Cash Flow and Earnings at Risk, WorldPower, Isherwood
Publications.
Blanco, C. and M. Pierce, 2010, Integrated Risk Modeling for Trading and Hedging
Decisions, WorldPower, Isherwood Publications.
Dowd, K., 2005, Measuring Market Risk (2e) (Hoboken, NJ: Wiley).
387
15
390
Allocate
portfolio
CVA to
individual
deals
Calculate
CVA for each
counterparty
Determine
CVA
method
1Y
3Y
5Y
7Y
10Y
450
400
350
300
250
200
150
100
50
9/
/0
03
03
/0
9/
20
20
12
11
01
0
/2
09
03
/
9/
20
09
/0
03
20
/0
9/
03
03
/
09
/2
00
08
391
Cons
CDS spreads
Bond yield
spreads
Historical
default
probabilities
Not market-based.
Slow to react to changing
conditions.
Hybrid
models
Internal
ratings
CVA methods
There are several ways of calculating CVA, but we can group the
various methods in three categories. The first is the discount rate
adjustment, which requires the use of credit risk-adjusted discount
curves to calculate fair values. A common way of creating the credit
risk-adjusted curves for a given counterparty is by adding the CDS
spread to the risk-free rate curves used for present value calculations.
Figure 15.3 shows the CDS spreads for various North American
firms, as well as the zero-coupon risk-free curve and the riskadjusted curves. The risk-free rate curve is the US dollar zero coupon
curve for September 3, 2012. The credit-adjusted curves for each
entity in Figure 15.3 are created by adding the CDS spread to the
zero-coupon rate for each maturity.
392
Risk free
Chesapeake
10
Morgan Stanley
Encana
The discount rate adjustment is the most widely used method for
fair value reporting due to its simplicity. One of the main shortcomings is that the credit exposure is assumed to be static, and therefore
the CVA is not dependent on the volatility of the mark-to-market
(MtM) of the deal, making it more likely to underestimate the credit
risk of the instrument.
The second type is known as the exponential CDS default method,
and requires the estimation of probabilities of default and recovery
rates. We can approximate the probability of default from quoted
CDS spreads for a given term by applying the following formula:
! CDSSpread t ( years) $
PD = 1! e #
!
&
10000 %
" (1! R )
where:
PD is the probability of default;
CDS Spread is the credit spread in basis points;
393
CVA = (1! R ) ! 0 S (t ) P (t ) dt
where S(t) is the expected exposure of the deal at time t, and P(t) is
the default probability time function.
As an alternative to calculating the full integral, we can divide the
time interval [0,T] into periods [ti, ti+1] and select ti [ti, ti+1].
A common choice for the time unit in each time interval is the
average between the two points:
T
where
P (ti ) =
394
ti+1
ti
P (t ) dt
Figure 15.4 Expected positive exposure and expected negative exposure profiles
$30,000,000
$20,000,000
$10,000,000
$0
-$10,000,000
Expected negative exposure (ENE)
-$20,000,000
13
20
1/
/1
01
20
13
01
/1
0/
01
9/
2
8/
20
1
01
/0
01
/0
20
13
7/
/0
01
13
/2
01
06
5/
20
01
/
20
13
/0
4/
01
20
13
3/
01
/0
20
13
2/
/0
01
20
13
1/
/0
/0
01
20
12
01
12
/
01
/
01
/1
1/
20
12
-$30,000,000
395
Description
Discount rate
adjustment (I)
Discount rate
adjustment (II)
Exponential CDS
default method
Exposure-based
methods
MtM
Citigroup
BNP Paribas
Goldman Sachs
Glencore
JP Morgan
Shell
Source: NQuantX LLC
US$5,034,352
US$3,775,764
US$4,14,604
US$100,651
US$9,165
US$6,873
# trades
US$45
US$32
US$12
US$7
US$23
US$11
Collateral
US$2,500,000
US$1,000,000
Net exposure
US$2,534,352
US$2,775,764
US$414,605
US$100,651
US$9,165
US$6,874
CVA
US$74,375
US$74,171
US$11,127
US$2,753
US$258
US$158
% MtM
1.48%
1.96%
2.68%
2.73%
2.81%
2.30%
Counterparty
397
3. Apply netting rules at the counterparty level for each scenario time step
report at the counterparty level with the PFE profiles for each counterparty.
From portfolio CVA to deal CVA
When two entities enter into a series of transactions, they also
exchange an implicit option to default. CVA is the price or cost of
credit risk for a deal or portfolio with a given counterparty.
CVA can be calculated at the individual transaction or at each
counterparty portfolio level. The overall CVA for the exposures with
a given counterparty is not simply the sum of the individual deal
CVA, because of the need to take into account credit risk mitigation
rules that apply to those exposures. For example, a trading entity
may have several deals with the same counterparty that have large
stand-alone CVAs, but if those exposures offset each other and there
are netting agreements in place, the overall portfolio CVA will be
considerably lower than the sum of the individual CVAs.
Despite the non-additive nature of portfolio CVA, it is possible to
398
US$14,000,000
US$12,000,000
US$10,000,000
US$8,000,000
US$6,000,000
US$4,000,000
US$2,000,000
US$
1M
3M
6M
12M
Citigroup
Goldman Sachs
JP Morgan
BNP Paribas
Glencore
Shell
2Y
3Y
US$16,000,000
399
BP Trading
Mark-tomarket
Stand-alone CVA
WTI swap
US$1,243,550
Brent swap
US$672,946
Natural gas swap
US$(831,503)
Natural gas basis swap
US$97,690
Totals
US$1,182,682
Portfolio
MtM
Stand-alone
CVA
Relative
weights
Credit-adjusted
MtM
US$10,724
US$5,114
US$(6,363)
US$302
109.63%
52.27%
65.04%
3.08%
US$1,232,826
US$667,832
US$(825,141)
US$97,388
100%
US$1,172,905
Credit-adjusted
MtM
US$9,777
Undiversified
CVA
Netting
ALL
Mark-to-market
Net exposure
Portfolio CVA
US$1,182,682
US$182,682
US$3,654
US$1,179,029
the relative credit adjustment method is relatively easy to implement, and superior to the in-exchange or full credit, and the relative
fair value methods.
The first step involves calculating the stand-alone CVA for each
individual trade. If we add the stand-alone CVAs at the trade level,
we can calculate the undiversified portfolio CVA assuming that
the portfolio consists of non-nettable, non-collateralised trades, effectively ignoring credit-mitigation effects. The magnitude and sign of
each stand-alone CVA determines the relative weights for the deals
that are part of that counterpartys portfolio. Table 15.5 shows the
deal-level breakdown of MtM and CVA of the portfolio with trades
made with EDF Trading as the counterparty. The bottom row shows
the portfolio MtM, the undiversified CVA as a sum of stand-alone
CVA, as well as the credit-adjusted MtM. The relative percentage
weights are calculated by dividing each individual CVA by the undiversified portfolio CVA.
401
Mark-to-market
CVA
weights
WTI swap
US$1,243,550
109.63% US$4,005
US$1,239,545
Brent swap
US$672,946
52.27%
US$671,036
US$(831,503)
65.04% US$(2,376)
US$(829,127)
US$97,690
3.08%
US$113
US$97,577
Portfolio CVA
bilateral
Portfolio MtM
(risk free)
US$1,182,682
Marginal CVA
US$1,910
100.00% US$3,652
Credit-adjusted
MtM
US$1,179,031
Advantages
Limitations
Relative fair
value
Relative credit
adjustment
Relatively simple to
implement. Allocation based
on actual CVA of each
instrument.
Marginal
contribution
403
Barclays
Morgan Stanley
J Aron & Co
Shell
BP
Exxon
Southern Company
Internal
rating
Current
exposure
Limit
Limit
usage
Potential
future
exposure
PFE/
limit
3
4
3
2
3
1
5
US$2,092
US$4,021
US$(461)
US$(18)
US$1,682
US$1,729
US$714
US$5,000
US$3,000
US$5,000
US$2,000
US$5,000
US$10,000
US$1,000
42%
134%
0%
0%
34%
17%
71%
US$7,540
US$5,650
US$12,350
US$325
US$4,500
US$3,450
US$1,250
151%
188%
247%
16%
90%
35%
125%
Current
exposure
Credit spread
(bp)
Credit
spread
Daily
charge
Credit Suisse
2,091,546
245
2.45%
US$140.39
MtM
Charge
allocation
Daily
charge
Trader
M. Smith
J. Arnold
C. White
M. Ford
S. Chance
Totals
US$1,235,000
US$(212,456)
US$324,500
US$750,700
US$1,069,002
US$3,379,202
36.5%
0.0%
9.6%
22.2%
31.6%
100.0%
US$51.31
US$
US$13.48
US$31.19
US$44.41
US$140.39
405
Trader
CVA collects fee and
protects credit
exposure
Credit
markets
Source: NQuantX LLC
406
CVA
desk
CVA purchases
protection for
unsecured exposures
from trading position
407
REFERENCES
Blanco, C., 2010, Collateral, Cash Flow & Earnings at Risk: Time to update your risk
metrics and policies?, Commodities Now, July.
Blanco, C., 2010, Credit Valuation Adjustment for Commodity Derivatives, Commodities
Now, December.
Blanco, C., K. Dowd, R. Mark and W. Murdoch, 2006, Credit Risk Measurement and
Management for Energy Firms, in P. C. Fusaro (Ed), Professional Risk Managers Guide to
Energy and Environmental Markets (New York, NY: McGraw-Hill): pp 6982.
Humphreys, B. and D. Shimko, 2005, Pay As You Go, Energy Risk, January.
Stein, H., 2012, Counterparty Risk, CVA, and Basel III, Columbia University Financial
Engineering Practitioners Seminar, March.
408
16
409
THE PAST
In 1990, with the approval of the State Council, the Zhengzhou Grain
Wholesale Market1 was founded as the first futures pilot programme
in China. Since then, Chinas futures market has continued to
develop, moving from chaos to governance including two
phases of clean-up and rectifications in the 1990s, as well as standardisation development in the 2000s. The futures market has grown
steadily in scale, with laws and regulations increasingly implemented, market functions well-performed and international
influence becoming even more significant. This has been especially
true since 2004, with more futures contracts being listed and traded,
forming an almost complete commodity futures market system
consisting of agricultural, metal, energy and chemical products.
The first 10 years (19902000)
In the 1990s, along with the establishment of a market-based
economic policy, China gradually opened its free commodity
market, resulting in frequent fluctuations in commodity prices. The
government began to develop a wholesale market of food, metals,
materials and other commodities, and futures trading of these products was gradually promoted. For a time, the commodity wholesale
markets and futures exchanges flourished everywhere in China.
From 1990 to 1993, the number of futures exchanges increased
rapidly, while futures contracts became multiply listed and the
markets were over-speculated. There were then more than 50 futures
exchanges in China, leading to vicious competition between the
exchanges. Disorderly market trading, market manipulation and
insider trading also occurred frequently during that time.2 Over a
thousand futures commission companies were founded, although
their operation and management verged on the chaotic. Customers
were often cheated and the interests of investors violated. The
brokerage services for overseas futures trading developed too fast to
be brought under regulation in a timely manner. The futures market
entered a stage of blind development.
The first phase of clean-up and rectification
On November 4, 1993, the State Council of the Peoples Republic of
China issued the Notice to Resolutely Stop the Blind Development
of the Futures Markets, and started the first clean-up and rectifica410
Trading turnover
50
20
40
15
30
10
20
10
3
5
6
8
9
0
1
3
5
6
1
8
9
0
4
7
2
4
7
2
199 199 199 199 199 199 199 200 200 200 200 200 200 200 200 200 200 201 201 201
411
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
60
30
Figure 16.1 Estimated Chinese trading volume (US$ trillion US$ equivalents) and number of listed futures
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
Table 16.1 Exchanges, brokerage firms, listed commodities and turnover in Chinese
futures
Year
Futures
exchanges
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
08
09
10
11
12
1
2+
5+
32+
14
14
14
14
14
3
3
3
3
3
3
3
3
3
3
3
4
4
4
Brokerage
firms
1000**
144
330
329
294
278
213
178
184****
187
176
172
166
164
165
163
164
163
161
161
Listed
commodities
contracts
52+**
35
35
35
35
35
12
12
12
11***
11
11
11
14
18
19
23
24
27
31
Trading
turnover
(in US$100 million)*
443.18
2536.23
8071.05
6751.14
4909.36
2966.87
1793.18
1290.71
2419.34
3169.35
8698.96
11792.56
10790.40
16857.65
32883.02
57716.05
104743.76
248087.05
220727.81
274675.97
Trading
volume
(contracts)
4,453,450
60,553,600
318,060,350
171,283,850
79,381,600
52,227,850
36,819,550
27,305,350
60,231,750
69,716,316
139,932,111
152,848,800
161,423,761
224,737,051
364,213,397
681,943,551
1,078,714,909
1,566,764,672
1,054,088,664
1,450,462,383
Source: Compiled from data in CSRC, 2001, China Securities and Futures Statistical Book,
apart from the number of exchanges in 1993 being taken from 100 Questions and Answers of
Futures Operation (China Material Publisher): p.138 (while the number of exchanges is put at
32 in this report, it was generally recognised that there were over 40 exchanges operating in
1993; the number of exchanges in 1990, 1991 and 1992, and the number of brokerage firms
in 1993, are the authors estimates).
*Trading turnover in Chinese yuan (Yn) was converted to US dollars at an exchange rate of
6.23 Yn/US$.
**The 19932001 listed commodities contracts data and the number of 19932000 brokerage
firms was taken from Xueqin and Gorham (2002).
***200212 listed commodities contracts dates came from:
http://www.cfachina.org/news.php?classid=108.
****The 2001 brokerage firms number was taken from:
http://www.yafco.com/show.php?contentid=40670, while the 200212 brokerage firms
number came from: China Futures Industry Development Report and the CSRC.
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
Shanghai Futures
Exchange
Dalian Commodity
Exchange
Zhengzhou
Commodity Exchange
China Financial
Futures Exchange
Futures Trading,5 and the third was the founding of the China
Futures Association on December 28, 2000.6
The second 10 years (200010)
In the first ten years of 21st century, Chinas futures market developed rapidly. The most significant events included new futures
contracts listed for trading, futures companies gradually opening up
and financial futures being launched successfully.
1400
1200
1000
800
600
400
200
0
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
415
Table 16.2 Futures contracts list for trading on China futures exchanges
Exchanges
Contracts
Time
Shanghai
Futures
Exchange
Aluminium
Copper
Natural rubber
Fuel oil
Zinc
Gold
Deformed steel bar
Wired rod
Lead
Silver
Volume
1992
March 1993
November 1993
August 25, 2004
March 26, 2007
January 9, 2008
March 27, 2009
March 27, 2009
March 24, 2011
May 10, 2012
9,953,918
48,961,130
104,286,39
1,971,141
53,663,483
7,221,758
81,884,789
3,242
293,280
308,239,140
3,942,680
57,284,835
75,176,266
9,132
21,100,924
5,916,745
180,562,480
2,717
68,646
21,264,954
365,329,379
Zhengzhou
Commodity
Exchange
7,909,755
139,044,152
128,193,356
120,528,824
4,320,115
152,901
(hardwhite
wheat)
25,802,102
21,016,438
148,278,025
121,245,610
6,248,568
6,262
5,925,454
316,107
406,390,664
3,838,320
3,797,412
16,136,920
137,084
421,207
347,028,203
50,170,334
25,239,532
26,849,738
10,662
58,012,550
325,876,653
45,475,425
37,824,356
10,400
68,858,554
95,219,058
22,593,961
9,438,431
1,512,734
289,047,000
71,871,537
43,310,013
6,900,153
32,915,885
633,042,976
50,411,860
50,411,860
105,061,825
105,061,825
1,054,088,664
1,450,462,383
China Financial
Futures Exchange
Futures trading
volume in China
Soybean meal
No. 1 yellow soybean
Corn
No. 2 yellow soybean
Soybean oil
LLDPE (linear low-density
polyethylene)
Palm oil
PVC (polyvinylchloride)
Coking coal
Volume
ShanghaiShenzhen 300
stock index
Volume
Total
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
417
Table 16.3 Latest trading volume of stock index futures in China financial
futures exchange
Year
CSI 300
2010
2011
2012
Total
91,746,590
50,411,860
105,061,825
247,220,275
Figure 16.4 Growth in trading (log scale) for Chinas futures market
Trade volume (US$ trillion, US$ equivalent)
100
10
0.1
0.01
3 4
5
6 7
9
8
3 4
1 2
0
5
6 7
8
9
0
1 2
199 199 199 199 199 199 199 200 200 200 200 200 200 200 200 200 200 201 201 201
418
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
50
40
2002
2003
2004
2005
2006
2007
2008
2009
2010
419
market in the world. On the other hand, the average annual share of
the Chinese futures market share to global futures and options
remained low, reflecting that the trading volume of Chinas futures
market in commodity options, stock futures and stock options are
not yet fully developed, with some products being totally absent
from Chinas derivatives market. In 2010, Chinas futures market
was one of the largest commodity futures market in the world,
accounting for a trading volume of 53.65% of the global commodity
futures market.
THE PRESENT
The micro characteristics of the market operation
The healthy development of the Chinese futures market has been
mainly based on the powerful spot market and an upward macroeconomic environment. Chinas consumption volume of nearly all
the commodities underlying the futures contracts ranks among the
global top three consuming nations (see Table 16.4).
Open interest
As research shows,8 legal persons9 hold 4060% of the 10 futures
varieties open interest,10 offering a reasonable market structure in
Figure 16.6 The historical ranking of Chinese futures exchanges among all
global exchanges
0
ZCE
DCE
SFE
CFFEX
5
10
15
20
25
30
35
2000 2001 2002
420
2003 2004
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
Number
20
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
US 28%
China 38%
UK 15%
India 15%
Japan, Russia,
others 1%
respectively
Source: Based
d on FIA data
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
15
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
60.00
Contracts in millions
GDP in trillions
1400
50.00
40.00
1000
800
30.00
600
GDP in trillions
Contracts in millions
1200
20.00
400
10.00
200
0
0.00
1993
1995 1997
1999
2001
2003
2005 2007
2009
2011
427
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
430
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
Global commodities
Global energy
Source: http://www.futuresindustry.org
432
Global agricultural
Global metals
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
As shown in Figure 16.9, in 2011 global energy options transactions accounted for 11% of its futures trading volume, global
agricultural options trading was 7.88% of the agricultural futures
and global non-precious metals and precious metals options trading
volume accounted for only 2.8% of the futures trading volume.
It can be seen that the original intention and purpose of listing
commodity options was mainly to serve as an insurance function for
futures and to enhance the quality of the futures market, not to
increase trading volume. For this reason, it is recommended that a
further study on the insurance function of options for futures and a
project on options training including simulated options trading is
needed.
CONCLUSIONS
For the optimal development of Chinas futures market, the
following should be carried out:
433
434
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
2 Natural rubber R708, China Commodity Futures Exchange, Inc of Hainan (CCFE) in 1997;
Coffee F605, F607, F609, F703, China Commodity Futures Exchange, Inc of Hainan (CCFE)
in 1996-1997; Jun Plywood 9607, Shanghai Futures Exchange (SHFE) in 1996; Red bean,
Suzhou Commodity Exchange in Jan-Mar 1996; Soybean meal 9601, 9607, 9708 Guangdong
United Futures Exchange (GUFE) in Oct-Nov 1995; Sticky rice 9511, Guangdong United
Futures Exchange (GUFE) in Oct 1995; Red bean 507, Tianjin Commodity Exchange in MayJun 1995; 3-year T-bond 314, 327, Shanghai Securities Exchange (SHSE) in 1995; Palm Oil
M506, China Commodity Futures Exchange, Inc of Hainan (CCFE) Mar 1995; Corn C511,
Dalian Commodity Exchange (DCE)Futures in 1995; Steel wire, Suzhou Commodity
Exchange in 1994-1995; Japonica rice, Shanghai Food and Oil Exchange in Jul-Oct 1994.
3 Including a serial of documents, such as Provisional Regulations on Futures Trading,
Futures Exchange Management Regulations, Futures Brokerage Corporate Management
Approach, Futures Brokerage Companys Senior Management Personnel Qualifications
Management Approach and Futures Industry Practitioners Qualified Management
Methods.
4 In the early 1990s, the Zhengzhou Commodity Exchange listed mung bean futures, the first
batch of domestic listed contracts. In 1998 and 1999, for two consecutive years it traded at a
peak of more than half of the national futures trading volume. In late 1999, after the margin
increased from 5% to 1520%, the mung bean futures had no trades. In May 2009, after the
CSRC approved the Request for Suspension of Mung Bean Futures Trading, which was
delivered by ZCE in 2008, the mung bean contract was delisted.
5 On June 2, 1999, the State Council issued the Interim Regulations on Administration of
Futures Trading. After it was revised, the new Regulations on Administration of Futures
Trading took effect on April 15, 2007. The newest Regulations on Administration of
Futures Trading were approval by the State Council on September 12, 2012, taking effect on
December 1, 2012.
6 China Futures Association consists of group members, including members of the futures
brokerage firms, special members of futures exchanges and individual members in the
futures industry. It accepts business guidance and management from the China Securities
Regulatory Commission and the Organization of National Social Group Registration
Administration.
7 http://futures.hexun.com/20120515/141434876.html.
8 According to the internal research materials of regulators (and the below is the same).
9 Refers to an individual or group that is allowed by law to take legal action as plaintiff or
defendant. It may include natural as well as fictitious persons (such as corporations).
10 Includes lead, fuel, copper, zinc, PVC, soybean meal, corn, strong gluten wheat, cotton,
PTA.
11 Refers to the ratio of the position of legal person to the total position in the related contract
market.
12 Refers to the ratio of individuals trading volume to total trading volume in the related
contract.
13 For example, if the accumulative price increase (decrease) based on settlement price in three
successive trade days (D1, D2, D3) of a futures contract reaches three times of the stipulated
increase (decrease) price limit in the contract, the exchange has the right to increase the
margin rate with the scale no more than three times of the trading margin standard in the
contract applicable at that time. Under circumstances of significant increased market risk
caused by the special situation of some futures contract, the exchange may take the
following measures according to the market risk of some futures contract, such as putting
limitations on margin movements, putting limitations on opening position and closing position, adjusting the trading margin standard of this futures contract and adjusting the range
of price limits of the contract.
14 Analysis and calculation based on data from the Futures Industry Association.
435
15 http://www.tygedu.com/newsviews.php?newsid=4234.
16 Annual growth rate from 2006 to 2010 is, respectively, 32.22%, 62.06%, 87.24%, 20.27% and
84.74%.
17 http://www.pbc.gov.cn/image_public/UserFiles/goutongjiaoliu/upload/File/%E4%
B8%AD%E5%9B%BD%E9%87%91%E8%9E%8D%E7%A8%B3%E5%AE%9A%E6%8A%A5
%E5%91%8A%EF%BC%882012%EF%BC%89.pdf.
18 No. 1 central file refers to the first document issued by the Central Committee of
Communist Party of China every year. It has become the proper noun for showing that
the Central Committee of Communist Party of China attaches great importance to rural
problems.
19 The monopoly behaviour of the futures industry in China is mainly reflected in the administrative monopoly, futures exchanges monopoly and futures brokerage industry
monopoly. For example, the regulatory department dominates the approval of varieties of
futures and products, listing locations as well as restricting every product to be listed on one
exchange without saying that listed procedures are cumbersome. In addition, in relation to
a futures company, an exchange has a much stronger voice and negotiation ability, etc.
20 In China, outside of futures exchanges, there are more than 200 electronic commodity
trading markets that trade almost the same contracts and use trading mechanisms and rules
similar to futures exchanges. This is called disguised futures or quasi futures. The
markets lack strict regulation and market rules, and their operation and implementation are
in chaos. To some extent, they inhibit the healthy development of Chinas futures markets.
21 Since the early days, risk events have occurred with futures companies misappropriating
customer funds and allowing customers to carry out overdraft trading. However, futures
brokers firms are not allowed to trade their own accounts and can only trade for customer
accounts, promulgated and provisioned by the regulations on futures trading of September
1999. The main business of futures companies in China is to trade on behalf of their
customers, so the firms income mainly comes from commission.
22 The listing mechanism for new futures contracts in China adopts a non-market-approval
system. In order to list a new variety of futures contract, it must first undergo a repeated
research and review process by the futures exchange and then report to the CSRC accordingly. After examination and verification, CSRC then submits a report to the State Council,
which needs to consult the relevant state ministries and commissions, related industry
administration departments and even relevant provinces and cities. After getting all feedback, the State Council might make written instructions. A new variety of futures contract
will finally be launched.
23 Chinas three commodity futures exchanges are institutional units implementing enterprise
management, while China Financial Futures Exchange is a corporate system, an enterprise
is a legal person. In fact, they are all to different extents the subsidiary of the regulatory
department.
24 Article 7: non-profit futures exchanges shall carry out self-regulation according to their
constitutions, and assume the civil liabilities with all their properties. A futures exchange
bears civil liabilities to the extent of all of its property. The persons in charge of futures
exchanges shall be appointed and dismissed by the futures supervision and administration
authority of the State Council. Article 18: The revenues obtained by a futures exchange shall
be managed and used in accordance with the relevant state regulations and may not be
distributed to members or diverted for other uses.
25 A futures exchange shall establish a board of directors. The chairman and the vice-chairman
shall be nominated by the CSRC and elected by the board.
26 Article 4: Registered capital of the membership futures exchange is divided into equal
shares, which is subscribed to by its members.
27 This is not only difficult to explain to most Westerners, but also to some Chinese.
28 The meaning is similar to demutualisation ie, the move from a member-owned organisation to a publicly listed organisation.
436
THE PAST, PRESENT AND FUTURE OF CHINAS FUTURES MARKET: TRADING VOLUME ANALYSIS
29 The Central Economic Working Conference of the Central Committee of the Communist
Party and the State Council is the highest economic conference in the nation. Its mission is to
carry out economic achievements, deal with international and domestic economic changes,
formulate macroeconomic development planning and deploy the following years economic
work.
30 Data source from FIA statistics and calculated by author (the below is the same).
REFERENCES
Falloon, William D., 1998, Market Maker: A Sesquicentennial Look at the Chicago Board of
Trade (Chicago, Ill: CBOT).
Gorham, Michael and Nidhi Singh, 2009, Electronic Exchanges: The Global Transformation
from Pits to Bits (Burlington, MA: Elsevier).
Hieronymus, Thomas A., 1996, A Revisionist Chronology of Papers.
Hieronymus, Thomas A., 1997, Economics of Futures Trading: For Commercial and
Personal Profit, Commodity Research Bureau.
Melamed, Leo, 1993, Leo Melamed on the Markets: Twenty Years of Financial History as Seen by
the Man Who Reolutionized the Markets (New York, NY: Wiley).
Ronalds, Nick and Wang Xueqin, 2006, The Dawning of Financial Futures in China,
Futures Industry, November/December.
Ronalds, Nick and Wang Xueqin, 2007, China: Futures Take Dragon Steps, Futures
Industry, September/October.
Ronalds, Nick and Wang Xueqin, 2007, Chinese Commodity Markets: History,
Development and Prospects, in Hilary Till and Joseph Eagleeye (Eds), Intelligent
Commodity Investing: New Strategies and Practical Insights for Informed Decision Making
(London: Risk Books).
Xueqin, Wang, 2008, Research on Options on Commodity Futures (China Financial &
Economic Publishing House).
Xueqin, Wang and Michael Gorham, 2002, The Short, Dramatic History of Futures
Markets in China, Journal of Global Financial Markets, Spring, pp 2028.
Xueqin, Wang and Nick Ronalds, 2005, The Fall and Rise of Chinese Futures 19902005,
Futures Industry, May/June.
437
Index
(page numbers in italic type refer to figures and tables)
A
agriculture:
and farmland as investment, see
farmland
and impact of non-fundamental
information on commodity
markets 79, 8, 9
market participants 24960
commercial traders 24955,
251, 254
commodity index and swap
traders 260
non-commercial traders
2556
proprietary traders: individual
and trading groups
2568
systematic and technical
traders 2589
market strategies in 27992
calendar spreads 2837, 2845,
288
crush spreads 28992, 291
directional 2823
geographical spread arbitrage
2879, 289
options 293
B
Barnett Shale 368
base metals:
exchanges that list 1445, 144
price movement in 6
BATS Exchange 424
BHP Billiton 373
BP 91
Brazil:
and coffee prices 74
growing economic prominence
of 86
as major meat exporter 177
see also BRIC economies
Brent 45, 5, 14, 935, 94, 979
Dated 94, 978
BRIC economies 105
see also oil and petroleum
products: historical price
perspective on
Brookings Institution 245
C
C2 Options Exchange 424
capacity allocation and congestion
management (CACM) 119
CBOT, see Chicago Board of Trade
CFFEX, see China Financial Futures
Exchange
Chvez , Hugo 106
Chevron 83
Chicago Board of Trade (CBOT)
166, 184
Chicago Mercantile Exchange
(CME) 27, 89, 101, 21415,
250, 260
China:
and farmland 2424, 243
futures market of 40937, 411,
440
INDEX
regulation 21520
consumption 21720
regulation 21516
supply and trade 216
terminology and conversion
statistics 2235
and transportation 21113
Comex Copper Exchange 144
commodities index investing
33941
Commodity Futures Trading
Commission (CFTC) 249
commodity markets:
coal 20725, 209, 216, 217, 218,
219, 223
characteristics of 20813, 209,
210, 21011
conversation statistics and
terminology 2235
financial markets for 21415,
215
and fuel-to-power spreads
2201
market structure for 21314
overview 2078
and supply, demand and
regulation 21516, 21520,
216, 21720
terminology and conversion
statistics 2235
and transportation 21113
and energy and commodity
physical and financial
portfolios, enterprise risk
management for, see main
entry
excess capacity enjoyed by 3
farmland 22947; see also
farmland
441
442
nickel 1534
palladium 164
physical factors driving
market in (listed) 148
platinum 163
precious 1457
prices 13944, 139, 140, 141,
142, 143
scrap 138
silver 1612
supply 1368
zinc 1556
North American natural gas
2564, 26, 28, 29, 31, 32, 34,
35, 37, 38, 39, 40, 45, 48, 50,
51, 55; see also natural gas
and coming decade, key issues
for 53
and demand-side dynamics
2836
and futures, price dynamics in
4953
geography of production and
demand 47
measures and conversions,
common units of 26
overview 256
and regasification 58
storage 436, 45, 47, 48
oil and petroleum, history and
fundamentals 75110; see
also oil and petroleum
products
putting momentum into 32535
and better strategy, building
3303
and commodity beta 326
and downside protection
3345
INDEX
443
444
INDEX
industry classification
benchmark 3634
innovative approach 3416
and problem formulation
3424
and SEI performance 34959
and selective portfolios,
statistical properties of
3559, 3567
Energy Information
Administration (EIA) 78
Energy Market Observatory 130
EPEX Spot 119
Essar Oils 99
European Network of
Transmission System
Operators (ENTSO) 130
exchanges:
Australian Stock 424
BATS 424
C2 Options 424
Chicago Mercantile (CME) 27,
89, 101, 21415, 250, 260
China Financial Futures (CFFEX)
416, 418, 426
Comex Copper 144
Dalian Commodity 166, 414, 416,
417, 418, 426
Dubai Mercantile (DME) 27, 99,
100, 146
India Joint Stock 4245
Intercontinental (ICE) 27, 94, 101,
214, 215, 425
London Metal (LME) 144, 145
Minneapolis Grain (MGE) 184
Multi Commodity (MCX) 146
New York Mercantile (Nymex)
27, 68, 69, 70, 71, 146, 299, 346
New York Stock 364
445
446
storage 198
trends and swing factors for
future 2045
Great Britain:
and wholesale power markets,
historical price perspective
1246, 125
Gulf War, first 104, 107
see also oil and petroleum
products: historical price
perspective on
H
Henry Hub 27, 62, 346
high-fructose corn syrup (HFCS)
179
Hubbert, M. King 103, 105, 108, 110
Hurricane Ike 92
Hurricane Katrina 42
Hurricane Rita 42
Hurricane Sandy 76
I
ICE, see IntercontinentalExchange
India:
Jamnagar complex in 99
and LNG imports 60; see also
BRIC economies
meat consumption in 1778
MMT growth of 56
India Joint Stock Exchange 4245
IntercontinentalExchange (ICE) 27,
94, 101, 214, 215, 425
International Financial Reporting
Standards (IFRS) 121
IranIraq war 103, 105
see also oil and petroleum
products: historical price
perspective on
INDEX
447
448
INDEX
449
P
PCA, see principal component
analysis
petroleum and oil products, see oil
and petroleum products
PetroPlus 84, 100
Ponca 91
precious metals 1457
exchanges that list 146
gold among most actively traded
146
gold market an outlier among 6
many trading centres for 146
most actively traded 146
principal component analysis
(PCA), explained 4
Purchasing Managers Index(PMI)4
R
regasification 54, 56, 58, 603
passim, 61
Regulation on Energy Market
Integrity and Transparency
(REMIT) 1301
Renewable Fuel Standard (RFS)
(US) 253
rice, as percentage of worlds
dietary energy 192
risk-off versus risk-on
environments 21, 22, 23
Russia:
becomes largest producer of
crude 101
growing economic prominence
of 86
and LNG capacity 63
and natural-gas pipeline exports,
decline in 63
see also BRIC economies
450
S
Saddam Hussein 104
Saudi Arabia, as swing oil
producer 105
scrap metals 138
see also metals
sentiment:
and commodities 920, 10, 11, 12,
13, 14, 15, 16, 17, 18, 19; see
also commodity markets
see also SG sentiment indicator
SG sentiment indicator, and
commodities 911
shale 3642, 38
Shanghai Futures Exchange
(SHFE) 144, 146, 414, 416,
417, 418, 423, 424, 426
Shanghai Securities Exchange 418
Shenzhen Securities Exchange 418
SHFE, see Shanghai Futures
Exchange
Shuanghui International 205
Singapore Mercantile Exchange 424
Smithfield Foods:
JBS acquires beef business of 200
Shuanghui International
acquires 205
South Korea, MMT growth of 56
Soviet era, and assertion for energy
dominance 103; see also oil
and petroleum products:
historical price perspective
on
spark and dark spreads 121
Spot Energy Index 33764
see also energy indexes: tracking
storage:
forward curves and market
value of 30911, 310
INDEX
451
452
INDEX
Z
ZCE, see Zhengzhou Commodity
Exchange
453