Category Archives: commodities

Be careful how you swing that hatchet!

May 21, 2013 – 12:35 pm

Eugene

During last year’s debate about the Volcker Rule, Morgan Stanley commissioned a study by the consulting firm IHS that predicted dire consequences for the U.S. economy. I called the study a hatchet job. My main complaint was that the study made the obviously unreasonable assumption that the bank commodity trading operations would be closed down and not replaced. IHS even excluded the option of having banks sell the operations.

So this story in today’s Financial Times gave me a good chuckle:

US private equity group Riverstone is leading talks on an investment of as much as $1bn in a new commodities investment venture to be run by a former Deutsche Bank executive…

Morgan Stanley is considering a sale or a joint venture for its commodities business… James Gorman, Morgan Stanley’s chief executive, last October said the bank was exploring “all form of structures” for its commodities business.

Glenn Dubin, Paul Tudor Jones and a group of other commodity hedge fund investors last year bought the energy trading business from Louis Dreyfus Group and Highbridge Capital, the hedge fund owned by JPMorgan Chase. The parties later renamed the business Castleton Commodities International.

And so, another industry funded hatchet job on the Dodd-Frank financial reform ages poorly.

By John Parsons | Also posted in Dodd-Frank, hedging, markets, OTC reform | Comments (0)

Backwardation in Gold Prices?

May 2, 2013 – 5:53 am

Izabella Kaminska at FT Alphaville clarifies what’s going on.

By John Parsons | Also posted in dynamic risks, exposure, markets | Comments (0)

Smooth Talk About Gold

April 23, 2013 – 6:52 pm

Bruce Bartlett used his New York Times Economix blog post today to argue that “Gold’s Declining Price Is a Reversion to the Mean”. He buttresses his argument by pointing out that,

In a recent paper, the economists Claude B. Erb and Campbell R. Harvey present strong evidence that the gold market was severely overbought. The increase in gold prices did not represent a change in the trend of inflation. As the chart indicates, even with the sell-off, the price of gold is still high and has a long ways to fall to get back to the “golden constant” that gold-standard advocates cite as proof that the dollar should be pegged to gold.

Bartlett Harvey

Read More »

By John Parsons | Also posted in dynamic risks | Comments (0)

Gold’s Random Walk

April 12, 2013 – 7:47 am

A number of journalists are helping to broadcast Goldman Sachs’ latest prediction for gold prices. Goldman’s press agents planted the story in the Wall Street Journal, the Financial Times and the New York Times, among other places.

This is silly. There’s plenty of scientific evidence that the gold price is a random walk. Here’s an old reference: Eduardo Schwartz’s Presidential Address to the American Finance Association back in 1996. There are older and more recent papers finding the same.

Last week I wrote a post in which I mentioned that the time series of commodity spot prices are often mean reverting. They contain an element of predictability. Gold, however, is the exception. Gold is very, very, very cheap to store. And it is widely held purely as a store of value without any use value. Consequently, the spot price of gold quickly incorporates changing market views about future supply availability and any other fundamentals like those itemized in the Goldman report. For all intents and purposes, a physical investment in gold is a financial security, which means that the spot price is a martingale. The distinction I made in my last post between the spot price series for a commodity and the time series for a specific futures price is a meaningless distinction for gold.

By John Parsons | Also posted in dynamic risks | Comments (0)

Dynamic Hedging or Futile Speculation?

April 3, 2013 – 10:28 am

chesapeake

Chesapeake still thinks it can time the market.

On Tuesday management held its Conference Call to update to investors and stock analysts. Steve Dixon, the acting CEO, said “We’ve also taken advantage of the recent surge in natural gas prices to lock in additional price protection in 2013, and we have begun to hedge natural gas production in 2014 at prices well above $4, a level the market has not seen for some time.”

The company has had problems in the past from its foolish attempts to time natural gas prices. Last time prices were falling and the company took off its hedges. This time prices are rising and its putting on hedges. But the mindset is the same.

Behind this dynamic hedging strategy is a common misunderstanding about mean reversion in natural gas prices. The same misunderstanding applies to other commodities as well.

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By John Parsons | Also posted in dynamic risks, hedging, speculation | Comments (1)

Crude oil basis risk is receding… for now.

January 17, 2013 – 5:59 pm

Companies that hedge oil prices have been forced to reevaluate their strategies over the last couple of years. Many companies have used the NYMEX WTI contract, one of the oldest energy futures contracts and still one of the most liquid. The WTI contract is for oil delivered into Cushing, Oklahoma, but since crude oil is a global commodity and transportation links have historically been good, fluctuations in the WTI price have been a reasonable benchmark for global supply and demand.

However, in the last few years, the differential between WTI and Brent, the other leading global benchmark, have exploded and been very volatile. Suddenly, geography made a great deal of difference. Technology has opened up new production in North America, first from the Canadian oil sands and more recently from US tight oil fields. A bottleneck in the capacity of pipelines for shipping production out of Oklahoma down to the US Gulf Coast meant that the central US experienced a glut of supply, disconnecting the regional price from the global one.

Historical Spreads 2

This has meant that fluctuations in NYMEX’s WTI futures price reflected local variations in demand and supply that did not necessarily track variations in global supply and demand and global crude price. Hedgers not located in the central US faced increasing basis risk in using the WTI contract. Some switched to using the ICE Brent contract instead. Others adjusted their hedge ratios. These events have been a key feature of the recent marketing duels between NYMEX and ICE over which contract is best.

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By John Parsons | Also posted in hedging, markets, packaging risk, volatility | Comments (0)

Futurization wheat and chaff

January 16, 2013 – 7:42 am

classroom

Finally, a journalist has located a real cost of futurization, as opposed to the many imagined ones.

 

By John Parsons | Also posted in Dodd-Frank, financial innovation, OTC reform, regulation | Comments (0)

Is wholesale power trading as profitable a line of business as they say?

January 8, 2013 – 9:05 am

EDF Trading

Gregory Meyer, in today’s Financial Times, reports that banks are scaling back their trading in U.S. wholesale electric power markets. In his companion article, he quotes me saying that

The banks had the balance sheet, but the reality was it was the taxpayers that were giving them the balance sheet. It’s not clear we want the taxpayer subsidising proprietary trading in electricity or even hedging in electricity.

I am very circumspect about whether power trading operations are as profitable as they are often advertised to be. Here’s one reason why.

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By John Parsons | Also posted in financial policy, measuring risk, pricing risk, valuation | Comments (0)

With a hedge, could Conoco have it all?

January 7, 2013 – 2:25 pm

conoco logo

Liam Denning’s Heard on the Street column in this morning’s Wall Street Journal is reliably hard-nosed about budget trade-offs:

Investors want it all—but they should be careful about companies that promise it.

ConocoPhillips is a case in point. … E&P stocks tend to compete on growth, whereas the integrated majors are prized for how much cash they return to shareholders. Conoco offers both. It targets annual production growth of between 3% and 5% a year out to 2016. And it offers a dividend yield of 4.6%, around double the average for its peers.

What’s not to like about that?

…Conoco’s near-term strategy implicitly relies on high oil prices, not merely to provide operating cash flows but also to attract high prices for disposals. The danger is not that Conoco suddenly can’t pay its dividend; indeed, it has prioritized it. Rather, it is that weaker prices or unexpected costs would upset the cash-flow math and force investors to dial back their enhanced expectations–and Conoco’s valuation with them.

Conoco’s exposure to oil prices is a matter of choice, not circumstances. The company does practically no hedging. The company’s stated “policy is to remain exposed to the market price of commodities.” In fact, the company takes this curious commitment so far that “we use swap contracts to convert fixed-price sales contracts which are often requested by natural gas and refined product customers, to floating market prices.”[1]

Conoco has good company as a non-hedger. We’ve written before about the notable fact that ExxonMobil refuses to hedge. But even among smaller E&P firms, roughly 50% of the firms report no hedges at all in any given year.[2]

Perhaps Conoco can afford to remain exposed. Its balance sheet is in very good shape so that it has unused debt capacity which could cover some shortfall. Nevertheless, if exposure to commodity prices were truly a threat to Conoco’s twin goals of investing for growth and paying a reliable dividend, the company could do something about that. But to do so would require giving up its third goal of being fully exposed to oil prices.

Two out of three ain’t bad.

[1] ConocoPhillips Form 10-K for FY2011, p. 74.

[2] Haushalter, G. David, 2000, Financing Policy, Basis Risk and Corporate Hedging: Evidence from Oil and Gas Producers, Journal of Finance 55, 107-152.

By John Parsons & Antonio Mello | Also posted in financial policy, hedging | Comments (0)

Reading the Term Structure

December 10, 2012 – 1:25 pm

Natural gas prices have been rising recently. But I always like to look at the whole term structure of futures prices to get a better sense of what is really going on. My colleagues at CRA, Billy Muttiah and James Dunning, prepared this chart which overlays snapshots of the term structure at the start of the last several months. It tells a simple story.

Natural Gas Futures Prices - 12-05-2012

What’s going on is mostly a story about the long-run. Only a small amount of recent spot price changes are due to short-run factors and changes in the spot vs. futures price. Prices at all maturities have been going up. And the shifts are roughly parallel throughout the term structure.

A quick look like this doesn’t clarify whether it is long-run demand shocks, long-run supply shocks or any number of other combination of factors. But it does focus attention in the right place.

By John Parsons | Also posted in markets, volatility | Comments (0)
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