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Currencies, Carbons and the CFTC

Shawn Baldwin from CMG dicusses the commodities markets and opportunities

I began my trading career with a research firm that focused on volatility and options data on all of the sundry commodities products complete with stochastics and various other technical data (thus the reason I always have lots of numbers in my writing). I was sent to London in the mid 90’s to grow our business with the derivatives traders at Canary Wharf and Cannon Bridge who used to these tools to determine cheap or richness when constructing and placing trades. To a large degree recent market events are like deja vu for me–it is once again time for commodities to dominate the international trading scene. Two of the most lucrative areas will be Foreign Exchange and Energy trading.

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You can count on commodities becoming increasingly more important as Emerging Markets continue to expand and as institutional investors with higher risk appetites invest in these markets more heavily. This trend will continue as the markets continue to look for a dollar alternative and higher returns.  The growth of commodities is directly tied to the growth of the global marketplace and one of the reasons that the venerable NYSE acquired the LIFFE ( London International Financial Futures Exchange). Recently the Euribor, which is an index comprised of the rate that multiple european banks lend to each other (works very similar to LIBOR) exceeded it’s sibling contract at the CME in volume making one of the clearest technical cases for global expansion that could be made. In terms of commodities overall, derivatives usage on the whole has increased over 30% during the crisis. Having said that, let’s examine where the opportunities will be..

REGULATION/CFTC

Dramatic regulatory changes will have sweeping affects on commodities requiring large capital surplus. New regulation always causes volatility as new rules are established and loopholes are created that traders exploit. During this period of uncertainty many corporate investors will seek to own the physicals as their respective balance sheets are limited.  This will be systemic if position limits are imposed, and this could result in hoarding since the CFTC doesn’t have any jurisdiction in the spot markets. Physicals can be an effective hedge against the inflation of currency or deflation by multinational corporations. Barney Frank will carefully consider and attempt to narrow the definition of who would qualify for the exemption under the term of “legitimate risk management”, this new legislation has been approved by the house financial services committee which forces derivatives into a centralized clearing and exchanges. This proposal excludes non financial companies who use the tools as “legitimate risk management”.

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Non Financial companies such as power (utility companies) and airlines will not be affected initially by these changes because they are exempt. These companies have lobbied long and hard to stay exempt. There is a contingency that wishes to rope them in under the regulatory umbrella although most experts agree that more stringent regulatory rules will most likely create loopholes and effectively cause firms to engage in regulatory arbitrage–which would be anti competitive for the United States. There is also a strong belief that this will increase balance sheet pressure on the corporations due to capital allocation for margin. These actions can increase transaction costs and not substantially reduce risk. A parallel bill crafted by the House comittee must be combined with legislation in the US Senate. The consensus is that the legislation passed by the committee that Barney Frank chair’s is likely to be the final product. Look for additional restriction in energy speculation–Presidential appointee Gary Gensler, the head of the CFTC, has been adamant about reform in response to the mantra of so many of the legislative branch who blamed high prices of oil on speculators.

The US government is seeking to impose trading limits which CFTC commissioner Michael Dunn has lobbied against. Dunn encouraged the US to engage the G20 before creating any measures because it would be anti-competitive to the United States and almost undoubtedly cause regulatory arbitrage since the Financial Services Authority in the UK doesn’t have the same policies as we do in the US. They believe that prices are caused by supply and demand versus capital inflows.

CURRENCIES/FOREIGN EXCHANGE

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 Foreign Exchange is emerging as an asset class and it is currently the world’s largest market with a volume of $3.2 trillion traded daily. Active currency management is a source of investment returns and institutional investors are gravitating to this arena. Watching dollar weakness is sending non-US currencies higher and causing an increase in risk appetite. We saw the dollar fall through $1.50 against the euro for the first time in a year and a half–expect high beta emerging market capital outflows to continue. Austrailia raised their rates 25 bps in a bullish move to respond to the dollar. Similarly, Norway and South Korea raised their rates as well. The looming question on a central banker’s lips is deflation or inflation? Treasury bonds tend to indicate deflation rather than inflation and the fear of rampant inflation due to history buffs and the diligent student of the depression– Ben Bernanke, inflation has been dutifully kept in check. Given the ridiculously low rates that can be forecasted due to these circumstances, the dollar is the currency of choice for tactics that are called “carry” strategies. These trading strategies essentially sell the low yield currency to purchase high yield assets. I know the mantra is that we want to have a strong dollar but the truth of the matter is that with the deflationary pressure in combination with the need to fund the huge deficits–the US is far better served with weaker rates. Please don’t tell President Obama I said that. The last thing that US need is high yields..

Currencies are also being lifted by the bullish sentiment of growth abroad. This will undoubtedly cause more pressure on the already weakened dollar as sophisticated investors invest in riskier currencies with higher potential yields..especially the commodity linked currencies of resource rich countries will be tartgeted. Banks in Japan, China and other regions in the Far East have begun to grow concerned over currencies as the violent fluctuations.Don’t look for that alternative to be the Euro–it’s far too regional and as a testament to it’s unsuitability for the roll think of the last time you heard of oil quoted in Euros..

METALS

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 The single largest beneficiciary of the weakened greenback seems to be Gold as we saw it soar to new highs in early October mainly on investors seeking refuge from the dollar. This high was done on relatively little volume–practically 1/3 the normal volume, since the implosion of Lehman, gold has risen over 40%. The largest factor in this dramatic rise was due to uncertainty on inflation which drives the price of gold up. Not just gold is up however–per Morningstar research, over 12% of precious metal funds are up over 40%. Platinum and Palladium have increased dramatically 38% and 56% respectively. Even Silver has increased over 42%. Both Platinum and Palladium while used as jewelry ( Palladium is used for jewelry in the far east) both have multiple scientific and manufacturing uses. The automobile industry purchases almost 50% of the production for the both of these 2 metals. Even base metals rose as much as 70% due to the cheap dollar making different economies who normally could affordable for global purchases of non-US origin.

OIL/ENERGY TRADING

 Oil prices have been up, as US inventories have pushed prices higher but the real story is in Natural Gas or as we affectionately call it Nat Gas.  Surplus Nat Gas recently reached a high of per BTU’s–oversupply won’t cover overflow storage capacity and if underground storage capacity is exceeded –a price implosion could occur. The estimated capacity of 3,589 billion cubic feet has approximately 10% more capacity before the previously stated price implosion issue would occur. Nat Gas is traded at both the NYMEX and the ICE, both of these areas are being targeted by the regulators for an extension of their oversight. Below average temperatures will increase demand and price. Oil will continued to be driven on demand from China and emerging countries–expect to see $100.00 per barrel again, oil is being depressed by political pressure. Analysts expect China to continue to be the fastest-growing economy in the Far East per the International Monetary Fund which raised its growth forecast for the world’s third-largest economy to 8.5% for this 2009 and 9% for 2010. China has a high demand for oil and it currently holds approximately 1 trillion dollars of US Debt instruments–making them very susceptible to a weak dollar. Sophisticated people see the trade there. 🙂

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Citigroup sold it’s cash cow Phibro to the Occidental Petroleum Corporation or as it’s known on the street: Oxy. The main reason was a guy whose name will sound very familiar –Andrew Hall. Mr. Hall was Phibro’s $100mm man and the subject for ire and angst of many regulators. Since Citigroup is essentially a subsidiary of the U.S. government, the compensation of this unit was subject to the ruminations of his highness Ken Feinberg, the “Pay Tsar”. The main issue was that Mr. Hall had a valid contract and it would have been both unseemly and un-gentlemanly to completely discard  his legal document. Sooo… the unit was sold to Oxy to avoid any embarassing issues and so that Mr. Hall could receive his full pay, Ken Feinberg be damned! There are lots of people who will opine on why this pay package is so unjust. I will not be one of them. The facts are that Phibro generated high profits when other units were down over the past 5 years Phibro has made over $371mm annually and as much as $700mm. Last year Mr. Hall is rumored to have made over $600mm for the organization–I think he is entitled to his cut per the contract both sides signed. Phibro has had a history of high payouts, it’s name was truncated from Phillips Brothers and it is where the superstar, US fleeing, Presidentially pardoned, billionaire trader Mark Rich traded. The firm later changed it’s name to Phibro in 1981, when it bought Salomon for $559m– at which point billionaire New York Mayor Mike Bloomberg left to build his media fortune.

Does anybody know where can I get an application? 

Pictured on the Newedge trading floor in Chicago from left to right:Bill Marcus, Executive Vice President of Newedge, which is one of the largest commodities brokers in the world. NewEdge was created through mergers and acquisitions and has hundreds brokers with operations in Chicago, New York and Paris; James Mitchell, Jr. a Sr. Managing Director of GE Alternative Asset Management a $40B assets under management investment firm and division of General Electric Corporation. GE Asset Management recently made an asset allocation into commodities; Shawn Baldwin of CMG.

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About the author

Shawn D. Baldwin is Chairman of the AIA Group (AIA), an alternative investment and advisory firm based in Chicago

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