London, 26 October 2009 - John Kemp is a Reuters columnist. The views expressed are his own
New disaggregated data on traders' commitments from the Commodity Futures Trading Commission (CFTC), with back data published for the first time this week, reveal the increasing dominance of commodity indices and hedge funds in the NYMEX light sweet, oil contract
http://graphics.thomsonreuters.com/ce-insight/CFTC-DISAGGREGATED-WTI.pdf
For the first time, the disaggregated reports replace the old, discredited "commercial" and "non-commercial" categories with a new four-way classification: (a) producers, merchants, processors and users; (b) swapdealers, including index operators; (c) money managers, including trading advisers, pool operators and hedge funds; and (d) other reportable traders not included elsewhere.
The most important changes are to remove swap dealers from the old commercial category, and break out managed funds of various types from the old non-commercial category as a separate class.
The new classification is still not perfect. The Commission continues to allocate all positions held by a trader to a single category (e.g. producer or swap dealer) even when they are held for a variety of purposes (some as hedges, others as speculative positions as part of the proprietary trading book) based on its assessment of the trader's "predominant activity". Nonetheless, the disaggregated data marks a huge improvement, and provides a much more nuanced insight into the market, especially the scale of the index funds and hedge funds.
While the Commission began releasing disaggregated data at the start of September, this is the first time it has published position data on the same basis all the way back to June 2006, covering the years leading up to the vertiginous spike in crude oil prices during H1 2008. Conspiracy theorists who want to blame the spike on the work of "speculators" will be disappointed. There is no "smoking gun" in the back data. But it does confirm the spectacular rise of the swap dealers and other financial participants, and why both the forward curve and price behaviour have altered profoundly in the last five years.
Rise of the Swap Dealers
Swap dealers (a category that includes investment banks using futures and options to hedge OTC deals and commodity index positions they have sold) have more than doubled their (gross) positions from 640,000 contracts (equivalent to 640 million barrels of physical oil) to 1.4 million contracts (equivalent to 1.4 billion barrels).
Swap dealers now account for more than one in every three futures and ( delta-adjusted) options positions on NYMEX (37 percent), up from 28 percent three years ago. Swap dealers have become indispensible providers of liquidity, essential to market functioning.
In fact, the CFTC data on swap dealers' positions understates their importance because it only shows their onexchange futures and options positions. As the Form Y-9C data on Goldman Sachs' and Morgan Stanley's trading books revealed, on-exchange positions were only a small part of their overall trading books at the end of Q2. Off-exchange forward contracts, OTC options and swap positions were much larger and only a portion of that was hedged out onto the exchanges.
Most of the growth in swap dealers' positions has come in the form of increased exposure to time spreads rather than outright longs or shorts. Spread positions have risen more than 1.5 times from 395,000 contracts to 1.051 million contracts, while combined long and short positions have remained broadly unchanged at about a third of this amount (300-400,000 contracts).
Spreads are most closely associated with the growth of commodity indices, exchange-traded funds and other investment strategies, rather than hedging, so the explosive growth in this category is some indication of how rapidly the sector has grown.
The sheer weight of spread positions helps explain why the traditional forward price structure in commodity markets has broken down, with the emergence of large and persistent contangoes in the markets for crude oil and products, 0devastating returns for long-only index investors.
http://graphics.thomsonreuters.com/ce-insight/CHANGING-FORWARD-STRUCTURE.pdf
Financial Players Dominate
By shifting the swap dealers' positions from the old commercial category to the old non-commercial one, then breaking them out, the disaggregated data has revealed just how far the market has become dominated by financial players rather than producers and consumers.
The scale and impact of swap dealers' positions is difficult to exaggerate. Swap dealers now account for many more positions (1.4 million contracts) than "traditional" market users such as producers, users, merchants and processors (822,000 contracts). If we include managed-money funds (604,000 contracts) and other reportable positions (698,000 contracts), then financial players' combined positions (2.7 million contracts) outnumber traditional market users by a ratio of 3:1.
In the traditional characterisation of a commodity futures market, most activity was linked to producer and consumer hedging, with a relatively small amount of speculative activity at the margin to provide liquidity and cover any imbalance between the amount producers wanted to sell forward and consumers wanted to buy.
In developing his theory of "normal backwardation", John Maynard Keynes assumed hedgers (who he thought would be predominantly producers wanting to hold a short position against future sales) would have to pay a "risk premium" to investors (who would have to be mostly long) to give them an incentive to take the price risk. The existence of this premium is crucial to long-run returns on long-only commodity indices.
But this characterisation no longer describes how the market works. It is producer and consumer hedging that now accounts for the marginal impact on the market, and financial positions which dominate. The idea that most positions involve producers and consumers, with speculators simply covering the remaining, narrow gap is not accurate.
Expectations or Fundamentals
Rather than being driven by actual, near-term changes in supply, demand and inventories ("physical fundamentals"), the price of oil and other commodities is increasingly being driven by investors' expectations about changes in availability and prices in the very far future, often over horizons of 5-10 years or more.
During the sharp run up in oil prices in H1 2008, and then again in H2 2009, analysts have been forced to cite the "forward-looking" component of prices and the risk of shortages far in the future to explain why the market rose strongly against a backdrop of ample supplies, insisting it was reflecting fears of shortages far in the future (1-4 years) rather than the present.
Most analysts are reluctant to ditch fundamental analysis in favour of an expectations based approach that treats commodity futures as a financial asset like equities or bonds. But the "financialisation" of commodity markets is increasingly embedded in both forecasts and market behaviour.
With financial players providing 75 percent of the interest, and almost all the liquidity, commodity futures markets are increasingly delinked from the underlying physical, trading more in line with macroeconomic and strategic influences alongside currencies, equities and bonds.
Ends –
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Oil and Gas Hedging: How will it change
Congressional representatives and White House officials have reached agreement on the details of a new law that will impact our nation’s financial system
JUNE 28, 2010
http://www.mercatusenergy.com/blog/bid/42728/Energy-Hedging-in-a-Reformed-Environment/
"Oil and Gas Hedging: How will it change?". In summary, their opinion, as we interpret it, is that oil and gas producers should still be able to engage in hedging "as usual" with a few, potential changes:
- Banks will most likely be forced to conduct commodity, including oil and gas, trading through affiliated entities rather than the bank itself.
- Interest rate and foreign exchange hedges will most likely receive an exemption from the bill and as such, banks will continue to be able to trade OTC interest rate and foreign exchange derivatives as they do today. One unintended consequence of this framework is that producers will, most likely, no longer have the ability to net their commodity, interest rate and FX positions.
- New and/or additional ISDAs will be required.
- Oil & gas producers will probably retain the ability to utilize assets as collateral for hedging.
- Hedging "costs" will increase as bank affiliated commodity trading entities will be required to maintain higher capital levels. In addition, these new entities may be required to clear their trades, which means they will need to post cash collateral, the cost of which will be passed on to their customers.
If you're interested in reading the full version of the "alert" it is available on the Thompson & Knight website.
On Tuesday, Alistair Barr at Marketwatch.com, authored an article titled, "Derivatives group sees $1 trillion regulatory impact." Among other things, the article states:
The International Swaps and Derivatives Association said Tuesday that the bill could lead to a requirement to post collateral for all over-the-counter derivatives that are not cleared, including those involving an end-user.
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