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Crunch time for commodity managers as fundamentals return
October 15, 2013 / 3:38 PM / in 4 years

Crunch time for commodity managers as fundamentals return

* Greater potential for tactical active management

* Dispersion increasing as risk on/risk off recedes

* Chinese demand growth unlikely to be repeated

By Claire Milhench

LONDON, Oct 15 (Reuters) - This year is likely to be make or break for commodity funds as supply and demand fundamentals gain the upper hand in driving prices following five years of dismal performance determined mainly by economic factors.

The resurgence of fundamentals should, in theory, make it easier for active managers with specialist knowledge and skills to deliver decent returns, but this change may not turn out to be the panacea that they had hoped for.

For Ric Deverell, head of commodities research at Credit Suisse, the problem is that leading commodities buyer China is unlikely to repeat its accelerated growth rates of the 2000s.

“It’s very improbable we’ll see 30 percent export growth again,” Deverell said at the World Commodities Week conference in London last week. “My suspicion is that we’ve already had the rebound.”

Kevin Norrish, head of commodities research at Barclays Capital, said that without the same kind of dramatic growth in Chinese commodity demand, long-only investment returns would continue to be lower than in the last decade.

“You’re unlikely to get very big directional price moves. It will be much more difficult to get a long-only return, and a lot more flexibility will be required,” he warned.

From the collapse of Lehman Brothers in 2008 until this year, commodity markets were buffeted by economic factors such as central bank money printing and fears over a break-up of the euro zone.

This created an environment in which commodity price movements became more correlated to other markets and each other.

Caught out by the risk-on/risk-off trading of generalist investors, active commodity managers performed badly as a group. Investors voted with their feet, leading to some high-profile closures such as Clive Capital.

Active commodity managers have hankered for a return to fundamentals in the hope it would cure all ills.

Research presented at World Commodities Week by Michael Haigh, global head of commodities research at Societe Generale Corporate & Investment Banking, suggests that commodity prices are again being driven more by fundamentals than external factors.

The bank found that 10 years ago fundamentals explained 80 to 90 percent of the movements in Brent crude oil futures prices , and the dollar explained most of the remainder.

The collapse of Lehman in September 2008 changed this. From that point, economic factors explained 60 percent of price movements and fundamentals only 30 to 40 percent.

With the onset of the Libyan civil war in 2012, fundamentals reasserted themselves, and they now explain 73 percent of Brent price movements, according to SocGen’s model.

It’s a similar picture in base metals, where the role of fundamentals diminished post-Lehman for copper and aluminium prices but staged a resurgence in the summer this year. By early October, fundamentals explained 74 percent of copper price movements and 88 percent of aluminium price movements.

“Fundamentals are now driving commodity markets at a level we haven’t seen in five years,” Haigh said.

DISPERSION INCREASES

In addition, commodities are no longer moving together. Dispersion has increased across the complex and within sub-sectors, Haigh said. This should allow manager skill and specialist knowledge to come to the fore.

“De-correlated markets provide greater opportunities for those managers who really know what they’re doing,” said Tim Edwards, director of index investment strategy at S&P Dow Jones Indices.

“Over the past few years it didn’t matter if you knew your market, you needed to have the right opinion on what the U.S. government was going to do or the Fed. When that dynamic ends, there is, at least in theory, a greater potential for tactical active management.”

But managers such as Kurt Billick, chief investment officer of San Francisco-based Bocage Capital, said the opportunities on offer would prove less profitable as the demand shocks driven by the rapid industrialisation of China are over.

“It’s more difficult to make money in bear markets than bull markets, and we’re clearly in a structural bear market for commodities,” he said.

“There is alpha to be generated, but the scale of that alpha will be much smaller,” he added.

Hedge fund managers are supposed to be able to generate returns in a down market by going short, but few have experience in managing commodities under bearish fundamentals for a length of time.

“Most commodity investors who are active today grew up in the bull market of the 2000s; there are very few dinosaurs who date back to the 1990s,” Billick said.

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