Long-only commodities funds suffered poor returns in 2012 and investment banks saw their revenues squeezed, but there are still growth opportunities.

The past 18 months have been a torrid time for commodity investors. Many commodities correlated highly to broader market sentiment around the eurozone crisis, impeding the ability to invest on a fundamental basis. Poor returns plus the revival of equity markets from late 2012 onward prompted some institutional investors to rotate out of long-only commodity exposure. One of the largest, the $255bn California Public Employees Retirement System, announced in October 2012 that it had cut 55% of its commodity index allocation.

The key commodity indices ended 2012 at least 5% lower than at the start of the year, and fell by a further 5% in the first half of 2013. William Miller, global head of sales for US commodity trading advisor (CTA) Drury Capital, says the phase of commodities trading purely on eurozone-driven risk-on/risk-off sentiment appears to be easing.

“There is a growing sense that commodity trend pricing is now returning to fundamentals, although daily volatility is still high. Agricultural commodities are mainly back to trading on weather conditions and after the breakdown of gold in April, good physical demand was uncovered from both India and the Middle East,” says Mr Miller.

Cramped activity

The reduction in commodity fund activity has cramped a potential source of revenues for investment banks. Industry data analysis firm Coalition Index estimates that investment bank revenues from commodities were down 54% year on year in the first quarter of 2013, after a fall of almost 24% in 2012.

However, the investor business remains an important part of a commodities offering, because it can help brokers to offset corporate hedging trades. Investment bank Jefferies purchased commodities broker Bache from insurer Prudential in 2011. Bache chief executive Patrice Blanc estimates that about 75% of the firm’s customer base is corporate clients, but Jefferies is looking to build the fund manager client base partly to ensure a balanced book of business.

“Generally for commodity hedge funds and CTAs, the past two years at least have been tough, but there are still many new players. Some funds are disappearing, but the market is still very dynamic, and since Jefferies has institutional clients who are end-investors, we are also looking to help them to discover good new funds and CTAs,” says Mr Blanc.

One of those new funds is Belaco Capital, formed in 2012 by a group of former commodities bankers from Société Générale. The firm has established a long-only fund and a long-short fund. Christophe Cordonnier, a founding partner of the firm, says the negative correlation between commodities and equities at the moment is an opportunity for long-short commodities funds to sell their product as a diversification play.

“New regulations such as Basel III for banks and Solvency II for insurers impose a capital charge for correlation, so the lower overall portfolio correlation that they get from diversifying into commodities should lead to a diminished capital charge,” says Mr Cordonnier.

New business model

Investment bank revenues have been further cramped by the direct clampdown on proprietary trading in the US and Europe, especially through the US Volcker Rule. Brett Tejpaul, head of global commodities and credit distribution at Barclays, says banks that maintained large principal trading activities have the most substantial adjustment to make.

He says Barclays’ business model in commodities was toward the client-driven end of the spectrum, and the bank has moved fast to go further in that direction. Barclays departed from the open-outcry floor of the London Metal Exchange in 2012, and pulled out of a number of businesses that had proved marginal – the Tricorona carbon trading firm, a ship chartering unit and an Australian power trading business.

“The savings from those moves have allowed us to invest more in areas that are valuable to clients. The two themes are the industrialisation of some trading processes – investing in technology to increase the velocity of business – but at the same time co-existing with creativity and bespoke solutions in risk management for clients,” says Mr Tejpaul.

The bank’s precious metals business mixes high technology with some very traditional services. Precious metals have been added to the Barclays Barx electronic trading platform, while in September 2012 the bank built one of the largest bullion vaults in Europe.

“Spot and short-dated precious metals are largely traded electronically, and they are also traded heavily by physical market participants who need storage, so it makes sense to provide both services if you have the right client base,” says George Cultraro, a managing director in the Barclays commodities division.

Another area of increased investment is energy trading, where a single division was replaced in April 2013 with two separate units covering oil (under Mr Cultraro) and natural gas plus power. This reflects the need for dedicated teams to service booming areas such as the North Dakota shale oil industry.

“We can finance a refinery or hedge its oil price exposure out to five years, and we can get comfortable with the credit exposure by collateralising it with oil deliveries, making use of our physical trading capabilities in Houston. That works better than unsecured financing in the new capital regime,” says Mr Cultraro.

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