Investment banks are paying more attention to commodities, building up their business to take advantage of the asset class’s growth in volume. Natasha de Teran reports.

Commodities have been the best performing asset class during the past 18 months, volumes are growing incrementally, and they are fast moving out of the preserve of the dedicated specialist.

With corporates increasingly focusing on risk management, the ongoing deregulation of the utilities sector and increased interest from the buy-side, it is unsurprising that investment banks have also woken up and taken interest. Investment banks, many of which had a small presence in individual commodities sectors, are now building up full-service franchises, keen to gain a foothold in the growing market.

New commodities players

Until recently, the investment banking side of the commodities sector was dominated by just two houses, Morgan Stanley and Goldman Sachs. In the past 18 months, however, many others have begun to invest heavily: ABN Amro, UBS Warburg, BNP Paribas, Deutsche Bank and Barclays Capital, to name but a few. The newcomers have been fortunate; their entry into the market coincided with the exit of several energy players that fled the market in more or less robust form following the Enron debacle, leaving expert staff ready for the taking.

Banks have also been able to transfer personnel from more commoditised areas, such as fixed income and foreign exchange. By importing derivative technology from other areas, they have been able to come up with innovative structures and solutions. As a result, commodity-based derivative capabilities within the investment banking community have grown tremendously in the past couple of years.

Fresh approach

Deutsche Bank has been building its commodities franchise since hiring Kerim Derhalli in 2001. Although Deutsche’s commodities business is still young in its current guise, global head of commodities Mr Derhalli does not perceive the group’s youth to be a disadvantage. “We have a strong client focus and because we are younger, I think we are approaching the business with a fresher angle. We have brought in a lot of derivatives expertise from elsewhere in the bank, which has also encouraged intelligent application of derivatives technology and innovation. It is in the more complex areas that we will really stand out,” he says.

Deutsche’s commodities group increased revenues by 30% in 2002. Mr Derhalli expects to see a similar increase in revenues for 2003 and anticipates the business’s volumes will grow by 90%.

At Barclays Capital, Benoit de Vitry, global head of commodities, declines to reveal revenue performance. Although Barclays Capital has been active in the energy and metals business for a long time, it has again only been building up a full-scale and service derivatives commodities group during the past couple of years. “We will continue growing and aim to be comparable to the more established firms in this business,” says Mr de Vitry.

ABN’s strategy, meanwhile, has included transferring its over-the-counter (OTC) commodity derivatives from its futures group into its financial markets division. This, ABN claims, has allowed for full cross-selling of the traditional interest rates and foreign exchange products with commodities. Brian de Clare, global head of commodity derivatives at ABN Amro, says that the result has been a rapid increase in products that involve a structuring component.

Welcome competition

The more established firms appear to be unfazed by the newcomers. Dick Bronks, co-chief operating officer, commodities, at Goldman Sachs, seems to embrace their arrival. “We are happy to see new players debut in this market,” he says. “Not only will the introduction of new players generate additional liquidity, but the more that are involved, the more customer education there will be. It’s terrific to have other people pushing the education process forward. We welcome and need the competition.”

Where the incumbents and newcomers differ is in how and where they situate their commodities businesses. At Goldman Sachs, the business operates separately to the rest of the bank’s groups, and even under a different name: J Aaron. Mr Bronks explains this: “Because we have a much larger team than many of our competitors, we can’t physically locate it alongside other departments. However, we have a good communication culture so this is not a hindrance, and we work closely with other groups when structuring transactions.”

The new arrivals have integrated their teams more fully into the capital markets area. Mr Derhalli defends the move by saying that this allows the team to leverage off the expertise and relationships elsewhere in Deutsche’s global markets group, and also from the bank’s corporate finance and commercial banking relationships. “A big percentage of our revenues comes from cross selling within the bank,” he says.

Mr de Clare believes this trend is important: much of his focus has been on delivering the commodity product suite to the bank’s already established client base, he says.

“ABN has, for example, a strong position in the integrated energy industry and our clients in this field are already transacting deals daily with the financial markets sales group globally,” he says. “This is equally true of the financial institutions group, which has dedicated resources. Leveraging these resources and the distribution network is the key to delivery of a high quality product at a competitive price.”

At Barclays Capital, the commodities business is situated within the bank’s rates group. Mr de Vitry says: “Operating as one team allows us to use the same quantitative analysts and IT groups, and also helps when we are working together on products. It offers huge benefits and economies of scale.”

Benoit de Vitry: challenging established firms

Brian de Clare: cross-selling trend is important

More business available

Although many of the energy and the traditional mining and extracting companies that once dominated the market have since reduced activity, bankers insist there is still plenty of business to be gained. Kevin Rodgers, head of correlation trading, EU power and gas, at Deutsche Bank, says he is witnessing more active commodity price risk management coming through from the industrial groups. “These have traditionally hedged out their foreign exchange and interest rate risk, but been less focused on their commodity risk. It is now an important and growing sector for us,” he says.

Mohan Rajagopal, the New York-based head of commodities trading strategy and product development at Deutsche, points to the energy sector. “There are massive opportunities in this area. The market has recognised that the right purveyors of risk management and risk transfer products are banks, not other energy companies,” he says.

Above all, though, the investor-side of the market has been driving banks’ interest. Hedge funds have long been active speculators in the market but a growing number of traditional money managers are now also delving into the commodities spectrum in a bid to pick up yield.

Mr Derhalli is adamant that commodities have an important part to play in portfolios – a message that investors are increasingly willing to take on board, he says. So much so that many insurance companies and pension funds are now reappraising their traditional asset allocations and including a 10%-15% allocation for commodities. “If you analyse the historical performance of portfolios, including this allocation, you increase returns, reduce volatility and increase Sharpe ratios. Obviously, managers are not seeking to go from a 0% to a 15% allocation immediately, but they are making a start,” says Mr Derhalli.

The figures show that funds have already gone some way in doing so. According to Heather Shemilt, head of commodity index marketing at Goldman Sachs, based in New York, there is now more than $12bn invested in the bank’s benchmark commodities index, the Goldman Sachs Commodity Index (GSCI), and that excludes hedge fund investors.

The growth of traditional investors’ involvement in the market plays to the strength of capital markets professionals, who are able to identify and structure precisely the kind of products these investors need. Mr de Vitry says: “While the traditional hedge fund investors generate flow business, the buy-side requires much more tailor-made products. Real money investors tend to invest in index-type products, while retail and insurance customers tend to look for credit-linked or principal guaranteed notes.”

New indices

To meet the growing demand for such products, Deutsche has developed two new commodities indices: the Deutsche Bank Liquid Commodity Index and the Deutsche Bank Liquid Commodity Index – Mean Reversion. Last month, it launched the first ever note linked to performance: the DBLCI-MR, a seven-year, principal-protected note. Mr Derhalli expects the notes, which can be tailor-made to fit clients’ exact needs, will prove popular with a wide range of investors, particularly private banking clients.

Many investors, however, are still not fluent with the asset class and are also looking for hybrid products – again playing straight to the strength of the all-service banks. Mr Rodgers says there is growing demand for structured notes or structured deposits that are based on commodities mixed in with fixed income and equities. “Combining commodities with other assets with which investors are already familiar is a good way to introduce them to the asset class in general,” he says.


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