However, while many of the larger, more traditional players are taking smaller positions, the volatility in commodities has brought to the market a slew of new entrants attracted by the opportunities presented, and creating a pressing and increased need for hedging instruments.

Smaller positions and new entrants

According to Oscar Bleetstein, head of commodity investor sales for the Americas at Credit Suisse, macro-economic uncertainty and "fat tail risk" has caused many commodity hedge funds to reduce the size of their OTC energy positions. “We are seeing the over the counter volume come off a little bit because people don’t want to take more than a certain defined amount of risk on their portfolio,” says Bleetstein, who works with large institutional clients.

On the other hand, volatility is attracting new funds and market-making firms. “Hedge funds that traditionally didn’t look at commodities are now looking at them because of those moves. When you have no interest rate movement and sugar moving 45% over a three-month period, that is going to attract market participants,” says Richard Giles, head of energy and commodities in North America for the GFI Group.

While there had been a summer malaise in commodities prices and volumes, the downgrade of the US credit rating from AAA to AA+ by Standard & Poor’s many expect will lead to downward pressure on the US Dollar, and continued volatility in equity prices.

All that glitters

Meanwhile, the subsequent interest in commodity derivatives will be focused on one commodity: gold. Prices and trading volume in precious metals, especially gold, head higher as investors scurry for cover in the wake of the US credit downgrade by ratings agency Standard & Poor’s. “The US dollar will be the biggest casualty of the downgrade, and lower dollar values drive commodity prices higher,” says Walt Zimmerman, president of United I-CAP.

Just over two years ago, gold was $1,300 an ounce. Now, it is over $1,700. No precious metal benefits more from bad news than gold. Propelled by professional buyers, like central banks, gold has risen to all-time highs, with some predicting much more to come. Kevin Grady, senior metals trader for MF Global at the Chicago Mercantile Exchange in New York, told FOW he anticipates gold could reach $2,000 an ounce by the end of the year.

“Everything I see happening in Europe and in the United States lends itself to a long term play in gold. Every short of gold as we speak right now, is a bad short. There is real buying underneath the market and the sell-offs in the last couple of months have been met with a tremendous amount of buying and very quick rallies right back. People keep saying there are going to be pullbacks, but the pullbacks are becoming less and less,” he says.

Much of the ‘real buying’ is being attributed to central banks, with many countries currently trying to offset their US Dollar risk by buying gold. Only recently, Thailand and South Korea reportedly purchased 300,000 and 500,000 ounces of gold respectively.

Professional buying by managed funds has also played a role in the price hike. “I think a lot of the movement in gold has been due to professional buying as fund managers want to be able to show progress when they compare themselves to a benchmark. So in order to keep performance optimum, they are buying commodities that are performing and with the need for economic stimulus on two continents, gold is seen as the better haven for precious metals,” says George Gero, vice president of global futures at RBC Capital Markets.

Separately, prices and volumes in industrial metals have not bounced back as well as precious metals. Nevertheless, analysts expect demand will rise, especially assuming China eases its monetary policy in response to the slow-down in Europe and the US, which will lead to increased imports of industrial metals. “While we have tremendous volatility, if you look at a long term chart on energy and all metals, there have not been any downs of any consequence that don’t bounce back,” says Gero.

Harry Tchilinguirian, head of commodity markets strategy at BNP Paribas, says oil and industrial metals prices are sensitive to supply side factors, such as low production levels. “In the case of oil, it is not just a volume gap in the market, it is a quality gap. In the case of copper, the US does not have the same discoveries it did in the past as well as there being issues of the quality of the ore that is extracted.”

Strategies and hedging

While traditional commodity derivatives investors have reduced their positions, most of the large long-term portfolio players remain invested, says Bleetstein. “While we see these investors are typically under allocated, we are not seeing them exit the asset class. We're seeing them demand more sophisticated products. To a large extent, commercial hedgers are looking at OTC options as opposed to outright positions.”

The last few months has seen a surge of interest in risk management for commodities exposure. A trend that many believe will continue. Giles at GFI Group says: “From what we see, producers are hedging in the normal way, which is through options. With the volatile markets, it is a real pressing issue. They have to hedge the price they are producing by and the price that they are selling by.”

Gero from RBC agrees. “I believe portfolio managers are hedging more than they ever have before. Silver and gold have had tremendous options activity in the past year.” According to Gero, RBC has also seen increased options and futures used against the ETFs. Those invested in gold and silver via ETFs, have to pay in full or be on 50% margin, so tax-advantaged ETF buyers like pension funds are not permitted to use the futures market, thereby leading to even more reason for investors to hedge their risk using options.

“With gold ETFs not taxed as long and short commodity trades or long and short security trades, people opt to buy them in tax advantaged accounts which cannot be on margin. As a result, since we raised margins on Comex to about $6,700 for a futures contract on gold and $10,200 for a futures contract on silver, people are using more and more options derivatives,” says Gero.

Inherent volatility

Volatility is inherent in commodities markets, specifically because they do not have the same depth as fixed income or foreign exchange markets - as such, there are less players in the market. As a result, when investors seek to hedge against price exposure, they have to be aware that because of lower liquidity they can experience wider bid offer spreads which lead to higher volatility.

“A lot of companies have put risk management products in place on their commodities. They clearly expect the volatility to persist and are using a lot of different hedging structures,” says Tchilinguirian from BNP Paribas.

When hedging, according to Tchilinguirian, it is important not to assume that everyone is operating in the same way given a level of price volatility. “There are a number of alternatives offered to companies depending on their risk profile, according to their credit worthiness, so hedging activity cannot have influence in terms of trading volume on the futures markets.

“We are seeing people buy puts to protect against the down side, buy calls to protect against the upside, and a combination thereof, with one providing the finance to purchase the other,” says Tchilinguirian.

Where to look for opportunity

Earlier in the year, falling prices and growing concerns of subdued global economic growth had some concerned that the commodities bull-run was losing steam with prices and volumes taking a dive. Some of the hardest hit commodities were cotton (down 25%) and coffee (down 22%) for the second quarter. July, however, turned into a positive month, with gains in wheat as hot weather damaged US crops and gold reached a record $1,638 an ounce.

Overall, industry and sector strategists agree that the continuing influence of China on the demand for global commodities and its substantial growth, means the commodities bull run is unlikely to end any time soon – debt crisis or no debt crisis.

“The figures coming out of China are still very strong. Its industrial output advanced 15% in June, the biggest increase since May 2010. No-one can underestimate how important china is in the global commodity business of demand, so as long as that demand is there, it is too early to talk about that bull run coming to an end,” says Giles, at GFI.

According to Bleetstein at Credit Suisse, expect to see many more large institutional investors reaching out for long/short hedge fund commodity strategies. A good example of this is CS Movers, which goes long commodities that have been trending higher and shorts commodities that have trended lower. “Coupling these types of strategies with a more traditional long only approach can protect investors on the way down while potentially offering them leverage on the way up,” says Bleetstein.

Sector wise, the biggest mover in commodity markets has been sugar, up some 33% since May. If measured from the low of the quarter to the high of the quarter, its price travelled a range of some 45% overall. Volatility plays are the order of the day, according to analysts.

Separately, the energy sector is typically known to rally from July into late October. After its usual pullback from spring to summer, Zimmerman from United ICAP believes there is no reason not to expect the same to happen this year. “This year’s hiatus came a little later than usual and is lasting a little longer, but expect to see new highs for the year in the next few months.”

According to Gero, more profits will be found not just in gold, but silver also, which he says is a bridge between investment and industrial demand. “Typically, gold can perform in a bleak investment outlook because interest rates stay down, however silver prices will stay down.”

Nevertheless Gero believes there is opportunity as silver as gold goes higher and some industries are simply unable to justify the cost. “I ask whether the jewellery industry will take silver instead of gold, which now has sticker shock. The price is silver is more attractive. The price of silver will be around $45 compared to $1,600 for gold.”

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