Showing posts with label Hedge Funds. Show all posts
Showing posts with label Hedge Funds. Show all posts

Saturday 20 August 2022

Commodities Lectures Series - Commodity Trading Companies vs Investment Banks and hedge funds vs - a new competitor - Commodity Producers

Without price transparency in physical commodities markets with clear and accessible reference commodities prices, physical commodities traders are in a powerful position to profit as they have a virtual information monopoly. Commodities Trading Companies such as Vitol, Trafigura, Glencore, Gunvor, Louis Dreyfus among others trade physical commodities taking advantage of this price opacity, investing in the physical and human capital necessary to transform commodities while simultaneously hedging their physical trades through financial (paper) trading on exchanges thus taking positions in the futures markets and the physical markets. Commodity trading firms do not tend to speculate on the outright direction of commodity prices, but instead aim to profit on the differential between the untransformed and transformed commodity specializing in (1) the production and analysis of information, buyers and sellers active in the market, supply and demand patterns, price structures (over space, time, and form), transformation technologies, and (2) the utilization of this information to optimize transformations in terms of space, time and form. Commodities trading firms attempt to identify the most valuable of these transformations, undertake the transactions necessary to make these transformations and engage in the physical and operational actions necessary to carry them out.

On top of physical trading, Commodity Trading Companies possess prop paper-trading desks. Using market intelligence coming from physical trading desks and ‘classic’ paper trading skills, these companies make profits on swaps, options and futures. They also use these paper trading books to hedge their physical exposure, which subsequently reduce their risk.These companies develop their own strategies and models - quantitative, computer-algorithm-driven or macro-driven similar to the models used in banks or hedge funds for derivatives pricing and market forecasting. They invest in physical commodities fundamental research to get an edge over their competitors and figure out where the market is going. They have on-site associates at origin and destination (offices in exporting and importing countries) to get a flavor of the local market as well as strong middle and back office for physical trading operations. They are highly skilled at managing their risks and know how to create sustainable and win-win relationships with potential buyers and sellers. Due to rising competition and change in business trends, these companies do invest at the source in mines, Exploration and Production (oil), and also transportation infrastructure such as ports. Vitol/Trafigura physically send ships to collect the cargo from the sellers, the miners and the refineries. Some like Glencore own mines (after buying Xstrata). Glencore is now a mining and trading company besides being a Commodities Trading Company. Trafigura is trading with no mining operations. It buys ore, concentrates or even refined outputs, ships them to the buyers. Trafigura model helps even for smaller operations.

Hedge funds on the other hand rarely trade physical form of commodities or take delivery concentrating only on financial or paper trading. Macro-focused hedge funds seek a hedge against an economic slowdown priced in by the market. Unlike many of their equity fund peers, commodities macro managers of the likes of George Soros and Louis Baconare are not dependent on rising markets for their gains. Rather, they look for volatility in commodities markets through 'Asset backed Trading' - a style of commodity trading which is used to seek and exploit market volatility in order to optimise the operational assets, inventory and future produce owned by trading entities. This is their core activity. However more sophisticated funds would also get into taking proprietary positions, market making and offer structured products to their clients. Hedge funds and Investment banks are beginning to exit the financial trading of commodities making daily price swings far greater than in previous years.

Financial trading is becoming an ever more important part of Commodities producers such as International Oil Majors Shell, BP, Total driven by fears that global oil demand could drop in the next few years as climate change concerns reshape society’s—and investors’—attitudes toward fossil fuel producers. The immense scale of the commodities producers' trading units gives them outsize clout. They have massive trading floors that mirror those of Wall Street’s biggest banks. Being a commodities producer gives an inherently bigger advantage with more reliable market information in trading strategy than commodities traders suchas Vitol/Trafigura. This is also the reason why in recent years, Vitol has started looking for refining and storage assets worldwide to control a bigger chunk of the supply chain. BP controls exploration and production as well, so BP obviously has advantage over oil traders who are unable to control costs associated with these projects and an oil company like BP will make more money when the production cost remains stable while prices rise. The problem for a crude oil trader like Vitol is to anticipate the price rise and buy oil from producers at sufficiently lower price to make a profit. Sometimes, the trading strategy for Vitol is so complex that the wafer thin margins made through a trade are actually made through minimizing on transportation costs of the oil instead of the oil price itself. On one occasion in 2016, for example, Shell bought roughly 70% of the cargoes of North Sea crude available for a particular month, triggering wild price gyrations while squeezing out commodities traders who privately complained to Shell. Commodities producers are also moving into the space formerly occupied by the commodities desks of Investment Banks. Shell, for example, in 2016 became the first nonbank to help the Mexican government hedge its exposure to the price of oil. BP's customers now include banks, hedge funds and private equity firms. Exxon is also hiring experienced oil traders to start making bets with the company’s money.

Sunday 28 April 2013

Jim Rogers, famous commodities investors cautions on investing in India and points to upcoming war due to water


UR6ZR6UN9U9W Legendary Quantum Fund manager (along with George Soros) and commodities investor Jim Rogers is short Indian equities and has categorically declared that India while an exciting place to visit is not a place for him to invest in. In an interview with Bloomberg last week, Mr. Rogers proceeded to urge the Indian Government to figure out somehow how to run a country pointing to the non-convertibility of the Indian currency, the Rupee on the international markets. He has also blamed the restrictions on foreign investors as another reason why he feels the Indian government does not know how to run an economy.



As posted in an earlier blog post, this view on the Indian macroeconomic environment is reflected in investors moving their capital out of India and I believe it is only a matter of time before the current bubble in Indian equities which has built up again since the last pop in 2007 will burst again in the near future perhaps quite dramatically. Mr. Rogers also pointed out about the possibility of an upcoming war due to shortages of water resources in India and Pakistan. I have previously blogged about this possibility of a war between India and Pakistan in the near future as well.

Friday 28 March 2008

Survival of the fittest Hedge Funds

In 1859, Charles Darwin introduced his theory on “On the origin of species” through this now famous preamble: “As many more individuals of each species are born than can possibly survive; and as, consequently, there is a frequently recurring struggle for existence, it follows that any being, if it vary however slightly in any manner profitable to itself, under the complex and sometimes varying conditions of life, will have a better chance of surviving, and thus be naturally selected.” The (very non organic) species of the hedge fund industry have been aptly playing out this struggle for existence over the last few months as famous names such as Peloton Partners, Carlyle Fund, Carrington Capital, Amaranth Advisors and the mother load at Bear Stearns end up in the obituaries column of financial journals. The much vaunted “strategy” which typifies the various hedge fund species be it equity long-short, event driven, arbitrage or other clearly needs to evolve to be naturally selected under the current complex and varying conditions of the market. As an example, consider Andrew Lahde’s Lahde Capital Management, a California based hedge fund: by betting against sub prime, his fund returned over 1000% in 2007 to investors. Mr. Lahde is already developing other contrarian strategies to prepare for the market’s next set of probable directions.

On March 18th, Martin Wolf wrote in the Financial Times that collapses are inherent in the hedge fund model because hedge fund managers have thus far been more lucky than skilled. I believe there definitely is a certain percentage of Alpha seeking managers who are indeed truly skilled but a large majority of managers have ignored the lessons of the efficient market hypothesis or unlike my MBA students have skipped class when the classic Black-Sholes option pricing model was being discussed. I have always argued that Alpha is a constantly moving target and seekers of Alpha may want to study Heisenberg’s uncertainty principle which describes how the momentum of an uncertainly moving target may be described more accurately through a probabilistic distribution rather than an assumed intermittent occurrence. This failure of managers to constantly seek a changing alpha which may occasionally have low probability occurrences will result in an extinction of their species.

The fittest species to survive in the hedge fund universe will be those who, as Darwin wrote, “vary however slightly in a manner profitable to itself” or in other words constantly seek Alpha by having an evenly spread probabilistic distribution of returns rather than maximize returns from higher probability events. Indeed this will be the species that will not only survive but also thrive.

Note: I have also published this article on Richard Wilson's hedge fund blog.

Tuesday 25 December 2007

Top 5 places in the world to distribute Hedge Funds and Private Equity in 2008

The ultra rich today may include people as diverse as Russian oligarchs, Arab oil sheiks, American tech moguls, English aristocrats, Chinese manufacturers or Indian software barons. As a group, they form the biggest investors in Hedge Funds and Private Equity after institutional investors. As a group, they also have a deep distaste for the local tax man and like to be close to their money. Small surprise then, financial centers with the friendliest tax regimes and proximity to the ultra rich have emerged as the top places in the world to distribute Hedge Funds and Private Equity. So, what are the best places in the world for Hedge Fund or Private Equity companies to gather assets in 2008?

Dubai, which has now become a byword for fantastic utopian glitz, arrived on the scene of the ultra rich long before the architects at Skidmore, Owings & Merrill designed the now nearing completion Burj Dubai tower with 156 floors. The tower reportedly cost over 20 billion dollars to build and 900 condominiums offered for sale in 2004 at undisclosed (albeit reportedly outrageous) prices sold out in 2 nights, for cash payments. One realtor in Dubai estimates that Russians own half of “The World”, Dubai’s multi-million dollar development of 300 man made islands in the shape of the world. There may be a credit crunch in the western world, but in this gulf oasis of finance, there is quite literally an avalanche of liquidity and all this liquidity swilling around has to be mopped up rather quickly. Mark my words, in 2008, Dubai will emerge as the #1 place in the world where assets for Hedge Funds and Private Equity will be raised.

As the first jurisdiction in the world that allows retail distribution of Hedge Funds for individual retail investors who are able to subscribe to Hedge Funds with a mere US$ 50,000, Hong Kong remains one of my favorite bets for distributing Hedge Funds and Private Equity. Although, over the past 5 years, Singapore has steadily attracted Hedge Funds from Hong Kong through tax incentives and increasingly friendly regulation, Singapore lacks the one ingredient Hong Kong has for distribution success: proximity to and close relationship with the mainland Chinese ultra rich. It may be very likely that the overheated stock markets in Shanghai trading (Yuan denominated) A shares and Hong Kong trading (US$ denominated) H shares, after having returned almost 90% in 2007 will flatten out in 2008. Brokers in Hong Kong who are able to advise their ultra rich clients to book their massive profits and park the proceeds in arguably safer US or European hedge funds will be ideal partners for hedge funds seeking to raise assets. Hong Kong brokers also act as a channel for the excess liquidity spilling over not only from the overheated Chinese economy and Taiwanese speculators but also Japanese funds escaping Japan’s draconian tax regime.

In Europe, Switzerland and Luxembourg will continue to dominate the European Hedge Fund asset gathering scene. Tax dodging European ultra rich have traditionally parked their funds in Switzerland and they are now being joined in droves by the new ultra rich from former Eastern block countries. The ultra rich from the former eastern block (and now mostly EU countries) do not have a wide range of investment choices to choose from in their home countries and certainly not the types that have potentially high returns. In 2007, Luxembourg replaced former Byzantine regulation with new Hedge Fund friendly regulation making it as competitive as Cayman Islands or other distant, difficult to reach Caribbean islands.

New York still wears the crown as the king of Hedge Fund asset gathering in the Americas. New York attracts the top hedge fund strategy talent in the world and is always on the cutting edge of constantly seeking alpha. This is indeed where the money still is but frivolous litigation and regulatory hurdles are beginning to drive business away.

Wishing you a happy holiday season and a prosperous New Year.

- Eric