Since the economic decline in 2008, there has been a growing demand of individual and institutional investors to consider various choices of non-correlated investments to reduce tail risk (downside deviation)(i) and correlation risk, often known as alternative investments.
There is a good chance an investor will have stocks and bonds in their portfolio via a 401k, IRA, pension fund or directly into mutual funds. Perhaps they have some real estate either as an investment or the home they live in and maybe some private equity.
In 2008 and 2009, most stocks both domestically and foreign became highly correlated as they headed south and everyone was seeking the exit door simultaneously, thus causing losses to extend as panic selling and the need to liquidate increased.
One of the increasing areas of non-correlation investment is the currency market or sometimes called forex or FX (foreign exchange). In August, 1971 President Nixon removed the U.S. dollar from the gold standard, ending the Bretton Woods agreement and causing currencies to float at market rates. In December 1971, Professor Milton Friedman wrote “The Need for Futures Markets in Currencies”.(ii) May, 1972, the Chicago Mercantile Exchange introduced currency futures.(iii)
Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Always review a complete CTA disclosure document before investing in any Managed Futures program. Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.
Published July 31, 2012 CBOE Futures Exchange “Futures in Volatility” Newsletter By Mark Shore
While analyzing the utility value of the CBOE Volatility Index (VIX) futures® contract relative to the underlying market (S&P 500), a question often arises regarding the correlation of these two instruments. In this article we look at various durations of rolling correlations to determine its utility value.
The “static” correlation of two investment components is often quoted in a correlation matrix table when multiple markets are discussed or if there are only two markets, a single quote.
From January 2004 to June 2012, static correlation of daily VIX end of day data to the S&P 500 is -0.75. However, a static correlation does not always offer a strong profile of correlation. Correlation typically depends on the time duration of a holding period, thus building a profile of that period. One must keep in mind the S&P 500 has a growth component, whereas the VIX is more of a mean reverting market with moments of upward or downward spikes.
Between January 2004 and June 2012, the VIX reached its maximum close of 80.06 on October 27, 2008. It reached a minimum of 9.89 on January 24, 2007. During this period the VIX has averaged 21.08
Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Always review a complete CTA disclosure document before investing in any Managed Futures program. Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.
John Kemp is a Reuters market analyst. The views expressed are his own.
Following recent falls, oil prices are much closer to the industry’s marginal cost, especially in North America, where light sweet crude futures are now valued at only a little over $80 per barrel.
For bullish investors, lower prices promise to provide support by threatening to curb rapid output growth, especially from high-cost tight oil and bitumen projects across the United States and Canada, as well as deepwater exploration, unless the global economy enters another tailspin.
But basing price forecasts on marginal costs is hazardous, as the troubled history of predictions for North American gas prices has shown over the last two years. Henry Hub prices have plunged through a succession of so-called price floors defined by estimates of marginal costs, first at $6 per million British thermal units, then $4, and most recently $2, triggering only very sluggish cutbacks by producers.
Oil prices could suffer the same fate. In the short run, commodity prices often deviate substantially from estimated marginal costs because both production and consumption are semi-fixed (the result of previous investment decisions). In the long run, competitive pressures force convergence, but marginal cost is itself a moving target, shifting as a result of changes in technology and industry structure, which are impossible to foresee with any degree of accuracy so far ahead.
“Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible…. We have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence” John Maynard Keynes wrote in 1936.
“It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain,” Keynes concluded (”The General Theory of Employment, Interest and Money”).
Investors typically fall back on a “convention” of “(taking) the existing situation and (projecting) it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.” This system may not be accurate or even realistic, as Keynes illustrated, but it reduces the enormous amount of uncertainty that would otherwise paralyze all decisions to make long-lived investments.
Pinning Down Costs
It is notoriously difficult to define marginal costs accurately. Estimates vary depending on the time frame used, the costs to be covered, and how marginal production is defined.
In the short-term, producers only need to cover the variable costs directly associated with operations. In the longer term, they also need to cover fixed costs for exploration and development. Estimates of long-run costs are extremely sensitive to assumptions made about the cost of skilled labor, materials and equipment, as well as improvements in technology and efficiency.
Then there is the question of “social costs,” which include a variety of taxes and royalties imposed by host governments, as well as price and revenue targets operated by the leading members of OPEC. Many oil analysts include tax and revenue requirements in their estimate of marginal costs on the grounds that OPEC producers and other states need certain minimum prices and revenues to balance their budgets and avoid social unrest.
But social costs are not really fixed in the medium term. Social spending in petroleum exporting states has always been pro-cyclical. Revenue requirements rise when oil prices are increasing, and tend to fall when oil prices come under pressure. In other words, prices tend to drive budgets, rather than the other way around.
Finally, there is the question of what constitutes marginal production. Analysts typically focus on a narrow definition of oil (including production from conventional wells, fracked wells, offshore resources, ultra-deepwater, bitumen and other heavy oils). But in the long term, anything over five years, the marginal cost of energy is set by a much wider range of technologies, including coal (via coal-to-liquids), natural gas (gas-to-liquids and LNG) and the power generation sector.
Crude oil and the products refined from it (principally gasoline, jet fuel, diesel and residual fuel oil) have a special place in the energy system owing to their exceptionally high energy density, which makes them particularly suitable as transportation fuels. But the technology to convert both natural gas and coal to liquids like gasoline and diesel is well understood and competitive with crude at prices well under $100 per barrel.
Shell has already built one gas-to-liquids plant in Qatar. According to press reports, the company has been studying the potential for a similar one in Louisiana, to turn cheap U.S. natural gas into diesel. Efforts are already underway to increase the direct use of natural gas in the U.S. transportation sector, including using LNG in heavy trucks, public transportation and potentially railway locomotives and ocean-going shipping.
Marginal Cost < $100
It may seem futile to try to identify a long-run marginal cost for oil, given that it does not drive realized prices in the short term, and is too dynamic to forecast five years or more into the future. Nevertheless, to the extent that it is possible to identify a long-term marginal cost, even if it is rather theoretical, it probably lies somewhat below $100 per barrel.
This is lower than estimates published by most oil analysts, which peg marginal cost at $100 or more, based on increasing exploration and production costs for unconventional oil resources, and the increasing revenue requirements of Saudi Arabia and other OPEC producers.
But it is consistent with the known economics of coal and gas to liquids technology, as well as the use of LNG in the transport sector. It is also consistent with the behavior of forward oil prices. Prices for long-dated (Dec 2015) U.S. and Brent crude futures have been stable at $83-106 and $84-109 per barrel respectively since the start of 2010 (Charts 1-2).
Chart 1
Chart 2
Forward prices do not necessarily provide a particularly accurate prediction of where the market will head over the next five years (just ask anyone who bought Dec 2015 natural gas futures at more than $11 per million Btu in 2008 and now finds them valued at less than $5). But they do encapsulate the current state of expectations.
Forward contracts imply that oil prices are expected to drop below $100 per barrel by the middle of the decade. At a first approximation, $90 to $100 appears to be a reasonable expectation for the long-run marginal cost of oil outside North America, and perhaps $85 to $95 in the United States and Canada, based on forward contracts for Dec 2015 and beyond.
Following recent price falls, prices for both U.S. crude and Brent are now close to these implied long run cost-driven levels. Dec 2015 futures contracts are trading close to the bottom of their post-2009 range for both WTI and Brent. Front-month prices have also been driven down close to this level.
Oil bulls will argue that marginal costs put a natural floor under the market at $90 to $100 per barrel for Brent (and a little lower for WTI) and help re-establish the case for taking a positive view for the market in the short to medium term.
Whether it is enough to stabilize the market must remain doubtful. Gas analysts have been waiting for marginal costs to provide some price support without much luck for more than two years. It has taken 18 months to trigger a substantial supply response, and even that may not be enough to clear the glut.
So the fact oil prices are approaching long run marginal costs does not eliminate short-term downside risk. Anyone who thinks prices cannot fall further should review the history of gas predictions. But it might just indicate that most of the downward correction has been completed, with further falls starting to curb supply growth.
By Mark Shore CBOE Futures Exchange “Futures In Volatility” Newsletter May 31, 2012
Many investors are familiar with the CBOE Volatility Index (VIX) that is calculated based on options on the S&P 500 Index option and is an indicator of implied volatility and investor sentiment. But some may not be aware that CBOE Futures Exchange (CFE) lists and trades the VIX futures contract (Ticker symbol: VX).
The popularity of the VX futures contract has grown and the VX futures contract recently experienced its highest trading volume month in March 2012 with 1.96 million contracts traded, which is an 84% increase from a year earlier.
As the popularity of the VX futures contract increases, CFE continues to expand the volatility index franchise to include futures and security futures contracts covering several underlying markets. See the table below for a list of the volatility index futures and security futures that CFE currently offers for trading on its market.
From the retail investor to the institutional investor or money manager such as a Commodity Trading Advisor or hedge fund, there is always the question: “How can an investor utilize these contracts in a portfolio?”
Mark Shore is also an Adjunct Professor at DePaul University’s Kellstadt Graduate School of Business in Chicago where he teaches a managed futures / global macro course and an Adjunct at the New York Institute of Finance. Mark is a contributing writer to Reuters HedgeWorld and the CBOE Futures Exchange.
Past performance is not necessarily indicative of future results. Â There is risk of loss when investing in futures and options. Â Always review a complete CTA disclosure document before investing in any Managed Futures program. Â Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. Â The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.
We find ourselves living in historic times along many fronts.
At a recent campaign event, presidential hopeful Mitt Romney took a hard look at the reality of government debt, noting that the thorny crisis caused by perpetual can kicking will likely be faced by our kids in the near future.
While Mr. Romney is right to address the seriousness of the government debt issue, he may be slightly off on the timing of this trade. While he anticipates the debt crisis to require attention “by our kids,” mathematical logic might indicate the problem could fester in the very near future – potentially in three to five years in the United States, according to some projections. The mathematical logic indicates that the over expansive monetary policy that lead governments to embrace expenditures significantly higher than their revenues is coming to an end. Greece is example A of a society that received a natural margin call. With debt to GDP breaking into triple digits, investors might take note that all governments will likely receive their “margin call” at some point. The question is, when?
Republican Congressman Paul Ryan (Wisconsin) may have corrected Romney’s timing. Speaking on Meet the Press on Sunday, May 20, Representative Ryan called for a potential US debt crisis in two to four years. This coincides with other credible projections. “We could have a debt crisis in (the US in) 2-3 years absent action,” observed David Walker, former US Controller General and head of the Government Accountability Office (GAO). “There is a lot of irony and hypocrisy in Washington’s desire to make sure that JP Morgan has proper risk management practices,” Mr. Walker added, noting a general lack of appropriate risk management in government regarding deficit spending and leverage usage. Mr. Walker has been the early leader in speaking to the mathematical logic of a coming debt crisis, a message that few care to hear.
Making the required difficult and unpopular political decisions required to fix the debt problem will require significant political will. David Gregory of NBC’s Meet The Press noted this in his May 20, 2012 grilling of Republican Congressman Paul Ryan and Democratic Senator Dick Durbin. This is because over-leveraged governments have really two choices, neither of which are positive. In other words, there are no easy answers to the debt problem, only “worse and worser,” as author John Mauldin is so fond to point out the harsh reality.
What is the mathematical and practical logic behind a two to three year debt crisis projection?
Here is the reality, the wakeup call: In the United States, a demographic shift in three to five years is about to strain budgets as the government continues to spend nearly double its revenue. This is well documented in a Bloomberg BusinessWeek article written July 27, 2011. This demographic shift occurs when baby booming seniors retire in historic numbers, straining government benefits. This strain may occur the same time interest rates have risen, as a once infallible fiat currency discovers its fallibility. This strains a budget just when expenditures are running nearly double revenues. That’s the mathematical logic, one potential outcome. But the undeniable truth is that deficit spending such as being exhibited by government would be alarming on any balance sheet, but the fact that it isn’t even being addressed in a serious fashion is troubling, the root cause of the debt crisis.
Consider Greece from the basic perspective of their out of control leverage usage, with government spending well beyond revenues for years. When asked to face the economic problem and address the core structural issues through austerity – the widely unpopular `political choice – politicians prefer to kick the can down the road. The problem Greek political leaders face is they have just discovered the limits of how far the can kicking can last.
Is Greece a “One Off?”
When investors take a pure mathematical look at the structural problems, similar core issues appear in other over-leveraged western societies. Portugal, Spain, Italy, France, to name a few, all have the same structural spending problem, which could come to a head shortly. And from a mathematical perspective similar problems exist with the government who currently holds the reserve currency of choice status. At a basic level an understanding needs to take place that the root of the difficult problem is spending must be cut and revenues need to be increased. This will become a political football, a tug of war of epic proportion.
Will False “Growth” Through Easy Monetary Policy Solve the Problem?
In the past, the easy solution for government has been to stimulate growth through quantitative easing. Such tactics of “adding liquidity” typically work well early in a debt cycle but have less impact the more they are used. An example of this in the US can be found by examining the significant impact of an easy monetary policy during the 1980s and contrasting this to the relatively diminishing return on “growth” that today’s quantitative easing has on the economy. If one were a trader looking at the debt crisis they might conclude the significant risk of adding leverage to the government debt trade might not be worth the diminishing reward.
The key for investors is to recognize that the market environment to which western economies are headed may require difficult political solutions, which will not be easily solved without volatility. This could lead to a very different economic environment to which investors should be prepared to defend against. Economic environments that perhaps could be punctuated with bouts of volatility with strong market price trends emerging both positive and negative.
Mark Melin will be speaking on a panel at HedgeWorld June 6 @ 1:30 regarding MF Global. Click here for the agenda.
About the Author: Mark Melin is host of the internet video show Uncorrelated Investing and editor of Opalesque Futures Intelligence, a newsletter written for professional investors that covers investments in the futures and options industry. A futures industry practitioner and consultant, Mark has taught managed futures as an adjunct instructor at Northwestern University / Chicago and has written or edited three books, including High Performance Managed Futures (Wiley 2010) and The Chicago Board of Trade’s Handbook of Futures and Options (McGraw-Hill 2008). Mark has worked as a consultant to the Chicago Board of Trade and OneChicago, the single stock futures exchange. He was director of the managed futures division at Alaron Trading until they were acquired by Peregrine Financial Group in 2009. Mark worked with Peregrine Financial Group until 2011.
Risk Disclosure: This article is intended for educational and informational purposes. Past performance is not always indicative of future results. There is risk of loss when investing in futures and options. Managed futures investing can involve volatility and may not be appropriate for all investors. The opinions expressed are solely those of the author, they are not appropriate for all investors and may not have considered all risk factors.
Reuters’ Elizabeth Koraca speaks with Jim Rogers, chief executive of Rogers Holdings, about regulating banks, why he’s not buying gold and why he’s short stocks.
“Listen, most of the management at JPMorgan, including the chairman, has no clue what’s going on in their back offices,” Rogers says. “All these guys are sitting there doing their thing. Do you think Jamie Dimon understands what’s happening in his offices? No, of course not.”
John Kemp is a Reuters market analyst. The views expressed are his own.
Major swap dealing banks and associations representing the financial services industry have been engaging intensively with the U.S. Commodity Futures Trading Commission (CFTC) over the last two years to shape the myriad new rules the commission has been crafting to implement the 2010 Dodd-Frank Act.
Since 2010, the CFTC has published a brief summary of all meetings between outside organizations and commissioners or staff about the implementation of Dodd-Frank regulations, in a bid to improve the transparency of the rulemaking process. The records provide only very limited information about the participants at each meeting and the topic(s) discussed. But they do provide some indication of the intensity and focus of interactions between industry and the commissioners.
The table below summarizes meetings between each of the five commissioners and the major banks and financial services lobbying organizations since the start of 2012, compiled from records published on the commission’s web site:
It overstates the total number of meetings since some are counted more than once, when a commissioner met more than one bank or organization at the same time.
For example, on March 13, CFTC records show Commissioner Scott O’Malia held a single meeting attended by representatives from Credit Suisse, Goldman Sachs, JPMorgan and Barclays as well as Newedge and Professor Ron Filler from New York Law School, to discuss “general” rulemaking.
Nevertheless, a broad pattern emerges of engagement between the industry and different commissioners since the start of the year.
The records show a much higher level of interaction (measured by phone calls and meetings) with O’Malia (a strong advocate for rigorous cost-benefit analysis) and the newest commissioner Mark Wetjen (who was only sworn in last October and is seen as a possible swing voter) than any of the three others.
John Kemp is a Reuters columnist. The opinions expressed are his own.
Bullish investors finally abandoned hope for a recovery in oil prices, at least in the short term, in the week ending May 8, slashing their long positions in WTI-linked futures and options by the largest amount in more than five years.
Hedge funds and other money managers reduced their long position in U.S. crude by the equivalent of nearly 54 million barrels of oil, the largest one-week decline since at least June 2006, according to data released by the U.S. Commodity Futures Trading Commission (CFTC) on Friday [May 11].
The long liquidation was three times greater than in the “flash crash,” almost exactly a year ago on May 5, 2011, when speculative longs were cut by a little under 19 million barrels.
Tumbling prices drew some fresh interest from speculators on the short side. Money managers boosted their short positions in WTI-linked contracts from 48 million barrels to 75 million, the highest level recorded for seven months.
The ratio of hedge fund long to short positions halved from 6.2:1 to just 3.2:1, the lowest since October 2011, and far below the recent peak of 11.8, back at the height of the oil price spike in February.
Net long positions held by hedge funds and other money managers have fallen from 304 million barrels on Feb. 28 to just 169 million barrels on May 8. The net long position has fallen to seven-month lows, reversing all the build up in speculative length since October last year.
Curiouser and curiouser
Long liquidation by the hedge funds and commodity trading advisers (CTAs) will grab the limelight, but the other side of those position changes is just as interesting.
Part of the adjustment came about from a fall in the massive net short position run by banks and other swap dealers, which was down by 27 million barrels. Another chunk came from a drop in reported producer/processor/merchant/user net short positions, down 15 million barrels.
But a big and unexplained chunk was simply transferred to the mysterious “other reportables” category. Net long positions held by other reportables rose just over 27 million barrels to a record 171 million barrels. Other reportables boosted their long positions by 11 million barrels and cut shorts by 16 million barrels. Other reportables now have larger gross long and short positions, and a larger net position, in the market than hedge funds, CTAs and other classified as money managers.
The overwhelming bulk of other reportables’ positions are held in the main NYMEX light sweet crude oil futures and options contracts, or in NYMEX calendar swaps, with a few more in average pricing options, with minimal holdings in European-style options and financial settled contracts.
The category is the fastest-growing participant in the WTI futures and options market, according to CFTC data, but almost nothing is known about the traders in this segment. The CFTC defines them simply as “every other reportable trader that is not placed into one of the other three categories is placed into the other reportables category,” which is not terribly helpful.
Repeated requests to the Commission’s staff to explain what sort of firms are classified under this heading, whether the classification has changed, or if the rise in other reportables’ position is due to organic growth, have failed to elicit any response.
What is clear is that other reportables have become crucial liquidity providers. Their willingness to take the other side of hedge fund/CTA positions helps explain why prices have moved so smoothly in recent months, despite the hefty accumulation and then liquidation of hedge fund holdings.
It goes some way towards explaining why the much larger long liquidation seen in the past fortnight has not generated the same flash crash as the much smaller liquidation in May 2011.
Market participants should press the CFTC for a more satisfactory explanation of the sort of firms being classified under this heading, which has become an expanding “black hole” in the commitments of traders report.
Behavioral trading rises
The cyclical accumulation and then liquidation of hedge fund long positions over the last seven months shows the increasing role of behavioral trading in the oil market.
While fundamental traders take a position based on their own evaluation of supply, demand, inventories and spare capacity, behavioral traders are more interested in the views of other market participants. Behavioral traders are anxious to spot and join the big waves of enthusiasm and repudiation that sweep across markets.
Most behavioral trade is grounded in fundamentals, at least at first, but the accumulation and liquidation of positions then takes on a life of its own as the market constructs its own narrative.
Something similar appears to have happened with crude oil over the past six months.
The threat of sanctions on Iranian oil exports, rising tensions between the western powers and Tehran, coupled with a string of supply outages from South Sudan and Yemen to the North Sea, was enough to prompt hedge funds to assemble a near-record long position.
Initial positions may have been established by fundamentals and the smart inside money, but once the trend was underway, the rally seems to have drawn in large amounts of behavioral trend-chasers.
Once the market had peaked, however, it is this behavioral money that has headed for the exits, slowly at first, but gradually accelerating.
This sort of liquidation (where slow selling at first triggers an avalanche of later sales) is characteristic of asset markets with strong behavioral or bubble characteristics.
Liquidation during the last fortnight is hard to square with any other explanation. Most of the bearish factors weighing on oil prices (rising Saudi output, swelling crude inventories, de-escalating tensions with Iran, signs of slowing growth in China and the eurozone, and a stalling labor market recovery in the United States) have actually been evident for some weeks, if not a month or more.
Nothing changed in the fundamentals in the week ending May 8 that could explain the huge liquidation of hedge fund long positions. Instead it appears to have been driven by the accumulation of selling itself, and the steady retreat in prices, that eventually convinced many fund managers that this time there would be no bounce back, and the uptrend was well and truly broken for now.
Commodity Customer Coalition co-founder and Typhon Capital CEO James Koutoulas talks with Capital Account’s Lauren Lyster about Rep. Michael Grimm’s campaign to get the Justice Department to appoint an independent counsel to investigate criminal wrongdoing surrounding the collapse of MF Global.
CNBC’s Kate Kelly reports on the details of legendary energy trader and billionaire hedge fund manager John Arnold choosing to retire and dedicate himself to philanthropy.
“This is a remarkable move considering that the man is only in his late 30s,” Kelly says.
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