Transcript [Presentation Subject]

Commodity Derivatives Desk, London
April 2007
Strictly Private and Confidential
Why the interest ?
 Strategic rationale
 Return - Historical absolute returns on commodity indices are higher than government bonds, credit and
comparable with those of equity markets
 Diversification - Returns generally have negative correlation with equities
 Insurance - Commodity exposure has historically provided a good hedge against Geopolitical risk and
inflation surprises
 Tactical Rationale
 Global growth
 China and India industrial growth
 USD weakness
2
[Section Title]
Strategic Rationale
Historical Returns higher than bonds and similar to
equities
Geopolitical Risk
–
Equities have posted negative returns in 9 of the past 35 calendar
years. Commodities have posted positive returns in 8 of those down
years, as oil shocks have tended to precipitate most bear markets
(1973/74, 1990, 2000 & 2002)
Inflation surprise
–
Commodity indices are positively correlated with inflation surprises. A broad
commodity index has generated positive returns in all six years when inflation has
surprised to the upside since 1990
100%
80%
60%
60%
3%
20%
GSCI return
Inflation surprise
40%
40%
2%
0%
20%
1%
0%
0%
-20%
-40%
GSCI ®
S&P500
-60%
70
-20%
-1%
-40%
-2%
-60%
-3%
90
3
92
94
96
98
00
02
04
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
04
Tactical Rationale
Chinese commodity use as % of world consumption
Global growth and USD weakness
▲ China accounts for only 10% of global GDP but a much larger
share of demand for certain commodities
▲ Industrial metals: 10%-20%
▲ Bulk commodities: 20%-30%
▲ Industrial metals have exhibited the strongest and most
consistent correlation with the global business cycle
▲ Chinese demand growth is also more rapid than other
countries’
▲ Metals’ cyclicality is even stronger than equities’
▲ Energy prices also exhibit some cyclicality, but are strongly
influenced by geopolitics
▲ Commodities are generally denominated in USD. A USD
depreciation makes commodities cheaper for non US based
investors/consumers and should attract more demand.
Therefore commodities tend to be negatively correlated with
the USD. Gold in particular has a strong negative correlation
with the USD
4
[Section Title]
Specific market drivers: Energy
Oil Demand
Oil Supply
 Macro Economy

– Sectoral trends – are growth sector energy
intensive?
– Power generation trends – what kind of fuel does
new generation use?
– Transportation trends – number and type of cars
sold?
– Tax and subsidy regimes – distort price signals to
consumers and affect their consumption behavior
 Weather, seasonality – winter heating demand,
summer cooling demand, holidays, vacation and
travel trends
Upstream investment – capacity
additions? Cost? Location? Type
of crude?
Oil Inventories

Level relative to demand

Natural decline rates – Field age,
field maintenance, geological
makeup
Level relative to long term
trend and normal
seasonality

Regional distribution

Geopolitics

Levels at transit points

Field maintenance, unplanned
outages

Crude versus refined
product levels

Weather (e.g. hurricanes)

OPEC decisions and politics –
internal politics, spare capacity,
relationships with consumer
countries

 Non-oil fuel markets, substitution (e.g. gas, coal,
hydro, nuclear)
Oil Refining

Refinery
capacity/investment

Planned outages,
unplanned outages

Refining economics, run
rates

Refined product yields
 Misc. events – e.g. SARS, Sep. 11
Distribution
Other

 Deals associated with mergers/ acquisitions
 Speculative flows
5
[Section Title]
Seaborne disruptions – weather,
traffic, accidents

Tanker supply/demand/rates

Port capacity, availability

Pipeline capacity/nominations
Biggest Producers and world reserves
– The world’s biggest producers are not necessarily the same as the world’s biggest exporters. For example, the US and China produce a lot
of oil, but export very little given high domestic demand
– OPEC members Saudi Arabia and Iran are the world’s biggest exporters of crude oil
– The Middle East has by far the biggest reserves of crude
Proved oil reserves, end 2003. Source: BP Statistical Handbook
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[Section Title]
So what happened to oil over the past few years
– Tight refining capacity in a strong oil demand environment tops the list of supportive fundamentals
– Infrastructural and distributional constraints also feature prominently
– Speculative investment in energy magnified prices moves
– Potential geopolitical supply-side risks generated market ‘noise’ – Iraq, Venezuela, Nigeria, Lebanon
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[Section Title]
Specific market drivers: Base metals
Economic Growth



Base metals are primarily used in industrial
applications. Consequently prices are
intrinsically linked with economic growth and
particularly with the global business cycle
Prices are cyclical and are sometimes used
as indicators of economic direction
Metal prices tend to rise in line with tightening
monetary policy
USD Strength/Weakness



Most base metals are traded and priced in
USD
A strong USD is beneficial to commodity
producers in weaker currency regions as cost
of production is in local currency and
commodity product revenues are in USD
Metal prices tend to perform better in a weak
USD environment
Do Metal Prices correlate with US Interest Rates?
3,800
[Section Title]
8
US Fed rates
6
2,800
4
1,800
2
800
0
Jan-00
Jun-01
Oct-02
Feb-04
Jul-05
Nov-06
Commodity Prices in USD and EUR terms
310%
LMEX Index
260%
LMEX in EUR
210%
160%
110%
60%
Jan-00
8
LMEX index
Jun-01
Oct-02
Feb-04
Jul-05
Nov-06
Base metals inventories
Prices track inventory levels



9
Base metals are held in LME-approved warehouses
around the world in order to fulfil physical contracts
Deliveries that do take place (i.e. LME contracts that
are not financially settled) reflect the physical market
supply and demand. Investors watch inventories as a
barometer for real demand
High overall inventory levels tend to restrict upward
price action

LME warehouse inventories are not the sole barometer
by which industry stock levels are monitored. Both
Comex and the Shanghai Metal Exchange regularly
publish their inventories held in their warehouses

Beside the LME warehousing system various industry
organisation publish monthly non-exchange metal
inventories

Reported stock: consumption ratios (measured in
days/weeks) are a good measure of appropriate
industry inventory levels. This is by no means a perfect
measure as there are significant quantities of metal
that are warehouse and unreported

Copper cash price and Copper LME warehouse stocks (‘000)
Improvements in Copper and Aluminium inventory
levels and the anticipation of new supply/smelter
capacity coming on-stream pose risks to current price
levels
[Section Title]
11,000
Copper LME warehouse stocks
Copper cash price
830
9,000
630
7,000
430
5,000
230
3,000
30
1,000
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
Jan-05
Aluminium cash price and Aluminium LME warehouse stocks
3,000
2,500
Aluminium LME warehouse stocks
Aluminium cash price
2,000
3,500
3,000
2,500
1,500
2,000
1,000
500
1,500
0
1,000
Jan-90
Jan-93
Jan-96
Jan-99
Jan-02
Jan-05
Specific market drivers: Gold
Supply
–
Mine output and scrap were the predominant sources of
supply historically

–

10
–
Majority of output comes from South Africa, North
America, Australia and China
Hedging / De-Hedging

–
Demand
Gold producers have been reducing their hedge
books significantly in the past years driven by
industry consolidation and a lower contango
(determined by the difference between gold lease
rates and LIBOR) which made forward selling less
attractive
Producer hedging traditionally was an accelerated
source of metal into the spot market, but now
producer hedge reductions have added to demand
for gold
Central Banks

Central banks sell from or lend reserves as part of
portfolio management

15 Central Banks are signatories to the 2004 Gold
Agreement which limits annual sales to 500 tonnes
and total sales to 2,500 tonnes in the 5 years to
Sep-09
[Section Title]
–
Fabrication demand

Carat jewellery is dominated by India while Italy is
a major manufacturer that sells finished goods to
other Western countries

Other fabrication (dentistry, electronics)

Gold Bar Hoarding and gold coin sales
Investor demand

Gold has traditionally been viewed as a “safe
haven” asset

Recent turmoil in financial markets, weakening
global economies, and geopolitical developments
have turned investor interest back to gold
Backwardation and contango
Backwardation, contango and roll yiel
– The slope of the futures/forward curve indicates
the state of available, deliverable inventory
relative to market demand
– Commodities in tight supply are typically
backwardated: short-dated futures prices are
higher than longer-dated ones
– Commodities with abundant supply are typically
in contango: short-dated futures prices are lower
than longer-dated ones. Precious metals are
usually in contango because of the significant
stocks available and therefore the low metal
lease rates
– To maintain a long positions in commodity
futures necessitates replacing maturing futures
contracts with longer dated futures. For a
commodity market in backwardation the investor
will benefit by replacing expensive futures with
cheaper futures and thereby lower their entry
cost and generate additional return from this roll
– “roll return”. For market in contango this may
represent a drag on the return.
Backwardation: Positive roll return
Price
Maturity
Contango: Negative roll return
Price
Maturity
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[Section Title]
Current contango and backwardation in metals and energy
Contango and Backwardation
–
–
–
Forward Curve of Energy and and Precious Metals
The commodities that are most in backwardation are:

Copper

Nickel

Ally
The commodities that are most in contango are:

Gold

Silver

Platinum (until a few weeks ago the curve was in
backwardation)

Palladium
130%
120%
110%
100%
90%
80%
70%
60%
WTI
Natural gas
XAG
XPD
Brent
XAU
XPT
Oct-06 Apr-07 Nov-07 Jun-08 Dec-08 Jul-09 Jan-10
A bullish structure on a commodity in backwardation
will generally be cheaper than on a commodity in
contango
Aluminium cash price and Aluminium LME warehouse stocks
110%
100%
90%
80%
70%
Copper
Zinc
Nickel
Aluminium
Tin
Lead
60%
Oct-06 Apr-07 Nov-07 Jun-08 Dec-08 Jul-09 Jan-10
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[Section Title]
Current volatilities in metals and energy
Volatility:
–
–
Commodity volatilities are generally higher than currency
or interest rate volatilities. This is because:
Volatility Curve of Energy and and Precious Metals
100%

Commodities are not as liquid as other assets

80%
Commodities can be subject to significant upside
squeezes due to underlying physical constraints
60%

Physical supply of the commodity can be disrupted
(e.g. Hurricanes)
The choice of structure may depend upon the level of
volatility – e.g. adding KO features allows one to benefit
from the typically high levels of volatility in energy products
XAU
XPT
Nat Gas
Brent
XAG
XPD
WTI
40%
20%
0%
Oct-06
Feb-08
Jul-09
Aluminium cash price and Aluminium LME warehouse stocks
35%
30%
25%
20%
15%
10%
5%
0%
Copper
Aluminium
Zinc
Nickel
Lead
Tin
Oct-06 Apr-07 Nov-07 Jun-08 Dec-08 Jul-09 Jan-10
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[Section Title]
Correlation
–
–
Correlation among the commodities has a direct impact on the price of multi-asset products
Unsurprisingly, commodities from the same sub-sector have a generally higher correlation (i.e. a precious metal
generally has a higher correlation with another precious metal than with another energy product)
Base Metals
AL
AL
Energy
CU
NI
PB
SN
ZN
XAU
XPD
XPT
XAG
Brent
WTI
NG1
70%
60%
45%
45%
50%
30%
30%
35%
40%
15%
20%
25%
55%
65%
50%
40%
35%
35%
75%
55%
65%
40%
30%
35%
15%
20%
20%
30%
30%
20%
15%
10%
35%
30%
15%
15%
20%
40%
40%
30%
25%
30%
20%
20%
15%
15%
40%
20%
20%
15%
20%
25%
25%
30%
20%
20%
25%
20%
35%
55%
15%
15%
20%
35%
55%
10%
15%
10%
40%
25%
25%
15%
10%
10%
5%
95%
50%
70%
60%
45%
45%
50%
55%
65%
40%
75%
50%
35%
55%
35%
65%
40%
XAU
30%
30%
35%
15%
20%
20%
XPD
30%
30%
30%
20%
15%
10%
20%
XPT
35%
35%
30%
15%
15%
20%
35%
35%
XAG
40%
40%
40%
30%
25%
30%
55%
55%
40%
Brent
15%
20%
20%
15%
15%
40%
15%
10%
25%
10%
WTI
20%
20%
20%
15%
20%
25%
15%
15%
25%
10%
50%
NG1
25%
25%
30%
20%
20%
25%
20%
10%
15%
5%
38%
M A R K E T S
CU
NI
PB
SN
ZN
C O M M O D I T Y
14
Precious Metals
Correlation amongst commodities from
the same commodity sub-sector are
generally higher
50%
34%
18
How can we help clients take exposure in the commodity space?
– Global Commodities have had recently the rollout of the new models for the Investor Product Business.
 Baskets (incl. quanto)
 American observations of single or basket underlying (quanto), ie KI/KO options (call, put, digi-call, digi-put)
 Single/double touch KI/KO for single or basket underlying (incl. quanto)
 Rainbow structures (incl. quanto) [i.e. where weighting is allocated according to final performance]
– Over the coming weeks, we will be adding further features such as autocallables, resettables and quantoed range
accruals.
– Underlyings that we can trade are:
 Oil
 Precious Metals





Base Metals
Commodity Indices (eg GSCI, DJAIG) and Sub Indeces
Refined Products (e.g Jet Fuel, Gasoil, Gasoline, Propane)
US Gas and Power
Coal
– Over the coming months, this will expand into European Power & Gas, and Carbon Emissions.
15
[Section Title]
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