Commodity price, Commodity risk, Hedging, Oil market, Risk management, Trading, Trend following

Groupthink in commodity price forecasting, its disastrous consequences and how to master price uncertainty

  • In financial and commodity markets, large-scale price events are not predictable. Even so, most market professionals rely on forecasts most heavily in making forward-looking decisions.
  • At times, this has disastrous consequences (see below)
  • Large-scale price events are far and away the greatest source of external risk for commodity-related businesses. Their severity and frequency has been on the increase in recent years.
  • An alternative approach to mastering uncertainty is to explore systematic trend-following strategies which, if used appropriately can turn price risk into a source of profit and hard to match competitive advantage

 

According to the latest Reuters survey, over one thousand energy market professionals expect the oil price to average between $65 and $70 a barrel in the years 2019 through 2023. Only 3% of respondents thought that Brent Crude Oil might increase above $90/bbl next year. So, market experts do not expect any surprises and largely agree that oil price will remain where it is. This groupthink reminds me of a similar situation some 15 years ago.

Every year, U.S. Energy Information Administration (EIA) produces long-term oil price forecasts in its “International Energy Outlook” report. In 2003, while oil was trading between $20 and $30 per barrel, the 2005 forecasts submitted to the EIA by a group of the industry’s leading research institutions [1] were all narrowly clustered between $19 and $24 per barrel. The oil price was going to remain where it was.

eia_2005oilpriceforecasts

Indifferent to these authoritative predictions, oil price trended much higher and the average 2005 price vaulted to over $55 per barrel – 2.5 times higher than the average EIA forecast. The same trend would push it to nearly $150 by the summer of 2008 – a scenario no market expert could have dreamed up.

The pervasive problem with market price forecasts

But the real problem with forecasts is not that many of them turn out wrong. The problem is that far too many market professionals rely on them to make hedging and investment decisions. A large 2006 T. Rowe Price/Citigroup survey of market professionals revealed that well over 60 %[2] of them rely most heavily on economic forecasts for their investment decisions. In managing commodity price risk, this can have disastrous results, as the following case illustrates.

A few years ago I looked at the hedging practices of nine independent North American oil & gas producers.[3] Eight of them on average hedged 25% of their 2004 crude oil production. But the most aggressive hedger among them, Kerr McGee, decided to hedge 70% of their volumes, fixing the selling price for their North American production below $28 per barrel. Remember, in 2003 the EIA and its contributing research institutions projected that the barrel would remain in the low $20s through 2005.

kmg_500mhedge

As oil price continued to rise through 2004, the year’s average on NYMEX reached $41.41. Kerr McGee’s hedge deprived the firm of $13.72 in extra revenues per barrel, resulting in $500 million in foregone revenue in 2004. In the stock market, Kerr McGee’s shares lagged by over 33%, compared to other eight producers, corresponding to a $3.5 billion shortfall market capitalization. In other words, Kerr McGee’s hedge contributed to the destruction $3.5 billion in shareholder value.

kmg_sharesunderperform

Complacency can carry a devastating price tag

Today again, the expert groupthink on the oil price also risks misleading managers into complacency. Getting caught unprepared by unforeseen events can be devastating. How devastating? When the price of oil collapsed some 70% between the summer of 2014 and January 2016, U.S. mining industry, which includes oil and gas producers, sustained $227 billion in losses, wiping out eight previous years’ worth of profits.

miningindustrylossesin2015

Just as nobody believed in 2003 that oil prices could rise sevenfold in the next five years, nobody expected that in 2015 they would collapse by 70%. But such events do happen and they are happening more often.

howmarketschanged_201711

Since about 2005/6, many commodity markets have experienced a dramatic increase in volatility and frequency of extreme price events. These events represent the single greatest source of external risk for commodity firms.  Indeed, recognizing the importance of price risk, nearly 90% of managers in commodity-related businesses view price risk management as a key source of competitive advantage.[4]

Quality price risk management should ideally enable firms to significantly reduce losses from adverse price events and to profit from favourable ones, which can be very significant in commodities markets. The problem of course, is uncertainty: large-scale price events can’t be forecasted with any degree of certainty.

Mastering the commodity price uncertainty

Given that timing and direction of extreme price events are unpredictable, how can firms master the resulting uncertainty and gain control over this source of risk?

Fortunately, there’s good news hidden in the very nature of price fluctuations. Observed day-to-day, markets appear to be driven by news events and data. However, extreme price events almost invariably unfold as trends. Such trends can span many months or even years, offering us the opportunity to capture value from them.

We can capture value from price trends by using systematic trend-following strategies. Such strategies can help hedgers decide when to hedge their price exposure and when to keep it unhedged. In this way, without needing to predict the future, commodity related firms can turn price risk into a source of profits and competitive advantage.

Of course, this is all easier said than done and industry practitioners, who honed their skills in the operational aspects of their core business, tend to be reluctant to engage in price speculation. For a number of good reasons, they are right to be cautious. Nevertheless, quality solutions to this problem do exist and given the importance of price risk management, they should be explored.

At Altana Wealth, we’ve developed I-System technology. After more than 15 years of continuous use we genuinely believe it to be the Rolls Royce standard of trend following models. Relying on this type of systematic trend-following model, rather than on market forecasts, offers market professionals to navigate commodity price roller-coasters profitably and with peace of mind. The following 12-minute video discusses our approach as well as our track record in managing price risk with I-System:

 

The beauty of this approach to risk management is that practitioners do not need to bet the proverbial ranch on it. They can test it on a limited portion of their risk exposure, analyse results, and expand on the concept as they acquire experience and know-how.

This year we will be rolling out a concrete service offering for industry hedgers to offer them the full benefit of our 20-year experience managing financial risk and trading in a wide variety of commodity markets.  For more information, you may contact me at alex.krainer@altanawealth.com. If possible we’ll offer a free test run.

For notes and references, please scroll down to the end of this post.

 

Alex Krainer is a hedge fund manager and commodity trader based in Monaco. He’s publsihed the book “Mastering Uncertainty in Commodities Trading

Trading and hedging commodity price risk

 

Notes:

[1] The forecasts were produced by Altos, DBAB (Deutsche Bank Alex Brown), EEA (Energy and Environmental Analysis), EIA (Energy Information Administration), IEA (International Energy Agency), GII (Global Insight, formed in Oct. 2003 through the merger of Data Resources Inc. and Wharton Econometric Forecasting Associates), NRCan (Natural Resources Canada), PEL (Petroleum Economics), and PIRA. Source: Energy Information Administration “International Energy Outlook 2003.”

[2] This 2006 survey of asset managers and pension funds from 37 countries managing some $30 trillion in assets was co-sponsored by T. Rowe Price Global Investment Services Limited and Citigroup. Questioned about what would drive their investment decisions over the next five years, majority of respondents indicated they would most heavily rely on the “medium term outlook in the bond markets,” (67%) and “global/regional economic prospects” (62%).

[3] These producers were Anadarko Petroleum, Apache Corporation, Burlington Resources, Canadian Natural Resources, Devon, Encana, Talisman Energy, Unocal and Kerr McGee

[4] Tevelson, Robert et al. “Key Challenges in Managing Commodity Risk” – Boston Consulting Group, April 11, 2013.

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