Commodity price, Commodity risk, Complexity, Economics, Expertise, Hedging, Market psychology, Market research, Market trends, Oil market, Risk management, Trend following

Market fundamentals, forecasting and the groupthink effect

Last month I had the privilege of meeting with Jaran Rystad of Rystad Energy to discuss strategic cooperation between our companies. On the occasion, he gave me a rather detailed presentation of his firm’s energy intelligence database. I must say, in my 20+ years trading in commodities markets this is by far the most impressive product of its kind I’ve ever seen. Even from the software engineering point of view, I was very impressed. For full disclosure, nobody asked nor encouraged me to write this. Much as you’d recommend a restaurant where you ate well or a doctor you respect, I wholeheartedly recommend Rystad Energy as a provider of energy market intelligence as a matter of giving credit where credit is due.

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With Jarand Rystad of Rystad Energy in Monaco – their oil market intelligence is impressive by any standard.

However, even with top notch data on economic supply and demand fundamentals, divining the future remains difficult and unlikely. John von Neumann rightly said that forecasting was “the most complex, interactive, and highly nonlinear problem that had ever been conceived of.” Continue reading

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Asset management, Behavioral finance, Market psychology, Market research, Market trends, Trading, Trend following

Trend following might save your tail

In the age of central bank quantitative easing, trend following has become an unpopular investment strategy, even earning tiself a bad name as trend following funds performed miserably compared to bonds, equities, and passive index funds. Below is a chart put together by AutumnGold showing a growing gap between Managed Futures funds the S&P 500 and Barclay’s Aggregate Bond index. Managed futures funds are a good proxy for trend following performance as most of them apply systematic trend following strategies in one way or another.

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Asset management, Behavioral finance, Hedging, Market psychology, Market research, Market trends, Risk management, Stock market, Trading, Trend following

Lessons Of Japan’s 1980s Bull Market

Afer popping, Japan’s 1980s bull market gave way to an 82% drop over the following 20 years.

Three decades later, Japanes equities are still more than 40% below peak valuations.

One of the most effective methods of navigating the boom/bust cycles has been the systematic trend following.

Sooner or later a crash is coming, and it may be terrific

Roger Babson, 5 Sep. 1929

If everybody indexed, the only word you could use is chaos, catastrophe. The markets would fail

Jack Bogle, founder of The Vanguard Group

As of December 2018, passive index funds controlled 17.2% of the stock of all U.S. publicly traded companies, up from only 3.5% in 2000. The 5-fold increase was in part the consequence of the ongoing stock market growth, which now has the distinction of being the longest running bull market ever recorded. Buoyed in large part by central banks’ unprecedented quantitative easing (QE) programs, the rising stocks have lulled many investors into complacency.

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Commodity price, Commodity risk, Energy crisis, Hedging, Market psychology, Market trends, Oil market, Risk management, Trading, Trend following

Six Principles To Adopting Best Practices In Commodity Price Hedging

  • This week Sinopec disclosed the latest hedging mishap, losing $690 million amid last year’s oil price collapse.
  • Unless price risk management is organized as an integral part of core business operations, it can devolve into eratic and risky game of speculation that can cause massive damage.
  • The six simple but important guiding principles could help commodity firms create a world class risk management process and turn price risk into a source of value and competitive advantage.

This week Sinopec disclosed that it had incurred $690 million in losses in the fourth quarter of 2018. The losses were attributed to Unipec’s oil hedging bets. Unipec clearly took the wrong directional exposure to oil prices in the period when they staged a sharp, 40% collapse (October-December 2018). This much is understandable. However, such losses did not need to happen – I maintained heavy exposure to oil prices over the same period and not only avoided heavy losses but actually generated significant profits by simply adhering to a systematic trend-following model.

As I detailed here, systematic trend following enables nimble navigation of market price roller-coasters, eliminating rogue trader risk and removing human error. Trend following models respond to market price fluctuations as they unfold, without distraction, without emotion and without strong convictions that could ultimately turn out wrong (always a costly discovery).

 

Unipec’s hedging mishap is only the last in a long series of incidents underscoring the fact that commodity firms ought to take their hedging operations seriously and seek to develop them following best practices in price risk management. Price risk management should be integrated with the firm’s overall business operation and make part of the firm’s business strategy. Otherwise, hedging risks to turn into a dangerous game of speculation which, in many cases, has spun out of control causing massive damage.

Organizing to manage price risk

A purposeful, effective approach to managing price risk requires an adequate organizational framework. For any organization, the questions of what risks are taken, in what measure, and how they are managed are strategic questions and should be decided at the board level. The implementation of these decisions should be owned by the firm’s CEO.

1. Explicitly designate the proper role of risk management

Managing commodity price, currency, or interest rate risk should enable a firm to take risks in a controlled and purposeful fashion, accept occasional losses and communicate such losses to its stakeholders openly and transparently, without losing stakeholder confidence in the validity of the firm’s strategic choices or the management’s capability to achieve them.

Without clarity and guidance from the company’s board and the CEO, the firm may be vulnerable to serious risk-related disruptions, or failure to take advantage of favorable market events.

2. Identify main sources of risk

Running a formal audit of key areas of risk exposure – by business unit and by risk category – should form the foundation of a firm’s risk management process. For each category of risk, alternative instruments and methods of risk management should be identified and their respective advantages and disadvantages thoroughly examined and documented. Having evaluated the pros and cons of the available alternatives, management can formulate specific objectives and strategies to be implemented in achieving those objectives.

3. Define firm’s risk appetite and methods of risk management

Definitive risk management strategies should set forth the company’s risk management methods and its appetite for risk. It should also set out the responsibilities for risk management throughout the organization. At that point, management should anticipate the necessary organizational adjustments, training and staffing requirements and it should undertake a thorough documentation of the management process, controls, restrictions and paperwork flow.

4. Adopt a gradual approach

The best part about developing an effective price hedging process is that firms do not need to bet the proverbial ranch on it. At first, firms can apply their new risk management process only to a smaller portion of their risk exposure – say, 5% or 10% of their hedge book – and add to that in subsequent periods as the firm, its staff and stakeholders grow more familiar and comfortable with the process and its impact on the firm’s performance.

5. Maintain and refine your operation continuously

Finally, the whole solution, once implemented will almost certainly need adjustments and maintenance. Constant monitoring and periodic reviews must remain an integral part of a firm’s risk management strategy. For this purpose, firms should establish an independent middle office staffed with a team of highly skilled risk professionals who regularly report on exposure and risk issues directly to senior management and the CEO. The challenge of developing and implementing this business process should be no more difficult than that of developing any other business project.

6. Communicate, communicate, communicate!

For this to happen, the communications aspect of the project within the organization may be as important as its operational execution: all parties involved should be offered the opportunity to question and understand the process and be periodically kept informed about its progress and results. While the challenges involved aren’t slight, the objectives and their potential should go far to kindle managers’ entrepreneurial spirits and be well worth their efforts.

If a crisis does arise… solutions will be familiar and mastered

As Milton Friedman famously put it,

it is worth discussing radical changes, not in the expectation that they will be adopted promptly but for two other reasons. One is to construct an ideal goal, so that incremental changes can be judged by whether they move the institutional structure toward or away from that ideal. The other reason is… that if a crisis.. does arise, alternatives will be available that have been carefully developed and fully explored.”

Risk management is no more difficult than any other organizational challenge

The considerable potential of an effective risk management process in terms of profitability and resilience should make any firm’s development initiative well worth the effort. And keep in mind: any practically solvable problem has no chance of remaining unsolved if you make a determination to tackle it. As Johann Wolfgang Goethe put it:

“Whatever you can do, or dream you can, begin it. Boldness has genius, power, and magic in it. Begin it now.”

 

Alex Krainer has actively traded commodities, FX and treasury and equity futures since 1996 and managed hedge funds based on his proprietary trend-following model. Over a six-year period, from 2007 to 2013 he has outperformed Dow Jones Blue Chip index of Managed Futures Funds (track record audited by KPMG). In 2015 he published “Mastering Uncertainty in Commodities Trading” that condenses his 20+ years of deep research into the problem of market speculation.

Description: Trading and hedging commodity price risk

Mastering Uncertainty in Commodities Trading

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Asset management, Behavioral finance, Commodity price, Commodity risk, Market psychology, Market trends, Psychology, Risk management, Trading, Trend following

Lessons in asset valuation: the great warrants bubble of China

Investors exert a great deal of intellectual effort to determine the correct valuation of securities. Economic value is central to our decision making and it plays a major role in our intuitive psyche. In daily life, when we buy a loaf of bread or a tank of gasoline, we tend to have a good idea about what we think is cheap and what’s expensive. We like bargains, don’t enjoy being ripped off, and in the same way we’re inclined to shop for value as consumers, we find value investing intuitively appealing. But here’s the critical difference between buying goods and investing: shopping for investments is speculative while buying stuff isn’t, and speculation activates the part of our mental circuitry that can heat up to a boiling point and overwhelm any rational consideration of value. Continue reading

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Asset management, Behavioral finance, Bitcoin, Commodity price, Market psychology, Market trends, Psychology, Risk management, Trading, Trend following

Of Bitcoins and bubbles

In my book, “Mastering Uncertainty in Commodities Trading” I argued that security prices “are driven by human psychology and its self-stoking collective action that can sustain major trends spanning many years.” That’s because in speculative decision making, our views about the actions of others can entirely override our rational appraisal of the underlying asset value.

The most recent example of this is the price of Bitcoin that has surged from below $400 in January last year to $4,300 this week. When we set up the Altana Digital Currency Fund several years ago, many people thought that digital currencies were just a strange fad and investors continued to show little interest in them – until very recently. Continue reading

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Asset management, Behavioral finance, Commodity risk, Complexity, Hedging, Market psychology, Market research, Market trends, Psychology, Risk management, Something completely different, Trading, Trend following, Uncategorized

Speculation in the natural world

Nature has … some sort of arithmetical-geometrical coordinate system, because nature has all kinds of models. What we experience of nature is in models, and all of nature’s models are so beautiful. – R. Buckminster Fuller

Nature’s survival strategies that bear the most similarities to activities of market speculators are those of predators. To live, predators must hunt and this activity includes elements of speculation. Like trading, predation requires knowledge, skills, judgment and decision-making. It also entails risk and uncertainty. A predator can’t be sure where her next meal is coming from. Each hunt is an investment of resources; it involves the risk of injury and loss of energy expended in failed hunts, which tend to be more frequent than successful ones. To survive and procreate, predators must consistently generate a positive return on this investment. Too much of a losing streak could turn out to be fatal. In his book, “The Serengeti Lion: A Study of Predator-Prey Relations” George B. Schaller painstakingly documented the details of hundreds of hunts by large cats in the Serengeti National Park in Tanzania. We have all seen wildlife television programs showing lions and cheetahs hunting, but Schaller’s work offers a much richer account of the life of predatory cats including their hunting behavior.

The anatomy of a hunt Continue reading

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