Manager Writes: Commodities Come of Age

The rise and rise of commodities

Per Tingberg and Avi Sharon, HSBC Halbis Partners
Originally published in the June 2006 issue

It is hard to believe that just two years ago commodities were commonly referred to as a relatively unknown asset class. Of course, that was before the accelerated uptrend in crude oil prices dating from October 2004, and the concomitant interest in the many energy-heavy commodity indexes (and now ETFs), which have utterly changed the commodity investment landscape.

Oil's rise over the past two years and the prospect of a secular bull market in raw materials generally (the belief that there will be more people eating beef in Beijing and driving cars in Calcutta), has clearly helped define and promote commodities as an asset class. However, in their infancy as an investable product, commodities have been understood as an asset to be accessed primarily through passive, long-only index strategies. One sign of this is the fact that, over the two-year period, assets invested in the most popular commodity vehicle, the passive, Goldman Sachs Commodity Index (GSCI) have nearly tripled to $60 billion.

But the accelerated maturity of the asset class has also wrought changes in its fundamental characteristics and raised questions about its future performance. Specifically, the massive flow of funds into long-only indices represents a significant demand shock which appears to have altered the term structure of some commodity futures markets. This phenomenon alone could be a harbinger of problems ahead, particularly for index investors who may be unable to pick up the structural roll yield (the main source of return for long-only commodity investors) that they have come to expect based on past history.

However, indexers are not the only scapegoats in this story, nor are they alone in their concern about emerging developments in the commodities markets. The boom in oil prices also caused a stampede of other commodity-hungry entrants, seeking to feed primarily at the energy trough. This includes Commodity Trading Advisers (CTAs) that, in a pre "super-cycle" world, tended to focus more exclusively on financial futures. It also spawned a relatively novel category of energy-focused hedge funds, some of whom have poached proprietary energy traders from their desks in a bid for insider insight.

This new array of available approaches to the commodities market, as well as changes within the market itself, have forced investors to ask what type of investment strategy may offer the most promise. Obviously there are clear dangers of applying a passive, long-only approach to commodity investments in today's market. On the other hand, most of the trend-following CTAs and Hedge Fund upstarts focus primarily, if not exclusively, on the energy sector, limiting the powerful diversification-effect that broad exposure to commodities convey to most portfolios. Besides, their price-momentum strategies rely upon the presumption that price moves in the past predict price moves in the future – never a sure thing, and particularly so in an environment of altered term structures. In our view, the best way to approach commodity investing going forward, whether from the angle of strategic portfolio diversification or from a return perspective, is to be active and tactical, with the ability to go long or short the full opportunity-set that individual commodity sectors and subsectors provide.

Rolling for (fewer and fewer) dollars?

Investment demand in the commodity markets effectively implies a right to future inventory. While investors are not likely to exercise their right to physical delivery of 1000 lean hogs or barrels of crude, they nevertheless have that right. As such, they compete with commercial participants, potentially bidding prices up and, in effect, hoarding inventory. In some markets where inventory relative to consumption is historically high, the flow of money from index funds, and others, has yet to make a significant impact. But in commodity markets that have a large weighting in the commodity indices and where the market is not amply supplied with inventory, the "index effect" has had a material impact on prices.

Take crude oil as an example. The market for crude has been in backwardation longer than any other (over 60% of the time in the last 20 years). As a result, having a long position in crude oil futures during this period has provided investors with a relatively consistent source of return – the convenience yield, sometimes referred to as the roll yield. For example, during the period 1999 to end-2003 the annualised spot return was 6.2% while the return for holding futures and rolling every month was 19.0%, giving an implied roll return of 12.8%. Yet during the period 2004 to present, while spot returns have produced a very impressive return of 39.2% annualised, this has been slashed by a negative roll return of -12.4% reducing the return to futures investors to 26.8%. The forward curves moved from backwardation a few years ago to suddenly inverting to a steep contango environment where spot prices are at a steep discount to forward dated prices.

What has happened? The very substantial flow of long-only investment into the crude oil market has pushed up futures prices relative to spot prices. How does this affect the physical market? As futures prices increasingly rise relative to spot it provides increasing economic incentives for physical participants to store the oil in tanks and sell supply forward, thereby earning a return – the opposite of the roll return referred to earlier. Since these players are selling forward, there has to be another side to the party. Index funds, among others, are providing a ready pool of liquidity willing to take the long side of these transactions. Anyone with the ability to store oil and sell forward would have earned almost 11% this year already whereas long-only futures investors would have witnessed a return of only 1% despite a 12% increase in the spot price.

So what does this mean for the future? While inventories increase, cost of storage rises and the forward curve remains in steep contango, further incentivising commercial participants in the market to store these increasingly precious raw materials. However, the increased inventories eventually become burdensome and, sooner or later, the market responds, leading to falling spot prices. That creates an unavoidable problem for passive long-only investor. The result could be a commodities double-whammy: falling prices and a negative roll yield. For example a 20% all in price over the course of 12 months with a term structure similar to today implies a negative return of approximately -40% to a long-only futures investor.

Going against the grain:

active, tactical, broad and absolute But beyond the "index effect," there are other reasons to rethink one's investment approach to the commodity markets, one of which is the simple fact of commodity market volatility, which can be sudden and intense. Even within a secular bullish cycle, short term supply-demand disconnects can cause individual markets to experience dramatic downturns, with occasional 50% declines in prices, regardless of general commodity market trends.

The use of a passive index, or an overconcentration in any single sector, may offer little relief from the sometimes dramatic volatility of the underlying commodity markets. In addition, insightful, active managers can anticipate opportunities related to cyclicality, seasonality, cross-correlation, and weather premiums – all tactical trading scenarios that an index cannot avoid and that a single-market fund cannot fully exploit. It may also be the case that these two approaches have now reached capacity.

Essentially, we believe the natural maturation of the commodity markets has prompted the evolution of a relatively new breed of hedge fund with a multi-sector, fundamental approach. In our view, a thorough understanding of the term structure debate, a commercial appreciation of how the physical markets operate and a deep familiarity with the theory of storage in commodity markets will provide opportunities for active, tactically-oriented long/short commodity investors to generate robust returns, irrespective of the broader market, by tapping the many sub-sectors of this still "new" asset class.

Commodities may be more popular with investors than they have ever been before, but the partners in the specialist resources hedge fund manager, Baker Steel Capital Managers, wanted to make clear that they are not a commodity trading fund. Instead they see themselves as primarily 'stock pickers' in resource companies.

The six-person Baker Steel investment team manages over $500m in resources assets. Their flagship Genus Natural Resources Fund, which was launched in June 2002 and had has about $100m in assets at the end of May, is largely invested in equities, with scope to invest a maximum of 30% in the underlying commodities.

"We are not commodity traders. We are investors," says Trevor Steel, co-founding partner in Baker Steel. "We do take views onindividual commodities from time to time, both long and short, but in a more strategic fashion that is based on the fundamentals. However, our core activity remains identifying under-valued and over-valued equities in the resources sector", Steel says.

It is unusual for Baker Steel to use all of its self-imposed headroom for commodity asset allocation. Recently the firm has utilised this allocation to commodities in what it terms "convergence" trades, or opportunities that a rise when there is a significant divergence between the equity prices of resources companies and the underlying commodity prices.

The volatility in base metal and oil prices increases the potential for trades in these commodities to go against the fund, as some hedge funds in the copper market will testify from their recent experience.

"The correlation between gold and gold equities is higher than with base metals or oil, so there is less risk associated with a convergence trade in gold," says Steel.

Baker said the fund was long gold equities hedged by a short position in gold that was in the process of being closed out during the month of June. "That trade was put down to gold mining shares discounting a considerably lower gold price", he explains.

Steel says the group has two key strategies. For the Genus Natural Resources Fund and the Genus Energy Fund, which was launched this April, it follows a long/short hedge fund strategy focusing on global equities. It has a long only gold and precious metals strategy in the Genus Dynamic Gold Fund, which was launched in April 2003, and in the three third party funds it is mandated to manage – CF Ruffer Baker Steel Gold Fund (a UK-based vehicle), Select Gold Fund, an Australian fund, and a Swiss-based gold fund.

Baker says the launch this year of the Genus Energy Fund followed perceived interest for an energy specific fund. "We carved out the energy strategy within GNRF and replicated it in GEF," he says. This formation underlines that the Baker Steel team abides by the true meaning of "Genus", where all three Genus funds have common characteristics, and aim to be distinct from any other funds.

Energy constituted around a third of the assets in the Genus Natural Resource Fund, which has generated an annualised return of 13.3% since inception, with gold and other mining representing about a third each of the fund's allocation.

There is some similarity in the energy equities held in the Genus Natural Resources Fund and the Genus Energy Fund, which include Sequoia Oil and Gas, Transglobe Energy, Cinch Energy, Petrolifera Petroleum and Dragon Oil.

The gold-focused portfolios managed by Baker Steel emphasise the equities of mid-cap gold producers. A Baker Steel view is that exploration companies are too risky because they don't have any tangible assets, and the large gold mining companies are growth challenged.

The portfolio of the Genus Dynamic Gold Fund, which has returned more 270% since inception. includes Kinross, Ballarat Goldfields, DRD Gold, Bendigo, Straits Resources, Sino Gold and Perseverance. Baker Steel measures its flagship gold fund against the FTSE Gold Mines index, which has returned 117.5%, and the gold price which has risen more than 90% over the same period.

About 82% of the $270m fund is in gold equities, another 8% in precious metals and stones, and the rest in base metal stocks and diversified miners.


"We have probably been pigeon-holed by the market in terms of people perceiving Baker Steel as having a focus on the small end of the market," says Steel.

"There is no doubt that we have made a lot of our really exceptional returns in the mid-cap sector, and I think the reason is that it is a sector that is less researched. With the specialist technical skills that we have and all our due diligence, we can actually identify some great opportunities."

A thorough technical and investment analysis is done before there is any change to the portfolios. Baker Steel's investment team would not be out of place in a mining or an oil company. Trevor holds a degree in geology from London's Royal School of Mines. David holds a degree in mineral processing and a Masters in mineral production, and he worked as a metallurgist before moving into investment.

The rest of the company's six-person investment team includes James Withall, an exploration geologist, Andrew Pullar, a mining engineer, and Peter Lynch, a petroleum engineer. The sixth member is Steven Miller, who comes from a proprietary energy trading background in the US, and who runs the Genus Energy Fund.

The combination of technical and investment market knowledge is the foundation of Baker Steel's investment approach. "We do a lot of fundamental analysis and site visits, because of our technical background in geosciences," says Steel.

"Mining is a risky venture…"

"Mining is a risky venture, particularly exploration. Exploration can create a tremendous amount of wealth for shareholders, but for every successful exploration company you hear about there are probably one hundred unsuccessful ones you haven't heard of," he says.

Baker Steel is happy for other investors to back exploration companies, preferring instead to wait to get involved when a proper reserve or resource has been delineated and then evaluate the technical and financial merits of the project before deciding on whether the project is worth adding to its portfolio.

Steel says the large gold mining companies such as Newmont, Barrick Gold and Anglogold face growth challenges in that, through acquisition, they have become so large, that they face a tough job to replace their reserves organically.

"It is really a function of mother nature," says Steel. He adds that the median gold deposit is only 3 million ounces, supporting about 300,000 ounces a year of production. "So if you are Barrick, which is going to be producing the best part of 10m ounces a year, statistically it is extremely difficult to replace those mines that are closing due to exhausted reserves. They [Barrick] are going to have to buy every new large gold discovery that comes along, and there are about 10 other gold majors all in there looking for those [mines] too."

However, Baker Steel did buy into a large cap gold miner last year, and it paid off handsomely. "Last year Placer Dome appeared on our pop chart as under valued. It is very rare that a major gold company would appear on our screen as a good value stock. Our investment was validated when Barrick Gold bid for Placer, because they could also see the value," says Steel.

The GenVal database

The nucleus of the Baker Steel investment process is its GenVal database, shorthand for general valuation. Steel says it is an NPV, net present value, based tool where the objective is to screen resources equities in an efficient way. Baker Steel has about 500 mines on its database, and about 200 miners, as well as more than 75 profiles of energy companies.

"GenVal is very dynamic in that we can change metal or commodity price assumptions at the flick of a button. We screen everything on the same assumptions, and then those companies that look cheap are the ones that we would look to do further analysis on with an eye to becoming potential longs. Those that look expensive, we will avoid or look to go short."

Another aspect of the Baker Steel approach to investment is the fact that it splits itself between London and Sydney. Thirteen of the 15 people at Baker Steel work in London, with David and Andrew Pullar, who is also on the six-person investment team, based in Sydney.

Baker says Sydney is a research office that provides the London team with up to the minute research when they arrive in the office in the morning. "It is also a good stepping off point for visiting resource companies, sites and assets in that part of the world, such as China. It also provides 24-hour coverage to the markets, which is useful, particularly as a hedge fund player," says Baker, who was on a visit to London when he spoke to The Hedge Fund Journal.

Teamwork as safety valve

The two teams also act as a safety valve for each other. "There are different views coming through, we have got to be very careful as an investment team that we don't get wedded to one idea. Things that challenge your views are very welcome and that is what we do between the two offices," says Baker.

The team approach works for Baker Steel, although they don't always agree. But they have known each other long enough to know that if one of the two partners has a serious reservation about a stock the other is recommending, then that is likely to result in a smaller position taken in the targeted stock. "That is until such time as that person can persuade his peers of the merits of the stock," Steel says.

"That is how we see managing money for the foreseeable future," he adds.

Baker and Steel are used to working apart as David moved to Sydney in 1994 to open up the Sydney office for the Mercury Asset Management mining team (predecessor to Merrill Lynch), where both partners had worked for more than a decade and helped to build the Gold and General Fund to be one of the biggest long-only resources funds in Europe.

"David and I felt that a hedge fund (in the natural resources sector) was the better long term vehicle than a long fund, because of its cyclicality," says Steel.

That was something that Merrill Lynch was not supportive of at the time. Many other investors were also not very keen on commodities as they had more or less wallowing in a bear market for about 20 years with many metal prices near multi-year lows in 2001.

Without any immediate support likely from Merrill Lynch, Baker and Steel decided to go it alone and set up their own hedge fund, taking the view that commodities were about to enter a long term secular bull market.

They found a willing backer in South Africanowned Coronation Fund Managers, which seeded Baker Steel's first fund. "That (Coronation) was the catalyst, and then 911 came along and Merrill's made it financially very attractive for people to leave, so all those things together just gave us the opportunity," says Steel.

Both Baker and Steel were becoming rare commodities in themselves as many other resource funds had closed down during the late 1990s, with investors and analysts ignoring resources in favour of technology, media and telecommunications.

"There was a lack of expertise around and we could see ourselves at Merrill's as the only resources team with any kind of substance to it, certainly in Europe because everyone else had closed down," says Steel.

Strong fund performances pay off

"In the first year of a new hedge fund's life, 90% of your time is spent trying to explain who you are, where you came from and why you are not going to fold," says Steel.

"I am pleased to say that comes up much less now. These days people are more interested in what we are doing and what our strategy is, as opposed to who Baker Steel is."

Baker Steel's clients are predominately European. "Most of our money has emanated from Switzerland and London with some offshore US money. Our Cayman-based Genus Funds are professionals-only funds and typical clients are private banks, funds of funds, family offices and wealth managers," says Steel.

"Switzerland was one of the first large pools of capital to recognise hedge funds. There are many high net worth individuals and they seem more willing to take a risk on newer managers where they can see attractive returns. We are incentivised through performance fees to perform, instead of being driven by asset growth. Investors in our funds recognise this. If we perform well they are happy and we make good performance fees," says Steel.

Baker Steel commands a performance fee of 20% from its Genus Natural Resources Fund, which is listed on the Irish Stock Exchange, and a management fee of 2% per year.

Steel says he and David were introduced to Jonathan Ruffer, who heads up the $2bn Ruffer Investment Management private client business, at the time they were putting together their Genus Dynamic Gold Fund.

"Jonathan Ruffer was very prescient in his foresight, anticipating that gold was moving into a bull market. He wanted more exposure to gold for his funds, but through a UK vehicle to suit his clients, so we decided to do something together as a UK OEIC (open-ended investment company)," says Steel.

Ruffer seeded the CF Ruffer Baker Steel fund with about $15m when it launched two years ago. The fund now has about £100m under management.

A similar experience occurred in Australia. Select Asset Management, a young alternative investment group selling products to high net worth individuals in Australia through the financial adviser network, wanted a gold fund suited to Australian investors.

The disciplined team investment approach of Baker Steel is a hallmark of the knowledge that David and Trevor gained from the late Julian Baring at Mercury. "Julian was a very important mentor for us, not least because of his investment discipline. He was best known for his colourful character and his communication skills, but actually when it came down to it, he was a very good investor. This success was based on a valuation discipline that we have evolved into our investment philosophy today," says Steel.

Kevin Morrison is the Commodities Correspondent at the Financial Times