Risk Management & Portfolio
Construction in a Commodity
Futures Programme
By Joseph Eagleeye & Hilary Till
This article focuses on risk management within the context of
An example of a processing margin
a total-return futures programme centred on commodities. The
trade is a long gasoline crack spread. In
following issues will be addressed:
this trade, one is long gasoline, and
• The evaluation of normal versus eventful risk.
short crude oil against it. The common
• The sizing of trades and strategy buckets.
theme to these trades is that an
• The construction of a portfolio, which takes into
investor is taking on the other side of
consideration these risk and sizing metrics.
producer hedging pressure. For these
We provide examples from three historical portfolios in order to
trades, timing is key. They are imple-
make this discussion concrete and practical.
mented at the peak of hedging pres-
sure in anticipation of seasonal inven-
AT OUR COMPANY, the primary discussion we have before initiating tory draws or expected scarcity.
a proprietary trade revolves around the economic service we are
providing the market and the risk assumed by providing that serv- Example From the Spring of 2003
ice. Risk management is perhaps the most important element of our The following example will highlight
commodity programme. Traditional asset classes rarely experience this class of trades. Historically, there
the type of volatility encountered in commodity markets. For exam- has been a strong incentive for refiners
ple, the implied and realised volatility of natural gas both exceeded to produce enough gasoline in the
100% at times in 2006. spring prior to the US summer driving
The other notable feature of commodity futures markets is that season. A well-known and popular trade
leverage is easy to attain. A futures investment requires very little has been to go long unleaded gasoline
margin. Some programs only require US$7 for each US$100 of expo- during this time.
sure. So traders can easily dial-up their leverage to magnify gains
and losses. In this environment, risk management is crucial. Fundamental Rationale
We largely view risk management as a product-design issue. We first Figures 1 and 2 show US unleaded
decide on the largest acceptable loss for the firm and that dictates gasoline inventories both on an
sizing on the position, strategy and portfolio level. We then have an absolute basis and in terms of days
expected range of outcomes for these strategies if the fundamental cover (which equal gasoline inventories
drivers we are exploiting continue to exist. Risk can be managed, but divided by implied demand). The
a threshold return from the market cannot be demanded. dataset covers 1985 through 2002.
Both graphs communicate the same
Traditional asset classes rarely experience the type
information. Inventories and days cover
of volatility encountered in commodity markets
both peak at the start of March, tem-
porarily plateau in May and June, and
The world of risk in commodities is bifurcated – there are ‘normal’ then hit their lows in the Fall. This fol-
and there are ‘eventful’ times. While Value-at-Risk (VaR) is one of lows a smaller inventory build from late
the risk measures we use, it is only one part of a complete menu of May through to the end of June.
risk-metrics. VaR generally only has meaning during normal times Cootner (1967) discusses how “prof-
and even then its usefulness has to be qualified since commodity itable [futures] strategies ... [tend to be]
returns are not normally distributed. Commodity returns tend to keyed off ... peaks and troughs in visible
have ‘fat tails’ and are sometimes serially correlated. ... supplies” in the grain markets. If this
Commodity futures investors generally desire a long options-like pay- idea were to hold in the unleaded gaso-
off profile. In other words, they like trades that are expected to have line market, the expectation would be a
positive outcomes and which allow them to participate in extreme long position initiated at the start of
price spikes during supply disruptions. As a result, there tend to be two March and exited in May would general-
sets of strategies. The first is outright longs, either directly or as intra- ly be profitable. As Figures 1 and 2
market spreads. The second is long processing margin trades. That is, show, May is a localised low point in the
one tends to be long the finished product and short the input. inventory cycle.
COMMODITIES NOW SEPTEMBER 2007 53
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