By Hamlin Lovell, NordicInvestor
Since the 1970s, the diversification benefits of allocating to commodities – partly as an inflation hedge – have been well understood. Some investors are also now seeking greater diversification within their commodities allocation, by adding new markets. Historically, many commodity markets were only accessible over the counter (OTC), but now more are available as exchange-traded futures, which makes it easier for investors to access them in a liquid way with limited counterparty risk. Some new or modified commodity futures are also motivated by ESG concerns, which can include reducing environmental pollution in various ways, or can also relate to controversies around sanctions.
Energy and emissions
CME Group already offers a range of oil benchmarks: NYMEX WTI (West Texas Intermediate) and NYMEX Brent are the two most well-known. The difference between these two contracts has traded in a wide range: Brent peaked at a premium of USD 14 over WTI, and it troughed at a discount of about USD 1 to WTI, over the past four years.
In November 2018, CME Group launched WTI Houston futures and options, to focus on oil prices in this specific area of Texas, which has seen increased interest after the lifting of the US export ban. This contract can also be used for relative value spread trading versus WTI and Brent oil benchmark futures.
Other new energy launches include Marine Fuel 0.5% futures, which are driven by the International Maritime Organisation’s new, cleaner and greener, marine fuel regulations for bunker fuel used by ships. The objective is to reduce emissions of sulphur oxide, which contribute to acid rain and human respiratory illnesses. The maximum mass by mass sulphur content will be 0.5% from 1 January 2020, a big cut from the current 3.5%.
These regulations could also increase demand for methanol, which can be used in shipping, and could be a real game changer for the market: “should methanol propulsion systems only capture 5% of the global marine fuels market, this would amount to more than 30M MT annual methanol demand equivalent – a massive change in an industry where global demand currently sits at ~80M MT p.a”, according to a CME Group report. Additionally, India’s government has ambitions to transition to a methanol economy, to reduce crude oil imports and carbon intensity.
CME Group has launched an FOB Houston methanol contract to complement its existing NYMEX European methanol. Natural gas is an important feedstock for producing methanol, and it is possible to do spread trades taking a view on the difference between the input and the output. One environmental angle here is that a much dirtier fuel – coal – is also used as feedstock for methanol particularly in China. Methanol can also be generated from biomass, and thus can potentially be a renewable fuel.
Metals and electric vehicles
In March 2019, the London Metal Exchange (LME) launched seven cash-settled futures contracts.
The LME’s new cash-settled alumina contract is based on the raw material for aluminium, and has been very volatile recently, offering good trading opportunities. The CME Group has also rolled out another physical aluminum contract.
The LME has offered a physically settled cobalt contract since 2010 and launched a cash-settled one in 2019. As well as being used in biotech and aerospace, Cobalt is an input for electric vehicle batteries and the LME also has plans to launch a futures contract in lithium in late 2019, which is another EV battery input. Lithium-ion batteries used in EVs are the key source of demand for cobalt, according to Global Energy Metals. They are used in EVs and Plug In Hybrid Electric Vehicles (PHEVs). Cobalt demand is expected to reach 120,000 tonnes per annum by 2020, according to Darton Commodities, and volumes in cobalt futures have been steadily rising.
Sourcing
Cobalt touches on another controversial ESG issue: responsible sourcing, which is well known in the context of “conflict diamonds” but less widely discussed in relation to metals. Most cobalt comes from the Democratic Republic of Congo (DRC), which is believed to have abused human rights, and is subject to sanctions from the European Union (EU) and United Nations (UN), amongst others.
The LME has proposed banning cobalt brands that are trading at a discount, on the basis that they may have provenance issues. In response, 14 non-governmental organisations (NGOs) have opposed the LME’s proposals, and argued that deeper supply chain due diligence is needed rather than just imposing a blanket ban on cheaper cobalt. It remains to be seen what the outcome will be.
Chinese commodities
The LME’s new cash-settled hot-rolled coil and steel are riding a wave of demand for Chinese ferrous (iron-related) futures contracts. This can be perceived partly as a response to Chinese commodity exchanges taking market share away from the LME – and indeed, the Chinese exchanges in 2018 have opened up to direct access by foreign entities.
The Dalian Commodity Exchange’s iron ore contract, launched in 2013, was in May 2018 opened up to foreigners. The volumes of this contract now make it the largest iron ore contract in the world and arguably mean China is effectively making prices globally.
China’s Zhengzhou Commodity Exchange in November 2018, opened its first futures contract – purified terephthalic acid – to international access. This chemical is used to make plastic bottles and polyester clothing.
And a Yuan-denominated Oil contract listed on the Shanghai futures exchange was opened to foreign access in March 2018. This effectively allows investors to combine a currency position with a commodity position.
China’s three commodity derivatives exchanges had historically been restricted to locals, but all three of them have now offering foreigners direct access to at least one contract. The fact that all three exchanges opened one commodity future to overseas access in the same year, could be coincidental but may also be a more coordinated action. This has some relevance to the ongoing US/China Trade War, where one of the US complaints is restrictions on foreign access to China’s markets. It seems probable that more Chinese commodity futures could be opened to foreigners over time.
Chinese derivative exchanges are also offering a wider and more sophisticated range of instruments. In January 2019 exchanges in China launched options on corn, copper and rubber contracts, adding to their existing options in soybean meal, sugar and copper. Some investors will combine positions in futures and options to generate different risk profiles.
