Commodities and Derivatives: Fund managers look to the futures

A DECADE ago, pure investor interest in oil futures was negligible. Nearly everyone who made use of the main exchanges - Nymex in New York or the International Petroleum Exchange in London - was involved in the oil trade.

Much has changed. Funds have grown increasingly prepared to use derivatives as an investment tool, and where commodities are concerned, energy futures generally top their shopping list as they benefit from the largest and most liquid of all the commodity futures markets.

As a result fund managers now account for almost a fifth of all contracts bought and sold on the IPE, while on Nymex the balance between investors and trade operators is roughly equal.

Of course trade operators can be investors as well. Any trade player - oil companies, distributors, producers, consumers - may use futures both to hedge physical positions and to speculate for profit.

But the motivation of an investor in energy futures trading is rather different.

As Alban Brindle, business development manager at the IPE, points out, oil prices rarely follow the pattern set by other financial assets (see graphic). This, he points out, can be useful. Considerable losses on most asset investments in the 1987 crash or the 1990 Gulf crisis could have been offset by investments in oil, for instance.

This inverse relationship is because the oil price has traditionally responded to political factors and has a big economic impact.

'It's pretty clear that over the last 30 years low oil prices have led to boosts in non-inflationary growth and vice versa,' Mr Brindle said. 'That means oil tends to perform very differently to, say, bonds or stocks and so can be used to complement other investments.'

Even so, only around 1 per cent of all managed funds (those dedicated to investing in derivatives) make use of oil futures. That is despite the fact that the value of funds available for investing in futures and options rose from under dollars 1bn in 1980 to more than dollars 20bn by 1992.

The funds in question also tend to be small, specialised outfits - or very large funds, like that run by Mercury, looking for spice for their portfolios.

When they do play the commodities markets they tend to pick oil, however. Partly that is because the energy markets are the biggest and the most liquid. But they also offer the possibility of cash settlement.

The key IPE Brent oil futures contract, for instance, is for cash rather than physical delivery.

Very few commodity futures contracts actually result in a physical commodity changing hands - they are bought as 'insurance policies' or 'bets' (depending on whether the buyer is attempting to hedge or to speculate). Nevertheless, the mere prospect of having to ensure or take physical delivery is enough to deter some investors.

A cash contract, in contrast, can be easily delivered into a bank account within two days of completion. Nevertheless, the oil futures markets are no place for amateurs. That is why the IPE is targeting its marketing effort on managed funds that specialise in derivatives.

Moreover, persuading other more conservative funds, such as pension schemes, to invest involves considerable obstacles - some legal and others based on taxation.

Unsurprisingly, the prospect of swings in oil prices in a year of (typically) 20 per cent and (sometimes) 200 per cent movements leaves them rigid with fear.

For the really sophisticated user, there is always an added incentive to play the energy futures markets: trading the 'crack spread'.

This is not anything that would get them arrested. Trading in the crack spread is based on spotting shifts in the difference between the price quoted for a refined product like gasoline or heating oil and the underlying price of crude oil.

(Photograph and graph omitted)