Nicky Ferguson - Global Macro Series - March 1st, 2023

[00:00:07] Nicky

Options will become the weapon of choice for a lot of the industry. We saw that very clearly last year where we had absolutely enormous positions in the options market, especially in crude, but a lack of people trading futures. Obviously, you need the futures market to move, to put those options positions in the money and we just had a disconnect. So everyone was sitting waiting on their options, but no one was buying the futures to actually make that happen for them. I think we’re going to get a few more contradictions like that. Staying on top of where these flows and positions are sitting, whether it’s in futures or options, will be really key going forward to understand where those constraints are.

[00:00:48] Intro

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Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:44] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting, as well as intellectually challenging, but also very important given where we are in the global economy and geopolitical cycle. We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like and we want to explore their perspectives on a host of game-changing issues and hopefully dig out nuances in their work through meaningful conversations. So please enjoy today’s episode hosted by Hari Krishnan.

[00:02:30] Hari

Thanks very much for the introduction, Niels. My guest today is Nicky Ferguson, founder of the research firm It’s Not a Science, in Basel, Switzerland. It’s a pleasure to have you on, sir.

[00:02:44] Nicky

Pleasure to be here, Hari. Thanks very much.

[00:02:45] Hari

Now, I don’t usually go too far into people’s backgrounds unless they wish to, but I noticed that you’ve worked at some major energy companies over the years. Maybe you can go into that a little bit and tell us how you came out on the other side running a research firm.

[00:03:04] Nicky

Yeah, sure. After my PhD looking for a job, I got headhunted, if you like, and ended up at Koch Industries in London, and it was a really interesting place. A lot of different asset classes traded on the floor, so you got exposure to a lot of things. I started off on the systematic desk, working with a great portfolio manager. We looked at everything in energy and it was how to put together more of a systematic portfolio but using not just price-based resources, but also fundamentals and really trying to determine how do traders look at markets, what is more important for each individual market, and can we take a data-driven approach to determine the optimal way that that should be looked at systematically, is that relationship persistent enough to trade of systematic signals.

We built a portfolio across everything in energy and that was very successful for a couple of years. Then I got poached within Koch to move to Geneva to the prop team there. I would describe that approach as maybe quant-aware discretionary trading, using a lot of very model-driven to determine lots of signals and classifications and how we think about markets and really thinking about the mechanism and trying to determine all the little individual bits in markets in terms of participant actions, in terms of flows, how can we use more quantitative tools to classify them so that we’re aware of them and we can embed them into our discretionary decision-making process and maybe we determine the weights and how to weigh that information using experience into more discretionary trading decisions.

[00:05:05] Hari

Okay. When you were running the systematic piece or when you were involved in that, what sorts of fundamental inputs did you find valuable?

[00:05:14] Nicky

I think it varies across assets and across time, and I think that’s still very true today. Markets, like natural gas, tend to be a lot more fundamentally driven than financially driven. But when you’re talking about oil, oil is a risky asset, so you need to approach it slightly differently and I think to the consternation of many traders out there, the oil futures market does not always reflect the oil fundamentals. So your approach has to really vary.

In natural gas, it’s a very data-driven, very quick-to-price, fundamental market and understanding the small changes of that interaction in the system matters a lot more than oil, where a lot of the fundamental data is slow-moving and also lagged when it comes to market. All of that is changing today. So it really varies, I think.

[00:06:11] Hari

Well, let me not hijack your biography. So maybe you can continue on there.

[00:06:15] Nicky

Sure. I moved to be BKW, which is a great firm. It probably flies under the radar a little bit based out of Bern in Switzerland, and they have a great team there. I spent basically that period trading through the pandemic, trading flat-price oil. Especially during that period, market flows were so much more prominent, participant constraints around those flows, and I just sat during that period thinking of all the things I wanted to build when I finally had time to do some research, if you like, and a lot of the ideas I got for my company were during that time.

[00:06:57] Hari

What years were you at BKW?

[00:06:59] Nicky

I’m going to say 2018 to ‘21.

[00:07:07] Hari

So you went through March 2020, obviously, at BKW?

[00:07:10] Nicky

Yeah, absolutely. That was a very interesting time. I think that the stresses of managing a flat price dominant portfolio during those years, it was interesting. You really had to be on your toes. I think, especially during those times, the market drivers were changing so quickly from week to week, and we had huge moves between the different relevant participants in markets because of the volatility conditions were also structurally driving changes across markets.

Obviously, with large changes in fundamentals, the commercial side of the business was also changing a lot. So you almost got a decade of trading in two years with all these structural changes. I think a lot of people aged quite quickly over those years, especially on a commodity desk.

[00:08:02] Hari

Yes. Very good, and then Statkraft. Is that the next one?

[00:08:08] Nicky

Yeah, that is a really great place to be. I think when I joined Statkraft, I left a great team at BKW and I almost realized that’s the time to start my own company. So it was a bit unfair on Statkraft to have such a short stint there. But there was the pull to actually get back into research and try and deliver a lot of these things I’d learned and thought about over the years to more clients. It was just too strong to resist in the end.

[00:08:38] Hari

It’s not that common for people to start off as a PM or in trading and then to move on to research, or is it? Am I mistaken here?

[00:08:48] Nicky

I wouldn’t say it’s uncommon. I think I did get a few questions when I started the firm of, why are you not doing this inside a trade shop? I have thought about that as well, but you don’t have that complete freedom to do original research always. You’re at the mercy of your paymasters in the end about what’s relevant at any given time. While I do try to make my research very relevant to what is actually pricing and important for traders, having complete freedom over what you work on, what’s interesting, how you do it, and also, you’re not constrained by a use case. Because as a researcher generally in a trading firm or hedge fund, you’re working for a PM who has their own ideas and needs, and they don’t always align with what you want to do.

[00:09:40] Hari

Perfect. Okay. Well, with that, there are a few major categories I want to go into and I’ve read a few of the research papers that you’ve written. I highly recommend them if members of the audience can contact you or access them. The first thing I wanted to talk about was positioning risk, which I think is an important theme in your work. It’s something that I’ve been interested in in other markets. I guess the first question is, who are the major players in the energy markets and how do they impact the market? How do they impact prices?

[00:10:17] Nicky

The major players are split between commercial entities, so the producers, trading houses, or refineries, anyone that’s transforming the raw commodity. Then you have the non-commercial elements. You could split between systematic and more discretionary participants. So CTAs are a major component, risk parity funds are a large component, and your general hedge funds that are active, some commodity-specific, some macro, but commodities are traded in a lot of places now.

[00:10:55] Hari

On the commercial side, I get a bit confused though, because don’t these entities trade as well? Don’t they have trading desks where there’s prop activity going on?

[00:11:05] Nicky

Absolutely. I think a lot of that prop activity is also leveraged around the physical commercial activity as well. I think if you look at the new MiFID reports that have come out in the last few years, you can see that there generally is a fairly big correlation between the non-hedge book and the hedge book. You could call it a speculative book, but it’s not always the same thing. A lot of the times, they do go in the same direction and I think that’s probably right. If you have a strong physical view and you see your physical traders taking large positions, as a derivatives trader around those positions, you have a much clearer insight into how the real fundamental markets are actually operating. It’s a very good edge.

[00:11:51] Hari

That’s a fascinating comment. It is a big edge, but I’m thinking now as just a finance guy, wouldn’t that be highly undiversifying to be doing the same stuff on your prop book as you are in the course of your commercial hedging activities?

[00:12:09] Nicky

That’s an interesting question from the finance perspective, because in general, finance and trade, everyone’s talking about diversification and getting rid of risks. But when you think about how people trade commodities, most people or almost traders are asset-specific specialists. So essentially, commodity traders are trading something with the volatility of a single stock and zero diversification or very little.

[00:12:39] Hari

Got it. But they might dampen the risk by trading spreads, calendar spreads.

[00:12:44] Nicky

Occasional arbitrages and cracks and things like that. Yeah. That’s the corrective side of trading and then you have the more directional side of trading.

[00:12:55] Hari

Got it. So then jumping again, if we look at some of the stuff that you have looked at, I’m sure far more than I have, such as Commitment of Traders reports and so on, you don’t need to be too worried about what the commercial users are doing in various parts of their business because they tend to overlap. Is that what you’re suggesting that makes the analysis a bit easier?

[00:13:17] Nicky

I wouldn’t say completely. But I would say when you look at the outright positioning, the commercials are clearly the largest positions across all markets. But when you look actually at the standard deviation of the position changes, speculative positions tend to be just as large. So when you’re thinking about what matters for pricing or price impact of positional changes and flows, the speculative side of the business is almost just as important as the commercial side of the business. This is not the same in every asset, but for things like crude and the energy space, the speculative side of the business is just as important.

The commercial side of the business, the positions are predominantly moving with fundamentals and inventory management, things that you can see live and compared to the size of their positions, it’s a slow-moving process. It hasn’t been during the COVID years when we’ve seen big swings in supply and demand on inventories where these positions had to change a lot. But many of them are linked to inventory management. So once you’ve understood that from the inventory side, a lot of the focus can actually be more on the speculative side.

[00:14:33] Hari

Got it. So in the absence of fundamental shocks, if you’re in a regime where there are no fundamental shocks, let’s say, I know that’s backward-looking, then you can focus a lot more on flows or repositioning of specs.

[00:14:47] Nicky

Yeah. Think about it this way. Commodity fundamentals are generally fairly slow-moving. Financial markets are very fast-moving. So you can use long-term commodity fundamental views, let’s say a forward anchor point, but the price path that you take to get there is more determined by financial flows than it is by anything else. I think that’s what leads to a lot of difficulty for traders in markets. Because most traders, not all, but most tend to be very fundamentally focused and that takes a lot of time and energy to get a correct fundamental view. They tend to miss the more financial driven elements of commodity markets, which at times can be very big and significantly bigger than the fundamental or the physical side of the business.

[00:15:42] Hari

Can you do fairly well with no knowledge of the fundamentals? Do you have a perception on that, a view on that?

[00:15:49] Nicky

I think you can. I’ve never done a fundamental balance in my career. I was involved in commodity trading for seven or eight years, and not once have I ever done a fundamental balance. I am aware, though, of when fundamentals are pricing and when they’re not and a general sense of where the fundamentals should be. So it’s not as if you sit with a bag over your head or in a box trading without any knowledge of what’s actually pricing in markets. Often, you can see by the pricing actually what fundamentals are doing.

So without seeing what stocks are in China or what the flows are between two different locational benchmarks, you can infer a lot of it from physical market pricing. In oil, if you have a strengthening of structure in the Dubai benchmark, you can infer that fundamentals are getting tighter in that market. Now, it’s not perfect, obviously, and the pricing tends to lag. But there are things that you can infer fundamentally from certain structures when you look at pricing in pockets.

[00:16:58] Hari

So the more granular regional flat price movements, if you assume those are more fundamentally driven, which they probably are, and if you also assume, which I’m sure is true, that the futures markets operate with a lag, standardized contracts operate with a lag, then the degree to which they’re moving together is some kind of basis is a measure of the degree to which fundamentals are driving the market?

[00:17:24] Nicky

I guess you could infer it like that. Yeah.

[00:17:28] Hari

I see. So if the futures are in the short term detached from the physical prices, you can say that that’s a flow-driven market, whereas if they’re moving in tandem…

[00:17:39] Nicky

Another way you could look at it is, if you’re a more fundamentally driven trader, you’re probably utilizing more time spreads or locational arbs or transformational spreads such as cracks, trade margins, and such. So the majority of our trading should be driven by those commodity transformation spreads, so whether you’re using time, location or product. When financials tend to be more important, it should be a more flat price-driven market. What you can actually do is when you look at the relative volumes traded between these two instruments, you can infer that way. That is actually very clear.

When CTAs are dominating markets, you have a lot more flat price-only driven trading, and when fundamentals tend to become more important or let’s say changes in fundamentals are becoming more important to the market, you’ll find that spread-driven trading picks up, and you can isolate these volumes quite easily.

[00:18:43] Hari

I think Charlie McElligott, I may have butchered his name, at Nomura talks about CTA positioning a lot and so on. I’m sure you know him. He may well have the CTA model on his desk. Is that the sort of thing you look at too where you’ll think, if I were to build a bog standard trend following system that traded all the major energy markets, I can tell when these players are fully loaded on the long or short side and maybe that heralds a potential reversal or something like that? Is that the sort of thing you’ll look at?

[00:19:21] Nicky

Yeah, absolutely. It’s also very regime dependent. But yeah, we do build essentially a full CTA operationally, internally, to back out the weights or portfolio weights and hence positioning in each of the assets. It’s very dynamic because when you’re doing your standard vol parody optimization with leverage, you’ll get out these varying weights. When you’re looking, really it’s precisely at the flow and what we do is try to predict forward flow in lots for each asset. It’s another challenge altogether, and then you have to think about the liquidity of each asset changes, understanding the participation ratios of each asset.

You cannot use the same leverage in heating oil contracts as you do in Brent crude. So you have to understand how that affects, how big that position can be and sometimes then how long it takes CTAs to flip positions. Because Brent is a lot more liquid than let’s say copper, so it’s going to take you a lot longer to flip a position of similar size. You’re not just going to go and do it all in one go, it gets sliced through several days. So the pricing impact becomes persistent because the flows are spread out depending on liquidity and participation ratios.

So getting down into the nitty-gritty, you can then forecast how much flow you expect to see each day and there are ways to slowly validate that. You can’t get perfect estimators. You get some funds trading Asian hours, some trade on the US open or US equity open when all futures contracts are going live so you see the impacts all at once across markets. You notice spikes in volume every 15 minutes, on the 15 minutes and spikes at the close as well, where all the different CTAs are programmed to trade.

It’s never perfect, but you actually clearly see it. But you can use classifiers to understand and verify that these models are actually pushing excess volume in the direction you expect at certain price levels.

[00:21:33] Hari

Perfect. Is it fair to say that risk parity operates more slowly or they lag to trend following?

[00:21:39] Nicky

Absolutely. I think risk parity, it’s kind of like your silent whale in the markets where most of the time, you don’t notice that they’re there because they’re using a longer volatility kind of optimization. So CTAs are a lot more short-term volatility. If you think about how strategies have changed over the last let’s say 10, 15 years in CTA strategies, going back pre-financial crisis, probably some of the optimal lookbacks for CTA strategies was maybe going out to 12 months.

These days, it’s a really a lot shorter. If you think the optimal probably lookback even just on the Sharpe ratio basis in Brent crude over the last decade is around one month. So it’s really changed a lot. CTAs are really short-term vol optimizers to get into those positions because the moves are happening quicker. Risk parity, you’re talking somewhere between the 200-day and a 1-year lookback on a trading day basis for volatility.

[00:22:46] Hari

If you knew what the lookback window was for the volatility measurement for a risk parity fund or for the aggregation of the funds, you might be able to say when they would be forced to rebalance and use that as a guide to marginal flows.

[00:23:03] Nicky

If you take the situation that we have today, last year, we had the impact of the Ukraine war coming through the market, we also had a big distillate shortage last summer, which also pushed a lot of volatility through the crude market in July, and then also the bond market crisis, particularly with gilts coming in towards the end of the year. So all that volatility is then just slowly rolling out of these risk parity portfolios. We’ve already lost probably most of the February and March impact of the Ukraine war from last year and risk parity is certainly starting to re-lever, particularly into crude.

In another six to eight weeks, a lot of that volatility that we saw last July is also going to start to roll out of that calculation. So the Brent weight or the weight in more energy products in these portfolios will start to go up. Also, when you look at risk parity, the portfolio correlations have started to come down quite significantly in the last two months, and that means that the follow-through impact on portfolio volatility as a whole is starting to come down. So if you think, as a benchmark, that risk parity has levered to a portfolio volatility target of 10%, for most of the last decade, we’ve been bumbling along somewhere around 4% or 5% deploying 100% of leverage on top.

Now you essentially last year de-levered all of these funds and now you’re starting to re-lever. So you’re going to have this double impact of energy markets optimally gaining from volatility rolling out of that portfolio in the next two months and portfolios generally re-levering as correlations come down and volatility comes down.

[00:25:03] Hari

Jumping around slightly, nat gas has been the poster child of high vol. I don’t know, it peeked over $9 in mid-2022. It’s down to about $2.30, $2.40 now, at least Henry Hub. To what extent was that flow driven? To what extent could one formulate a bullish view based on the notion that vol cannot sustain itself at these levels indefinitely?

[00:25:30] Nicky

Yeah, in nat gas, vol is coming down. I think a lot of the moves that we have seen… Let’s say that the beginning of the move to come down was fundamentally driven. Nat gas is a fundamentally driven market, and whether you’re taking the signals from European gas now as markets become a lot more globally integrated and that was the reason we had a spike in gas prices. It was coming out of Europe. I think the moves this year in US natural gas have been a lot more flow driven.

We haven’t seen major position changes from any other major participants other than speculative money, and we’ve seen a drop basically from $4 to nearly $2 we reached earlier this week. That’s predominantly CTA-driven. Its positions are getting bigger, it’s mechanical selling into the market. We have seen more discretionary traders, they’re still short, so they are profiting from this. But on the other side of this trade, we’ve seen ETFs buying the biggest ever natural gas position and outright lots at least over the last decade, if not longer.

I think if you go on Twitter these days, you see people are getting quite excited about trying to buy the dip in natural gas and using the big US-listed ETFs to do so. Over 100,000 lots, it’s a significantly large position for that particular market. Given where natural gas or US natural gas particular liquidity is, we’re at a multi-year low in terms of trading liquidity in that market. So any kind of mechanical selling is just having an outside influence now.

[00:27:16] Hari

You said something that’s probably quite deep in there and I’d just like to unravel it a bit. Are you assuming that if a certain order goes through the market, that the number of lots traded is an important factor in price impact as well as the notional amount traded? If so, why do you believe that?

So in other words, if I’m trading 100 bucks of something and the price has gone down by 50% so I’m trading twice as many contracts, are you claiming that the price impact of that will be bigger than if the price were higher and I only traded a standard number of contracts?

[00:27:57] Nicky

It’s interesting to put it like that because I think most commodities traders don’t think in terms of notionals. You’re really thinking about the volume that you’re trading and the liquidity that’s in the market. You might think about, in terms of risk, but certainly, I don’t know that many people that think in pure notional terms. It’s more liquidity-dependent. If there’s someone on the other side of your trade, you can have huge amounts of volume go through with very little price impact.

But if general market participants are still constrained and there’s no risk absorber, you’re going to have a much larger price impact. I think that’s one of the most important things about studying flows or financial flows in commodity markets. The impact is very situation dependent and usually dependent on whether there is a risk absorber for that flow. The biggest moves that you usually see in commodity markets are when the normal risk absorber tends to become very risk constrained and either has to stop out or can’t or is var constrained and they can’t add any more positions.

I think those are the kind of times and situations that are usually extremely difficult for more fundamentally led traders because they’re having to usually stop out of positions without fundamentals actually changing.

[00:29:23] Hari

Yeah, we found the same thing in other markets, that lot size actually is significant. It isn’t just the notional amount traded. But I was wondering whether that’s simply because for risky assets like stocks or stock indices, when they go down, vol tends to go up, which maybe indicates less liquidity in the market. Whereas for commodities, I’m not sure what the relationship is. I’m guessing there’s a put skew for nat gas, but maybe oil has a persistent call skew because surprises tend to be to the upside. I’m just curious on your view.

[00:29:55] Nicky

Yeah. It varies by market. I think you’re right with natural gas. We’ve had extremely heavy fundamentals for a decade and not a lot of discipline from producers. But in oil, you have probably a lot more upside risk that’s quicker with geopolitical risk being built into the market. But it varies also because producers use a lot of options in crude. So how that bounces around depends on the amount of demand for producers on a hedging basis.

[00:30:23] Hari

Understood. I understand that these markets have fatter right tails, especially crude. But once there is a spike, does the risk become more symmetric? So in other words, if crude spikes from 60 to 100, that’s a huge upside spike. Let’s say vol was pretty low coming in, once the spike occurs and vol picks up, does the risk become more symmetric to the upside and downside? Is that something that you considered in your trading or you consider now in the way you think about risk?

[00:31:00] Nicky

Not necessarily. I think about it in terms of path of least resistance rather than symmetric risks. Usually, after such events, you do tend to get negative skewness in these returns. Because ultimately, in commodity markets, you have corrective mechanisms kicking in at some point. Now, you can say in a wide range of prices, demand could be relatively inelastic, but there is always a constraint eventually. Now, whether that’s in gas, people running out of money to pay for it, US gasoline demand gets a bit twitchy above $5, there are constraints there, it’s just where you find them.

So the corrective mechanisms eventually do kick in, but they could take a bit longer. If you don’t get a production response, supply responses tend to take longer than demand responses. So understanding where your constraint is, where your corrective is, whether it’s on supply or demand and at what price levels, that’s also kind of important to understand where that skew in terms of profitability lies.

[00:32:15] Hari

Which brings us to a research paper that you sent me, kindly sent me, where you try to relate fundamentals to price action, and you used OilX, which is an oil nowcast, as I understand it. I’ve seen nowcasts for GDP and inflation, I haven’t really seen one for oil. I believe OilX was bought by some larger research firm recently. I can’t remember the name.

[00:32:41] Nicky

Energy Aspects.

[00:32:43] Hari

Energy Aspects, that’s the one. Maybe you can tell me how you use the index and what you found in terms of the interaction between fundamentals, flat prices, term structure, and so on?

[00:32:59] Nicky

Sure, yeah. It was a really interesting project in collaboration with OilX. They have really interesting data series using really innovative ways to put those together in a more high frequency basis than we’re traditionally used to in oil markets. So they combine this satellite data and measurement of oil, all the oil that is moving around the world, with the machine learning models that they have to match it to historical recorded fundamental levels, to then come up with a daily measurement, if you like, of how that supply and demand balance is moving. They also record oil stocks daily and how that balance gets revised over the following months.

[00:33:54] Hari

How do they know how much oil is in storage? Did they use a radar or something?

[00:33:57] Nicky

Yeah. So they measure essentially the shadows on the tanks, because in oil markets, you have floating roofs depending on how much crude is in there. So the satellite can measure how full each storage tank is.

[00:34:12] Hari

There’s no privacy constraints in doing this? There are corporations moving oil around. It’s all perfectly fine?

[00:34:21] Nicky

I would imagine so. They’re in the open. I guess unless you’re not going over military space, I think it’s perfectly fine.

[00:34:29] Hari

Okay, so that gives a good indication of supply perhaps. How about demand? That seems harder to measure.

[00:34:37] Nicky

It is harder to measure and I think across most commodity markets, traditional analysts are all focused on the supply side. Demand is much harder. But you can make inferences based on how that data fits up with more higher frequency measures of demand. So you know the number of flights that take off every day. Mobility data is getting a lot better these days. Whether it comes from TomTom or Google, depending on the market, you can track movement a lot more. But then you’re still going to have those changes that you missed in the parts of the market that you can’t see from demand.

But if you also know how much refineries are running every day, you can get the real time measures or the pipeline flows into refineries. In some markets, you can get that data. So you can get some good measurements of demand and then you’re trying to understand the sensitivity of your demand indicator fitted against realized demand data, and then you can build a model out of that.

[00:35:43] Hari

So basically, you’re saying you only need to know the changes in demand, you don’t need to know demand itself. If you have some good measures and you assume everything else is noise, then at least you’ve got some estimate of the change in demand over time.

[00:35:59] Nicky

That’s the direction, yeah. I’ve not put this data together myself. I relied on OilX on it so I’m not the expert in collecting this type of data.

[00:36:13] Hari

I know you have an interesting section on oil on water, but maybe you can summarize what you found using OilX.

[00:36:20] Nicky

I looked at a bunch of the different data sets and I’ll just comment on the stocks first because that was a really difficult one, because we’ve essentially gone through a period in markets where inventories in oil have not necessarily been pricing, because you had essentially a global government intervention in storage with the release from the SPR. So it makes it very difficult to then ascertain how commercial entities are really reacting to this in a more manipulated variable there. I predominantly focused on looking at the daily changes in the supply and demand balance, according to their nowcast.

My first main question to ask is, do we see participant flows on the back of this? So before I even look at whether it has a price impact, I want to know if there is some trading activity around that. Predominantly for the supply and demand balance changes, we were seeing more physical market trading, which you would expect, than more speculative trading. The speculative trading from more managed money type of entities was more focused on the revisions to the balance that came later and this as more new data is released so there is a lag when bigger agencies start to report, there’s more prominence around some of these releases.

As that balance gets updated, that’s when you start to see it move further down the curve to more discretionary traders that potentially have poorer information historically than the physical commercial entities, they would trade a bit later. So within these types of mechanisms, it creates a persistence because you have different actors making the decisions at different stages through that cycle if you like. It just shows how difficult I think oil market fundamentals are and the importance of lags and getting good information.

We are moving to a world where getting real-time data and information is a lot easier and becoming much more important. Second, when you think about the price impact, it also follows a similar type of structure. The price impact of let’s say the S&P changes is more quickly observed in the more physical aspects of the crude market such as dated Brent, rather than in the futures contracts immediately. The prompt elements of the futures curve in crude are very noisy. You have a lot of roles going on, you have a lot of positional changes, as well as more discretionary and commercial trading around the physical books, more financial books as well.

So it takes a little bit of time for that information to move, let’s say, down the futures curve. Because discretionary or more speculative discretionary traders are trading again with a lag, you get that persistent effect coming actually through later.

[00:39:24] Hari

But for an entity such as a CTA or a discretionary macro that trades the futures curve, trades the forward curve, don’t they also have to worry about things like seasonality, whereas in the spot markets, it’s just instantaneous demand for the commodity? Doesn’t that create an added wrinkle?

[00:39:43] Nicky

Yeah, but very strongly by commodity, I think.

[00:39:46] Hari

Okay. The other thing that I wanted to ask you about was this oil on water input that seemed to be quite related to whatever’s been going on in Ukraine. As far as I could see from your paper, there was a strong uptrend in oil on water supply and a strong downtrend in land supply. Can you explain what your interpretation of that is?

[00:40:13] Nicky

Sure. The redirection of flows has been very inefficient for the market. As more restrictions on the movement of Russian barrels came into place, ships have had to take longer journeys and use more ships to move that oil. So it’s just led to a structural increase in the amount of oil that we now see on tankers moving around the world. As ships are having to take longer journeys and to also then transform the crude in different places to move it back to unsanctioned places, it gets a lot more complicated.

[00:40:53] Hari

So that should put upward pressure on prices. Is that the rough conclusion?

[00:40:59] Nicky

I wouldn’t say that. I think it’s putting upward pressure on freight prices. Probably the shipping markets absorb a lot of the price increases. The demand for tankers goes up, but the demand for oil has not necessarily changed. It’s just the system and the cost involved have become a bit more. So maybe there’s a bit more involved in that. But whether that really follows through into the futures market or whether it gets absorbed through some of the arbitrages and the freight elements remains to be seen, I think.

[00:41:34] Hari

Perfect. The final major topic I wanted to discuss was the almighty US dollar, I guess, maybe that’s the wrong phrase. But obviously, major commodities are priced in USD, and they continue to be, at least for the foreseeable future. Where is the DXY, which I think is produced by the Fed, flawed in terms of looking at changes in a nation-weighted dollar versus changes in commodity prices? Can you explain what you’ve done there and why you think it’s significant?

[00:42:10] Nicky

I wouldn’t say it’s completely flawed. But for the relevance for commodity traders, it’s just not very high. The DXY is I think 52% or 53% euro, then you have yen and Swiss franc in there and some of the Scandinavian currencies. It’s a very old index and it doesn’t really reflect the importance of commodity importing countries at all. The biggest commodity importers are actually missing mostly from that list, ex Japan.

[00:42:44] Hari

What’s a big importer? Korea, perhaps?

[00:42:46] Nicky

Japan, Korea, India, China, a lot of the incremental commodity demand is coming from Asia and so this index doesn’t really capture any of that whatsoever, really. So what I wanted to do is create an index that was reflective of the major commodity importers. As we spoke about how the elasticity affects demand, earlier, it also varies by nation, especially nations that import a lot more commodities, in dollarized terms, than they export. So those countries in my index have a much higher weight than, say, big commodity exporters such as Australia.

But you need to have all those countries in order to understand the actual impact of the dollar changes on the currencies of those countries that are importing the most commodities and not transforming them again and then exporting them. So there’s a kind of dual effect there of really understanding where the sensitivity should be and how it should be weighted and accounted for. I think that’s where you get the demand response.

Some countries are a lot more sensitive to pricing. What I found when I was looking at the dollar is it’s really more about the speed of change. Because when you’re seeing quick moves in the dollar against these countries, you see more of a pause.

Even if you’re looking at commercial data on this, in strong dollar upswings, let’s say that your commercial long element of your commodity markets tends to slow down, so the buying slows when it’s moving quickly. Once the volatility comes down and you reach a level, the level is less important because people adjust. It happens slowly, but they adjust to a new normal and a new level and that’s the basis of business. But when things move quickly, especially on the upside so that things are getting more expensive, there is a demand response where buying slows down and it’s kind of a wait and see, a wait does happen it comes back down or wait to see what the new normal is.

[00:42:56] Hari

This is sort of embedded in the bigger discussion that goes on all the time about how the volatility of inflation, broadly, is more dangerous to the global economy than just the level even if the level were 8%, 10% if it just stuck there.

[00:45:18] Nicky

Exactly. Especially when we’re talking about macro variables, there always is an adjustment. But it’s more the volatility in short-term moves that tend to put the brakes on things because people can’t make good forward assessments.

[00:45:35] Hari

Well, the Fed apparently uses oil price expectations, actually, oil prices and inflation expectations as inputs to its, at least informal inputs to its policy decision-making. Is that something that you have looked at that you find relevant in your own work as well, looking at expectations rather than just price action?

[00:46:01] Nicky

It depends how you want to measure expectations because if you’re using commodity futures curves to do that, that’s a very silly way to do things because commodities are spot assets, they’re priced on the spot. So if you’ve got a very backwardated futures market (and I have seen this mistake made over and over again), saying because the price in the future is lower, that’s not the expectation of the price. It’s not a bond curve where the forward bond futures represent forward pricing expectations. Commodities are not like that at all. It’s the spot that really matters.

[00:46:43] Hari

A storable commodity. Yeah. Right. Understood.

[00:46:45] Nicky

Exactly. So thinking about it in those senses, it doesn’t really make sense. Now, commodities are a risk asset where inflation is hedged on. When you look at the best inflation hedges that you can get, CTAs are a part of that, but also energy and industrial metals are very strong inflation hedges as well. So you see the impact when inflation expectations are rising, positions built on forward inflation expectations increase in the market and it gets a lot more price sensitive to moves. They are intertwined, obviously, because higher oil prices do increase forward expectations for inflation. But again, it’s the rate of change that matters for that, not the other way around.

[00:47:37] Hari

So this mythical academic quantity called convenience yield contains more information about hedging activity than it does about real expectations for price action?

[00:47:49] Nicky

I think you could argue that. Yeah. again, I think you just have to understand the dynamics of each individual market. Not all futures curves are equal.

[00:48:02] Hari

I think we’ve covered the three major things. I was hoping that you could maybe spend a minute or two telling us about your current business, what sort of clients you have, and what your outlook is or your prospects, your strategic vision might be, just to string together a bunch of business words for the future, for the business.

[00:48:22] Nicky

Sure. We predominantly focus on a lot of the things I’ve discussed today. It’s solving that puzzle between what is actually pricing at any given time and who the marginal buyer and seller need to be in any given moment to assess actually what the forward price drivers are, and who, as in a group of participants, it will be by understanding the incentives and constraints of each of the major participants. We try to formulate the path of least resistance on a short-term basis. So our research, our weekly research tends to be highlighting where the market sits today and over the next one to two, three weeks, given those participant constraints where we expect it to go, and it’s trying to make sense of a lot of that noise.

Most of our clients are fundamental traders sitting in major trading houses or hedge funds where this is a bit of a blind spot for them because they’re mostly focused on actually understanding the fundamental side of their markets. Then we also produce, as you’ve seen, some more long-form deep dive research. That dollar piece I wrote last summer when for all of Q3 for crude, fundamentals were not pricing. We had a very macro-driven environment in Q3 last year and the dollar was the key element of that because it was the fastest-moving and most prominent piece of that puzzle.

So helping traders explain and understand and then measure the impact of that on commodities when you have major themes popping up is something that we try to stay on top of and contribute to.

[00:50:10] Hari

Perfect. Do you provide advice in the options markets as well for the various assets you trade?

[00:50:16] Nicky

Absolutely. I think the options market is probably going to become a much bigger market going forward. We’ve seen a trend over the last several years of a lot more commodity traders now sitting in hedge funds and pod funds where they have a lot stricter risk controls than they might have been used to in the trading houses because trading houses understand commodity volatility very well and understand that you have to warehouse risk to make money in this market.

Whereas in the traditional hedge fund world, having very tight drawdowns and limits and stops putting on positions, it means that options will become the weapon of choice for a lot of the industry. We saw that very clearly last year where we had absolutely enormous positions in the options market, especially in crude, but a lack of people trading futures. Obviously, you need the futures market to move to put those options positions in the money, and we just had a disconnect.

So everyone was sitting waiting on their options but no one was buying the futures to actually make that happen for them. I think we’re going get a few more contradictions like that. Staying on top of where these flows and positions are sitting, whether it’s in futures or options, will be really key going forward to understand where those constraints are.

[00:51:39] Hari

Speaking of options, do you have a vibe on what the natural skew should be for the various markets that you talk about? You mentioned oil should have a call skew because there’s a greater risk of some external shock driving prices upward rapidly. Do you have a view on other markets like nat gas or things like that? Is that stuff that you look at or you include?

[00:52:04] Nicky

Yeah. I don’t look at the world from an options trader. I look at how does the options market influence the futures market, which is where the price gets determined. So I think skew is less important than positioning and flows for looking more for futures market impact. I think skew is more important potentially coming from your background with a volatility view.

[00:52:30] Hari

I see. Understood. But if people are using options more and more, based on their constrained risk profiles, clearly there will be distortions that are formed based on what people have to do to stay below the limits.

[00:52:43] Nicky

I think that’s absolutely right. But if you think about who some of the major participants are in options markets’ commodities, directional traders probably don’t care as much about volatility. They’re more price-takers here. Producers, again, don’t care about the volatility measurement. They get a price and whether it’s acceptable or not, they’re going to execute it. So for volatility traders, probably, in commodity, there’s going to be a rich hunting grounds as more price-insensitive flows move towards that market.

[00:53:17] Hari

Got it. Okay, great. I am tapped out. If you’d like to say anything, in conclusion, be my guest. It’s great to have someone like you on.

[00:53:26] Nicky

Yes. Well, thank you very much. If any of your listeners want to know more about our company, they can visit our website at itsnotascience.com and find out more there.

[00:53:36] Hari

You’re perhaps the most scientific person who has the disclaimer INAS stuck on your logo. So congratulations for that. I respect that.

[00:53:46] Nicky

Thank you very much.

[00:53:47] Hari

With that, I hand it back to Niels.

[00:53:51] Niels

Thank you so much Harry and Nicky for a very insightful conversation into what really drives commodity markets from a macro and capital flows perspective. There was a lot of information to digest, but of course, it was fascinating to learn what the real market drivers of the energy markets are and in particular during periods like COVID. Of course, the influence of commercial participants and speculators like CTAs is very useful to understand especially during which periods one group is more dominant compared to the other, and also because of Nicky’s view that many commodity market participants miss the impact of financial flows within commodity markets.

Also, the recent activity by ETFs in the nat gas market was quite interesting to learn about, as well as the difference between how CTAs and risk parity funds react in these markets was super useful to understand. Finally, the section about the challenges within the DXY construction, as it lacks exposure to the biggest commodity importers, was quite unique in my view. As I’m sure you can tell, we think energy and commodity markets, in general, are super important and critical to understand, and we will do our best to continue to bring you more great content in this area of finance.

Make sure you go and follow Nicky’s and Hari’s work because as you can tell from today’s conversation, there are many exciting facets to learn from these people who have been in the trenches for many years, and we really look forward to exploring many more of them as our series continues. From Hari and me, thanks so much for listening and we look forward to being back with you on the next episode. In the meantime, take care of yourself and take care of each other.

[00:55:41] Ending

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