79 The Romance of Trading Commodities with Mike Coleman of RCMA Asset Management - 1of2

Niels

Welcome to Top Traders Unplugged, where my goal is to give you the clarity, confidence and courage you need to invest like or invest with one of the top traders in the world. It is the stories that you never get to hear set out in the most honest and transparent account I can make of what goes on inside the minds of some of the best investors in the world. Today you’re listening to episode 79. If this is your first episode you’ve heard, you might want to go back and listen to all the earlier conversations. Before we go any further, let’s find out who’s on today’s show.

Mike

This is Mike Coleman, Founder of RCMA, and you’re listening to Top Traders Unplugged.

Niels

Thanks for doing this Mike, and by the way, if you want to read the full transcript of today’s episode just visit the TOPTRADERSUNPLUGGED.COM  website and sign up by hitting the button in the top right-hand corner, it’s really that simple. Now let’s get started with part one of my conversation. I hope you will enjoy it.

Mike, thank you so much for being with us today. I really appreciate your time.

Mike

Thank you!

Niels

Now you are a little bit different from most of my guests in the podcast, since you’re the first manager that I’ve spoken to that is based in Asia, and more specifically in Singapore. I guess another slight difference about our conversation today is the fact that I just visited you in your offices in Singapore where we had a chance to meet up in person, which unfortunately I don’t have a chance to do with most of the people that I speak to.

Of course, another unique thing about you and your firm compared to many other firms is your focus and dedication to the commodities, both the physical and via commodity futures. So, I think we’re in for a rare treat today during our conversation as we get into your story and your strategy. Before we jump into all of the details, I just have a simple question that I try to ask all of my guests in order to appreciate the many different answers there are to this question. It’s a little bit about what you answer and how you explain what you do when you meet people for the first time who don’t know you, and they basically want to find out what you do. How do you respond to them? How do you explain what you do?

Mike

Yeah so we’d explain it that we’re trying to make available to investors the trading approach, style, and philosophy, that the large physical commodity trading houses utilize on their prop desks. So, if you could isolate what Cargill’s corn desk, how it analyzed markets how it takes positions. And we try and apply that philosophy style and approach, and make it available to general investors.

Niels

Excellent, but we’re going to stay with you a lot longer now because I really would like you to go and tell your story –  how you got into the business in the first place. Perhaps in order to put a little bit of extra color on this, tell me a little bit about what you were like as a kid or a young man growing up. So, I’m going to leave that with you now, and sit back for a little while, while I listen and learn as well.

Mike

Okay, well I come from the Northwest of England, just outside Liverpool, in a town called Saint Helens, which for people who know it, is a sort of Northern industrial English town. So, I grew up in a town that was coal mining, and glass making, and very famous for its Rugby team, so a working class background. As a kid, I guess there were two things relevant to how my career turned out. The first thing was that I always wanted to travel, and the second thing was I, from quite an early age; I was always trying to figure out how you might be able to make money. In particular, I had an Uncle, who was very keen on horse racing. He used to have me run these bets down to the bookies and explain to me alts and so on, and so that play gets passed in the long run.

I went away to university in 1979, with no idea that I might become a commodity trader. My degree is actually in geology, and at the time I was thinking that you know, I’d like to be an exploration Geologist out in the field, you know, prospecting for gold or, petroleum or whatever. Purely by chance when companies were visiting the University in our final year, and you’re beginning to think about what jobs you’d like to do. I was on my way back from Rugby training one evening when one of the guys I was with said that there were free drinks at the East Gate Hotel tonight. There’s this company called Tradex from Geneva whose throwing this drinks party. And Tradex was the name under which Cargill operated in Europe in those days. So I went to lunch with this drinks party, and they showed a video, but probably in 1982 it wasn’t a video, it was a film or something about grain trading. The film started, there was a shot of combine harvesters rolling in the Midwest, cut to the trading floor in Chicago, a shot of a Panamax boat loading in Baton Rouge, flashed to a trading desk somewhere where traders were screaming into telephones. And I just looked at this and thought, that looks like an incredibly fun way to make a living. There was a big  attraction that played into my desire to travel more widely was that they were offering second interviews in Geneva, which as a poor student was quite an interesting proposition.

So, I went along. I learned a lot more about what Cargill did, what Tradex did, what commodity trading was. The analogy that sort of struck my mind immediately was you know, in a way this is just like being a bookmaker, and so I can sort of think about that and you know… and it just struck me as what a fun way to make a living. Cargill at the time was quite concerned, and I think is still concerned today. How do you know whether somebody’s going to be a good trader or not? And the answer is, you don’t until they actually do it. And so you’re looking for clues and signs and so on, but a big element is about somebody’s personality. Is it robust enough to be able to stand first of all, the pressure of market price movements and constant P&L feedback? Secondly, is it robust enough to be able to sit on a trading desk and be shouted at, be sworn at?

So Cargill went to some pains, that once they selected the people who were going for second interviews. They encouraged us just to go and spend a day on the grain desk in the UK, which in those days was at Maidenhead, near London. So, do you think you’d be able to work in this environment, and they went through great pains to stress, you know, this is not an environment that would suit everybody. And again, I went down and… Trading floors today are very tame and very quiet. So first of all, nobody talks on the phone anymore, they’re all busy instant messaging, but when they’re on the phone they’re by the standards of 1982, very polite. So you know I sat around this trading room, and people were screaming and swearing at brokers. Phone abuse was a big problem. People would literally slam their handsets and break them. Today you walk in, and at the risk of sounding like Madmen or something, was the world really like that? Yes, it was! It was a very, very, very different world. So, just that combination of…

Niels

The energy!

Mike

The energy, the excitement of markets. I think what you find when you talk to a lot of people about why commodities, rather than equities or bonds. I think there is the physicality of commodities that they’re real things – their historical context, you could argue that the modern economy as we know it came about with sugar, and coffee and the whole colonial movement if you like (generated commodities) from the sixteenth century onwards. And so commodities have this romance, a physicality that’s sort of missing in bonds. Bonds are a piece of paper, and equities are a piece of paper. A Panamax of grain is something you can get your hands on. Please stop me if you think I’m going on too…

Niels

No, no, absolutely go ahead!

Mike

Anyhow, at the end of the day I had to make a decision. I was offered a job by an oil company to be a petroleum exploration geologist, and the job by Cargill to be a trainee commodity merchant. I decided that probably being a commodity merchant would be much more fun. So I took Cargill’s job. Then in a sort of quirk of fate, I took the job fully expecting to be a grain trader. It so happened that that year Cargill had bought some soft commodity trading businesses, and so my first posting ended up being to this newly acquired rubber trading business. So I started my working life as a junior merchant in Cargill’s rubber department in London. Two years later I was given the opportunity to spend some time in Singapore. This was originally a two-year assignment, and I’m still here today.

So, I came to Singapore in 1984, spent the 30 years since the first year, in Singapore. My career in Cargill was very atypical. I spent a long time in one location. Usually, the normal experience is that you get moved every two or three years to different locations, and different commodities. I ended up running Cargill’s worldwide rubber business in the early 90’s. In the late 90’s I ran Cargill’s petroleum trading for the Asia Pacific, so I’m a rubber trader who became a petroleum trader.

In 2001, I left Cargill and went to work with Marubeni, and while I was at Marubeni is where I developed the idea for what became the Merchant Commodity Fund and this idea of if an investor… and this is now 2002, 2003. At that time, if you were an investor wanting exposure to commodity markets, you could go buy a commodity index and be long-only commodities. You could go buy the equity of a mining company or an agricultural company, and you’d be long because of the company specific risk. What you couldn’t easily get exposure to was you know, how do professional commodity, physical commodity traders make money? And you know if you think about it in terms of sustainable alpha generation, this is a model that when done well has enabled companies. You know Cargill, this year is celebrating its 150th Anniversary, and Dreyfus is probably older than Cargill.

So you know, for centuries the approach of utilizing fundamental supply-demand analysis, a deep understanding of how the commodities produce process move, what it’s elasticities and frictions are that this is a sustainable way to take alpha out of commodity markets. So back in 2002, 2003, investors were unable – there was no way to get access to that, and there were very few discretionary and fundamental commodity fund offerings.

There were traditional CTA’s but by the early 2000’s they were typically more financial than commodities and the approach, generally systematic rather than fundamental. And so I felt there was a real market need for the approach because at the time it was becoming clear that what was going on with China was transitioning the commodity markets out of what would have been a long, bearish couple of decades into a bull market and potentially bull market that could run for some time, and that, therefore, there would be investor interest in commodities. And the weaknesses of long-only investing would become apparent fairly quickly.

Niels

Right, right. I wanted to ask you… I mean, the way you explain it, and I think that it’s very interesting about just the brief introduction you’ve given about what it really takes to take alpha out as a fundamental commodity trade. I mean I can’t think, off the top of my head, of any other firms, and I know that they exist today. Do you find that there are many people doing what you do and offering it to investors in the way you do it? I mean, are many of your types of strategies out there?

Mike

No, there aren’t many. There are more than there were in 2003; there are less than there were in 2011. So, the bull markets in commodities sparked interest, and if you like, people like ourselves, the early movers, demonstrated that you could raise significant assets with the right offering. There is naturally a limiting factor to our approach. That is that you need to have a really good understanding of the commodities that you’re trading, and more importantly you have to have a good enough network to gather real-time fundamental information in what are very opaque markets.

So, if you think about it, in the world there are hundreds of thousands of equity and bond traders, hundreds of thousands of FX traders, but there are only several thousand commodity traders. So it’s a much smaller universe. It was also a universe that was generally contracting during the 80’s and 90’s. So, from the early 80’s onwards, commodity markets have had a very strong 1970s. That was like the climactic moment, you might say, when a bunch of metals traders were able to buy the world’s biggest bond traders. So, when Phibro bought Salomon Brothers sort of marked the high water mark of commodities relative to financial assets.

By the mid 80’s we were just beginning the 30 year bond bull market, the 20 year equity bull market, and the tide was shifting. The 80’s and 90’s saw in a lot of commodities, a significant downsizing of the numbers of companies active in those commodities and to an extent was one-off of shift of commodity traders into the financial markets in the mid to late 80’s. So by 2002, you know if you think… Let’s say to be able to offer this strategy credibly you have to have experience in commodities. You would probably have worked for one of the big commodity houses, and by definition you’re going to be somewhere… You can’t be much younger than your mid 30’s. So, that pool of people in 2003 was quite a small pool of people. By 2011 it was a bigger pool of people, but the opportunity cost of giving up a job on a prop desk at Cargill, or Dreyfus, had gone up considerably from where it was in 2002, 2003.

Niels

Sure. I agree with that, That’s a key difference in many of the systematic strategies that I am more familiar with. Essentially technology allows you, even at a young age (if you understand technology well)… You probably need to understand a little bit less the underlying markets, because in itself, it’s systematic, and they don’t look at fundamentals. So you see certainly more of the sort of younger generation getting into that space. So you make a very important point there. But I also wanted to ask you, before we move on, as you look at your career at Cargill, what do you think of all the things you learned, what do you think has been the most important thing to bring to the fund management side of what you do?

Niels

That’s an interesting question, I think there are two aspects. On the investment side of things there is the process of supply-demand analysis, and the understanding of how that interacts with price and the source of nonlinearity of price behavior to… sort of the straw that breaks the camel’s back. So, a global surplus of 1% might have no impact on price, whereas widen that surplus to 2% and the price halves. And it has to do with free inventory levels and the ability of the system to carry inventory and so on.

On the business side of things, and I think maybe this was equally as useful, because Cargill… if you’re in the management trainee program and so on, and you know, my career I was given the opportunity to manage trading businesses from about… you know I was a desk head at the age of 25, 26, in what was a small new business. But the fact is that you get lots of experience in how to run a business and how to… You know, how does the accounting function work? How does the logistic function work? How do workflow process, so on and so forth. Usually, an important element was I started work several years before computers started appearing on people’s desks, and one of your key jobs as a junior merchant was to do the P&L by hand.

Niels

Right! Hard to imagine these days right?

Mike

Hard to imagine these days! What that does do, that gives you a really great understanding of how the pieces fit together. Also very importantly, it was a matter of your professional developments as a trader, that you should always know what your P&L is, better than the accountants do. So if ever you get a number that you should instantly recognize whether the P&L number that’s being put in front of you is right or wrong. And that’s actually very important, I think a lot of guys, particularly if you grow up on the trading desk of a big investment bank where everything from that aspect, everything’s a black box. Your accountants hand you the P&L report each day, you’ve not played a hand in constructing it, you maybe don’t know what costs are being allocated, so on and so forth. So, that very nitty-gritty of how do you run the mid and back office of a trading business? It was actually very… A hedge fund management business in terms of complexity is actually not a very complex business relative to when you’re moving cargos, a physical commodity from point A to B.

Niels

Yeah, and I wanted actually to ask you about that because today, in a sense, you’re objective is to make money. Back then I imagine without being an expert here, I imagine a big part of what you were doing was also logistically, as you say, you were moving physical goods. Goods from one place to another and so on and so forth. So, how was… what was the sort of day-to-day back then, really the split between the physical side if we call it that, and just the side of saying, “Well you know, we obviously need to make money. That’s part of our objective as well?”

Mike

As you move up the organization, typically early in your career you’ll be focused largely on the physical side, so in effect you’ll be a sales trader. So, the desk head or the senior trader in your area would say we need to get some stem for this vessel. Here’s the price we’ll pay, and you go sweet talk the supplier A, B, C, D, and get them to sell it to you. And equally the boat’s arriving in a week, we haven’t sold anything yet, go hit the SEF market with offers and do that.

So, on any trading desk, typically in the physical commodity, most of the people are actually involved in that procurement/sales process. The number of people who are actually managing the price risk that’s been built up and aggregated is actually quite small. And I guess the sort of first few years of your career, the company is assessing, are you one of those guys who can move into the trading roles? The true trading roles? And for many people, it’s a real skill to be able to sell the commodity, buy the commodity. You find people who that’s their highest and best use, and they have very satisfying careers, can make very, very decent amounts of money without being the primary managers of the P&L. There’s a smaller subset who have the… On the trading parts of things, the analogy I like to use to some extent it’s like playing the game. It’s like a sport that you and I can read the rules of soccer.Wwe can watch a soccer game, and we can understand. We can recognize, he’s a good player, he’s a bad player, here’re the tactics that they’re using, this is what the coach is thinking. Could we get on the field and actually score a goal? That’s only ever going to be 1 or 2 people out of 100.

Niels

Sure, sure. Now, before we move on, I just want to ask you a completely different question, and that is obviously running the business today is a big part of your life, but what do you do when you’re not working? What do you like to do in your spare time?

Mike

My wife would say, lying in front of the TV and reading books, which to an extent is true, but my passion outside of work is Rugby, and I used to play when I was younger. In more recent years, I had the opportunity to become an owner, a part owner, and director of my hometown professional Rugby Club, which gives me a lot of… I was going to say pleasure… but, heartache and pleasure depending on how the results go. So, then I enjoy traveling with my wife, my kids now are grown up. Ones in Hong Kong, one’s in London, so, I get around to seeing those guys.

Niels

Sure. Just on sort of a broader question, but someone with your experience might be able to shed some light on it. I mean, in order to succeed when you set up a business, really regardless of what industry it’s in, you need to be sort of at the right place at the right time, with the right team. When you were starting out, did you feel you had those three things covered? Or how do you ensure that you have those things lined up when you start out?

Mike

I think as I look back now, and maybe it’s the way most businesses start, that you’re a naive optimist. So, I got seed investor lined up; I was excited about the chance to do this. I was a bit disappointed for their own good reasons, Marubeni had not wanted to do it, so I had made the decision to come out and set up my own business. Looking back, there’s a lot of stuff that could have gone wrong that didn’t, and we were definitely very lucky. So, I think it’s an interesting thing, I mean a lot of people and particularly when it’s established firms, they develop investment products to meet the market need. What Doug and I did differently, was that we gave the market the product we had. We were very lucky timing wise that that happened to coincide with a period when the market really wanted the product. So, you know, our two year results in 2013 and 2014 are far superior to the first two year results we had as a startup unknown hedge fund. Yet we’ve raised less money in the last 24 months than we did in the first 24 months, and that’s because there was a lot of investor interest in commodities in ’05, ’06. So if we would have started two years earlier, or had just started two years ago, we might not have made it through the burn period.

Niels

Sure, sure, no absolutely. Remind me here Mike, because I’m sure you know this, someone who also lives in Singapore, very famous, Jim Rodgers. Was the time when you started your business, was that around the same time that he launched the Rodgers commodity index and all of that? Was that taking place at the same time?

Mike

I think he was a couple of years earlier. He hadn’t yet moved to Singapore, but I think Jim Rodgers had started doing that a couple of years earlier, so late 90’s, early 2000’s.

Niels

Yeah, because clearly I remember that it also put the spotlight on that sector, there was a lot of interest…

Mike

It took a couple of things to start happening that came together. The first thing was that commodity prices went up, and particularly the oil price went up. So, the oil price had been very weak after the Asian crisis. It was a big deal in I think 1999 when it got back up to 20 for the first time in a long time. Then in 2002, 2003, the oil price got to 50, which that was like unimaginable. It got through the peak of the first Gulf War and back to the level of 1980.

Because originally the fund had been due to start in mid-2003, and because of Marubeni’s rethink, we think we ended up not getting started until the summer of ’04. We were actually frightened that we’d miss the big bull markets of 2002 to 2004 because during the 80’s and 90’s no bull markets have lasted longer than 18 months. So, there was a lot of things coming together; people were beginning to realize that it wasn’t business as usual in China and that this would have quite potentially profound impacts on commodity prices.

Niels

Absolutely, another thing is, is that part of the process of striving towards something, which you clearly set out to do, it’s also about enduring a certain amount of, for lack of a better word, suffering. I mean I know you had a great run to begin with, but you also had a big “setback” in terms of AUM later on. So, many entrepreneurs if I put you into that category like so many other fund managers, there’s the good times but then there’s also the suffering to some extent during this journey. How do you frame that? How do you frame that part of the journey that allows you to carry on, instead of just saying, “Well I’ve had enough.”? How do you frame those periods?

Mike

So we had two periods of what you might call suffering, so we took no salary for almost two years. So, if you look at the evolution of our AUM we started with 10 million dollars, we were still only 10 million dollars a year later. At 18 months, we were still only 30 or 40 million dollars. So we started in June ’04; it wasn’t really until May, June ’06 that we felt that the business reached sustainable cash flow profitability. So, we had two years in the beginning, and you know the burn rate at that time as a percentage of our net worths was quite significant and so I’d gone into it saying… I discussed it with my wife, saying, “Listen, I really want to do this, I think there’s a chance it could be very successful. I’d kick myself if I didn’t take the chance.” But we’ve got enough money… you know it’s a three year project. If at the end of 3 years it’s not working then at that point I’ll have to go back and get a job.

By late ’05 we were… you know it was like returns are good but the money is still not coming. It was a touch and go period, but, fortunately, that then turned around very dramatically at the beginning of ’06. The experience in 2011 to recently, in a way it’s more difficult because like everything in life it’s harder when you have something taken away from you than when you start with nothing and build it up. So we were almost five years above 1 billion dollars, and then suddenly we’re approaching 100 million. Again, can we face doing this again? And we decided we could, and I think it’s a variety of reasons we decided that. First and most importantly we felt that our models still worked and that we could still sustainably generate alpha, and it’s actually what we enjoy doing. Secondly, we did feel an obligation, a sense of responsibility to the by now, small number of investors who’d stuck with us to get them back to high water. And there was, of course, personal pride, we didn’t want to walk away on the down low. So it’s that combination of things. So that’s tough but you can’t shed too many tears for us because we’d had five years of being over 1 billion dollars. So from a material point of view, 2004, 2005 was a lot more psychologically difficult because where you’re not got… you’re burning through what capital you’ve managed to build up in your life to that day, so that’s a much higher risk.

Niels

That’s very true, and of course today we’re going to be talking about the… I mean I guess the merchant commodity fund, is everything you manage today, is that inside the fund? Or do you actually do it by managed accounts as well?

Mike

No, everything’s in the fund.

Niels

Okay, okay. I wanted to jump to sort of the first topic that goes more into sort of the strategy and the business. It’s a little bit about how do you organize yourself as a business in order to run these things? Now as I said in the beginning, my strength is not sort of discretionary commodity trading; it’s in the systematic space. So, I know that pretty well, but what does it take from an organizational point of view to run the strategies that you do? And I don’t even know whether that changes a lot, whether you have 100 million dollars or at your peak 1.5 billion dollars under management. How have you organized your business?

Mike

2.5! In June, our peak AUM was 2.362 billion in June 2008. Oh, February! One of my colleagues listening in is saying I’m wrong, 2.538, February 2008. Anyhow, we… and again this is just… We didn’t design it this way; it’s the way it is. We were very fortunate in the scalability of what we do. So, the majority of the instruments we use in the fund are exchange-traded futures and options, mostly futures. So, that allows great scalability, so actually our mid back office is the same size today as it was when we were 2.5 billion. It’s just a matter instead of trading. If we were 1 billion dollars today, for every 1 contract we trade today we’d be trading 5, but it would be the same number of tickets, it would just be bigger tickets.

So more importantly we’ve always had the benefits of scalable simple to administer instruments. So if you’re doing a credit strategy where you’re dealing in synthetic credit obligations then you’ve got mountains of paperwork and legal understandings, you know we’re dealing in simple instruments. What’s very important are the processes for managing risk and managing position. So we have, which again was the benefit of our backgrounds that we were able to very quickly put in place a system that enabled us to… the basic principles of trade reconciled, P&L reconciled, building the… So we’re able to build our internal NAV every day. So, you need to be able to put in place those processes, and we were able to do that. So just the principles, I think a lot of people when they start up, you know the focus is on have you got the investment side right? This obviously is the key driver, but equally you have to be able to demonstrate to people that you can run a business as well. So we were a bit older maybe than your typical start up manager, so I was 44 when Merchant Commodity Fund kicked off, Doug was about 37. We’d run big complex businesses, so the setting up of the processes and the business didn’t faze us.

Niels

Right, and how big is your team today compared to how big it was maybe at its peak?

Mike

So at its peak we were about 16 people, and today we are 11.

Niels

Okay, alright, so not a huge difference.

Mike

No, no, because when we downsized we just downsized the front office, so the mid back office stayed unchanged. What happened was we took away three traders and three analysts.

Niels

Right, and if you weren’t… since you’re now back in the growing phase of the business, I’m just curious here, once you start adding new people to your firm again, what would you be looking for in those people? What’s important to you in building your team and the team you’ve built?

Mike

Well, on the front office side of things obviously it’s a deep understanding of if we have enough assets, and then we decide, okay we want to go deeper into this particular area or start looking at an area we’ve not been looking at. Then you’re looking for good traders with great networks, a high level of personal integrity, guys you can trust, and guys who are real professionals. And for us that really means that they have got to have had some significant time moving commodities. So far, we’ve never taken somebody who’s come purely from a derivative background.

Niels

Right, right, and in terms of culture in an organization, you obviously worked for many, many years within Cargill, as did Doug. What was the culture like, and have you adopted that culture? Have you developed kind of your own culture in your business?

Mike

Well I think it’s one of Cargill’s great strengths is its culture. I think I said earlier they’re celebrating their 150th year this year, and so clearly they do something right on the cultural front. Not to say it’s perfect and so on, but the sort of trading environment culture that we grow up with in Cargill, we’re very much products of that. It’s about integrity, honesty, being willing when you’re wrong, admit it, put your hand up, don’t put the trade in the draw. Be willing to stand up and argue your position, don’t slight hierarchy. So, that’s the culture we grew up in. We think it’s a good culture. We’re fortunate that we can apply it in a small organization. Like all big companies, you get into some bureaucratic issues when you get to lots of people. We were able to… A big drive for what we wanted to do with the hedge fund was that in a way we wanted to get away from managing lots of people and a big corporate process, and get back to the essence of what we do.

Niels

Sure, sure, and part of the essence of what you do, of course, is developing a track record, so let’s talk a little bit about that.

When I talk to systematic traders to some extent you could possibly argue that it’s easier for investors to look at a track record like that and have some idea as to how it would perform in the future if some of the same events would occur, but you’re somewhat different. There is a again for lack of a better word, discretionary inputs in your analysis and so on and so forth. So, how do investors get comfortable with a track record like that? Because it doesn’t necessarily reflect, you have to do the same thing next time if something comes along, so how should investors really read a track record from a discretionary trader?

Mike

I think they have to focus on firstly the process that the trader’s going through. So, is that process robust? Does it endure over time? And secondly and there’s no way to get away from it, in a discretionary offering you’re making a bet on the person or the people. And therefore you have to get really comfortable with the people, and so in a way that’s sort of a drawback to the scalability of what we do.

Niels

And in your case Mike, who would you say are the people who drive, besides yourself, that drive the performance that people have to get comfortable within your organization?

Mike

Today, because I’m not on the trading side anymore day to day… so it’s the people managing the risk, so the CIO and the trading team, and then you have to be very comfortable with the risk process that’s putting the parameters around that team.

Niels

Yeah, yeah, and in terms of… and again I’m using sort of maybe terms that come from the systematic space, but allow me to try anyway. Is the program itself, or the strategy, is that performing as you would expect from your “research”? I mean I guess you have expectations to some degree as to what you expect the alpha or the performance to be using the strategies or the models that you have. So, is it doing exactly what you expected or expect from it?

Mike

I think generally yes. So, we start off with targeting the volatility, so we’re targeting 21.5% volatility.

Niels

Okay. Why 21.5? That’s a funny number.

Mike

It was a back-fit So, when we first started… and again, we’re new to the world of asset management, and so people said to us, “What vol are you going to target?” And we said, “Hmm, interesting question, I haven’t really thought much about that.” And the only reference point we have was in our lives as prop traders, the benchmark for a prop desk was to make a 20% return on equity. We said, “Well okay, well then we want 20% return on equity. That seems like a reasonable expectation, and we’d like to deliver a sharp ratio of 1 or better, so, therefore, let’s…” We spent our whole life managing around being tasked with making a 20% return on equity with a leverage commodity book, so we know we can do that. And then we asked the question, “What number do you think would make investors nervous if we lost it in a month?” And we decided 5% probably get’s people’s attention and putting the two together it turns out that the volatility to give you a 5% weeks, 21.5%. So, it was a back-fit into a weekly risk budget.

Niels

Sure, sure, and during the period you’ve been trading as we talked about earlier on in 2011 was a difficult period. Was that a difficult period for generally your types of strategy or was it unique to just your specific firm? Or… I don’t have a reference point in that sense. I know it’s been a very, I mean… ’11, ’12, ’13, was very difficult for the systematic guys, but I don’t know about discretionary, whether that has to follow in line with that or not?

Mike

No it doesn’t have to follow, and some people had… I think very few people had a good 2011. In the small universe of discretionary, commodity, fundamental managers, the majority lost money in 2011, and the majority have actually lost money over the whole period, 2011 to 2014. But, 2011 was really the most difficult year. We think that has a lot to do with the source of the high level of macro correlation, around the market. Every market was being driven by the Euro crisis in the summer of 2011, and that was creating a lot of… you know it was overriding fundamental signals. It was overriding technical signals. By its nature, how do you interpret a statement by Mrs. Merkel or whatever… it’s you know… none of us as managers have a particularly competitive advantage in that yet.

Niels

That’s very true, that’s very true! Now, over the years since you started, and we’ll talk a little bit about the specific strategies you do in a little while. Have you changed from an overall point of view, have you introduced new types of strategies? Or are you doing exactly the same kind of style of strategies that you started out with?

Mike

Exactly the same. We’ve broadened the commodity range a little bit, so when we first started I think, coal, iron ore, ocean freight, was still not really… they were at the very early stages of development as derivative markets. In the last few years, they’ve become much more developed, much deeper, much liquid derivative markets. We added coal freight, and iron ore, but in terms of the trading approach, the trading style, that has not changed at all.

Niels

Okay. Now you briefly touched on it earlier today, but you spent a little bit more time with me last week in your office explaining a particular characteristic about commodities, which I actually think is very important for the listeners to understand, and this is the thing where you just say, “A small change in the supply-demand equation can lead to big moves in the markets, from being overbought to oversold.” Tell me a little bit more about that, but also more importantly, tell me how you then used that in your strategies today. Because to me it sounds like… or it certainly confirms that commodities from time to time will have some large moves which you can utilize from a directional point of view. But, unlike many other managers, you are not just doing directional trading, you’re also doing relative value trading. So, how does this unique characteristic, how does that play out? And how do you make use of that?

Mike

Yeah, so commodities you could characterize the price behavior of commodities is really dictated by the inelasticity of both supply and demand in the short term. So, for most commodities a change in price doesn’t quickly deliver a change in either consumption or production. Therefore, the market has to adjust firstly through the carrying charge. If a market’s in oversupply, you can’t easily create new demand, and you can’t easily shut off existing production. So, in essence, the market has to bring forward future demand by creating economics to store the commodity.

Conversely if you’re in a situation where demand is moving ahead of supply, and where inventories are being reduced, then firstly the market  has to bring as much material out of storage as possible to meet current demand. It does that by inverting the time curves. So, in essence, a contango time curve is saying, “Please take my commodity, and I’ll give you a profit for warehousing it.” In an undersupplied market, the time curve is saying, “Please give it to me today, I’ll pay you a premium to have it today.”

The directional phase of the market and the shape of the time curve are very fundamentally and deeply linked together. Then you have more sort of relationships around how you process commodities. So, if you look at petroleum, the refining margin and the crack spreads, the relationship between the prices, the crude oil inputs, and the petroleum output. And again that’s the market creating economics, or dis-economics to adjust the supply-demand balance for… You know if you’ve got too much gasoline and not enough heating oil, then the price of gasoline relative to the price of heating oil has to change so that the refiners make more of one and less of the other. So, essentially what we’re saying is, “OK, what’s our view of supply-demand over the next six months, 12 months?” So, typically we’re not particularly interested in what’s going to happen in five years or even three years, where we’re operating more… what’s happening in the next crop? What’s happening in the next calendar year?

Then we look at our supply-demand model that we modeled, and then we look at the price curve as it is today. So firstly, what’s the directional price? Is our supply-demand model indicating that there’s going to be some significant need to change the outright price of the commodity? So, are you generating meaningful surpluses or meaningful deficits? The second question then is, “Okay, what’s the shape of the time curve?” So our supply-demand model says that the supply of soybeans is going to be very heavy after the harvest, so, therefore, the time spread is too narrow at the moment, it should widen out.” And the relationship: are the farmers getting the right signal to plant corn relative to soybeans? So, we’re looking relative to the supply-demand model, what’s been mispriced today? Or what is the market not pricing? So then you initiate your trade, and then as you move through time, you’re then trying to by looking at what’s going on in the physical market,.. How is the price of the physical commodity relative to the futures market? Is Chinese demand… are the Chinese pulling… You’re trying to get a look for indicators that are confirming or challenging your supply-demand model. So, it’s a constantly evolving process and feedback between what’s happening in the marketplace and what’s happening in the model.

Niels

I wanted to ask you Mike; you mentioned China here. Is it really like this today that if you don’t know what they’re doing then you don’t… it’s kind of the major key to understanding commodity price developments? Is that really down to what China is doing underneath all of this?

Mike

If you had to take one single factor, then for a range of commodities China is the biggest consumer, the biggest importer of many major commodities. It’s also the biggest producer of several commodities. And so what happens in China is very important, and it’s more important for some commodities than other commodities. But, there is other stuff that goes on, so weather is very important for some commodities, demand… for instance the gasoline market is still very much American, you know, America is the major driver, it depends on the commodity. But, as a general proposition, if you could only have one insight, certainly for the demand for commodities you’d pick, you’d pick China.

Niels

Now you talked about putting this kind of information into your model…

Mike

That’s a bit of a grandiose way, when we talk about a model we’re generally talking about a supply-demand – commodity people refer to a supply-demand balance sheet.

Niels

Right, and I’m just wondering here, are the things that you see when you do that, when you analyze it in this way, is it so, in your world, that the patterns repeat? Meaning if supply-demand is “this number” so to speak, then 90% of the time the price will do this. Is it that kind of repeating scenario of repeating patterns? We know, systematic traders, they look for patterns in the markets that repeat themselves, and they just follow those. Is it kind of the same thing, just using slightly different inputs in your world?

Mike

To an extent yes. So, the key output from your analysis that you’re generally looking for is the stocks to use ratio. So, you know, how large are inventories or supplies of the commodity relative to the demand for the commodity? And depending on the commodity, there are sort of threshold levels where if you take the stocks to use ratio below 15% for corn or soybeans, that’s usually accompanied by sharply higher prices and inverted time curves, but maybe only 7 times out of 10. So, it’s not…

Niels

You can’t use it as a 100% guide, as with all of these things.

Mike

Yeah, I’m sure there are people who do it much more statistically than we do it.

Niels

What about correlation? You mentioned that briefly when you said that difficult in 2011, markets were highly correlated, etc., etc. I mean when you talk about these ratios, to me it doesn’t sound like correlation plays a big role, but it probably does somehow. How does it play a role in what you do?

Mike

So, correlation plays a big role in risk because we’re running a VAR model, and so to the extent that things are getting more or less correlated than our VAR model would be allowing us more risk or less risk. On a more macro level, a challenge always for us, is…

Ending

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