- Commodity trading is a complex, dynamic space but ultimately a rewarding pursuit for investors who can separate the signal from the noise.
- Nicky Ferguson aims to help energy commodity traders do just that with the research he produces for Its Not A Science, a firm specializing in quantitative assessments of the latest market behavior.
- Nicky joins Hari Krishnan to talk about using data-driven research on financial flows, current fundamentals and the macro environment to provide insights on today’s prices — and tomorrow’s smartest moves.
The volatility of commodities is usually what makes them so appealing to investors, but quantitative strategist Nicky Ferguson knows that understanding supply-and-demand dynamics is the only way to reap rewards in the midst of so much risk.
Nicky is the founder and one-man force behind Basel, Switzerland-based energy markets research firm Its Not A Science (INAS) — an apparently tongue-in-cheek name for what is clearly a scientific pursuit.
“Financial markets are inherently noisy and complex,” he writes on INAS’ website. “Investment management is not a science. There is more than a little art to it.”
Nicky’s mission is to apply “scientific principles to market-oriented thinking” about energy commodity derivative markets to provide clients with a “data-driven framework with which to view price discovery and actionable insights.”
INAS’ approach “encompasses three key dimensions: financial flows, current fundamentals and the macro environment,” he explains. “We identify the mechanisms through [which] these dimensions drive a diverse set of market participants to act with competing flows.”
Nicky joined Hari Krishnan on a Global Macro Series installment of Top Traders Unplugged to discuss speculative positioning in energy futures, including how to distinguish between fluctuating prices driven by fundamentals and those driven by flows. They also talk about modes of oil transport and other real-time indicators of oil supply and demand and how new players in the market have increased options flows.
Read on for a recap of Nicky’s take on the need for quantitative research geared toward commodities professionals — and why the DXY is an imperfect metric of commodity prices.
The science behind Its Not A Science
Nicky’s work at INAS focuses chiefly on “solving that puzzle between what [in terms of commodity volatility] is actually [driven by] pricing at any given time, and who the marginal buyer and seller need to be in any given moment, to assess what the forward price drivers are,” he says. “And who, as in a group of participants, [those buyers and sellers] 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.”
His weekly research tends to highlight the market right now (as in today) and where he expects it to go over the next one to three weeks, given those participant constraints.
“It’s trying to make sense of a lot of that noise,” says Nicky.
Most INAS clients are fundamental traders at major trading houses or hedge funds, for whom technical analysis is a blind spot because they’re mostly focused on understanding the fundamental side of their markets.
INAS also produces long-form, deep-dive research that can help traders “explain, understand and then measure the impact” of various forces on commodities, as well as “bespoke, ad hoc advisory services.”
Options on the rise
Nicky thinks the options market will probably become a much bigger market in the near future. He cites the trend in recent years of commodity traders “sitting in hedge funds and pod funds, where they have [much] stricter risk controls than they might have been used to in the trading houses.”
That’s because trading houses understand commodity volatility quite well. They also “understand that you have to warehouse risk to make money in this market,” he says.
Traditionally, hedge funds put tight drawdowns and limits on risky positions, which is why Nicky predicts “options will become the weapon of choice” for a large segment of the industry.
Last year, we saw that in action. Investors had “absolutely enormous positions” in the options market, especially in crude, but a lack of people trading futures,” he notes. “Obviously, you need the futures market to move to put those options positions in the money, and we just had a disconnect. Everyone was sitting waiting on their options but no one was buying the futures to actually make that happen for them.”
Nicky predicts “a few more contradictions like that” as we head into the second quarter of 2023. “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.”
As the adage goes: You can’t manage what you can’t measure.
The U.S. Dollar Index (aka USDX, DXY, DX or the “Dixie””) is a measure of the value of the U.S. dollar relative to a “basket” of six foreign currencies.
Established by the Fed in 1973 after the U.S. ditched the gold standard and the Bretton Woods Agreement dissolved, the DXY is traded 21 hours a day and maintained by ICE Data Indices, a subsidiary of the Intercontinental Exchange (ICE).
The U.S. Dollar Index was given a base value of 100.000 when it launched, and values since then are relative to this base. A value of 90.000 represents a -10% drop in the value of the dollar relative to the currencies in the basket, while a value of 110.000 represents a +10% rise.
The members of this “basket” of foreign currencies are some of America’s most significant trading partners. The index is calculated by factoring in the exchange rates of the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc. The euro is by far the largest component of the index, making up 57.6% of the basket.
An imperfect basket
Of course, the index is subject to macroeconomic factors, including inflation and deflation (both of the dollar and the other currencies), as well as recessions and economic growth in all the countries that use them.
Major commodities are priced using the DXY and will continue to be, at least for the foreseeable future. But, Hari asks, is the DXY flawed in terms of looking at changes in a nation-weighted currency versus changes in commodity prices?
“I wouldn’t say it’s completely flawed,” Nicky says. “But the relevance for commodity traders is just not very high. … 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 mostly missing from that list.”
Nicky isn’t alone in that criticism. The makeup of the basket of currencies has been changed just once: in 1999, when the euro replaced the German mark, French franc, Italian lira, Dutch guilder and Belgian franc. A lot has changed since then, and the index doesn’t accurately reflect America’s trading partners. In coming years, the Mexican peso, as well as Japanese, Korean, Chinese and Indian currencies, might become additions to the basket; some could supplant other currencies.
“A lot of the incremental commodity demand is coming from Asia, so this index [DXY] doesn’t really capture any of that whatsoever,” says Nicky.
The need for speed
Fundamentally, the DXY as a tool for pricing commodities is “about the speed of change,” Nicky argues. “Because when you’re seeing quick moves in the dollar against these countries, you [will conversely] see more of a pause.”
If the commercial long element of commodity markets slows down, buying slows. Once the volatility comes down, people slowly adjust “to a new normal and a new level, and that’s the basis of business,” he adds. “But when things move quickly, especially on the upside — so things are getting more expensive — there is a demand response … but “it’s kind of a ‘wait and see’ … to see what the new normal is.”
This phenomenon is embedded in a larger discussion about “how the volatility of inflation, broadly, is more dangerous to the global economy than … if the level [of inflation] was 8% or 10% and it just stuck there,” Hari suggests.
“Exactly,” Nicky replies. “Especially when we’re talking about macro variables — there is always an adjustment. But it’s more the volatility in short-term moves that tends to put the brakes on things because people can’t make good forward assessments.”
(Futures) curves ahead
Hari notes that the Fed seems to use projected oil prices and inflation expectations, rather than solely price action, as “informal inputs to its policy decision-making.”
He asks Nicky whether he finds that to be relevant in his research.
“It depends on how you want to measure expectations,” Nicky says. “If you’re using commodity futures curves, 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 backward-dated futures market — and I have seen this mistake made over and over again — saying that because the price in the future is lower, that’s not the expectation of the price. … Commodities are not like that at all. It’s the spot that really matters.”
Commodities are a risk asset that hedges on inflation. So when inflation expectations rise, positions built on forward inflation expectations increase in the market, “and it gets a lot more price sensitive to moves,” Nicky says. “They are intertwined, obviously, because higher oil prices do increase forward expectations for inflation. But again, it’s the rate of change that matters, not the other way around.”
Hari wonders if that means the “mythical academic quantity called convenience yield” can tell us more about hedging activity than it can about realistic expectations for price action.
“I think you could argue that,” says Nicky. “I think you just have to understand the dynamics of each individual market. Not all futures curves are equal.”
If you want to stay ahead of those curves, watch this space.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.