Macaskill on markets: After a sunny start, will commodities put Goldman in the shade?
A couple of extremely well-timed commodity price calls by analysts at Goldman Sachs helped to exacerbate the recent sharp volatility in the asset class and prompted gnashing of teeth at the bank’s rivals.
Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks
Competitors were convinced that Goldman had been able to boost commodity trading profits by deploying research to move markets in its favour. The accusation is one that has been levelled at Goldman over various business practices for many years and would have been dismissed in the past as sour grapes on the part of disgruntled rivals.
Goldman certainly cannot be condemned for being a sharper commodities dealer than its peers – it remains the clear leader among banks in the sector – and it would seem strange to pull up any group of analysts for calling the market correctly.
But if the uncanny ability of the firm’s analysts to predict oil and metals prices correctly in April and May becomes an issue in further investigations into commodity market practices and returns the spotlight to the broader theme of proprietary position-taking by banks, Goldman might have sacrificed a short-term trading gain for more long-term reputational pain.
In mid April, Goldman’s analysts called a top to the strong 2011 rally in a range of commodities, including oil, on the grounds that the price appreciation had outpaced fundamental changes in supply-and-demand dynamics. The analysis, coupled with reports that leading investors including George Soros were taking profits in markets such as gold, helped to fuel a plunge in most commodity prices in May.
Almost as much attention was paid to a follow-up report by Goldman’s analysts on May 24 arguing that the downward shift in prices had created an attractive entry point for fresh position-taking. The latter report came after a recovery in a range of commodity prices from mid-May lows was already well under way. And Goldman’s revised year-end forecast of a $120 price for a barrel of Brent crude oil, followed by a further rise to $130 next year, left it close to predictions by other banks.
The reports still raised hackles with competitors and could eventually feature in investigations of Goldman’s business practices, however.
This might cast a cloud over what is shaping up to be a relatively buoyant year for Goldman and other banks active in commodities. Last year was one to forget for commodities dealers, as trading opportunities were limited in the main energy markets of oil, power and gas, and client volumes fell, both on the investing and hedging fronts. Total commodities revenues for the main investment banks in 2010 were no more than $7 billion, according to an Oliver Wyman/Morgan Stanley estimate in April, marking a fall of roughly 50% from 2009.
After taking stock at the end of the first quarter of this year, senior bankers were expecting to make up much of the ground lost in 2010, with predictions that the revenue pie would increase to at least $10 billion in 2011. Bankers gave the first four months of the year a mixed report card, depending on the commodity sector. Rallying prices gave an obvious boost to demand from investors with an agnostic approach to individual asset classes and there was an increase in hedging activity in sectors such as metals. Client volumes in the main energy markets – which are far bigger than metals and agricultural instruments – were lower than some bankers had expected, however. Natural gas has missed the commodities rally of 2011 completely and even core client flow in oil was below expectations.
The wild price swings in May, with oil moving by more than $10 a day at times and price moves of over 30% in speculative markets such as silver, certainly boosted client volumes for dealers, which can normally rely on volatility to increase market-making revenues.
But it also increased regulatory and political attention on the energy markets and that in turn could bring a focus on the extent to which dealers rely on position-taking to juice their commodity revenues.
"A grey area for black gold"
In oil, the biggest commodity market, the interaction between physical and derivatives trades presents the key proprietary dealing opportunity for both banks and independent traders. Derivatives trading is an extremely large multiple of physical volume in oil, with futures and swap trades running at about 50 times activity in the physical market. Shifts in physical supply continue to drive derivatives prices, however. The relation of physical and derivatives prices presents a potential for outright market abuses. At the end of May the US Commodity Futures Trading Commission accused oil trader Parnon Energy of manipulating oil prices in 2008 via combined physical and futures trades, for example, and further cases are likely.
Decisions on physical and derivatives position-taking by banks are also a grey area in the implementation of the Volcker Rule portions of the Dodd-Frank financial reform legislation in the US.
Goldman Sachs and other leading investment banks provide almost no disclosure about their commodity revenues, never mind any detail about the approach taken to physical trading of energy products and the timing of exposure to positions that will ultimately end up with clients. Commodity value-at-risk numbers are released by most of the main dealers but there is no break-down of how much of an input is made to broader fixed-income trading revenues.
If recent price swings in commodities increase the attention given to the way that banks continue to rely on positioning to boost sales and trading revenues then relatively minor gains might be outweighed by the cost of potential future restrictions on trading. Even if banks manage to turbo-charge their commodities revenues this year to a total well over $10 billion – which is a big if, given that there are bound to have been trading losses at some houses in May, along with gains for others – the sector is still highly unlikely to amount to more than 10% of overall fixed-income revenue this year. At an exceptional $12 billion or $13 billion, commodities revenues would still lag behind foreign exchange earnings that are likely to be at or around $16 billion and fall far short of credit revenues at $35 billion to $40 billion and a rates pie of about $45 billion.
Gus Levy, who ran Goldman Sachs in the early 1970s, is credited with coining the phrase "long-term greedy" to describe an approach to trading that does not leave clients feeling that they are at an unfair disadvantage in any given market. If Levy’s successors – at Goldman and elsewhere – come to be seen as having exploited their role in commodities during 2011, they could eventually end up undermining revenue prospects in the broader sales and trading markets.