Commodity Alpha Q1 2022 commentary

Market overview 

Coming into 2022 many commodity markets were trading at very high levels from their 2021 rally—in particular the soy complex and energy. These price characteristics generated short signals, suggesting prices would fall and revert to their mean. The strategy took short positions in energy, because this very fast rally in energy prices represents a blowout versus the short- to medium-term price trend it expects prices to see in a normal market environment.  Therefore, it recognises these high prices as a short opportunity, expecting the price to retract and revert to their historical mean.

However, price reversion failed to kick in and volatility continued to remain high due to macro events. The trend model also failed to capture the rally in the broader commodity space. The systematic (technically driven) model behind the strategy shorts the weakest trends and enters into long positions for the strongest ones. 

Like all investment strategies, market-neutral strategies may lose value throughout time. The algorithmic model behind the trading strategy assigns a conviction to trade signals and only enters the highest conviction trades. Q1 2022 featured some wide swings across markets worldwide, being characterised by high volatility. The initial spark for the volatility was the sudden shift in expectations around the Fed actions in the opening days of January, fuelled further in February by Russia’s war against Ukraine. The current economic sanctions—bundled with the fact that both Russia and Ukraine are critical suppliers of commodities (most specifically oil, natural gas, coal, aluminium and wheat)—made the price behaviour of these commodities abnormal and therefore more difficult to predict for the trend-following model.

Strategy performance (net of fees)

Since inception (May 2020): 75.43% (net of trading costs, service fee and performance fee - considering a performance fee for investing since inception but, since your performance fee will depend on your point of entry, your net returns will vary too).

Strategy positioning throughout Q1 2022

January has been a challenging month for the strategy. Agriculture has been the toughest sector with losses driven by the soy complex, followed by energy. In the soy complex the market is concerned with a La Nina–driven drought in Brazil and Argentina. This is a crucial period for the new crop but there is still time for the weather to improve and rains in February would bring much relief. 

In energy, there is a shortage of oil inventory as OPEC+ have restricted output to drain the excess supplies that accumulated over the past two years. The fear that Omicron would bring further lockdowns has gone and markets expect oil demand to grow. Natural Gas prices have also rallied, pricing in a disruption to export on a Ukraine-Russia war.

In February the strategy gave up gains in the first half of the month as the tensions on the Ukraine and Russian border escalated, eventually culminating with the invasion of Ukraine. Many commodity markets rallied on supply disruptions. The two countries are major producers and exporters of numerous commodities. Threats of sanctions, disruption to normal production and second-order effects caused by higher energy prices are causing havoc across the space. Strong signals in Gold led to a buy signal. With increased geopolitical risk and increasing inflation expectations, the metal is seen as increasingly attractive by the broader macro community.

In March, gains generated by positions in Softs, Agriculture and Precious Metals were not enough to offset losses in Energy. The worst performing positions were short positions in Natural Gas, which were affected by increased demand. Most of Europe’s imports for Russian gas is via pipelines, with just a small fraction coming via Liquified Natural Gas (LNG). 

As the war in Ukraine escalated, the US and EU reached a deal to boost the supply of LNG to European countries. Currently Europe competes with Asian countries for the world's limited supply of LNG. Towards the month end, Russian president Vladimir Putin insisted that the country's natural gas must be paid for with Russian roubles and that supplies will be cut off if buyers don’t agree with the new terms. 

Soft commodities were the strongest Alpha generators, and this is where the strategy entered long positions. Cotton contributed the most to the performance of the strategy as several factors pushed cotton’s price higher. Looking at positive performances, the oil shock moved the prices for petroleum-based fibres such as polyester and nylon high; when these types of synthetics get costlier, natural fibres such as cotton benefit from additional demand. This pushes the price of cotton up too, and Commodity Alpha’s long positions on cotton have been able to capitalise on that.