Nicholas Johnson, executive vice president and a portfolio manager focusing on commodities, discusses the evolution of PIMCO’s commodity alpha capabilities, PIMCO’s outlook for the asset class, and how our expert commodities team develops bottom-up trade ideas and leverages the firm’s resources to find attractive value for our clients.
Q: Can you provide a brief summary of your current outlook for commodity index returns?
Johnson: In the years following the financial crisis, the historic rationale for a commodity allocation, which has typically been based on diversification and inflation protection benefits, has been called into question for some investors. While this period certainly tested this rationale, we believe recent market dynamics are signaling a favorable shift for commodities.
To start, the roll yield associated with commodity index investing has turned positive and has been a tailwind for investors over the past year. When this is coupled with our expectation that spot prices will generally be more stable, we believe commodity index investors can now get paid to hold commodities, which presents a unique opportunity relative to the recent period leading up to the global financial crisis.
Next, due to a more stable outlook for global growth, commodities have returned to trading more on fundamental supply factors, which include weather, geopolitical activity, production dynamics, etc. and which, importantly, do not have a similar impact on stock and bond markets. This is a reversal of the first few years post-2008, when many asset classes saw higher correlations due to the large decline in global GDP. With GDP more stable, the supply-demand balance, which sets commodity prices, is set just as much, if not more, by supply shocks as demand shocks.
Finally, PIMCO’s forecast calls for a rise in core CPI in 2014, and unexpected inflation has the potential to negatively affect the value of stocks and bonds in an overall portfolio. Commodities can be a direct shock absorber for unanticipated spikes in inflation. Overall, commodities tend to have a positive beta to changes in inflation and to changes in growth. Our expectations for forward-looking growth are fairly consistent with the market. Therefore, in aggregate we see modest positive upside from upward inflationary pressure and a positive commodity roll yield.
Q: How have PIMCO’s commodity alpha capabilities evolved since since we first began managing commodity portfolios?
Johnson: We first started managing commodity portfolios in 2000. At that time, our objective was to replicate commodity index returns and add value through the active management of the underlying fixed income collateral portfolio; essentially a “portable alpha” approach comparable to PIMCO’s StocksPLUS strategies.
As we became more familiar with commodity index construction, we identified a number of structural opportunities that we believed could provide our clients with incremental returns above what we were able to deliver via our portable alpha approach. We started adding commodity alpha in 2004, using simple concepts like rolling – selling a maturing contract to buy a contract further forward – our commodity futures outside of the standard index roll dates. Since then we have discovered many other structural opportunities such as spreads between summer and winter natural gas or selling implied volatility in oil, and today we have dozens of structural strategies across the entire range of commodity markets.
As the commodity markets have become more efficient and our knowledge and sophistication have grown, we decided to take the next step to evolve our business. In 2011, we broadened and deepened our commodity alpha capabilities to incorporate extensive fundamental analysis in the individual commodity markets and bolstered our team’s capabilities to include expertise in specific sectors of the commodity markets by hiring specialists in particular areas like energy and agriculture. This added expertise has been a benefit in our effort to continue to generate commodity alpha for clients.
Greg Sharenow, a senior member of our commodity portfolio management team, joined PIMCO in 2011 with more than 10 years of energy-related experience. His expertise has been a huge asset, enabling us to expand the types of energy-related trades in our commodity alpha portfolio. For example, over the last couple of years we’ve often held a relative value position between West Texas Intermediate (WTI) and Brent crude oil. While these two oil prices had diverged in 2011 due to growing U.S. oil production, our view was that they would become relinked due to new pipeline projects being completed in the U.S. In forming this view, we also leveraged PIMCO’s credit research team’s pipeline company knowledge to develop an information edge as to the probability that different pipelines would be completed for various dates. Overall, the information from our credit team combined with Greg’s bottom-up supply-demand models helped us to optimize the size and optimal point on the curve of our long WTI versus short Brent positions.
In addition to his role in portfolio construction and generating alpha, Greg has also been an important contributor to the firm’s view on topics like geopolitical risk in the Middle East and the shale revolution.
Continuing in the spirit of adding specialized expertise, our team was further bolstered by Gillian Rutherford, who has more than nine years of agriculture-related experience. Like Greg, Gillian has also bolstered our commodity alpha opportunities. For example, Gillian was instrumental in the development of a recent trade – to underweight wheat – that was incorporated into our commodity portfolios. The thesis behind this trade was that wheat prices were being excessively influenced by the geopolitical situation between Russia and the Ukraine. While both countries are incrementally important for global grain supplies, wheat prices were moving in lock step with Russian credit default swaps. Gillian viewed the wheat market as reasonably well supplied globally and saw the run-up in prices on the back of the headlines as ultimately unsustainable. In fact, for the month of May 2014, wheat was down 13% – the second worst performing commodity in the Dow Jones-UBS Commodity Index.
Q: How does the team develop commodity alpha trade ideas? Who is involved in idea generation?
Johnson: Our approach to constructing commodity alpha portfolios is to develop a well-diversified and robust set of trades. Typically, we aim to incorporate between 10 and 20 concurrent active commodity trades with each trade scaled to reflect our view on risk-adjusted return. The process for how a trade is added to the portfolio is that each specialist presents their trade ideas to the six-member commodity team and the group debates the thesis.
These discussions often lead to ideas being challenged, requiring further research and analysis before being considered for placement into the portfolio. As part of the research process, we often work closely with PIMCO’s credit and equity analysts. Furthermore, our team of three dedicated financial engineers provides quantitative rigor for reference throughout our decision-making process.
Overall, I view this process as being very collaborative and iterative. Ultimately, each trade that is incorporated into the portfolio is vetted by our entire team and is constantly re-evaluated based on its perceived value relative to the current set of opportunities. It’s a very fluid and consensus driven process.
Q: In addition to the portfolio management team’s views, what other resources does the team utilize to make investment decisions?
Johnson: At a high level, PIMCO’s large, stable capital base allows us to be a liquidity provider for the market, which provides a key advantage for us to add value for our clients. For instance, oil production in the U.S. has experienced significant growth over the last several years, which has resulted in growing oil-hedging activity, particularly by small and mid-sized companies who tend to hedge much more than the large multinationals. As a result, 12-month forward oil is priced at a $10 discount to its spot price, which in our view does not reflect the market’s expectations for future oil prices; this provides us an attractive investment opportunity given our long-term and stable base of capital that can be used to support these hedging activities.
We benefit from being part of a firm with extensive resources and infrastructure. The commodities team works closely with the firm’s more than 50 credit and equity research professionals,* covering industries from metals and mining to pipelines. Incorporating their views and company understanding enhances our fundamental research. We also collaborate extensively with PIMCO’s analytics professionals. One example of this is the development of an in-house analytical tool to measure commodity risk, both in absolute terms and relative to the benchmark. The model builds risk estimates from the bottom up by building a giant covariance matrix, spanning more than 40 commodities and each commodity’s term structure from one month out to five years. It allows us to easily “zoom in” on detailed risk contributions by market and “zoom out” to get a broad view of broad portfolio risk. Such a model is very helpful for understanding the correlation risks and diversification benefits inherent in a large portfolio of alpha trades.
Q: What role does PIMCO's macro view have on commodity alpha generation?
Johnson: At a high level, commodity prices are set by the interplay of supply and demand. The supply side is generally very micro and bottom up in nature, however the demand side is much more related to macro factors. It is here, on the demand side, where we leverage PIMCO's macroeconomic outlook. If you look at oil demand growth in a given country, it is highly related to the level of GDP growth. In addition to oil, the same is true for other commodities with an industrial demand component like base metals and natural gas. In fact, if you look historically over the past 10 years, there is a fairly high correlation between year-over-year changes in global GDP growth and year-over-year changes in broad commodity prices. Having a good forward estimate of global growth is a clear edge in trading commodities.
In addition to commodities where demand is related to changes in GDP, the macro outlook is also the most important factor in setting gold prices. In a recent Viewpoints article, we discussed how we believe the single biggest factor impacting gold prices is the level of real yields, and the level of real yields is a key part of the firm's macro outlook. In fact, lower real yields is one of the central themes of PIMCO's secular New Neutral outlook. Overall, when we try to add value in the commodity markets, we look for a confluence of factors, and the best opportunities are where both the macro and bottom-up outlook support a trade and the market levels provide an attractive entry point.
On the whole, PIMCO’s capabilities for managing commodity portfolios have expanded considerably over the last 14 years. From running a collateral-based portable alpha-based strategy in the early days to successfully managing a comprehensive commodity alpha portfolio today, we are well equipped to continue to provide a robust and consistent source of excess returns for our investors, which can further enhance what we currently see as a favorable environment for commodity returns. As mentioned earlier, today’s combination of the positive roll yield, diversification benefits and inflation protection provide compelling support for a commodity allocation.
* As of 31 March 2014.