This week’s blog features guest commentary from Steve Sinos, Managing Partner at Blue Lacy Advisors. Steve analyses the importance of risk management during a period of high interest rates, low investment rates, and increased volatility.
Strategy is easy. Execution is hard. Long-term forecasts guide strategy. Short-term volatility defines the path-dependent outcomes of success/failure.
Traders and risk managers realize this and understand that the last few years' volatility in prices and costs has driven their success.
Capital costs affect both long-term expectations and short-term risk management. This regime of high interest rates, low investment rates, and increased volatility puts into focus the importance of risk management, regardless of fundamental views.
Strategy v. Execution
Strategy is easy. Execution is hard. I use this phrase often because it succinctly describes the difference between successful and unsuccessful investors. This lesson stands out among the many lessons I have learned in my >20 years in energy markets. Its simplicity defies its importance. Maybe that’s why so many leaders dismiss it and, ultimately, lose money. Consider the last few years, during which oil prices have gone from negative to triple digits. How many consumers were hedging at the bottom? How many producers were hedging at the top? How many leaders were able to plan strategy and execute successfully through this volatility? We argue too few, largely because they didn’t appreciate the importance of the relationship between strategy and execution, i.e., the difference between developing your fundamental view and managing the daily risk once you set out to realize that goal.
For operators, the long-term view is their business. As such, they tend to have financial obligations that align with this tenure. They develop assets with useful lives that may stretch on for decades. Focusing on things like Return on Capital Employed help investors track cycles and identify opportunities. Investment cycles that dictate the pace at which new supply comes online dictate the long-term trends. This upward pressure on prices is intuitively easy to accept and should attract capital. The super-cycle bull market thesis says this isn’t happening. It is an argument that is both easily digestible with its intuitive application of supply and demand growth comparisons and probably directionally right. Still, volatility has been extreme while we wait for the thesis to play out.
Volatility has fallen from last summer’s highs above 50 across the term structure to the low-mid 30s as of Friday’s close. Operators welcome this downward trend but like prices, volatility trades at a premium to pre-COVID benchmarks. For example, in early December 2019, vol traded in the mid-20s across the term structure.
With prices that may vary by 30% or more annually, operators should be able to articulate their ability to protect returns from these gyrations. Thankfully, it looks like this component of return variation is moderating.
Traders Seldom Ouch
Traders and risk managers appreciate the relationship between strategy and execution in ways that most corporate leaders and fundamental analysts don’t. This is why the revenue of trading houses has tripled over the last three years. Strategically, traders want volatility. Risk managers accept it as a reality that must be addressed. Importantly, volatility and costs tend to be positively correlated for trading because margin, internal estimates of risk, and financing all rise. This is why open interest often falls when volatility rises. For example, when vol spiked last March, ICE rose margin requirements, and open interest dropped. As things have calmed in recent months, open interest has slowly increased.
ICE, BANTIX, CFTC
Traders constantly, sometimes multiple times daily, assess capital deployment decisions to assess return potential against risk. They will have a fundamental view, just like operators, but have a more immediate need to consider risk. In other words, they must react more actively to the short-term than hedgers.
Operators and traders share a sensitivity to the cost of capital. The ten years leading up to the pandemic were fantastic from the perspective of capital costs. Interest rates were so low that it seemed like there was almost no cost of leverage. As interest rates have risen, duration exposure has been front and center, notably among banks. Ideally, operators will pass the increasing cost of capital on to their customers, but it takes time to adjust. Traders finance their business through various credit facilities, which are likely shorter in term than the asset-backed facilities operators typically employ. Still, the cost of debt/credit has risen for all market participants over the last year at a rate few prepared for. For many, this has been exacerbated by falling availability, as well.
In the short term, rising costs and volatility actually put downward pressure on markets. For example, a trader might reduce the volume of physical commodity inventory he carries in response to increasing costs and rising capital requirements. A sustained reduction of global stocks might lead to higher volatility, further depressing potential investment and possibly leading to higher prices. This is, in effect, the commodity cycle.