June 22, 2023 Cosmo Shield

The Rise of the Commodity Quants

Trading commodities has always been about information and
relationships. Traders build a network of contacts and spend much of
their time gathering information to give them an edge.

The quality of that data always relied on developing relationships with

the right people and finding the right source with exclusive
information about the movement of any commodity.

The problem with that model has always been that each source would
only have a small piece of the overall picture, and getting all the data
required to make a well-informed trade was time-intensive. There’s
always a risk that the information might be days or weeks out of date.

Trading commodities has always been about information

and relationships.

But our industry – as with many others – has been transformed by

digital disruption in recent years. And, as access to data and
information has become universal, so is a fundamental trader’s ability
to trade on proprietary information blunted.

Being a successful trader is now less about who you know and more
about what you do with all the data and models you can access.

Trading commodities is no longer just a relationship business; it’s

becoming a data science business. That’s where quantitative trading
and research are key.
The age of the quant

That disruption has heralded the emerging age of the ‘quant’.

Quantitative strategies have revolutionised how commodities are

traded and the diversity of tools available to our traders.

Long the preserve of hedge funds, these quant strategies, like the
growing area of risk premia, that take advantage of factors including
trend, carry, momentum seasonality and congestion, are perfectly
suited to commodity trading.

This is because our markets are built on known – but sometimes

idiosyncratic – underlying fundamentals, i.e., supply and demand, the
weather and storage capacity.

At Engelhart, we know how valuable fundamental analysis can be,

particularly in non-benchmark markets where data isn’t always as
clear or readily available. That will almost certainly always be the case,
and we view the future of commodities trading as human traders and
machines (or algorithms) working in symbiosis.

In a trading landscape where a minute can make all the difference and
volatility is abundant, everyone is looking for an edge, and that’s what
our team of quantitative analysts gives us.

But our approach to quantitative analysis is always underpinned by a

simple question:

How can quantitative research help our traders trade better?

The technology catalyst

The recent growth in technology is creating a step change in how we
can trade commodities markets.

Quantitative strategies that first emerged in the 1990s and 2000s and
gained the greatest traction with a new generation of hedge funds have
become established as a vital part of our diversified trading strategy.

In the last decade, we’ve seen a revolution in big data, cloud

computing, machine learning and AI, all of which have enabled the rise
of the commodity quants.

The exponential increase in commodities data generation and storage

capacity particularly has created the perfect sandpit for quantitative
analysts to build models and test ideas.

Across all commodities, there’s been an extraordinary increase in the

availability of real-time data. Cheap sensors, ubiquitous internet
connections and real-time monitoring make it possible to track and
quantify many of the commodities we trade.

Satellite imagery, weather data, and the Automatic Identification

System (AIS) tracking ships are just three examples of the big data that
can be used in quant analysis to inform our trading strategies.

In agricultural commodities, for example, our quant analysts can

process weather model output data to assess the likely weather
patterns. They then compare that data to historical analogues and
remote sensing imagery of current crop states to predict crop yields
and hence accurate supply and price predictions.

Many of the strategies that we use to trade commodities

today are only tradeable and priceable because of the
technology

Cloud computing power

The rise of quantitative trading in commodities is also correlated to the

cost-effectiveness of such strategies. The cost of the hardware and
computing power needed to analyse large datasets or run complex
models was prohibitive to commodities traders for many years.

Cloud computing has changed that. We no longer need to make a

substantial investment in physical infrastructure, and we can pay-as-
we-go for computing power. This enables us, and many other
commodity traders, to run complex quantitative models without
significant overheads.

Many of the strategies we use to trade commodities today are only

tradeable and priceable because of the technology and the giant leap
forward that computing power has taken in recent years.

The exciting thing is that quantitative analysis is evolving as quickly as

the technology is. Each year brings new quant strategies capable of
isolating specific types of returns in a cost-effective way.

How does quantitative trading work?

To the uninitiated, quantitative trading can feel complex and

confusing, but once understood, it’s clear how powerful quantitative
strategies are for commodities trading.

At its most basic level, quantitative analysis uses powerful computing,

mathematical models, and huge datasets to either identify trends and
price patterns, develop new and faster execution strategies or support
fundamental traders in making trading decisions.

Quantitative trading strategies are valuable because they’re

agnostic

There’s a simple analogy with meteorology: a meteorologist forecasts a

90% chance of rain on a day that starts sunny. Even though it may feel
counter-intuitive, they’ve made the forecast by collecting and
analysing the global ‘starting conditions’ and then feeding that data
into the physics package in their weather model.
The analysis identifies specific patterns that human nowcasting may
miss; and in this instance, it suggests that 90% of the time, this
specific pattern means rain is likely. The meteorologist can then make
their forecast with confidence, and so it is with quantitative trading.

Quantitative trading strategies are valuable because they’re agnostic,

part of a dispassionate decision-making process where it’s the patterns
and numbers that matter, not emotions associated with some high-
stakes financial trading.

But there are risks and limitations.

The machines aren’t taking over

There’s inherent complexity in many of the commodities we trade, and

although our quantitative models can help our traders make better
decisions, the knowledge, experience and expertise of our fundamental
traders are still our principal IP.

We can see the limitations of quantitative trading, particularly in the

division between benchmark and non-benchmark commodities. Non-
benchmarks, like some local energy markets and carbon, for instance,
sometimes lack historical data and/or liquidity; they also may face
significant variables like changing regulations that quant analysis can’t
model.
These markets need specific knowledge and insight from fundamental
traders, and both man and machine were required to capture the
outsized rewards that were available in 2021 when we saw markets like
European natural gas surge 270%, German power 300% and carbon
145%.

The financialisation of commodities

In comparison, quant strategies shine in the more mature benchmark

commodities like crude oil, copper and gold, where fundamental
traders are now struggling to make money. That’s because of the
increasing financialisation we’re seeing in these markets and how far
prices can decouple from the underlying fundamentals.

Instead of supply and demand and the many variables like weather and
seasonality being key price drivers in these commodities, it’s actually
now more likely to be investment flows – actual and anticipated – that
shape the price action and risk appetite. If more market participants are
using commodities to hedge inflation, or gain exposure to China’s
reopening, as we’ve seen this year, prices may not reflect
fundamentals.

The oil price this year is a powerful example of the dangers for
fundamental traders operating in these financialised markets against
their algorithmic counterparts. It’s fair to say that most experienced oil
traders have been bullish on the price of oil this year; in fact, there have
been some big bets in that direction, and yet the price of oil is down
around 10%.

That discrepancy has, in part, been driven by quant strategies and

algorithms speculatively selling.
 Fundamentally we don’t believe the machines are taking
over

Instead, we’re planning for the continual evolution of the synergy

between our fundamental trading teams and our quants. We expect to
see even more integration between quant analysis, algorithms, and the
more traditional trading and origination roles in the future.

Quantitative data coupled with market insights from a trader’s

experience gives traders the ability to conduct superior analysis. In
turn, that leads to better trading strategies than algorithms alone.
We’re embracing digital transformation at Engelhart and would
encourage our whole industry to identify opportunities from the
technological advances we’re seeing.

Quantitative trading risks

While quantitative strategies hold immense potential, they also present

challenges and risks that must be mitigated. These include:

Model risk: The risk that the mathematical model is incorrect or

misused.

Data risk: The risk that the data used is incorrect or misinterpreted.

Regime change risk: Risks associated with the macro economy,

geopolitics or policy change that quantitative models can’t predict.

Successfully navigating these risks requires the deep understanding of

commodities markets our fundamental traders provide, in combination
with the insights provided by our quant analysts iterating and
improving our trading strategies and models.

Quantitative strategies must constantly evolve to maintain their edge

in an ever-changing market environment. This includes incorporating
the latest advances, such as machine learning and artificial
intelligence, which hold great promise.

The rise of the quants has created a significant paradigm shift in

commodity trading. Quantitative strategies have become an
indispensable tool for navigating the complexity and volatility of
commodity markets. They provide a scientific, data-driven approach to
trading that complements, rather than replaces, traditional
fundamental analysis.

In general, over the long-term, commodities will always naturally

revert to their underlying fundamentals, but their path along that trend
can be derailed at any time by increased financialisation,
macroeconomic factors, and a change to the fundamentals themselves.

No quantitative models alone could accurately predict that path, just as

no single fundamental trader could. It’s the synergy between
quantitative analysis and fundamental trading that’s so important to
how we do business, now and in the future.

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