Streetwise Professor

October 27, 2014

Matt Levine Passes Off a Bad Penny

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 5:36 pm

Bloomberg’s Matt Levine is usually very insightful about markets, and about financial skullduggery. Alas, in his article on developments in the copper market, Matt is passing off a bad penny.

The basic facts are these. A single firm, reportedly well-known (and arguably infamous) metals trading fund Red Kite, has accumulated upwards of 50 percent (and at times as much as 90 percent) of copper in LME warehouses that is deliverable against LME futures contracts. Such an accumulation can facilitate a corner of the market, or could be a symptom of a corner: a large long takes delivery of virtually the entire deliverable stock (and perhaps all of it) to execute a corner. So the developments in LME copper bear the hallmarks of a squeeze, or an impending one.

What’s more, the price relationships in the market are consistent with a squeeze: the market is in backwardation. I have not had time to determine whether the backwardation is large, controlling for stocks (as would occur during a corner), but the sharp spike in backwardation in recent days is symptomatic of a corner, or fears of a corner.

Put simply, there is smoke here. But Matt Levine seems intent on denying that. Weirdly, he focuses on the allegations involving Goldman’s actions in aluminum:

Loosely speaking, the problem of aluminum was that it was in deep contango: Prices for immediate delivery were low, prices for future delivery were high, and so buying aluminum and chucking it in a warehouse to deliver later was profitable. So people did, and the warehouses got pretty jammed up, and other people who wanted aluminum for immediate use found it all a bit unsporting.

. . . .

The LME warehouse system is an interesting abstract representation of a commodity market, but you can get into trouble if you confuse it with the actual commodity market. One example of the trouble: Goldman and its cronies were accused of manipulating aluminum prices up by putting too much aluminum in LME warehouses.

Well, yes. But the point is that there are many different kinds of manipulation. Many, many different kinds. An Appeals Court in the US opined in the Cargill case that they number of ways of manipulating was limited only by the imagination of man. Too true. The facts in aluminum and the facts in copper are totally different, and the alleged forms of manipulation are totally different, so the events in aluminum are a red herring (although it is copper that is the red metal)

Levine also makes a big, big deal out of the fact that the amount of copper in LME warehouses is trivial compared to the amount of copper produced in the world, let alone the amount of copper that remains in the earth’s crust. This matters hardly at all.

What matters is the steepness of the supply curve into warehouses. If that supply curve is upward sloping, a firm with a big enough futures position can corner the market, and distort prices, even if the amount of copper actually in the warehouses, or attracted to the warehouses by a cornerer’s artificial demand, is small relative to the size of the world copper market.

Case in point. In December 1995 Hamanaka/Sumitomo cornered the LME copper contract holding a position in LME warrants that was substantially smaller than what one firm now owns. Hamanaka’s/Sumitomo’s physical and futures positions were small relative to the size of the world copper market, measured by production and consumption. But they still had market power in the relevant market because it was uneconomic to attract additional copper into LME warehouses.

Another example. Ferruzzi cornered the CBT soybean contract in July, 1989, owning a mere 8 million bushels of beans in Chicago and Toledo. But since it was uneconomic to move additional supplies into those delivery points, it was profitable for, and possible for, Ferruzzi to corner the expiring contract.

World supply may have an effect on the slope of the supply curve into warehouses, but that slope can be positive (thereby creating the conditions necessary to corner) even if the share of metal in warehouses is small. The slope of the supply curve depends on the bottlenecks associated with getting metal into warehouses, and the costs of diverting metal that should go to consumers into warehouses. These bottlenecks and costs can be acute, even if the amount of warehoused metal is small. Diverting copper that should go to a fabricator or wire mill to an LME warehouse is inefficient, i.e., costly. It only happens, therefore, if the price is distorted sufficiently to offset this higher cost.

Levine ends his post thus:

One example of the trouble: Goldman and its cronies were accused of manipulating aluminum prices up by putting too much aluminum in LME warehouses.The worries about copper — that it could be cornered, pushing prices up — stem from there being too little copper in those warehouses. Both of those things can’t be true.

Yes they can, actually. Different commodities at different times with different fundamental conditions are vulnerable to different kinds of manipulation. It is perfectly possible for it to be true that aluminum was vulnerable to a manipulative scheme that exploited the bottlenecks of taking the white metal out of warehouses starting some years ago, and that copper is vulnerable to a manipulative scheme that exploits the bottlenecks of getting the red metal into warehouses now. No logical or factual contradiction whatsoever.

I know you are better than this, Matt. Don’t let your justifiable skepticism of allegations of manipulation make you a poster child for the Gresham’s Law of Internet Commentary.


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