Streetwise Professor

December 22, 2015

Embarrassing Silliness on Commodity Market Financialization in the FT

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 8:04 pm

Satyajit Das writes some smart things. He also writes some silly things. This article in the FT is definitely in the silly category. Embarrassing is more like it.

Das claims that “increased financialisation” has “exacerbated” the downturn in commodities. What does he mean exactly?

Let’s start with the what Das means by financialization. (I’m ‘Merican and I’ll spell it like a ‘Merican, dammit!) This has become a term of art to mean traditional financial investors (pension funds, hedge funds, retail investors etc.) taking on direct exposure to commodity price risks, usually via derivatives (including ETFs). But Das treats anything touching finance as financialization. His use of the word is so broad as to be meaningless.

Cash flows from future sales were monetised to raise large amounts of debt to finance expansion. The collateral value of commodities secured expansion in borrowing and trading.

Uhm, when has this not been true in commodities? Commodity production tends to be highly capital intensive, which requires, you know, capital, which requires tapping the capital markets to, you know, fund. Since the dawn of capital markets, lenders and equity investors have mobilized savings to supply capital to miners, drillers, etc., to fund the digging of mines and the drilling of wells, based on the expectation of being paid back from cash flows from future sales. That’s exactly what finance is. If that is “financialization,” pretty much everything is “financialized” and the term is so general as to lack all meaning and analytical bite.  Modern markets have always been financialized in this way.

Natural resource firms have long been major users of the capital markets. Indeed, many of the earliest stock and bond markets developed to finance commodity investments, and mining and E&P firms have long been leading names in major stock and bond markets. In that respect, commodities have been financialized a lot more for a lot longer than most sectors of the economy.

In fact, it is the very capital intensity of extractive industries (which made natural resource firms reliant on capital markets from the first) that  explains the boom-bust cycle. Most of the costs of natural resource extraction industries are sunk costs. Literally sunk: very expensive, very long-lived holes in the ground that can’t be undug and used for something else. If demand turns down after these investments are made, it usually makes economic sense to continue operating , because the variable costs of operation tend to be relatively low and can be covered even when prices are low. Since the capacity is long-lived, exit does not occur, meaning that low prices can persist for long periods. But that’s economically efficient when investment is largely irreversible.

Which brings me to Das’s next groaner:

The need to maintain cash flow to service debt requires production levels to be maintained, even if it is below cost. This delays the withdrawal of supply and correction of prices. It also destroys the value of equity, making it difficult for firms to raise new capital to reduce debt.

Producing “below cost” (by which I assume he means continuing to produce when prices are below cost) destroys cash flow, rather than maintains it, if cost is measured properly. It is optimal to operate as long as prices cover avoidable costs (e.g., variable costs, and fixed costs that must be incurred as long as output is positive), even if prices are below some measure of accounting cost which typically embeds sunk costs: you can’t judge economic operation by looking at income statements, which have sunk costs baked in.

This kind of continued operation doesn’t “destroy the value of equity.” To the contrary, it is shutting down when price more than covers avoidable cost that destroys the value of equity. The fact that avoidable costs in natural resource extraction tend to be low relative to total costs means that not exiting even when prices are low is economically efficient.  (Another implication of the cost structure of natural resource production is that it is typically efficient to produce either at capacity or shut down altogether.)

Debt costs reflect the sunk costs of investment. Sometimes–like now–cash flows are insufficient to cover the costs of servicing this debt for many firms. That’s what bankruptcy laws are for. If they work well, the continued operation (or not) of insolvent firms will depend on current and expected future margins between price and avoidable costs, not the Ghost of Sunk Costs Past.

Then there’s this:

For industries like shale gas and oil which were cash flow negative even at high oil prices because of the need to invest in new wells to maintain production, reduction in the supply of capital affects the ability of firms to operate.

Again, Das is apparently utterly confused about the proper cash flow concept to apply. If “maintain production at all costs” was truly the mantra of the E&P industry, the problem would not be financialization, but management retardation. Finance would be implicated only to the extent that financiers are similarly retarded and gladly shovel good money to them to permit continued value destruction. If anything, it is the need to access the capital markets that prevents retarded managements from wreaking havoc: few things are more destructive of value than CEOs with bountiful free cash flows that relieve them of capital market discipline. Cutting off capital from negative NPV projects is a boon, not a burden.

Finally we get to derivatives!:

Hedging ameliorated the effect of declining prices. Derivative gains contributed in excess of 30 per cent of revenues in the US shale industry in 2015

And this is a problem why? This is exactly the way “financialization” is supposed to work. It transfers price risks to those (namely, well-diversified financial investors) who can bear them at a lower cost. Yes, investment probably would have been lower, and prices higher, had this risk transfer mechanism not existed. But this doesn’t mean that the level of investment with an efficient risk transfer mechanism is too high: it means that the level of investment without one is too low.

More bad derivatives stuff:

Margin calls further complicate matters. An airline that has hedged future oil purchases at high prices may face margin calls that make unexpected claims on its cash flow.

Yes, cash flow mismatches on hedges can be a problem. Which is exactly why corporate end users strongly preferred (and prefer) OTC hedges which embedded credit to mitigate these problems.

More financialization evils, according to Das:

Financialisation altered fundamental industrial structures. Traditionally high barriers to entry, such as technology, expertise and access to capital, led to domination by large producers who planned and controlled production.

Now specialised resources service firms provide access to technology and the willingness of capital markets and non-traditional lenders to provide finance allows easier entry resulting in a more fragmented industry.

These are features, not bugs! These are benefits of financialization! Breaking down oligopolistic and monopolistic market structures is good, not bad!

At the same time, trading in financial claims on future commodity cash flows has encouraged institutional investment in the sector as part of diversification into new asset classes. Hedge funds and trading firms now act as quasi banks financing and facilitating risk management by commodity market participants.

So facilitating the flow of capital from savers to investors is a bad thing? Facilitating risk management is bad too? Who knew?

This is just bizarre:

This activity is marked-to-market daily or secured by the value of the commodity. Any change in value can trigger calls for additional collateral complicating cash flow management or force liquidation of holdings. Capital market investors may lack the ability to ride out prolonged corrections. It complicates dealing with financial distress and the necessary restructuring.

Tapping into a deeper pool of capital, which financialization (as defined by Das) allows, spreads the risks and makes it easier to ride out prolonged correction (which, again, are an inherent consequence of the cost structures/operational leverage of natural resource extraction), not harder. And the statement about complicating dealing with financial distress and restructuring is completely conclusory, with no supporting argument or evidence.

Yes, in a world with poorly developed financial markets, large scale investments in industries characterized by irreversibility and large scale (like natural resource extraction) are expensive to fund. “Financialization”–which in Das’s expansive usage, apparently just means lower cost access to bigger pools of investment and risk capital–indeed leads to a bigger natural resources sector. Yes, by its very nature this sector will inevitably go through protracted periods of low prices, which will impose losses on investors. But that’s a risk that they willingly choose to bear, in exchange for an expected return that they consider compensatory.

Das appears to be afflicted with Bastiat Disease, i.e., the inability to distinguish between the seen and the unseen. Das sees the financial carnage that the current natural resources depression has created, but hasn’t considered what would happen if the world was less financialized. What are the unseen consequences of that?

I can tell you: a poorer world.

There are some forms of finance that are wealth-destroying rent seeking. The financing and risk management of the production of minerals and energy are not among them.

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  1. Right on man. Well done for calling him out on his lazy, poorly thought through arguments. While the internet provides immense benefits to all, one down side is the constant rush by some to trade quality for quantity in pursuit of that never ending need for “content”. I understood and agreed with all your points.

    Comment by Dan Osborne — December 22, 2015 @ 10:30 pm

  2. His position is quite coherent at one level: He prefers a stable cartel to a fluctuating free market, even if the former has higher average prices, lower average quantities, and lower per-capita economic welfare.

    If it weren’t for sunk cost fallacies, what would economists do for fun?

    Comment by srp — December 23, 2015 @ 9:19 pm

  3. As usual, well said.

    Comment by MS — December 27, 2015 @ 8:09 pm

  4. What saddens me, yet is no longer surprising, also sadly, is that “expert” retardation is quite strong and vibrant in media and think thanks. This is so, whether it be economic or Russian experts. What this implies about the firms that employ them, and the consumers of the output of of said firms, just makes me want to start reading openly honest fiction again…

    Comment by Kavkazwatcher — December 28, 2015 @ 8:44 am

  5. ” To the contrary, it is shutting down when price more than covers avoidable cost that destroys the value of equity. “.

    I’d expand on this as follows:

    It was the PRICE DECLINE that destroyed the equity, and shutting down when price covers more than variable cost just destroys MORE equity.

    Comment by MIchael Sessa — January 12, 2016 @ 1:11 pm

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