Streetwise Professor

July 24, 2010

Get a Room

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 10:17 pm

Today’s FT runs another cringe-worthy PDA with Anthony Ward of Armajaro.  It is as probing and hard hitting as anything you would expect to read in, say, TigerBeat.  Its tone runs the gamut from credulous to worshipful.

I found the last two paragraphs particularly entertaining:

He is said to argue now as he did in 2002, that all he has done is go to the futures market “to buy cocoa in the most efficient and low-risk way possible”. The trade is likely to bring a stream of profits to Armajaro, particularly if the new Ivorian crop, due in October, disappoints.

Even if prices decline, Mr Ward is unlikely to suffer. A competitor who knows him well has no doubt he will have hedged his position. One admiring executive says: “No one knows the cocoa market better than Anthony.”

Paragraph 1: He’s long cocoa, so if prices rise due to a disappointing crop he reaps a stream of profits.

Paragraph 2: He’s hedged, so if prices fall, he doesn’t lose.  That is, he isn’t long cocoa.

If both of those things are true, he would indeed be a great trader: prices rise he wins, prices fall, he doesn’t lose.  He’s long the upside but not the downside.

How does that work, exactly? I mean, these diametrically opposed statements are in adjacent sentences.  Didn’t an editor think that such a feat was unlikely, or at least sufficiently intriguing to demand further investigation, explanation, and reconciliation?

There is, of course, a way that it could work: Armajaro could be long cocoa puts.  But this seems highly unlikely, as the traded put market is small relative to the deliveries that Ward has taken.  At the very least, though, the tension between the last two paragraphs should have spurred the report to do some actual, you know, investigation and reporting, to see whether the put story has any factual basis, and if so to provide some background on the cost of the puts and its effect on the profitability of the strategy.  And if it doesn’t (as is likely the case), to state forthrightly that Armajaro’s position is a risky one subject to a risk of losses symmetric to the prospect of gains.

But instead the reader gets a breathless fan mag portrayal of the hero who is able to do things that are impossible, or at least so unlikely as to demand further explanation.

This is all bad enough, but nothing compared to the apparent failure to ask any aggressive questions to test the reasonableness of Ward’s denial of squeezing or cornering the market.   If the questions were asked, but not answered, that should have been made plain, or the piece shouldn’t have run at all.  But that would ruin a nice piece of hagiography.

Mr. Ward’s evident hold over the FT is very curious.  An enterprising competitor could do worse than trying to figure out why–after, of course, doing some serious reporting on what has transpired in the cocoa market in recent weeks.

July 23, 2010

Timmy! Antoinette

Filed under: Derivatives,Economics,Energy,Financial crisis,Politics — The Professor @ 9:08 pm

Dripping with condescension, Timmy! blew off the concerns of, oh, I don’t know, just about everyone in every kind of business about the effects of the regulatory avalanche that the administration and Congress have unleashed.  No sign here of that deep empathy that is supposedly he hallmark of Obama appointees (h/t R):

“Businesses always want their taxes lower and always want to live with low regulation,” Geithner said. “There is nothing remarkable, or particularly interesting frankly, that we’re in the midst of another debate, which you hear in almost any administration, with people looking for ways to help affect the outcome on the basic path of regulation and taxes.”

. . . .

But when asked a third time by The [Daily Caller] to address the [Business Roundtable] memo, Geithner said it was “a long, diffuse list of familiar concerns, again reflecting nothing remarkable … in the fact that business would like to operate with fewer restrictions.”

Translation: “The concerns expressed from coast-to-coast by businesses large and small, in virtually every industry, are not legitimate.  They are just petty, grubby attempts to achieve favorable regulatory treatment and reduced taxes.  Those who advance these concerns are self-interested and mercenary, and beneath the contempt of a high minded Olympian such as I.  Let them eat regulation.”

Astoundingly, Geithner dismisses any idea that the financial deform and health care bills are creating spending-suppressing uncertainty:

Geithner contested the idea that the health and financial regulation bills have made it more difficult for businesses to plan for the future.

“The basic framework is set. And that should help again give people a lot of clarity about what the basic rules they’re going to operate under is [sic],” he said. “But of course there’s a lot of rule-writing design, and there should be. A lot of the existing set of rules, muck of rules, were not any good. And so you want people to go back and revise and reform.”

Anyone who could say this is either a mendacious liar or a clueless clown.  (And yes “both” is making a strong run for the money.)  In the financial bill alone, there are at least 243 rules touching on every aspect of banking, securities, and derivatives markets that remain to be written: the true total is probably higher.  Nobody knows what those rules will be.  Nobody knows how those rules will interact.  Nobody knows how businesses and households are going to respond to this blizzard of new ukases.

A lot of clarity my [insert body part of choice here]. “Revise and reform” suggests an incremental process to fix known problems.  In contrast, what we face in the coming years is anything but incremental, but is instead a wholesale re-engineering of the entire financial sector.  And the same is true of the health care legislation.

Let’s just take one slice of one piece of legislation: the derivatives title of Frank-n-Dodd.  What has to be cleared?  No idea.  What will margin requirements be?  Who knows?  What capital requirements will regulators impose?  Oh, probably somewhere between zero and 100 percent.  Who will be exempted from the clearing requirements?  I’ll get back to you on that.  How will derivatives be traded (e.g., WTF is a “swaps execution facility”)?  I haven’t the foggiest idea.  What will energy position limits be?  Ditto.  And on and on and on.

Then, once you’ve finally learned what the rules will actually be, now try to figure out how market participants will respond to them.  What will happen to credit?  Prices?  Entry and exit?  Liquidity?

I talk to quite a few people in finance and energy on a regular basis.  A big part of the reason that I talk to them is that they’re trying to figure out what the hell is in the bills, how regulators are going to respond, and what the implications are for their businesses, and they figure that maybe I have some insights onto that.  And my answer is: I only wish I knew.

“A lot of clarity.”  All that people are clear about is that NOTHING is clear.  As a result, the pucker factor is quite high.

In typical administration fashion, Geithner admits that there is uncertainty out there, but this has nothing to do with anything the administration or Congress has done.  It’s just a psychological phenomenon, a sort of financial post traumatic stress syndrome dating to 2008–conveniently before Obama and Geithner arrived to save us peons:

“The big uncertainty that the world is still in … is that people, again, scarred by the trauma induced by the crisis are still looking to see how strong is growth going to be,” he said.

No, Timmy!  The big uncertainty is that, letting “no crisis go to waste,” the administration and Congress have played the Sorcerer’s Apprentice, and cast spells touching on every aspect of the economy, the effects of which by their own admission they have not the slightest understanding.  (Cf. Nancy Pelosi: “And we will find out what is in the Bill, as soon as it passes,” and Chris Dodd: “We don’t know ultimately how well the ideas we’ve incorporated here will achieve the results we desire” and “No one will know until this is actually in place how it works.”  Yeah, just screams “clarity,” doesn’t it?)  If the people who wrote this stuff have no idea, how are the rest of us poor slobs supposed to figure it out?

In fact, if it sticks with the attitude Geithner expressed, the administration is signing its own death warrant.  Call it a capital strike, going Galt, what have you.  With this barrage of regulations; pea soup fog of uncertainty; and higher spending and taxes as far as the eye can see, investment and consumer spending and employment growth will remain moribund, at best, with devastating political consequences.  And in 2010 or 2012, if things do indeed play out this way, the incantation “Bush did it” won’t work any electoral magic.  Sadly, by then the damage that the nation will have suffered will be immense.

Shameless Self-Promotion

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Financial crisis,Politics — The Professor @ 12:00 pm

I have a  couple of recent publications that may be of interest to some of you.

A couple of folks have expressed interest in my recent Energy Law Journal paper on manipulation.  Here it is: my policy recommendations are at the end.

Cato just released a Policy Analysis I did on clearing mandates. The link is here: you can download the paper from that page.

July 22, 2010

A VAT Trojan Horse?

Filed under: Economics,Politics — The Professor @ 4:38 pm

This story is creating something of a stir (h/t R): gold dealers are up in arms over a provision buried in the thousands of pages of mind numbing verbiage of the health care law.  The provision requires firms to submit a 1099 for “purchases of all goods and services by small businesses and self-employed people that exceed $600 during a calendar year.”  Gold dealers are peeved because with gold at $1000+ an ounce, virtually every purchase and sale they do will require submission of a 1099.

The ostensible purpose of this provision is to permit the IRS to capture billions of dollars of taxes on transactions that currently go unreported.  That was necessary to make the health care bill pay for itself.  Or, I should say, it was necessary to make pretend that the health care bill pays for itself.  Any sentient being knows that it can’t, won’t, and never will, blizzards of 1099s or no.

But there is something more worrisome about this provision.  Virtually exhaustive documentation of transactions is necessary to make a value added tax work.  I suspect, therefore, that the true motive–or at least, a collateral benefit, in the eyes of our tax junkies in Washington–of this provision is to lay the administrative and operational foundation for the adoption of a VAT.  Just saying.

Chocolate Kisses, or the FT in the Tank

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 10:34 am

I have been a close observer of manipulation since the mid-1980s, when the Japanese were squeezing the 30 year while I was devising interest rate hedging strategies for the clients of the FCM I worked for.  Since then, I have examined, intensively and forensically, manipulations in soybeans, Brent, Bunds, Treasuries, canola, copper, aluminum, propane, natural gas, WTI, and other things.  I have researched every major manipulation that I could identify, dating back to the 1860s.

I have heard all of the lame alibis, sometimes directly from the manipulators’ mouths, sometimes from the mouths of their mouthpieces.  Excuses from the likes of them are to be expected.  It is disappointing, however, to see the Financial Times regurgitate their tripe.

Yesterday the FT ran an editorial that recycled many of the tired tales that manipulators tell in defense of Anthony Ward’s actions in the cocoa market.  None of it is exculpatory, in the least.

To start with, the FT opines:

Armajaro breached no rules when, in pursuit of its view that cocoa prices would rise after a poor harvest, it snapped up contracts to purchase cocoa beans on the Liffe futures exchange. These gave it the right to take physical delivery of the beans if it chose. What stirred the controversy was that Mr Ward exercised that prerogative over 24,100 contracts. These amounted to about 7 per cent of annual world production.

Yes, the old “I had the contractual right to do what I did” defense.  But a market power manipulation involves the opportunistic use of this contractual right to distort prices and the flows of a commodity in commerce.  This action degrades the effectiveness of futures contracts as a risk shifting and price discovery mechanism, and leads to wasteful use of the commodity.  If “contractual right” trumps everything, then rules against corners are a nullity.  If that’s the way the game is played, maybe I should start The Corner Fund and go to town.  I’ll hire the FT to flack for me.  But I probably won’t even have to hire it: it seems it’s willing to do it for free!

The FT continues with another old standby: the “They had it coming to them for walking in this neighborhood alone dressed in shorts like that” story:

There is no doubt that his decision caused agony for some on the other side of the contracts. A number of cocoa traders use Liffe to hedge against falls in the prices of the stocks they hold. They suffered because they not only hedged their beans – but their holdings of cocoa powder and butter also. These were ineligible for delivery against the contracts, thus forcing the hedgers to settle contracts for cash at penal premiums or to buy sufficient beans to close the trade.

It is hard to see how Mr Ward can be blamed for this. The hedgers did not need to run a mismatch risk. They could have found other ways to insure their exposures – such as entering into a derivative with a bank. That would have been more expensive, but would also have been safer.

But the whole point of centralized markets is to concentrate liquidity, thereby permitting out-of-position hedgers to reduce risk with maximum flexibility while incurring low transactions costs.  They willingly trade basis risk for transactions costs.  That is no reason to excuse opportunistic actions that exacerbate basis risk.  The risks of being cornered induce hedgers to take costly preventative measures, such as investing collecting information about the activities of other traders that is socially wasteful because it is merely intended to reduce the risk of being the source of a wealth transfer, or using markets where transactions costs are higher.

Beating me to the punch, Tullet Prebon’s CEO T.C. Smith skewers the FT’s fatuousness–and hypocrisy:

Many commentators maintain that one lesson of the financial crisis is that all over the counter derivatives should be traded on exchanges.

I wonder how the revelation in your editorial, that the cocoa consumers who attempted to hedge their powder and butter through the imperfect mechanism of the Liffe futures in cocoa beans would have suffered much less if they had taken out OTC contracts with banks which precisely hedged their risk, fits their theory.

They can file your editorial with the reports on the as yet unexplained “Flash Crash” of May 6, in which Apple’s shares traded at one cent per share and $100,000 a share within 20 minutes.

But then, why let the facts get in the way of their theory? It will all be safer and more transparent when everything is on exchange.

Couldn’t have said it better myself.

The FT then plays three card monte and attempts to distract attention from the real issue:

It has been suggested that Mr Ward’s conduct was akin to cornering, and thus led to a disorderly market. But this is a hard case to sustain. Disorderly markets occur when two-way prices cease to be made – thus making cash settlements impossible. But the open interest on the cocoa contract fell in the weeks prior to expiry.

That is, shall we say, an idiosyncratic definition of “disorderly market.”  In fact, in many corners trading activity can reach a frenzy.  There are two-way prices, but the prices are far above where they would be in a competitive market, and the “cash settlements” are at essentially extortionary prices.  Apparently that’s hunky dory with the FT.  And even in cornered contracts open interest typically falls.  In fact, that’s almost always true.  Indeed, it often falls the most when the cornerer makes money by liquidating futures at supercompetitive prices.

The FT then suggests that the quiet word among gentlemen approach is preferable in such matters:

However, squeezes can be managed. Liffe tries to do this by directly stepping in where necessary to guide the activities of traders. This approach, which has been compared to being summoned to the “headmaster’s study for a quiet word”, effectively substitutes for a detailed rule book. The flexibility it provides can be valuable so long as the market is actively policed.

Yeah.  That works, except when it doesn’t.  And the London markets provide numerous examples of it not working.  Remember Sumitomo, and the LME’s rather, shall we say, prone, not to say accommodating, posture in dealing with Hamanaka right to the end?  Or all of the Brent shenanigans that occurred over the years?

And in that vein, a shout out to LIFFE, for validating my 1995 JLE article arguing that exchanges were unlikely to act against manipulation.  It would be hard to write a letter that does a better job at missing the elephant in the room.

Perhaps due to space limitations, the FT does manage to overlook some of the standard lines from the manipulator’s manual.  But a couple of commentors over at SeekingAlpha fill the void.

In this case, it appears that Armajaro already had customers for the cocoa delivered to it.  See!, the commentor says, there is real demand, real customers.  Well, if you know anything about manipulation, you know that the biggest danger is related to burying the corpse of the manipulation: that is, selling the massive deliveries that you take to squeeze the market.  A clever fellow bent on manipulating the market pre-arranges the funeral.  If the reports about forward sales of old crop cocoa to processors are correct, that was done in this case.  So, rather than being exculpatory, such sales are actually evidence of manipulative intent.

(I’d be interested to know who is making the deliveries.  It would be telling if any of the deliveries were made by those who had contracted to buy from Armajaro.  It would also be interesting to know more of the details of those contracts, not just the pricing terms but any other features in the contracts relating to use or marketing of the cocoa, and the delivery locations for the contracts.)

The other common excuse, again seen in my SA comments, is that the stuff that is delivered will be consumed.  Well, duh.  It’s not like the guy is going to eat it all himself, or burn it, or build houses out of cocoa beans.  It is going to be consumed.  But manipulation distorts consumption pattens–the timing and location of consumption.  The stuff is consumed, but in the wrong place at the wrong time, and too much of it is shipped around to the wrong places.  The fact that the delivered cocoa will eventually be consumed does not imply that the deliveries are efficient.

All in all, none of the arguments raised in Armajaro’s defense are even remotely exculpatory, and some are actually adverse.  A final judgment would require a full forensic and econometric evaluation of prices, pricing relationships, price-quantity relationships, and movements of cocoa.  Time permitting I hope to do some of that.  But at this juncture, there is sufficient evidence to conclude that there is a colorable case against Armajaro, and that the arguments raised in its defense are risible.

Taking huge deliveries in a large backwardation is consistent with manipulation.  This is especially true when one party takes all the deliveries.  Delivery economics are pretty straightforward, and if they work for one party they tend to work for several.  One firm taking all of the deliveries is suspect.

Moreover, the purported rationale for the trade–an expectation of a small new crop in the autumn–does not explain why the old crop price richened relative to the new crop price.  If the real motivation was a view that the market did not appreciate sufficiently the likelihood of a small crop, then the trade should have been to go long the new crop and cash in if and when that view was validated.  Taking delivery into a big backwardation, and seeing the backwardation actually increase as result of the deliveries, is not a sensible way to play an anticipated shortage in the new crop.  The backwardation across crop years screams: “don’t carry over inventory into the new crop year.”  So current inventories do nothing to alleviate future shortages (because the spreads signal that all of the cocoa should be consumed before those shortages arise).  (As an example of how the market should work in response to anticipation of a crop shortfall, during the big US drought of 1988, the old crop-new crop spreads for corn and soybeans snapped into a huge carry; indeed, the spreads exceeded full carry charges measured using official storage rates.  The warehouses in Chicago were filled to the top with grain and beans. That’s because the market realized that it was desirable to carry over old crop supplies in larger quantities than usual to alleviate the anticipated shortfall in the 1988-1989 crop.)  (Ferruzzi told the same lame betting on a new crop shortfall story during its bean manipulation in 1989.)

The rise in the London price relative to the NY price is also what you’d expect to observe in a corner.

I’m not rushing to judgment.  But neither should the FT .  Its unseemly haste to play Ward’s mouthpiece, its heaving up of tired excuses made for manipulators from time immemorial, and its complete lack of any skepticism, are not befitting a premier financial publication.

Atlanta, 22 July 1864

Filed under: History,Military — The Professor @ 7:59 am

On 22 July, 1864 occurred one of the most remarkable battles of the Civil War, but one that has not received the attention it deserves.  It is sometimes called “The Battle of Atlanta” but it was also known as the “Battle of July 22nd.”

The battle was part of newly appointed Confederate commander John Bell Hood’s effort to smash back Sherman’s relentless approach to Atlanta.  On the 21st, Leggett’s division of Blair’s XVII corps took Bald Hill on the Confederate right in a bold assault.  In moving forward to occupy the line Leggett’s men had seized, the left flank Sherman’s Army of the Tennessee was in the air.  Perceiving the chance to mount a second Chancellorsville, Hood endeavored to strike the vulnerable flank.

Hood’s plan was a good one (especially for Hood), and tolerably well executed.  He placed three strong divisions on the vulnerable Federal flank, advancing north.

But Hood was not facing the dodgy XIth corps of Chancellorsville infamy: the Army of the Tennessee was a much sterner opponent.  Indeed, in my view, this force was the most effective body of troops, man for man, to fight in the Civil War.  It had experienced plenty of combat, and so was tough and battle tested.  But it had not suffered the shattering losses of men and officers that other forces, like the Army of the Potomac or the Army of Northern Virginia had.  It had never suffered a serious reverse, and was highly confident.  Its men were highly self-reliant.

So rather than running when finding a large force on their flank, the Federals fought fiercely.  A small brigade of Iowans directly on the vulnerable flank stood and splintered the assault of Cleburne’s vaunted division.  Other parts of that division swept on, and attacked other elements of the XVIIth corps from the rear.  But while Civil War units would typically break when attacked from the rear, the Federals just jumped to the other side of their earthworks and beat off the attack, at times in hand-to-hand combat.  The commander of the 15th Iowa, William Belknap (later disgraced in a scandal in the Grant administration in which he served as Secretary of War), grabbed the 45th Alabama’s Col. Harris Lampley by the lapels, pulled him over the earthworks and shouted in his face: “Look at your men.  They are all dead.  What are you cursing them for?”  When another assault came from the direction of Atlanta–their former front, their new rear–the Federals just jumped back to the right side of their breastworks and beat off that attack too.

The Rebels eventually pushed back the Federals to Bald Hill, where a vicious, muskets in the face fight broke out over the embrasures of a small fort on its summit.  The Confederates assaulted again and again, but were beaten back by Leggett’s men.  The fight came so intense that when the commander of the brigade holding the hill, Manning Force, wounded terribly in the face, asked for a flag, his frightened aide brought him a white rag, thinking that Force intended to surrender.  Force cursed the man–“I meant an American flag.”  Force’s men fought on.  (Force was awarded the Medal of Honor.)

Another Confederate assault further north gained a temporary lodgement in the Federal line, but a smashing counterattack pushed them back.

By the end of the day, the Confederate assault had been crushed everywhere.  Exact casualty figures are in doubt, but best estimates are that Hood’s army suffered 4 times the casualties as the Army of the Tennessee.

One Federal casualty was the AotT’s commander, James Birdseye McPherson.  He was beloved by many, most notably Grant and Sherman.  Sherman cried when McPherson’s body was brought to his headquarters on a makeshift stretcher fashioned from a door.  McPherson was bright and engaging, obviously, but something of a disappointment as a battlefield commander.

But to me, one of the most interesting and tragic casualties of the battle was someone you’ve probably never heard of, Lucien Greathouse, the commander of the 48th Illinois.  He died leading a local counterattack to save Gay’s Iowa battery. He must have been a remarkable leader.  Sherman and Logan (McPherson’s replacement as army commander) eulogized him, as did Gay and his replacement as commander of the 48th.  All did so in terms that were remarkable, compared to the mention that most deaths merited by that time of the war when so many had already perished.

He was 22 years old.

Today the field of the 22nd is an urban neighborhood.  You can trace some of the action, and see some markers, but the battlefield is essentially obliterated.  Bald Hill–named “Leggett’s Hill” afterwards by the veterans–is no more. It is now an interchange on the interstate.  During the 1930s, the government decided that it had enough money to preserve one battlefield from the Atlanta Campaign.  The choice came down to the field of the 22nd, and Kennesaw Mountain.  The latter won out, and the field of the Battle of Atlanta was swallowed by the city that gave it its name.

The field is gone, but the battle should not be forgotten.  It was one of the most remarkable feats of arms seen in a war that featured many.

July 20, 2010

The Grandfathers Are Dead. Long Live the Elephants.

Filed under: Military,Russia — The Professor @ 10:10 pm

I have written from time to time about the practice of dedovshchina in the Russian army.  When Russian conscripts served two years, the second year soldiers–the “grandfathers” or dedys–brutally hazed the first year soldiers.  The violence was sickening, often resulting in horrific injuries and deaths, and leading many recruits to commit suicide.

In an attempt to eliminate the practice, the Russian military replaced the two year service term with a single year stint.  But to no avail.  For dedovshchina lives, in an arguably more twisted form.  In the old two year system, there was a natural progression from oppressed to oppressor.  In the new one year system, evidently, there is a Darwinian struggle to determine who gets to be “elephants”–the soldiers that brutalize the others.  There is arguably more violence in the current system than the old one: it is more anarchic.

No amount of rejiggering the terms of service will cure this cancer.  At root, the problem is attributable to the abdication of the responsibility of Russian officers, and the lack of a professional cadre of NCOs.  The Russian army is notoriously over-officered.  Just what do these people do?  The isolation from the enlisted men, the failure to exercise any control over the barracks, fosters a sort of Lord of the Flies environment.  Until that changes, all that adjusting enlistment terms will do is alter the process by which the elephants evolve; it will not render them extinct.  But the likelihood of that happening seems remote, at best, as it does not appear to be even a subject of discussion, let alone action.

It Must Have Been the Heat. Yeah. That’s It.

Filed under: Russia — The Professor @ 2:51 pm

There’s sick, and there’s Russian sick.  (H/T Renee).  Some marketing genius thought it would be great for a parasail business at a private resort at Golubitskaya in the Krasnodar Region on the Sea of Azov  to strap a donkey to a parasail and give it a ride.  For 30 minutes.  No.  Seriously.

According to the paper, Taman, the donkey flew so high that children on the beach cried and asked their parents: ‘Why did they tie a doggy to a parachute?’

Its editor, Elena Iovleva, said: ‘The donkey landed in an atrocious manner.

‘It was dragged several metres along the water, after which the animal was pulled out half-alive onto the shore.’

The incident is stunning even for a country where animal cruelty is widespread and came as a shock to the locals, Miss Iovleva said.

Kudos to those humane individuals who rescued the poor beast from drowning.  But there is this tidbit:

‘The donkey screamed and children cried,’ Krasnodar regional police spokeswoman Larisa Tuchkova told the AFP news agency.

No-one had the brains to call police.’

Was it lack of brains, or just a testament to the fact that expecting anything constructive from the police is foolish?

Update.  Thinking about this story reminds me of de Custine’s accounts of the cruelty to animals he witnessed on his journey across Russia.

July 19, 2010

All Contangled Up

Filed under: Commodities,Derivatives,Economics — The Professor @ 8:27 pm

In addition to his other sins, John Maynard Keynes sowed confusion in his analysis of commodity forward curves.  He appropriated language from the markets–backwardation and contango–and misused the terms in a way that has left a trail of confusion ever since.

Unfortunately, even the estimable Izabella Kaminska of FTAlphaville has succumbed to this muddle, as has Joelle Miffra at EDHEC.

Here’s the issue.  As used in the markets, “backwardation” describes a situation in which the price for future delivery is below the price for immediate delivery, or more generally, the price for delivery at T’ is below the price for delivery at T<T’  “Contango” is the reverse: prices for nearby delivery are below prices for deferred delivery.  That is, contango and backwardation refer to the relation between traded prices for different delivery dates, where the prices are quoted simultaneously.

That’s not how Keynes used the term.  He used backwardation to refer to a situation in which the expected spot price for a future date is below the current futures price for the contract expiring on that date.  That is, rather than comparing two traded prices for different delivery dates, he compared a traded futures price to the price expected to prevail at a future date.  This difference between a futures price and an expected spot price is a risk premium. The expected spot price is a mathematical construct, and is not observable.

Izabella and Miffra also utilize the basic Keynesian hedging pressure explanation for contango and backwardation.  Here’s Izabella:

The background here is that the long side of the curve in commodities was traditionally always set in backwardation (the opposite of contango, when futures prices are lower than spot). This was because the curve had developed as a financial method for producers to hedge downside risk — meaning most of the risk befell those going long on the opposite side of the trade.

It consequently also meant that those going long demanded compensation for taking that risk — something which was achieved via the backwardation premium at rollover.

However, with the long side increasingly focused on wealth preservation rather than speculation, the risk along the curve has over the last five years or so shifted to the short side — resulting in a contango structure.

Et voila, the most rewarding ‘have your chocolate cake and eat it’ trade in all of history may have become the consequence. For, if you have the means to go physically long the commodity and short the paper, you can quite literally have it all.

You can gather contango yield (which is attractive in a low interest rate environment), whilst also speculating on the appreciation of the underlying price.

This is basically a hedging pressure story a la Keynes.  Hedging pressure and speculation affect risk premia, which doesn’t translate directly into the shape of the visible forward curve.  For instance, you can have a market, like that for an equity forward or a bond forward, that is always at full carry (contango) because the asset is always in positive supply, but for which the risk premium can be of any sign, and can change sign over time, without the shape of the forward curve changing.

Markets can be in backwardation or contango, properly defined, if risk premia are zero, positive or negative.

A little (relatively) simple math.  Consider a commodity or asset that is always in positive net supply (no stockouts).  It has a risk premium of u.  The risk free rate of interest is r.  The current spot price is S.  The forward price, due to traditional arbitrage considerations, is F=(1+r)S: it is in contango.  The expected spot price is E(S)=(1+r+u)S.  If u>0, E(S)>F.  If u<0, E(S)<F.  Neither the sign nor the magnitude of u affect the forward curve.  Arbitrage considerations drive the visible forward curve.  Risk allocation considerations drive the risk premium.

The Keynes explanation is also a little long in the tooth, even as a theory of risk premia.  It implicitly assumes that markets are fragmented, and that speculators do not hold positions across many markets.  Perhaps that was true at one time, but it is certainly not true today (consider hedge funds).  With diversified investors and integrated markets, the risk premium in any commodity is driven by economy-wide risk prices.  For instance, if you believe in CAPM (not that I do, just using this as an illustration), you believe that the beta of the commodity price with respect to the market portfolio drives the risk premium, and hedging pressure matters not a whit.  David Hirschleifer generalized things in the late-80s, with a model where speculators incur fixed costs to participate in a market.  In this case, speculators are not perfectly diversified, and hedging pressure can matter.  But market wide risks matter too.  The more integrated the markets, and the more diversified the commodity players, the less hedging pressure matters in driving the risk premium.  And markets have certainly become more integrated lately, much to the chagrin of some traditionalists.

At best, the Keynes “normal backwardation” story is a useful pedagogical tool that should be used as the start of an examination of the determinants of risk premia in commodities, and certainly not the last word.  It is most useful as a foil, than as a proper explanation.

Contango and backwardation in the visible curves are driven in the first instance by intertemporal allocation considerations.  Storage can be used to allocate a commodity over time.  The forward curve should adjust to give people an incentive to make that allocation optimally.  When future availability is expected to be low, relative to current availability, storage is optimal: forward curves move into contango to provide the incentive to undertake that storage.  If current availability is low relative to what is expected in the future, you would like to bring the commodity from the future to the present.  That’s not possible, so the best we can do is not store.  Backwardation punishes storage, and provides the incentive to consume today rather than carry inventories of a scarce commodity to a future date when it is expected to be less scarce.

Market power can also affect forward curves.  Corners create artificial near-term shortages, leading to backwardation.  The crucial thing is that if the short-term shortage is real, inventories should be low, but artificial shortages are often associated with large inventories.*

If you want to understand the curve, first focus on these intertemporal considerations.  And don’t mix up the visible–the observable forward curve–with the invisible–risk premia.  Keynes did, and has befuddled a lot of people since, and not for the first time and not about only that.

* My 1996 book on manipulation and several of my papers show how manipulation affects the forward curve and forward curve-inventory relations.  Holbrook Working discussed this in detail in the 1930s in his work on the wheat markets.  I have a book forthcoming (draft chapters available online) that is all about the implications of intertemporal resource allocation for the shape of forward curves.

Cuckoo For Cocoa Corners

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 7:49 pm

This is not the summer for the corner Starbucks.  This is the summer for the Starbucks corner.  First, there was an episode in coffee.  (Yeah, Arabica, not the kind of stuff you’ll usually find at Starbucks, but work with me here.)  And now, cocoa.  There were huge deliveries stopped on LIFFE’s cocoa contract, which calls for delivery in various European warehouses.  There are reports that a single trader stopped all the deliveries.  The name mentioned in this episode is Anthony Ward.

The cocoa market has moved into backwardation and there are reports of a large differential between European and US cocoa prices.  (I haven’t had time to run the data yet.)  The coexistance of a backwardation with large stocks is frequently symptomatic of a manipulation–a corner.

Stories say that Ward is speculating on short crops in the coming season.  But if that’s true, he could profit on that view without taking delivery.  He could just buy futures, and if he’s right, the futures price will rise and he can profit by liquidating his futures position.  Also, if he believes that there will be a shortage in the new crop, that view is best acted on through a purchase in the new crop contracts, not taking delivery.  Furthermore, a looming shortage in the new crop should lead to a rise in the new crop price relative to the old crop price in order to encourage the holding of stocks to meet future shortages.  The reverse has happened: rather than the curve moving to contango, it has become severely backwardated.  Thus, non-manipulative explanations are hard to credit.

The commodity markets, especially for the softs, are relatively small compared to the amount of money that can be amassed by hedge funds and others.  This means that the markets are potentially vulnerable to manipulation.  It looks like that’s going on in the Starbucks commodities this summer.  Look out, sugar!

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