Streetwise Professor

May 14, 2009

What Kind of Green Shoots? A View From the Metals Markets

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis — The Professor @ 7:41 pm

I’ve written about the hard-to-explain behavior of oil prices and stocks.  But oil isn’t the only commodity around, so I thought it would be worthwhile to look at some others to see whether their behavior may shed light on which version of the “green shoots” theory their behavior supports–the green shoots of a recovery in output, or the money-is-green version that the price rises are a harbinger of inflation.

The best data on prices and especially stocks for industrial commodities is available for non-ferrous metals.  Here are the comparisons (all data from the LME):

  • Copper 3/2/09.  Cash: $3329, 3 Months: $3355, Stocks: 530,875 MT.
  • Copper 5/13/09.  Cash: $4507, 3 Months: $4530, Stocks: 373,750 MT.
  • Lead 3/2/09.  Cash: $1160, 3 Months: $1166, Stocks: 60,750 MT.
  • Lead 5/13/09.  Cash: $1450, 3 Months: $1440, Stocks: 73,500 MT.  
  • Nickel 3/2/09.  Cash: $9602, 3 Months: $9607, Stocks: 99,378 MT.
  • Nickel 5/13/09.  Cash:  $12450, 3 Months: $12545,  Stocks: 111,648 MT.
  • Primary Aluminum 3/2/09.  Cash: $1270, 3 Months: $1310, Stocks: 3,243,900 MT.
  • Primary Aluminum 5/13/09.  Cash: $1428, 3 Months: $1521, Stocks 3,880,325 MT.
  • Tin 3/2/09.  Cash: $11,047, 3 Months: $10702, Stocks: 9,140 MT.
  • Tin 5/13/09.  Cash: $13,890, 3 Months: $13,615, Stocks: 13,405 MT.
  • Zinc 3/2/09.  Cash: $1078, 3 Months: $1104, Stocks: 355,500 MT.
  • Zinc 5/13/09.  Cash: $1430, 3 Months: $1475, Stocks: 322,025.

Note that the prices of each commodity have risen.  Depending on the metal, the rises have been between about 15 percent and 40 percent.  For some of the metals, spreads have narrowed.  For instance, the contango in copper has decreased, as has that of lead (which has gone from contango to backwardation).  For aluminum, however, the spread has widened, as it has for zinc (though not in percentage of the spot price).  

Interestingly, lead, nickel, tin, and especially aluminum stocks have increased; stocks for copper and zinc have decreased, especially the former.  Aluminum is of special interest, as this is a major industrial commodity, and is highly sensitive to industrial uses (e.g., in autos).  

Overall, the story is quite mixed.  Copper suggests bullish fundamentals: a sharp rise in price and a pretty steep fall in stocks.  But, overall, the stocks data give no evidence of a near term strengthening in demand that would explain the price rises across all metals.  Note the rise in aluminum price and the contemporaneous nearly 20 percent increase in stocks.  Hardly a signal of a rebound in industrial demand.

There are two interpretations consistent with the data: (1) spot demand remains low, but demand is expected to pick up in the future, and (2) real spot demand remains low, future real demand is expected to remain in the doldrums, but prices are being buoyed by expectations of a possible inflationary burst (i.e., the money is green version of green shoots).  

Even the copper data, and perhaps data from the oil market, are potentially consistent with (2).  It is widely reported that China is stockpiling copper and oil.  Indeed, some of the copper stocks decline may be a mirage as copper is merely being transferred from LME warehouses to Chinese strategic stockpiles that are invisible to the market, rather than being consumed.  This could reflect a Chinese substitution of dollars/dollar denominated assets into real assets such as copper (and perhaps oil) due to their fears about the US dollar and inflationary pressures in the US.  That would be consistent with the inflationary expectations story, and indeed, a channel by which these expectations influence current prices.

If I had to choose between (1) and (2)–between an anticipated increase in future real demand and an anticipated increase in nominal demand due to inflationary pressures–I guess I would choose (2).  Suffice it to say that although I’m not metaphysically certain as to which explanation is right, the data do not contradict the inflationary expectations story.  Moreover, the future demand/spot demand story is not that convincing.  Anticipation of future demand should lead to an increase in current demand, but that is not being reflected in stocks.  

With stocks largely signaling weak real demand (especially when one considers that the copper stock drawdown may not reflect an actual increase in copper consumption), but prices rising, there is a very good chance that metals prices are in fact a harbinger of inflation.  In his speech at the Atlanta Fed conference on Tuesday, John Taylor suggested that the Fed may not have much time before it has to decide whether to switch gears and fight inflation.  The metals data support that suggestion.  Indeed, if China’s actions in the copper market reflect a substitution of real stuff like the red metal for dollar denominated nominal claims, rather than a real need for the commodity, the time for choosing may be coming much more quickly than is conventionally believed.

Just sayin’.  Or, perhaps I should rephrase that: Just the metals market sayin’.  Listen up, Chairman Bernanke.

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  1. I like this analysis. I am convinced that this indeed in a signal of future inflation. And I started thinking about the social consequences of this. I believe that this would be a good market mechanism for forcing the industry to take profit cuts. Inflation would lead to increased costs of production. But, prices cannot really go up because consumer demand is low. Thus producers cannot simply raise prices as would happen in the case of wage-rise induced “normal” inflation. Thus the great unwashed forces the capitalist to take profit cuts.

    Comment by Surya — May 14, 2009 @ 9:19 pm

  2. Yes, copper has been called a Ph.D. in economics because demand for copper very accurately reflects future expectations of the business community. And, if the business community starts investing, economic downturn will ease, if not end.

    But may it be that this time it’s really different?
    May it be that the Chinese are buying copper and other stuff just because they want to invest their dollars before they – the dollars – lose a lot of value?

    I dunno. Just a thought that those who are concerned about inflation might be hedging against inflation. I might be wrong, of course.

    Comment by Michael Vilkin — May 15, 2009 @ 2:24 pm

  3. Surya, you said:

    “Inflation would lead to increased costs of production.”

    That is not always correct.
    Suppose, a business borrowed at 8% when expected inflation was 3%.
    In reality, inflation in that year hit 5%.
    It’s actually a gain for the borrower, and an equal loss for the lender.

    Inflation is a zero-sum gain. Your gain is my loss, – or vise versa.
    Amount of real wealth does not change because of inflation.
    Just some redistribution of wealth.

    Comment by Michael Vilkin — May 15, 2009 @ 2:35 pm

  4. I think the futures market is being gamed. Sure the Chinese are stockpiling commodities, but, China’s economy in my opinion is much more vulnerable than investors or the economic media chattering heads think.

    Copper as I understand it measures the housing and automotive industry’s usage, both are dead in the water for quite some time to come.

    I think we are looking at one of those weird bear market dead cat bounces with oil, natural gas and base metals due for a big sell off.

    My eyes glaze over at the thought of where the morons in Congress and the White House are taking us. God spare us all.

    Comment by penny — May 15, 2009 @ 11:20 pm

  5. Dear Professor:

    Agent Sublime is gone. Now you will have more time.
    Please give me your opinion in a few words. I don’t need long explanations.
    But your opinion should not be as short as “See a shrink”.

    I did search for “Keynesian”, and I loved related articles.
    I totally agree with you. Let me repeat those lovely points.

    1. And that’s why inflation is bad. It F*CKS UP relative prices !
    2. When all you have is a hammer, everything looks like a nail. Aggregate demand is the Keynesian’s hammer.
    3. I say Brad DeLong has performed an extremely important public service. By equating completely distinct economic processes he makes abundantly (and painfully) clear the intellectual void at the heart of Keynesianism.

    I totally agree with these three points.
    Now let’s look at what I say.

    Any loan made by a bank increases M2 by amount of the loan.
    Aggregate demand goes up.

    Now let’s distinguish a loan TO BUY a house from a loan TO BUILD a new house.

    1. $100,000 to buy a house.
    2. $100,000 to build a new house.

    In both cases M2 will increase by the same amount.
    But in the first case wealth of the nation does not increase. In the second case new jobs will be created, and wealth of the nation will increase, and inflation will be lower than in the first case because supply of housing will increase.

    Keynesian economists do not distinguish between these two very different types of loans.
    For them all that matters is total aggregate demand.

    I’m attempting to show that these two types of loans are different in their affect on economy.
    Am I wrong?
    If yes, where, in a few words?

    Thank you very much, Professor.

    Comment by Michael Vilkin — May 16, 2009 @ 3:07 pm

  6. MV–

    RE S/O–I’ve heard THAT before. LOL. S/O’s-DR’s theme song is Hotel California–he can check out, but he can never leave;-)

    I’ll try to respond to your questions this evening. In a nutshell, though, the key thing is not to start the story in the middle–or end it there: you need to figure out what the person who sold the house for $100K is going to do with it. Could be a difference between the two, but maybe not.

    More later.

    The ProfessorComment by The Professor — May 16, 2009 @ 4:53 pm

  7. Thank you very much, Professor !

    Let me follow the clue.

    BTW, I was careless in my earlier statements, like “Who cares about inflation?”
    But it was a bad choice of words.
    What I really meant was that banks increase money supply by making loans; it increases demand and general level of prices. The result is increase in inflation. The problem now is to reduce the inflationary effect of bank lending.

    The logic here goes like this: a new loan will either increase wealth of the nation, or will not.

    If the loan did not increase wealth of the nation – fraud, whatever – it’s just increase in inflation.

    If the loan increased wealth of the nation, it’s intuitively a better choice.
    How much better? Should we quantify the effect?
    Let me explore a chain: Bank – Real estate developer – RE buyer – Bank.
    For the sake of simplicity the bank does not sell mortgage and will keep it on its books.

    Real estate developer got a $100,000 loan to build a new house.
    M2 increased by $100,000.
    Some time later the house is ready.
    BTW, how many jobs are created?
    If an average construction worker earns, say, $25,000 per year,
    $100,000 spent in construction will create jobs for ($100,000 : $25,000) 4 workers for 1 year.

    When house is ready, the RE developer sells the house to RE buyer.
    RE buyer takes, say, $110,000 loan to buy the new house.
    Money supply increased by $110,000.

    RE developer repays, say, $105,000 to the bank.
    M2 decreased by $105,000.

    RE developer borrowed $100,000 and returned $105,000.
    Money supply decreased by $5,000 because $100,000 was created and $105,000 was destructed.

    Now RE buyer will start paying 30-year mortgage.
    During that period RE buyer will pay, say, $250,000 to the bank.
    Money supply will be reduced by $250,000.

    RE buyer borrowed $110,000 but will return $250,000.
    Money supply will be reduced by ($250,000 – $110,000) $140,000.

    The bank has expenses as any business, both fixed and variable.
    Moneys paid by the bank increase M2.
    Otherwise, the banking system over time would suck in the whole
    money supply like a giant black hole, and contraction of money supply
    would devastate the economy. Milton Friedman was right, of course.

    So, where am I now?

    …to figure out what the person who sold the house for $100K is going to do with it.

    If there was no RE developer, I took the construction loan, hired a construction company, and built the house. I can either live in it, or can sell it.

    1. I sold the house. The buyer took out a new loan. I took the payment from him and paid off my loan. One loan was replaced by another loan. No change, basically.

    2. I live in the new house. In this case money supply increased by the amount of the construction loan, and new wealth of similar size has been created. It’s not just worthless inflation.

    At the first glance, in the second case supply of housing did not increase, because I did not offered it for sale. But on the other hand…

    If a RE developer built a house and offered it for sale, supply of housing did increase.
    If I hired a construction company and built the house, it looks like I acted as a real estate developer, and then I sold that house to myself. Looks like I increased supply of housing, and then bought it from myself. Otherwise, how can I buy newly created wealth if there is no increase in supply?

    But the most important point is that new wealth has been created with new money.
    Which is much better than NO wealth created with new money.

    During the recent real estate boom hundreds of billions of dollars of new money have been created with new debt. I’m trying to say that loans to buy homes increase demand. It’s Keynesian approach. But construction loans increase supply, which is what Keynesian economists do not care about.

    What I’m trying to say is not exactly supply-side economics, even though I’m talking about increase in supply.
    But what the hell is it?

    Dear Professor, take your time.
    I appreciate your help to sort things out.

    Comment by Michael Vilkin — May 16, 2009 @ 6:49 pm

  8. Michael V. First, it’s important to distinguish between money and credit. Money, properly defined, is the numeraire asset. In the US, it is currency + reserves held at the Fed. Banks can create credit, but not money properly. Inflation results when money supply properly defined grows more rapidly than the demand for it. It is often the case that credit and money move together, and that increases in money can cause expansions in measures of credit (e.g., M2). But, it is important to remember that money and credit are distinct concepts, and that different mechanisms can affect each. The supply of savings and the demand for investment–which is ultimately about attempts of individuals to alter their consumption patterns over time–determine credit market equilibrium.

    Second, banks are basically intermediaries that channel resources from savers to investors. Ultimately, credit extended by banks will be used to increase somebody’s consumption, either today or in the future. Even in your selling a house example, the credit was initially used to create an asset that gives off a stream of consumption services. A better way, perhaps, to think about your second example is that the amount of credit stays the same, but is merely transferred from one debtor to another. The stock of real assets does not change (the house still exists). But originally, the investment in the house, financed by debt, was an increase in real assets that was actually financed by some savers somewhere; the bank was just the mechanism by which the resources necessary to build the house flowed from the savers to the investor/builder.

    In your build the house example, the credit is used to secure the resources necessary to build the house.

    In the housing boom, credit was created that was used to create real assets. Real resources were used to create them It’s both supply and demand in operation. People around the world–e.g., individuals in China and Japan–saved. They deferred consumption, and invested the difference between their income and their consumption. Some of this excess was used by others to consume more today–e.g., to pay for construction workers who built houses and used their wages to buy clothes produced in China and electronics from Japan.

    Both supply and demand were in action. The supply of savings. The demand for investment and current consumption. The particular preferences of the savers and investors determined the mix of goods and assets created. One of the major problems with Keynesianism IMO is its treatment of every good as some indistinguishable, homogeneous lump. In fact, there is no such thing as “aggregate” income. One plausible cause of the credit crisis was that expansive monetary policy encouraged a credit boom that led to a distortion in the mix of assets produced and held. (The attempts to encourage homeownership arguably exerted a major influence as to why the distortion was in the form of excessive investments in housing.) The current process is the result of an adjustment in relative prices to correct for this distortion.

    I often think a useful way of looking at things is to consider the flow of real resources–from Chinese producers/savers to California construction workers, for instance. Banking and finance are primarily mechanisms for facilitating that flow. Ultimately, the flow of resources is driven by the preferences of individuals, and the productive resources they command. Sometimes focusing on the financial aspect leads one to confuse the means (finance) with the ends (the allocation of resources across time and space).

    A lot of stuff going on in this reply, and I hope it helps. A lot of stuff in your questions. But to repeat, I think it helps to look at the “real” economy, the “real” flow of resources, the underlying preferences, endowments and technology that drive that real flow, and then to look at the role of the financial system in facilitating that flow.

    The ProfessorComment by The Professor — May 17, 2009 @ 8:37 pm

  9. Thank you very much, dear Professor !

    You gave me a useful framework so that I do not stray away from the right path.

    My understanding is that you do not oppose my assertion that a loan to build a house is better for the economy than a loan to buy a house.

    I’ve examined basic ideas of all the economics schools, and by elimination I came to the conclusion that my arguments – money supply increases and decreases, compared with amount of wealth created – fit into monetarist school of economics, even though supply-side economics is somewhat close.

    A Keynesian school is amazing and amusing. I don’t understand their logic.

    1. Government borrows money by issuing Treasury securities and spends the money in order to increase aggregate demand. But a bank can not buy the paper unless it has excess reserves.

    If a bank has excess reserves it can make a loan to a private party, or to the government, – by investing in Treasury paper.

    Suppose now, government wants to build an apartment building, – in the best case. And the private party wants to build an identical apartment building.

    How can it be proved that an investment by the government is more useful for the economy than identical investment by the private party?

    Only if people do not trust the banking system, they will buy Treasury securities instead of depositing money in the saving accounts, thus depriving bank of loanable reserves. Otherwise, there is no reason to expect that the government will do better.

    2. If a bank has excess reserves, it can make loans to private parties. Private parties can invest, for example, to build housing. New housing means increased supply of housing. So, while increasing supply of housing, new jobs and new wealth will be created in the economy.

    We can say that the best approach to improve economy during Great Depression was to increase supply of goods, – both capital goods and consumer goods. Increased production would create new jobs and new wealth.

    How can anyone believe that the right tool was to increase demand for goods, and not supply of goods?

    But again, the most important thing is to have excess reserves in the banking system. And this brings us to the next question.

    3. Obama administration started this circus about stress testing banks. I’m not saying they are stupid. No. They are up to something, – because their obvious goal is to increase banking reserves.

    The question is, Why do they want to increase banking reserves?
    The right answer very well might be that they will force the banking system to invest money in Treasury securities so that the administration will have enough money to start this Keynesian circus.

    The sad part is that they will do it, and many more people will believe that government knows better than the private sector, and not many people will compare efficiency of government investing with efficiency of private investing.

    Then again, we need investment in infrastructure. It’s painful to drive on some roads. But the size of budget deficit suggests that government investment will be far beyond any reasonable needs, and most of the money will be looted.

    The question now is how to use excess banking reserves to make loans to private parties to increase supply of goods, – and not aggregate demand for goods.

    Dear Professor, am I on the right path and within the framework?

    Thank you again for your comments.

    Comment by Michael Vilkin — May 17, 2009 @ 10:48 pm

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