Commodity warehousing, the interest rate connection

Commodity warehousing, the interest rate connection

Izabella Kaminska

| Jul 23 19:29 | 10 comments | Share

There are three things that must be remembered when it comes to banks, trading houses and warehousing plays.

  • One is that banks and trading houses would not have an incentive to store commodities if the forward market did not compensate them for doing so — meaning speculators are as much to blame as anyone for the hoarding problems, because they are basically the ones donating money to ensure stocks of commodities are built up during times of plenty on the assumption that seven years of scarcity will follow, making it all worthwhile.
  • Second, there would be no incentive to hold commodities as stock, even during a contango, if regular risk-free financial investments offered a better return. Contango is meaningless unless the yield that can be extracted from the forward markets more than compensates for your financing and warehousing costs. During high interest rate periods, chances are that it pays commodity players much more to sell stock as soon as they produce it, and to reinvest in yield-bearing instruments. During low interest rate periods, when safe returns are lacking elsewhere, the incentive to extract yield from storing commodities and futures rises.
  • None of this is necessarily the product of a sinister plot. If there is manipulation, it is the result of collective responses to market dynamics that present exploitable arbitrage opportunities to intelligent agents. It is unwitting manipulation at worst. The question we should be asking is whether banks (who have fiduciary duties, unlike traders) consciously exploit or mislead institutional clients and investors in the process. It is entirely possible, however, that they not only believe in their own scarcity projections, but that they feel they are fulfilling an economic duty in bridging today’s oversupply with tomorrow’s undersupply.

But even then, it only pays to store for as long as the commodity returns beat money-market returns. And that means, it only pays to store for as long as someone in the market is prepared to pay a premium for delivery of the commodity tomorrow rather than today.

Backwardation means the market believes there is a disadvantage associated with taking delivery tomorrow rather than today — mostly because it pays to monetise the commodities to earn better rates over time in money markets, or re-invest the capital in overcoming today’s scarcities.

That said — very importantly — you can still have an incentive to store commodities during backwardation if money rates are negative yielding. In that case, even if there is no benefit to storing commodities (because the commodity holder is effectively paying the market a fee for the favour of hedging his commodity stock, and thus making it a safe store of value), it may make sense to do this, if the fee is lower than the negative yield associated with money instruments.

Backwardation station

If the market realises that real interest rates are on the rise because of deflationary forces, it may make sense to monetise commodities as soon as possible so as to transfer as much capital into the money market as possible.

The current backwardation we are seeing in some commodities such as WTI is evidence of the fact that money instruments may now be offering enough of a yield to incentivise monetisation of stock. (After all, it’s unlikely that the money is being reinvested in more supply due to the Saudi America effect).

That — we presume — is a function of the fact that a) inflation expectations have beenfalling and b) because taper talk created a unique opportunity to lock in good yield, and an exit opportunity from increasingly burdensome commodity stores.

By the way, it’s worth mentioning that you can have a destocking incentive during contango, providing the contango yield is insufficient to beat the market money rate — a situation that squeezes the market until the forward market begins once again to believe in future scarcity. This was arguably the case from 2004 until 2007, when interest rates were on the rise.

The problem with the destocking incentive is that it leaves markets lacking the inventory needed to buffer supply shocks, and thus makes it susceptible to squeezes — which can be confused for more permanent supply issues. Are these squeezes the reflection of insufficient supply? Perhaps. But just as likely they are the market’s own way of dealing with oversupply — more artificial scarcity and Opec cartel, than anything else.

But things may swing back in favour of commodity stocks very quickly if yield-bearing investments begin to get pricey again.

None of this logic, of course, is new.

L. Randall Wray did a good job of making that point, in his own inimitable style.

FT Alphaville has also referenced the point that Keynes himself understood only too well that commodity producers and middlemen always have a tendency to organise, so as to create cartels that can inflict artificial scarcity on the market.

But others are finally considering the connection.

Note the following from Robert Campbell at Reuters about WTI’s sudden and epic backwardation this Tuesday:

So it is safe to say that it was not a discrete physical market event that triggered this rally. Rather, this was a short-covering event as sentiment swung in the financial markets against the dominant narrative.

What about shifting patterns in financial commodity products? The Brent-WTI move did coincide with the so-called “taper tantrum,” the brief jitters over interest rates that roiled financial markets after the U.S. Federal Reserve started to hint that it would start to reduce its monetary stimulus sooner than later.

When WTI was in a deep contango anyone who had access to storage at Cushing could borrow money cheaply, buy crude oil and skim off a profit just by riding the futures curveIn many ways this was a license to print money.

The steep rise in the forward price curve allowed the stored oil to be sold forward at a high enough price to pay for the low cost of the loan to buy the crude as well as the storage fees, leaving plenty left over for anyone sitting on stored crude.

That said, Campbell remains a sceptic because of the timing:

So is the July Brent-WTI rally really just an unwinding of storage plays made profitable by ultra-low interest rates? This seems unlikely.Timespreads on the WTI futures curve had already swung away from contango undercutting the profitability of physical storage plays. Front-month WTI began trading at a premium to the contract for delivery six months later towards the end of April. Any unwinding of paper deals tied to storage plays was probably already well underway by the time the taper tantrum hit.

We think he’s missing a major point, however.

First, contango began to decline when passive investors first became disillusioned with WTI being a useful inflation hedge, inducing outflows from commodities into alternative asset classes. This was about October 2011.

This happens to coincide with the point that large time-spread discrepancies (the marker for securitised trades being roll over perhaps?) began to even out, something which arguably eliminated the incentive to stockpile or securitise fresh crude.

But the current contraction in the WTI time-spread on closer inspection actually began at the end of 2012, and became a veritable trend in February and March (something which coincides with the interest rate pull from Abenomics, and the moment the Fed’s inflationary QE measures became increasingly ineffective):

So, while Fed taper talk may have exacerbated the unwinding it wasn’t necessarily what caused it.

If anything, it was the unexpectedly disinflationary CPI print in April which finally eroded the profitability of the trade by pushing financing costs up in real terms. Given the diminished number of passive institutional buyers on the forward curve already, there was now little point in rolling the trades on — and if anything much more of a justification in putting on the opposite trade (shorting physical, buying futures).

All of which would have encouraged a lot of liquidity to flow out of commodity markets and into fixed income securities — potentially exacerbating the repo squeeze or leading to even lower yields, if not for taper talk.

Worth noting, the end of April also coincided with a market bottom for US Treasury yields, a repo squeeze and a large liquidation in gold (chart via Bloomberg):

The key point being: central banks play a vital role in creating the conditions that make such warehouse trades profitable, and banks and trading houses often find themselves simply responding to the incentives presented.

Of course, if interest rates really are the primary factor, we should find out soon enough. All we need is a further reduction in yields and a renewed repo squeeze to encourage the rebuilding of stocks, which could catch out anyone who has positioned themselves for a return of contango, making things pretty squeezey.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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