Opinion

The Great Debate

Contango and the real cost of carry

- John Kemp is a Reuters market analyst. The views expressed are his own –

For the last two years, the contango structure embedded in futures prices has far exceeded the actual cost of owning physical raw materials such as crude oil, aluminium and copper, explaining the strong interest from traders and hedge funds in owning inventories or the warehouses, elevators and tank farms that store them. Well-connected banks and physical traders have exploited the difference between the actual cost of financing, storing and insuring raw materials and the implied cost in upward sloping futures prices, as a source of comparatively low risk profits.
It has helped commodity markets carry record stocks and supported overproduction of many raw materials through the recession and the early stages of the recovery with only minimal downward pressure on prices.But the days of physical commodity storage as a licence to print money are ending. An increasing number of other institutions and hedge funds have created their own “virtual storage” plays, with negative positions in the spreads, or a short position against commodity indices or customised swaps. As storage plays become more crowded, the contango will continue to erode gradually until it resembles the actual costs of finance, storage and insurance, and this source of relatively risk-free profit is removed.

MARKET INEFFICIENCY
The gap between the contango and the actual cost of carry stems from a number of imperfections in physical and financial markets:
(1) Contango compensates stockholders for the interest cost associated with buying and carrying inventories. But the actual cost of finance varies widely. In the current environment, high-rated issuers, banks with access to official liquidity, and other institutions long of cash face a much cheaper cost of funding than other participants. They have natural advantages funding and owning raw materials. They can transform their privileged position in the financial markets into a privileged position in commodities.
(2) Storage costs are not uniform. Firms which own or lease warehouses, tank farms and grain silos have an obvious advantage (though real profits depend on the cost of capital for carrying these physical assets). Even firms which do not own or lease facilities may be able to strike attractive storage deals below “normal” market rates in return for guaranteeing minimum levels and duration of usage.
(3) There are opportunities for banks and physical merchants with very high ratings or close banking relationships to “make the turn” by engaging in maturity transformation — financing medium or long-term positions in inventory by borrowing cheap funds short-term, and constantly rolling them forward.

ZIRP AND HIGH STOCKS
Several aspects of the current environment have combined to make cash-and-carry strategies extremely profitable:
(a) Banks and physical traders have exploited the gap between the low cost of funds for institutions at the heart of the financial system and the much higher cost of borrowing for everyone else, as well as the big gap between short term and long term rates.
(b) Central bank commitments to keep rates at exceptionally low levels for an extended period have slashed risks associated with maturity transformation.
(c) High inventories and persistent oversupply have reduced the likelihood stocks will be needed in the short to medium term, making it less risky to strike storage deals in exchange for guaranteeing stock will be held for a minimum period.
Recession, the credit crunch and zero interest rate policies (ZIRP) have come together to create ideal positions for cash-and-carry strategies.

PENSION FUND PRISONERS
The final factor has been strong interest from pension funds, other institutions and retail investors who see commodity indices and exchange-traded products (ETPs) as a hedge against inflation, dollar devaluation and counter-party risk.
By establishing long positions in futures and options, but never wanting to take physical delivery, pension funds and investors are natural counterparties for the cash-and-carry trade, which wants to be short futures and options, but never have to make delivery.
Constant rolling of index and ETP positions has forced many markets into much larger and more persistent contango structures than before 2004-2005 (when commodities first became popular as an “asset class”).
In theory, there is no reason index and ETP rolls should force markets into a big contango, any more than cash-and-carry shorts should force them into a big backwardation. In practice, the shorts have had two advantages which have given them the upper hand.
First while longs have no choice but to roll forward, however large the contango becomes, since they can’t take delivery, the cash-and-carry shorts always have the option to deliver.
Second, the investment objectives of the longs are very long term. They are using commodities as a hedge against the risk of inflation/devaluation/repudiation at some unspecified point in the future, possibly the far future. The prospect of capturing some massive leap in prices in future has made them insensitive to the month by month costs of holding long positions in the meantime.
In contrast, most cash-and-carry traders are price sensitive. They will not roll shorts in a backwardated market unless the backwardation is small and/or expected to be fleeting. In event of a large or sustained backwardation they will close out short positions by delivery, since any money made on the turn is quickly dwarfed by roll losses.
Pension funds and other investors have become prisoners of their own long-term thinking about inflation and insensitivity to roll costs. The longer inflation has failed to materialise the more losses have mounted. The cash and carry trade has been the main beneficiary, together with commodity producers who have been able to continue selling (surplus) production at higher-than-normal prices for this stage in the cycle.

Morgan Stanley commods risk hits post-crisis high

John Kemp is a Reuters market analyst. The views expressed are his own.

Morgan Stanley reduced the amount of risk-taking in its trading book last quarter, but only marginally, and boosted risk in commodities to its highest level since the financial crisis struck in summer 2008, according to the firm’s earnings release.

Morgan’s relatively high appetite for trading risk sets up an intriguing contrast with Goldman Sachs, the other leading commodity bank, which cut risk aggressively across most asset classes, including commodities, in the three months April-June. Morgan Stanley cut firm-wide value-at-risk (VaR) to an average of $139 million per day, down just 2.8 percent from the first quarter’s $143 million, and slightly up from $132 million in the same period a year earlier. In contrast, Goldman cut firm-wide VaR more than 15 percent in April-June compared with the previous quarter.

Morgan Stanley boosted the VaR allocated to commodity risk slightly from $27 million to $29 million, while Goldman slashed its own commodity exposure from $49 million to $32 million. Goldman and Morgan Stanley have traditionally dominated commodity trading. But in recent years Goldman’s commodity exposure has outpaced its rival, in line with Goldman’s greater appetite for trading risk. The contrasting performance in Q2 2010, with Goldman taking risk off while Morgan Stanley continued to boost it, suggests the gap might be starting to close.

Goldman slashes risk-taking in commodities

John Kemp is a Reuters market analyst. The views expressed are his own

Goldman Sachs cut the amount of risk it staked on commodity trading during Q2 2010 by almost 35 percent, part of a broad-based reduction in risk across the bank’s trading book. Value-at-risk (VaR) linked to commodity prices fell to an average of just $32 million per day between April and June, down from $49 million in the prior quarter and $40 million in the same period a year earlier, according to the firm’s earnings release. Cuts in VaR allocated to commodities were in line with reductions elsewhere, including interest rate risk (down just over 20 percent) and equities (down just over 30 percent). Only currency trading saw a slight increase in risk taking (up 3 percent). Commodity VaR was reduced to its lowest level since the three months ended September 2009, and before that November 2007.

Goldman has been reducing firm-wide VaR (net of diversification) since the middle of 2009 — shortly after the firm converted to Bank Holding Company (BHC) status regulated by the Federal Reserve, subsequently changed to Financial Holding Company (FHC) status, rather than its previous incarnation as a securities firm. Gross VaR (excluding diversification) started dropping after Q3 2009 (when it peaked at a massive $416 million). Gross VaR now stands at a more modest $272 million (down 35 percent). The firm’s massive interest rate risk (which peaked at $218 million in Q1 2009) has been cut to less than half that ($87 million in Q2 2010). But the April-June quarter was the first time the de-risking process had extending to commodities.To some extent, VaR is endogenous. Unless position limits are changed to offset it, VaR naturally rises and falls with market volatility. But firms can always over-ride fixed limits to keep VaR “budgets” unchanged despite changes in volatility if managers decide it is worthwhile.

What is notable is that market volatility rose during Q2 2010 in most asset classes (including commodities) after a quiet Q1. Yet Goldman’s VaR measures declined almost across the board, suggesting a deliberate policy to cut risk. Opportunities to generate revenue by taking market risk appear to be declining across the company’s trading operations. One crude measure of the firm’s “trading efficiency” is the amount of dollars it generates in net revenue for every $1 put at risk (VaR). Trading efficiency peaked at $46 for every $1 risked at the start of 2007 and has never recovered to the same level. Efficiency in Q2 2010 was just 24:1, down from 32:1 in the prior quarter, and less than half the peak (Charts 4 and 5).

Micro and macro volatility in the oil market

- John Kemp is a Reuters market analyst. The views expressed are his own –

“Most probably we will continue to have reasonably high short-term volatility but in a narrower price range between $60-95 per barrel”.
That was the (accurate) forecast for crude oil prices given by Mercuria’s head of trading Daniel Jaeggi to the UN Commodities Forum in Geneva back in March [ID:nLDE62M0MT].
In fact front-month futures <CLc1> have been trapped in an even narrower range of $60-86 for the past 12 months, shrinking to $64-86 so far in 2010. Spot prices have barely budged since July last year, despite a substantial improvement in demand, as one puzzled investment bank noted recently.
Yet many traders complain high volatility is making either directional or technical strategies difficult to implement.
The apparent contradiction (high levels of very short-term price movement in a market trending sideways) highlights the different levels of volatility prevailing at different time horizons.

PICK YOUR HORIZON
Standard measures of volatility take price changes from the close of one business day to the next, averaged over the last 20 or 30 trading days, and then adjust them to an annualised rate.
On this basis, oil price volatility has been unusually low in H1 2010. Close-to-close volatility hit a 2.5 year trough of 19 percent in March.
Volatility increased as the rally broke down, peaking at almost 40.5 percent in late May and early June. But even that was low compared with peaks of more than 50 percent or 60 percent during previous periods of elevated volatility.
Close-to-close volatility is now back to just 28 percent, putting it in the 30th percentile of the distribution for all periods since the start of 2005.
But over other time horizons, volatility looks very different (http://graphics.thomsonreuters.com/ce/VOL-HRZN.pdf).
Intra-day volatility is higher compared with past periods. The real measure of intra-day volatility would take 5-minute or even 1-minute price changes over an hour or a day and annualise them. In practice that is too data-intensive for anyone not undertaking a full modelling exercise. But the daily trading range (high-low) is a reasonable if rough proxy.
Intra-day volatility (based on the high-low trading range) is currently running around 15 percent per year. While that is low compared with the close-to-close measure (28 percent) it is quite high compared with previous periods.
Intra-day volatility is currently in the 40th percentile (compared with the 30th for close-to-close volatility). Moreover, intra-day volatility peaked at the 90th percentile back in late May, compared with a peak in the 81st for daily volatility at the same time.
Traders who complain about large intra-day price swings are not imagining it; the market really is exhibiting unusually wide daily trading ranges at present.
Weekly volatility (measured from the close of business on one Friday to the next) is even more elevated compared with past periods. On a week-to-week basis, volatility is currently running at just over 41 percent, putting it in the 75th percentile of the distribution since the start of 2005.

TELLING A STORY
The challenge is to find a “narrative” explaining high levels of volatility at intra-day and weekly levels, yet comparatively low levels of volatility at the daily and yearly ones.
As former Federal Reserve Governor Lawrence Meyer remarked “When I’m asked what my profession was prior to joining the Board of Governors, I do not say that I was an economic forecaster, but rather a storyteller. As a forecaster, I had learned that neither my students nor my clients wanted to be buried in reams of computer output. They wanted me to tell a story that brought together in a coherent way the implications of the large numbers of economic indicators they saw as otherwise unconnected and therefore confusing”.
So can we attempt a “story” to explain different oil market volatility at different time horizons over the past 12 months?
Overall the market appears to have found a balance between bullish and bearish forces in recent weeks and months — which might mark an equilibrium (my view), an “uneasy truce” (the International Energy Agency’s view, expressed in its Medium Term Oil and Gas Markets Outlook) or a “state of disequilibrium” (Barclays Capital Commodity Refiner, Autumn 2010, page 62).
However this state is defined, it accounts for the broad sideways trend in prices over the past 9-12 months in a fairly narrow range of $70-80 or $65-85 per barrel, and the relatively low level of volatility over longer horizons.
But as the market has fluctuated between extremes or poles of euphoria and despair, prices show large week-to-week variations within the band. The price has “cycled” between the high end of the range and the low one, accounting for the high level of volatility at intermediate horizons such as the weekly level.

BP’s crisis is no Three Mile Island

The catastrophic blowout at Macondo has sliced 40 percent off BP’s market capitalisation, and led analysts to speculate about lasting reductions in deepwater drilling and the resulting impact on both long-term oil supply and the fate of climate change legislation.

The underlying fear is that Macondo is the oil industry’s Three Mile Island, an accident that turned public opinion against nuclear power for three decades.

Investors are right to fear the long-term impact on the company. But they exaggerate the impact on the wider industry and the prospects for climate change legislation. BP however faces a very changed operating environment in future.

Senate vote exposes Wall Street impotence

Wall Street’s diminished influence in Washington was made plain yesterday when the Senate voted to approve financial reform legislation by 59 votes to 39.

Industry lobbyists will point out the bill only just managed to scrape the required votes needed to end debate and forestall a filibuster. It fell far short of a lopsided bipartisan majority.

But the formal tally on HR 4173 (Wall Street Reform and Consumer Protection Act 2009) as amended by S 3217 (Restoring American Financial Stability Act 2010) conceals a much wider bigger majority of 63-37 for enacting far-reaching reforms.

Don’t bank on return of backwardation

Many energy analysts are predicting the crude market will move into backwardation before the end of the year.

Increasing demand and rising refinery runs will, in their view, reverse the unusual build up of inventories around the NYMEX delivery point at Cushing, and the market should revert to a more normal term structure.

The extreme contango visible at the front end of the NYMEX futures curve in the last seven weeks is certainly evidence of a “dislocation” caused by congestion around the delivery point. Front-month NYMEX futures have been trading at abnormally large discounts not only to second- and third-month NYMEX futures but also to Brent and other spot crudes such as Tapis.

After clash, Senate filibuster ends in whimper

Just a few minutes after the Senate failed for a third time in as many days to reach the 60-votes needed to approve a cloture motion on the financial reform bill (failing 56-42), Senate Majority Leader Harry Reid rose to his feet and asked the chamber’s presiding officer:

“Mr President, I now ask unanimous consent the motion to proceed to S 3217 be agreed to.”

After the president officer asked for objections, and heard none, he replied “Without objection, it is so ordered,” according to the Congressional Record.

Financial reform bill puts GOP in dilemma

- John Kemp is a Reuters market analyst. The views expressed are his own -

Financial reform legislation is set to reach the Senate floor as early as this week. With U.S. President Barack Obama and Senate Majority Leader Harry Reid holding most of the cards, pressure on Senate Republicans and Wall Street to find a compromise is becoming intense.
(more…)

U.S. currency bill likely misses target

U.S. Senators Charles Schumer (D, New York) and Lindsey Graham (R, South Carolina) have announced plans to introduce a bill allowing the Commerce Department to take account of currency undervaluation when calculating anti-dumping duties.

The target is clearly China. It threatens to inflame the already rancorous and dangerously escalating dispute with Beijing over exchange rate policy to no good purpose.
Legislative pressure will not make China’s government any more likely to accelerate the renminbi’s revaluation. If anything it will cause the government to postpone a revaluation most officials concede will eventually be necessary.
China’s government cannot afford to show weakness in succumbing to pressure from “western devils” (“gwai lo”) without losing face in the eyes of its own public. China’s Premier Wen Jiabao has already branded U.S. pressure on the currency issue as a form of “protectionism.” The Schumer-Graham bill is likely to draw an even more angry response.

So the Schumer-Graham bill is a piece of election year theatre, but a counterproductive one. It threatens to worsen already poor relations between two countries that need to be friends but are currently experiencing a steady escalation in tensions on everything from economics to Tibet and weapons sales to Taiwan.

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