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Introduction
:
In the many pieces
I posted last year on the coming bear market on commodities, three salient
points were made:
- Data on bank commodity derivatives suggest a
flood of investment and speculation that has probably been too large for
these relatively small markets to absorb.
- This consequent increase in the amplitude and
duration of this commodity bull cycle will inevitably encourage supplies
and ration demands. This process is now throwing markets into
surpluses which will eventually weigh on prices.
- The combination of surpluses and huge buying
pressure by investors and speculators is throwing commodity markets into
forward premiums or contangos.
This
has already happened in many commodities. High contangos
impose a high cost of carrying commodity futures. This has made the
return to commodity index baskets negative if one presumes historical
low trend nominal rates of appreciation in commodity prices in the
future.
I amplify on
these points in what follows.
The Explosion
In Commodity Derivatives
The latest data
provided by the U.S. Office of the Controller of the Currency and the Bank
For International Settlements provides an ever more startling picture of
explosive growth in commodity derivatives. The data on U.S. bank
positions shows a large increase into mid 2006.
Integrated Oil
Update, Mike Rothman, ISI, December 19, 2006
More striking
is the data on the same derivative positions of all global banks compiled by the
BIS.
Integrated Oil
Update, Mike Rothman, ISI, December 19, 2006
Though the six
fold increase in such positions over a few brief years is striking, it is the
magnitude of these positions that is most alarming. From what we know
of this data there is considerable double counting. But, offsetting
this, this compilation may be incomplete, as it may exclude the positions of
some investment banks who are important intermediaries in the commodity
derivative markets.
It is hard to
know what to make of this data. But it is noteworthy that several years
ago, at the then prevailing lower commodity prices, the entire above ground
stock of all commodity inventories was only in the hundreds of billions of
dollars. If only a fraction of the increase in global commodity
derivative aggregates in recent years corresponds to a net long position of
investors or speculators, it would appear that this increased demand for
commodity derivative positions has overwhelmed what have been relatively
small markets.
No wonder then
that even the largest commodity market – that of crude oil – has
been pushed by the forward purchases of investors and speculators into a
forward premium or contango that is several times
the cost (interest, storage, insurance) of carrying the physical commodity.
Investment Or
Speculation?
The question
arises, who are these new investors or speculators in world commodity markets
and what is their behavior?
Investment in commodities
today probably refers above all to pensions and endowments who have made long
term strategic allocations to commodity futures index baskets for
diversification purposes. However, the total assets of all these
baskets is somewhere between $100 and $200 billion – up from perhaps a
total of several tens of billions at the start of this decade 6 years
ago. These investment positions are quite straightforward; there are
few, if any, spread products or options or leverage that would augment this
overall position. If so, one is hard pressed to explain the increase in
recent years in commodity derivative positions at banks of many trillions of
dollars.
There is
another alternative: speculating hedge funds. It is estimated that the
total assets of hedge funds of all types globally now approaches $2 trillion
(up from several hundred billion 6 years ago) and many of the types of funds
who speculate in commodities employ huge leverage. The increase in
gross assets of those speculators could account for much more of the growth
in commodity derivatives. But do they?
We got
something of a window on this world at the end of the third quarter with the
collapse of the hedge fund Amaranth. Apparently this fund lost perhaps
$6 billion or more in one commodity –U.S. natural gas – in a
matter of weeks. The magnitude of this loss and the change in natural
gas forward prices at the time implies a gross position in that commodity
that was at least a small whole number multiple of the $6 billion loss.
By contrast, the nominal value of all the U.S. natural gas derivative
positions of all outstanding commodity baskets was not much larger than
Amaranth’s loss.
Clearly, in
natural gas one speculative hedge fund, Amaranth, was many times
“larger” in the gas forward markets than all the world’s
investors in commodity baskets. And Amaranth was only one hedge
fund. So speculative positions in commodity futures might outweigh
investment positions, and by a very large margin.
Is There More
Evidence Of Speculation On Such a Scale? Yes.
In a recent
major report on metals one arm of the world’s biggest brokerage house
Merrill Lynch went bearish. On its cover page summary it made the
following rather startling comment.
“We view
investor/hedge fund manipulation at the highest levels for some time (one
investor has >50% LME aluminum inventory) and
coupled with fears of a slower 2007, this will likely result in a substantial
correction in metals prices from spot.”
Time To Take
Select Profits Ahead Of Q1 2007 Volatility
December 8,
2006
Apparently
Merrill Lynch fears that hedge fund speculation in some commodities has moved
to the point of manipulation.
So far we have
been considering major commodities with futures and forward markets.
But it appears that some minor commodities have attracted relatively large
hedge fund speculative demands. Uranium is a commodity with no futures
or forward market. In fact there isn’t even a daily active spot
market. Prices are established through occasional auctions.
Reports are surfacing that hedge funds are major purchasers of this extremely
illiquid commodity on such auctions.
"One of
the things you have now is that the hedge funds are involved in the market,
so you have some additional demand," Ux Consulting
president Jeff Combs said in an interview.
Hedge funds and
financial investors now account for roughly a third of the uranium spot
market purchases, according to Mr. Combs and other industry experts.”
Hedge Funds
Ignite Uranium Price, Andy Hoffman and John Partridge,
The Globe and
Mail, December 20, 2006
“Outsized”
speculation by leverage hedge funds appears to have become a focus of
official sector entities who have gone public with their concerns. We
have had warnings of this sort from, among others, the N.Y. Fed, the BIS, the
Swiss Central Bank, the German Finance Minister, and the ECB. In once
such case- the Bank of Japan- leveraged speculation in commodities was a
focus.
The Bank of
Japan devoted its December monthly review to “Changes in Hedge Fund
Investment Behavior And The Impact on Financial
Markets/Position Concentration, Expanded Scope, And Market Liquidity Risk”,
December 2006. In this review the Bank of Japan expresses concern about
“hedge fund positions (that) are large in comparison to (a)
market’s liquidity or size”. Emerging market currencies and
commodities are focused on, and Amaranth is brought up as a case in
point. The Bank of Japan mentions that it has been exchanging
information on these topics with other central banks at the Market’s
Committee meetings of the BIS where “there have been discussions of
specific efforts to monitor the developments in commodities markets.”
A more pointed
assessment has recently been made by China’s National Research
and Development Commission (NDRC). Formerly China’s planning
commission, the NDRC may be its most important government body responsible
for economic matters. And in recent years it has been very focused on
reducing the exposure of China’s
manufacturers to high commodity costs.
There has been
a recent huge expansion in Chinese production of aluminum
and alumina. Chinese production of the latter is up 54% this year,
adding an 8 percentage point increment to global alumina production growth in
2006. Not surprisingly the alumina price fell in 2006 from a peak of
$640 a tonne to $225.
Based on
projects in the pipeline, further large Chinese alumina supply increases lie
ahead. Alumina is the most important component of the cost of producing
aluminum. Historically the price of aluminum has averaged about 6 times that of
alumina. Yet despite this cost decline the current aluminum
price remains near its recent high at $2800 a tonne.
The NDRC notes
that China
will probably increase aluminum production in 2007
by 1.2 million tonnes. A larger increase in capacity is expected
outside China.
With the margin of the aluminum price at a record
over its principal cost component, alumina, if anything global capacity
utilization should increase. An 8% increase in global aluminum output would seem possible. That exceeds
almost all forecasts of demand growth in 2007.
Considering the
above, the current aluminum price seems anomalously
high. The NDRC makes it clear, based on its assessment, why this is the
case.
"The NDRC
said: "Possibilities of a steep fall in aluminum
prices could not be ruled out if international hedge funds pull out of the aluminum futures market next year." It stressed that
hedge funds' massive buying into aluminum futures
was another cause of the bullish prices this year."
China Daily,
December 28, 2006
There is more
and more corroboration of this position taken by the NDRC. In the last
few days there has been a great deal of press commentary on the positions of
a single hedge fund in a single commodity market – aluminum.
These articles have appeared in the Financial Times and on Reuters and
Bloomberg. There has also been a great deal of commentary on this event
by the major dealers.
The allegation
is that one hedge fund owns almost all of the LME aluminum
stock which, at over 700,000 tonnes, is very large. This same hedge
fund allegedly owns large off warrant physical positions. This same
hedge fund may account for a very large long position in LME futures.
I know of no
incident in which one player has taken such an overwhelmingly dominant
position in a single large commodity market. There is no other term for
this but manipulation.
Let me present
some of the public commentary on this remarkable episode. It is repetitive
but worth the read.
A battle raged
in the aluminium market on Monday between one investor holding a $1.7bn long
position – betting that prices will rise – against a number of
shorts who are equally determined that prices will fall.
Those holding short
positions have made no effort to decrease their exposure in the market and
they potentially face significant losses if prices move against them.
Market talk
suggests the holders of the short positions have substantial amounts of
aluminium available for delivery to market.
This could
wreck the strategy of the investor, thought to be a hedge fund, holding the
long position, which is understood to have maintained its position since
mid-December.
Analysts
say the position is equivalent to nearly 645,000 tonnes, almost equal to the
size of the LME’s aluminium stockpiles of
695,000 tonnes. At current market prices, it would cost $1.7bn to buy 645,000
tonnes of aluminium.
Copyright The
Financial Times Limited 2007
All eyes focus
on aluminium
By Kevin Morrison
One party has maneuvered itself in a position where it could take
delivery of almost 650,000 tonnes of the metal, or about 93 per cent of total
LME aluminium stockpiles. At current prices, it would cost $1.7bn to buy
650,000 tonnes.
If the demand
for aluminium was booming, there would be a clear-cut reason for the
confidence to hold such a position. But demand from aluminium users is not
robust, with US orders falling and forecasts that production is set to
outstrip supply in China
this year.
Still, cash
aluminium prices were priced at more than a $80 premium to the benchmark
three month forward contract yesterday. The premium has narrowed from more
than $100 a tonne on Monday. The aluminium cash price tends to trade at a
premium to the forward price, when demand is strong and inventories are low.
The last time aluminium cash prices were trading at such a high premium to
the three-month price, the London
Metal Exchange launched a probe into the aluminium market about
“possible collusion between market participants”. The
investigation was launched in August 2003 but was abandoned the following
year after regulators failed to find any evidence of collusion.
However, this
time the LME said it could see nothing untoward in the aluminium market. The
LME has the power to inspect the trading books of all its members, which are
mainly financial institutions, and their clients. But Robin Bhar, base metals strategist at UBS, said:
“Aluminium cannot be described as a tight market and based on current
supply and demand trends there is no need for cash prices to be trading at a
premium.
“This
suggests that the current premium has been financially engineered by a large
fund player, who maybe is acting alone or with other players.”
Traders and
brokers said that it was thought the market participant started accumulating
its long position more than four months ago, at prices below current levels.
John Kemp,
metals economist at Sempra Metals, said one entity held a long position for
delivery today, the third Wednesday of the month, a key date for delivery of
metal that has been bought more than three months ago.
Mr Kemp said
the long position equates to more than 40 per cent of the open interest, the number
of aluminium contracts outstanding. This represents more than 25,200 lots
covering about 630,000 tonnes of metal.
A second large
long position of 10-20 per cent of the open interest, or up to 315,000
tonnes, had also been built up.
By Anna Stablum and Pratima Desai
LONDON (Reuters)
Aluminum
traders were edgy as a squeeze tightened ahead of the third Wednesday of the
month, by when investors must have decided how they want to close nearby
futures positions.
One player has
built a dominant position and controls some 90 percent of LME stocks -- more
than 690,000 tonnes.
Jan. 25
(Bloomberg) -- More than 90 percent of the LME-monitored nickel stockpiles
were held by a single firm as of three days ago, data from the bourse
show.
The so-called
warrant cash holdings, documents on the ownership of metals registered at
LME-monitored warehouses, also indicate single companies each held at least
the same proportion of aluminum, aluminum alloy, lead and zinc inventories. The report was
updated at 10:30a.m. in London.
The companies may no longer hold the positions as of today.
It is amazing
to me that any one hedge fund would take so conspicuous a position in a
single large commodity. Given the current press attention, the odds are
that the institutional investors in this hedge fund are becoming aware of its
activities. Most institutional investors are concerned about volatility
and risk management. It seems to me that, with this awareness and in
the aftermath of Amaranth, requests for redemptions will follow.
As I have been
suggesting for many months now there probably will be more Amaranths ahead in
the commodity space. With such incidents there is a threshold
effect. The first instance may be viewed as an exception. But if
others follow it may come to be regarded as a trend. Faced with this
prospect trustees of pensions and endowments and their lawyers will insist
that their institutions leave this space.
The break in
commodity prices so far this year
Most commodity
prices soared into a spike peak in May of last year. For many, that was
the high price so far for the cycle. Prices broke in May-June and then
recovered. By fall some commodity prices, like the energy complex and
copper, started down. Others like nickel, lead and, zinc soared to new
highs well above the past May peaks. With the very start of this year
almost all commodity prices lurched downward. The decline persisted
through much of January. As a result of this decline most of the commodity
indices made new lows and the overall chart spanning through 2006 into
January 2007 looks like a huge top after a five year bull market.
What has led to
this emerging bear trend in commodity prices? Let me take you back to
the three salient points I have made again and again and repeated at the
beginning of this paper.
- Data on bank commodity derivatives suggest a
flood of investment and speculation that has probably been too large for
these relatively small markets to absorb.
- This increase in the amplitude and duration of this
commodity bull cycle will inevitably encourage supplies and ration
demands. This will throw markets into surpluses which will
eventually weigh on prices.
- The combination of surpluses and huge buying
pressure by investors and speculators is throwing commodity markets into
forward premiums or contangos which is making
the cost of carry in commodities prohibitively expensive.
If commodity
prices are falling it should be because the high amplitude and long duration
rise in commodity prices in this cycle has created surpluses and these
surpluses are growing. In addition, the high contango
and their implied carrying cost, along with increasingly visible surpluses,
should now be curbing and even reversing the flood of investment and
speculation that has been responsible for the strength of the commodity bull
market in this cycle.
Let us consider
energy first. Many attribute the recent serious spill in the crude oil
price to unusually warm weather in much of North America and Europe. No doubt, warm weather has played a role.
But so has a growing surplus and the pain to investors and speculators
from a high cost of carry.
For many, many
months now OPEC and the IEA have been warning about demand rationing and
supply increases. Progressively they have been ratcheting
down their estimates of, and forecasts for, crude oil demand growth for 2006
and 2007. In one report I have received it is estimated that crude
demand in the United
States in recent weeks has been below
comparable calendar date levels both a year ago and two years ago. Some
of this is due to weather. But some of it is due to demand rationing.
At the same
time, the estimates for non-OPEC supply growth in 2007 are edging
higher. Many now expect non-OPEC supply growth to increase this year by
more than in any year over the last three decades.
This has become
apparent in OPEC’s decisions to cut output and the emergence of growing
unutilized capacity in the global crude oil market.
Let’s go
on to metals. I have been contending for over a year and a half now
that hedge funds have become buyers of physical metal. These holdings
have not been made public; they have constituted” hidden
stocks”. I believe such purchases have persisted right through
2006.
Should we
believe my contention? I have reported on numerous occasions that many
accounts of such accumulations of physical metals by hedge funds have come my
way. In addition, in an earlier document I noted that exchange
inventories of palladium-a minor metal- have risen from roughly 100,000 ounces to
over a million ounces. People familiar with these stocks say they are
held by several hedge funds.
Earlier in this
document I cited reports that hedge funds have bought significant quantities
of uranium- another minor metal.
Lastly, above I
have also provided reports that one hedge fund holds 90% of the 700,000
tonnes of physical aluminum that are on warrant in
LME warehouses and single hedge funds own a comparable high share of other
LME inventories.
If hedge funds
own illiquid minor metals like palladium and uranium and hold huge quantities
of warranted base metals, why should we not believe the many reports of hedge
fund hidden stocks of physical metal that have crossed my desk and which I
have discussed in the past?
Our
“official” statisticians for the various metal markets cannot
accurately measure demand for, or consumption of, these commodities.
They surely cannot assess the amount of metal “consumed” in
purchases of end use products embodied in the goods that households and firms
purchase. For this reason demand for a primary metal like copper
cathodes or aluminum ingots is defined as
the purchase of these primary metals by first stage processors. Copper
consumption, for example, is the copper cathodes delivered to wirerod mills and brass mills.
But even our
data on metal consumption defined in this way is flawed. For most economies
It is just too difficult for statisticians to get the actual data on
deliveries of primary metals to such processors. For this reason,
statisticians have been forced to have recourse to a concept of
“apparent” demand. Demand is calculated by taking all known
supplies (which are easier to estimate) plus the change in visible stocks as
a measure of demand for a given country. Supplies come from domestic
refineries and from net imports (exports minus imports). The problem
with this procedure is that for most commodities there is no good data on
changes in stocks. Most primary metal inventories are not
recorded. As a result, if there is a build in unreported or hidden
stocks, this build is recorded as an increase in demand. Such an
increase in demand is reflected in the market balance: deficits are
overstated and surpluses are understated.
The official
data on metals shows, for the most part, that the deficits of several years
ago are now giving way to a market balance or a surplus. For example,
the ICSG “official” data on the global copper market shows a
905,000 tonne deficit in 2004 evolving into a 200,000 tonne surplus in 2006.
But, if with
the rise of massive hedge fund speculation over the last two years, hedge
funds have been accumulating significant hidden stocks of base metals, these
markets are in smaller deficits or larger surpluses than the official data
suggests.
For these
reasons I conclude that the base metal sector is responding to price
signals. Demands are being rationed; supplies are being
encouraged. These markets are probably all now in surpluses, which are
growing.
This has
probably contributed to some of the price weakness in the metal sector in the
last few months.
So much for the
real world of supply and demand. In addition to this, we must consider
the financial world of investment and speculative flows.
Without a doubt
there were huge inflows into commodity derivative baskets and commodity
oriented hedge funds in 2005 and the early part of 2006. In fact, the
parabolic blow off in many commodity prices into early May of last year was
probably a response to large allocations of new funds by pensions, endowments,
private client bankers, and high networth
individuals into commodity funds of all kinds with the onset of the new
year. It has been assumed by many that these allocations to commodities
have now become a permanent feature of the investment landscape and these
flows would remain highly positive throughout last year and into 2007.
In a Veneroso’s Views I posted in September
entitled “The Pin Stripe Investor in Commodities: The Four Stages of
Revulsion” I argued this would not be the case.
I think my
forecast was correct. From what I can garner from reports from
investment bankers the overall net flow into commodity baskets abated into
insignificance by the second half of last year. Apparently, paying a
16% plus annual cost of carry proved to be too painful. Johnny-come-latelys in the institutional world were allocating new
monies to these products; but other institutions, experiencing a loss from a
costly contango, were redeeming.
So what
happened in the first two weeks of this year? I believe the opposite of
what happened in the beginning of last year has occurred.
Big
institutions like pensions and endowments tend to make major portfolio
allocations at key calendar dates. The beginning of the year is most
key. Just as they allocated considerable new funds to commodity
derivative baskets and commodity hedge funds in early 2006, I believe that on
a net basis they may have withdrawn funds this time around with the start of
2007. Perhaps the big motivator was the pain of the costly contango. Less important but perhaps of
significance is the fact that commodity prices were rolling over and,
independent of the contango, commodities as an
asset class were no longer providing positive price appreciation.
Lastly, there may have been some nagging concerns about a risk of a global
economic slow down in the wake of the U.S. housing bust and the
possibility of more Amaranths.
The Future:
More Price Declines
If this account
of the recent fall in commodity prices is correct it represents only the
beginning of a process that will unfold over time. When high commodity
prices throw commodity markets into surplus there are long lags
involved. It takes years to build major production facilities.
The decisions have been made. The financing has been obtained.
Construction has begun. Now, with big sunk costs, there is no
turning back. But, in many cases, there is no production yet either.
That all lies ahead and, for the most part, it cannot be stopped.
The same can be
said about demand rationing: there are long lags. Consumers, burnt by
high commodity prices, have to find new ways to get by with less. They
must find ways to economize and substitute. Decisions have to be made,
new production procedures must go beyond the design stage, new capital equipment
must be built that produces goods in a different way. Here again, the
impact on consumption is only beginning to be felt. It takes years for
new production processes to penetrate global manufacturing.
Lastly, as for investment
and speculative flows, the reversal, if it is occurring, has only begun.
Though the
permanence of the costly super contango could be
easily deduced from over investment and speculation in commodity derivatives,
few recognized the obvious. To this day the investment bankers and
others who sell commodity derivative products keep trying to lead the
uninitiated among investors into their products, even though, over time, such
investments ensure deep losses. It will take time for the slow moving
behemoths of the institutional investment world to catch on to the folly of
allocating funds to these products and to reverse past decisions which were
made only a short time ago.
But the
prohibitive costs of carry of these baskets ensures that widespread
“revulsion” against these products will set in and most of the
fund flows into these products will be reversed before it is all over.
As documented
above, pension and endowment allocations to commodity derivative baskets have
been small when compared to investments by these same institutions and others
in commodity-oriented hedge funds. When it comes to the financial side
of the commodity bubble what happens to hedge fund flows will matter
most.
The amazing
mountain of commodity derivatives- most of which must be attributable to
hedge funds- implies large leveraged long positions by some funds.
Reports about the activities of these funds corroborate this
assumption. The fretting by officialdom over excessive leverage by
hedge funds in illiquid markets provides yet further corroboration. The
example of Amaranth provides yet further corroboration.
If I am right
that the very high commodity prices of recent years is throwing these markets
into ever-greater surpluses, and if I am right that there will be
“revulsion” from commodity derivative baskets, commodity prices
will fall significantly further.
If there will
be further price declines in the commodity complex the odds are that there
will be more Amaranths among the “leveraged community.”
Pensions, endowments,
and private client bankers are the principle investors in such hedge funds
and they tend to be risk averse. I have no doubt that Amaranths’
70% loss of assets in a matter of weeks has unsettled many. But such
events, when they are singular events, tend to be treated as
exceptions. They do not appear to most as the beginning of a trend or
the surfacing of systemic risk. But if there is more than one such
episode a threshold is often reached. Then there emerges fears of a systemic
risk to a whole sector.
For this
reason, I believe that, if there are more Amaranths among commodity-oriented
hedge funds, the “revulsion” by institutional investors towards
commodity baskets will spread to commodity related hedge funds. Except,
with the examples LTCM and others in 1998, as well as that of Amaranth last
year, such “revulsion” could be far more dramatic.
Herein, I
believe, lies the greatest risk to commodity prices over the coming year.
A Post Script
on Gold
The above
account is a very bearish one as regards the base metals. I laid out
this bearish case in more detail in my piece entitled “The Coming
Nuclear Winter in Base Metals”.
I believe the
same applies for the white metals, even though they are quasi precious.
Given the huge increase
in exchange inventories of palladium I think there can be little doubt that
palladium prices are where they are only because of hedge funds activities
that are large in scale relative to the size of this little market.
My pessimism on
silver is controversial and unpopular. I am sent analysis after
analysis written by silver bulls. Demand outside photography, which is
in decline, is supposedly soaring. Investment demand, it is alleged, is
also very strong. Just look at the growth of the assets of the silver
ETF, it is claimed.
When it comes
to silver I believe the historical record is clear: silver demand was
virtually stagnant over the decade from the mid 1990s to 2005. As for
supply, despite the low silver price during that period, primary supply grew
a respectable 3% per annum. In recent years, silver supply growth has
increased. But the real expansion lies ahead. Primary lead and
zinc production could expand by 11% per annum in 2007 and 2008. This is
a major source of byproduct silver. Gold
production in Mexico
is also rising fast. It too is a major source of byproduct
silver. Lastly, there is development of many smaller “close to
pure” silver mines.
Below I argue
that the price of gold is not too high because it is still “held down”
by central bank actions. One can argue that the future prospect for
gold is positive because some central banks will buy as other central banks
liquidate. None of this can be said for silver. Central banks are
no longer depressing the silver price because their stocks are now
minimal. And no central banks are going to turn to low value, bulky
silver as a reserve asset.
But, while the
white metals may go the way of the base metals, gold should not. Its
fundamentals are totally different from the base metals and the white
metals.
From what I can
tell, the base metals and silver are as “scarce as dirt.”
There is no limit to the availability of ore bodies of these metals which can
be developed profitably at prices well below prevailing levels. But gold
really does appear to be scarce. Over the last decade of low gold
prices mine supply fell- in contrast to the supply of base metals and white
metals which rose at trend rates. And even that stagnant level of gold
mine supply was possible only because the gold miners high graded. Now,
at higher prices even though new projects are being brought on, aggregate
gold supply growth is restrained because of the need by miners to back off
from their prior high grading practices. As an example, witness the projected
halving of production at the great Yanachocha
Mine.
And then there
is the official sector whose activities are so important to the gold
market. The official sector continues to sell physical gold which
restrains the gold price. In addition, there has been huge investment
and speculative flows into gold derivatives along with such flows into all
other metal derivatives. Somehow someone must take the other side in
these derivative contracts. In base metals, it is consumers with inventory
to hedge and miners and refiners with future production to hedge. But
that does not happen in gold. Gold miners hedged in the past to a great
degree when miners of other metals barely hedged at all. But now,
having experienced losses on those misplaced hedging bets, gold miners, under
pressure from share holders, have been reducing their hedges.
If so, who has
taken the short side of the investment and speculative longs in gold
derivatives in recent years? By process of elimination, I believe it
must be, in some way or other, the official sector.
Therefore, I
conclude that the price of gold has gone up in percentage terms by less than
other metals because it has been restrained by physical and forward sales by
the official sector. There are now very large outstanding long
positions in gold derivatives by the pensions and the endowments and the
private client bankers and the hedge funds. All those investors and
speculators will eventually exit the entire metal sector in
“revulsion”. Some of these investors and speculators might
discriminate; they might regard gold differently than other metals and hold
it while they sell the others. But such discriminating investors and
speculators will surely be in the minority.
Pensions and
endowments have just entered the metal sector for the first time. This
sector has never been regarded as a respectable asset class by these
investors. It suffers from relative liquidity, high cyclicality, a lack
of transparency, poor regulation, and a long history of manipulation.
When “revulsion” towards this sector finally occurs these staid
institutions will make the same kind of big picture allocation they made when
they entered this space in recent years: they will exit simply by reversing
those past allocations, by cleaning house of commodities and metal baskets
and commodity hedge funds. Gold will not go unscathed.
The same will
be true for the hedge funds that have herded into all the metals by way of
derivatives. Yes, some will see that gold has different dynamics than
the base metals and the white metals. But most of them, caught in the
redemption dynamics of “revulsion”, will have no choice but to
sell across the board to meet redemptions.
So the odds are
that, when the metals liquidation comes, it will adversely impact gold.
It is possible that gold will escape such contagion. It is possible to
envision a U.S.
recession where the Fed panics, the base metals fall, while the gold rises
because the dollar crashes. But given the institutional structure and behavior behind the financial inflows into metals in
recent years, one has to assume this favorable
outcome has a lesser probability, at least initially.
But once the
correction in all the metals is well underway, the odds favor
an eventual sharp divergence between gold and the other metals. The
odds are that, in a price decline in gold, official sector selling will turn
to buying as physical liquidations abate, forward short sales are taken in,
and some central banks looking to buy will step in.
Nothing like this
can be expected in the base metals and even the white metals.
So, after the
initial contagion impact gold should diverge from the base metals, driven
upward by the eventual abatement in aggregate official supply. While
the other metals are buried by the long lagged aftermath of demand rationing
and supply encouragement.
By :
Frank Veneroso
The Gold Newsletter
www.goldnewsletter.com
Editorials and essays by Frank Veneroso
are available on The Gold Newsletter
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From
1991 to 1994 Frank Veneroso was the partner responsible
for global investment policy formulation at hedge fund Omega Advisors. From
1995 to 2000 and prior to 1991, through his own firm, Mr. Veneroso
was an investment strategy advisor to global money managers and an economic
adviser to institutions and governments around the world in the areas of
money and banking, financial instability and crisis, privatization, and
development and globalization of securities markets. His clients have
included the World Bank, the International Finance Corporation, and The
Organization of American States. He has advised the Governments of Bahrain, Brazil,
Chile, Ecuador, Korea,
Mexico, Peru, Portugal,
Thailand, Venezuela and
the United Arab Emerates. Frank is a graduate from
Harvard and has authored many articles on the subjects of international
finance.
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