Friday, June 25, 2010

"Bread and Derivatives: Goldman’s control of market structure might just starve us, strand us, and leave us in the dark. Literally." (GS)

Oh My Goodness.
For three years I was writing about Goldman's use of their designation as a "Commercial" trader to avoid and help their clients avoid the position limits that the CFTC applies to "Speculators".

I felt like the provebial [it's Matthew 3:2, not Proverbs -ed] voice crying in the wilderness,

A quick note on nomenclature. In commodity markets speculators provide a societal good.
Where things got interesting was GS being a "commercial" allowed them to take positions that they would put into index form and then swap with the true speculators. Or sometimes just straight swap the position.
These speculators included giants such as CalPERS and other public employee pension funds and University endowments. I'll have more after the jump.
From New Deal 2.0:
In 2008, before the financial system almost melted down and threatened an economic collapse of biblical proportions, some very odd events occurred in the market for commodities derivatives.  It is now clear that financial institutions and investors already understood that the mortgage market was teetering and that severe problems for the financial firms were on the horizon.  Stress was building, but how did this relate to the commodities markets?  We still do not know for certain, but we do know that it coincided with peak investment levels of $317 billion in several investment vehicles known as commodity index funds.
In 1991, Goldman Sachs invented the commodity index fund.  While several other firms have replicated the fund, Goldman has maintained a 60-75% market share.
A key factor in the success of commodity index funds was an exemption granted by the CFTC from limits on speculative positions. It allowed the fund holdings to grow enormously.  Whatever the rationale was at that time, the conditions have changed and history suggests that the decision was unwise.

Goldman would take in funds from clients and invest the proceeds in futures contracts, a portfolio of energy, agricultural, minerals and financial contracts. It would be a sponsor and manager of the structure, not a principal. Futures contracts fluctuate based on the price of a commodity at a specified date in the future. For example, a barrel of oil to be delivered in August might be worth $70 to both a buyer and a seller as of today. The futures contract between a notional buyer and seller is essentially a financial instrument which continuously tracks that price each day until August arrives and the final price is known. It is not about actual oil, but rather the price of actual oil on a future date.  A futures contract is the functional equivalent of a swap and is a derivative of the cash market for the given commodity.

The idea of the fund was not to trade short and long positions or hedge physical prices on delivery of the commodity. The fund ignored market views and only bought one side - the side on which value of the futures contract increased as the expected delivery price increased.  The fund sponsor rolled over each contract into a new contract before the notional delivery date occurred.  By rolling over the contracts, the fund became infinite, a rolling investment in an index of prices for commodities that never had an end date.

Goldman and other banks made plenty of money from fees and float (the cash paid by investors was mostly held by the banks as long as everything worked well).  A side benefit was the huge increase in the volatility of commodities markets.  By flooding the markets with one sided contracts (especially on roll over dates), price movements became more severe.  Absolute commodities prices trended relentlessly higher and higher.
Volatility is essential to profits for the trading operations of the banks. Traders make money from price movements; stable prices mean low potential for trading profit. The logic is that commodities index funds lead to volatility which leads to trading profits for the fund sponsors. Goldman and other banks discovered that the commodities index fund operation, originally designed as a product for clients interested in investing in commodities markets, changed the marketplace and allowed them to trade for their own accounts far more profitably.

In recent years, most fund clients were not directly interested in the underlying commodities.  In a 2005 paper by Gary Gorton and Geert Rouwenhorst, it was demonstrated that returns on commodities are inversely related to stock market returns.  This relationship is especially strong in early stages of a recession and when share prices are lowest.  If you believed that equity prices were going to go down (or if you wanted to hedge exposure to the stock market), you could make money by buying the index. By 2007/2008, as investors became concerned about returns on their equities investments, the commodities index funds grew rapidly as a hedge against a falling stock market and futures prices rose....MORE
Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.
HT: Clusterstock

Some of our posts:

July 2008 
Dear CFTC: About those Oil Markets. And: A Stock Tip
...The long-only index investors have created such a distortion in the market that very few speculators are willing to go short, which is one of the functions of speculators in the markets. Now, if you have program trading kicking in, only a fool would take the other side of a buy order. The CFTC has become the Nevada Gaming Commission....
October 2008 
Commodities: $50 bln in 'long-only funds' flees commods markets. And: Calpers says staying the course on commodities
...I am looking forward to CalPERS quarterly results. While the recent ugliness won't have an immediate impact on their ability to meet their promises to retirees, I'm guessing that it will end up being a good thing that they can make up any longer-term shortfall by taxing California residents. This could get serious.

Regarding the long only commodities "investors", look for a hit to Goldman's earnings. As proprietors of the GSCI they have at least half the "roll" business. Assuming 2% slippage (fees, spreads, commissions) on the $50 Bil. just removed from the markets and you have $500 mil. in gravy they won't get to put on their spuds....
October 2008 
Calpers fund down 25 percent for year

February, 2009
Danish Pension Fund Giant Investing 'up to $400 Million' in Hudson Clean Energy
...Instead, CalPERS' idea of alt investment is buying raw land top tick of the housing bubble ($1 Bil. write-off) or gunning commodity prices via long-only index investments and swaps*....
...*Goldman bagged 'em. I mean they took CalPERS deep! First they tout $200/bbl. oil, then after the collapse:
From Barron's, Nov. 20, 2008 via our post "It’s official, Goldman capitulates on oil"-...
February, 2009 
U.S. Oil Trust Investigated by CFTC (USO)
...The “speculator limits”, says Nymex are there to “effectively restrict the size of a position that market participants can carry at one time and are set at a level that greatly restricts the opportunity to engage in possible manipulative activity on NYMEX.”
The position limit during the last three days of the expiring delivery month on Nymex WTI is 3,000 contracts....MORE

June, 2009 
How commodity indices broke the wheat futures market
I've been beating the drum on the index investors in the commodities markets (especially oil) for over a year now, see link below the headline story. From Felix Salmon at Reuters...
... Here's a quick search of Climateer Investing for Calpers, long-only, index.
June, 2009 
Goldman Raises Year-End Crude Forecast by 31% to $85
Always, always be skeptical of anything Goldman says regarding commodities.*
J. Aron is one of the company's crown jewels and was the springboard for CEO Lloyd Blankfein.**...

...Goldman marketed the fact that CalPERS and other long-only index buying institutions could piggyback on GS's status as a 'commercial' to avoid position limits by entering into swaps with the bank. The institutions thought it was a sweet deal, until it wasn't. If it comes down to throwing customers under the bus or protecting the propritary trading, there's no decision.

**"When Blankfein asked about his title, a boss at J. Aron said, 'You can call yourself contessa if you want.'"
-Fortune, January, 2006 
July, 2009 
Goldman, Morgan Stanley Threatened by CFTC Review (GS; MS)
Spokesmen for both banks declined to comment, as did one from Barclays Plc. Spokesmen from JPMorgan Chase & Co. and Citigroup Inc. didn’t immediately return calls for comment....MORE
On the other hand we've never been shy about commenting, see:
June 16, 2008: Goldman, Morgan Stanley Profits Conceal Reliance on Commodities
June 25, 2008: Which Former Goldman Sachs Chairman Should We Listen to on Oil Market Speculators?
August 19, 2008: Goldman’s Oil Thesis: Timing is Everything
October 7, 2008: Goldman: We Got Our Shorts On, Oil not Going to $200.00
October 27, 2008: The Goldman Commodities U-turn, again
November 20, 2008: It’s official, Goldman capitulates on oil
December 2, 2008: Oil speculation: It's back
December 12, 2008: Goldman Cuts Oil Forecast to $45 (vs original $200) Sees Bottom
June 5, 2009: Are Goldman's Oil Swaps Clients Piling Back Into Oil? 

July, 2009 
Oil: the Market is the Manipulation
...Here's Chris Cook at TOD:
   ...When I joined the International Petroleum Exchange as Head of Compliance and Market Regulation in 1990, the growing market in oil derivative contracts (futures and options contracts the purpose of which is to manage oil price risk) took off dramatically with the first Gulf War, and the IPE never looked back....
...The manipulation in the oil market is taking place at a different “meta” level to the Leesons and Hamanakas. The Goldman Sachs and J P Morgan Chase's of this world do not break rules: if rules are inconvenient to their purpose they have them changed....
October, 2009  
CalPERS Playing with Fire
...In our July '09 post "CalPERS Clipped for $970 Mil. in Real Estate Fiasco" I said "It's called reaching for yield. And it's stupid, especially when a fiduciary does it."

We have dozens of posts on CalPERS. This outfit is going to cost the taxpayers of California billions over the next decade as markets refuse to accommodate the fund's requirement of 8.5% average annual returns. They have made promises to their public sector retirees that they won't be able to meet and are trying to make up the difference by engaging in behavior that no fiduciary should even contemplate, let alone execute.

If you recall, they were one of Goldman's* largest "long-only index investors" in oil and the GSCI, scaling back only after their commodity bets lost billions. They also engaged in loser hedge fund behavior, selling their most liquid investments at the bottom to prop up their non-trading investments....
October, 2009 
Short Interest Declines Again (and Why it Matters)
...*From our June 2 post "Markets: What Happened to the Bears?":

We are coming up on the anniversary of an event in the oil market that may bear [so to speak -ed] some resemblance to what has been happening in the equity markets.
On June 6, 2008 oil staged it's largest dollar gain in history....

...After talking to some folks who had been mauled [cute -ed] I decided that the short-sellers had just given up. It is no fun to be selling into the buying of Goldman and their long-only index clients, CalPERS, the universiy endowments et al.
So they said to hell with it. Oil continued to rise for another 33 days before peaking on July 9.
On July 29 I had this comment at Environmental Capital:
Mike @ 4:13,
Two separate thoughts in that first post.
As best as I’ve can tell approx. 40% of the move from $80 to $147 (25-28 bucks) came from “speculation”. I use quote marks because of the terminology problems most of the talking heads have when the subject is commodities. Speculators in commodity parlance take the other side of a hedgers trade, thus performing a societal good.
The problem was, until last week, the shorts had been beaten up so bad by the relentless flow of “investor” money that were out of the game. The $10.75 uptick on June 6 was their capitulation.
They covered and said screw it....
And many more.
We're no blogger come lately, no sirree.

If I were a betting man my money would say that one of the big reasons that gold has moved out of proportion to oil is that GS realized that continuing the same old game in consumables would result in such a hue and cry among the citizens that the politicians would be forced to shut down the game permanently.
Rather than risk that they went to something that people didn't get price quotes on every time they gassed up, or bought a loaf of bread.