Tuesday, May 1, 2012

Before You Risk Another Penny in Commodities: Can You Trust the Inventory Numbers

Market participants have been commenting for months on how weird some markets are acting.
Here's part of the puzzle from FT Alphaville:

Dark inventory, a volatility shock absorber
From oil to copper, something strange is going on with commodity inventories.

Official stocks are rising across numerous commodities, but analysts and traders swear fundamentals remain tight, while prices stay supported:

Expanding on this curio, the FT’s commodities correspondent Jack Farchy writes on Tuesday (our emphasis):
Moreover, metal in Chinese bonded warehouses is trading at a premium of about $50 to the LME, according to traders. While that is down from as much as $150 a few months ago, it is still surprisingly high given the soft demand in China.

The reason, traders say, is that much of the copper in bonded warehouses is locked up in “financing deals”, in which companies import copper in order to use it as collateral for bank loans. With financing for such trades relatively plentiful, traders say that only a fraction of the metal in bonded warehouses is available for sale.
Now, if the same logic is applied to the oil market, this could suggest that inventory figures are not at all what they seem. Indeed a breakdown of what inventory is “available for sale” and what proportion is “unavailable for sale” might be required in order to even begin to understand what’s really going on.

Though, how anyone can tell which commodity stock has been ‘encumbered’ via a financing deal and which hasn’t, we don’t know.

The point is that the market may be under appreciating the influence of commodity encumbrance. It is, after all, giving rise to a situation whereby inventory is being withheld from willing buyers, creating something akin to an artificial squeeze.

There are important implications of these developments.

For one thing, consider what European bond markets have taught us already (yes, really). When the ECB stepped in as financier extraordinaire of what were previously illiquid and unwanted peripheral bonds, it encumbered so much supply for so long that it easily managed to push spot bond prices towards recovery (albeit temporarily in most cases)....MORE
You can draw an analogy to U.S. labor markets.
The day-labor roofer in the Home Depot parking lot was never included in the official numbers during the boom so when the crash came and they were laid off the Dept. of Labor reported job losses that were on the order of one million less than actually occured in the real world.
A human shock absorber.