Tuesday, July 10, 2012

"the biggest commodity and carry arbitrage of all time"

That's what the woman said.
It is stuff like this that puts the lie to silly economists.
Back on Jun 8 we linked to an FT Alphaville post in "Interest Rate Observer's James Grant Picks a Fight With the Financial Times' Izabella Kaminska" ipon which I commented:
"Right now I'm going with Ms. Iz and hoping she fleshes out the piece, maybe touching on the role of storage/hoarding in commodity and other "monies" markets."
Here's the rest of the story.
From FT Alphaville:
Confused curve signals
A while ago we observed that negative gold leasing rates were potentially signalling something awry with the Libor rate.

That judging by gold forwards, the Libor component of the gold lease rate calculation  (Libor-GOFO = Lending rate) was coming in much lower than what might otherwise be expected.

At the time we rationalised that this was likely the result of the funding market having become extremely long-tailed — a fact which had presented those banks with genuine access to this low Libor rate with something of a unique opportunity in the gold market. Since their cash had become more valuable to the market than their gold, they could now make a return from lending cash against gold, as opposed to gold against cash.

Simply speaking, the lending curve had inverted and in so doing the cash-for-gold trade had been born....

...Which brings us to the subject of curves in commodity markets, more generally.

If we apply the rhetoric we have learned from the gold market — that commodity markets can sometimes reflect true funding costs more accurately than interest-rate markets — we wonder, could the current “scarcity amid plenty” conundrum in the oil market be indicative of a very similar phenomenon? Namely that for a large portion of the market, with cheap access to cash, the only funding that is now profitable is the type that ensures commodity collateral is either encumbered or taken out of the market completely?

When backwardation becomes contango
At this stage we’re going to get very hypothetical. But please do stay with us. (We recommend reading our negative carry posts which explain why it is that negative interest rates tend to incentivise the destruction of production capacity and/or the cornering of markets via hoarding.)

Let’s presume the same gold market dynamics apply: That for a few market players the cost of funding is epically low — possibly even negative — while for others the cost is far higher than anything indicated by Libor. If you’re not one of the lucky few, of course, the only way to bring down funding costs is now to secure your loan with a collateral pledge. For physical commodity producers with short-term funding needs that means giving up commodities in return for cash at a negative rate.

In this way you see how a securities/commodity lending business turns into a secured funding market.
So, rather than paying to borrow a commodity so as to sell it into the market  –  presenting the opportunity  to profit from a potential price decline — you, the funder, are being rewarded for cornering the market instead. Effectively being incentivised to take the commodity out of circulation until prices are supported enough to help you realise a profit on your holdings....MORE