the same stuff she talks about at Alphaville-- but a little less edited, a little more stream of consciousness and a little less tolerant of morons.
In this installment she teaches a masters class in commodity price dynamics.
From Towards a Leisure Society:
Gold, the rate of reburying trade
I wrote the following in response to a comment I received on my perpetualisation of debt post earlier on FT Alphaville.Mavens will probably recognize the germ of the idea in the line attributed to Warren Buffett:
The guy I was responding to didn’t get the analogy. But perhaps readers of this Tumblr will understand (have expanded a little):
Gold in many ways is a completely false market. Gold is more abundant than any other commodity because you can’t eat it or consume it. It’s purpose is to be financialised. To be pledged as collateral and hedged. The price of gold is dictated by a tiny freefloat of the gold that’s not encumbered in vaults. In reality the gold market represents the biggest con in the world in my view…
You dig something out of the ground that cannot be consumed.. and when its supply becomes too plentiful because it cannot be consumed, you effectively buy it back at a lower price and rebury it in the ground.
The process allows you to capture carry.
Extract => sell at market price => buy back at lower price => Rebury to support the price => sell at higher price
As long as the difference in price covers your extraction and burying (vaulting costs) you’ve captured a carry.
The price is almost designed to stay stagnant and deliver carry.
And that’s how contango/backwardation works.
The only difference is that rather than being reburied commodities are warehoused or vaulted, and the interim price exposure (between you sell it and buy it back) is immediately hedged with a future.
Delivery of additional supply to the market is incentivised by backwardation — the knowledge that your sale should bring down prices to where the future is trading…
The “rebury” trade is incentivised by contango — the knowledge that your sale should help to support prices.
And this is why aluminium and metals markets are now the new financiialsed competition to gold.
The ONLY reason we saw a lift in the clearing price of gold in 2008 is because people were reburying the gold more quickly than they were extracting/unburying it. And that led to a loss of contango carry… because if everyone reburies at the same time — guess what, the price dampening effect of the original sale (and the carry) disappears.
The mechanics of the market inverted.
The flattening of the curve finally made the rebury trade totally non-sensical.
You went from:
Extract => sell at market price => buy back at lower price => Rebury to support the price and sell at higher price
to ..
extract => sell at far too high price => find yourself unable to buy back at a low enough cost to cover costs and to incentivise the carry rebury trade.
Suddenly from a financial standpoint vaulting gold becomes unattractive....MORE
...It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head....Just the germ however. What Kaminska is positing goes much deeper.
So there you have it. Anyone messing with commodities must have this stuff incorporated into their worldview the way a bond trader uses the interest rate/bond price see-saw without even thinking about it.
Now, you can either re-read "Gold, the rate of reburying trade" or you can read "The Working Curve and Commodity Storage under Backwardation":
Abstract
There remains controversy over whether the empirical curve relating intertemporal commodity price spreads and stocks, originally drawn by Holbrook Working in 1933 (i.e., the Working curve), is a valid stylized fact in commodity markets. The core of the controversy is the portion of the curve representing commodity stocks under backwardation. In this article we analyze the original data used by Working, plus more disaggregated numbers. We find that the Working curve is indeed valid. The diversity of stockholders and different stockholding motives most likely explain the empirical Working curve relationship.
But if you're going to do that you should probably read Keynes' "theory of normal backwardation" (not to be confused with backwardation).
Working differed with Keynes on some very basic points, see "The Theory of Speculation Under Alternative Regimes of Markets". And then...
...just read Izzy.
to understand what Goldman was doing to their "Long-only index investors" with the GSCI swaps (it's no accident that the GSCI is so weighted to oil) or...
...just read Izzy.
Front futures $1,676.20.
