From Craig Pirrong at the Streetwise Professor:
Riding His Anti-Hedge Fund, Anti-Speculation Hobby Horse
John Kemp of Reuters-accompanied by cheerleading by Izabella Kaminska at FT Alphaville-is going on about the “disconnect” between nearby and deferred Brent. He blames-wait for it-hedge funds. Natch.
The Brent market is currently in a steep backwardation. I demonstrated empirically almost 20 years ago that backwardation is associated with low correlations between spot and futures prices for oil and a variety of other commodities.Just yesterday I was thinking of doing a backwardation/contango post.
Indeed, my 1994 criticism of the Metallgesellschaft 1992-1993 “hedging” strategy-which led to several confrontations with Merton Miller-was based on the fact that MG’s “hedge” of long the nearby against distant deferred short positions was in fact risk increasing due to the fact that MG implemented this strategy during a backwardation, and this reduced substantially correlations thereby making the MG position very risky. My 2011 book provides a robust model that predicts exactly this result.
The intuition is quite straightforward-as I’ve been teaching for about 20 years too. Inventory is what connects spot and futures prices. When inventories are large, the market is in contango, and spot and futures prices move together: cash-and-carry arbitrage connects these prices. In contrast, when inventories are low, the market is in backwardation, cash-and-carry arbitrage doesn’t link the spot and the futures, and the correlation between these prices can go very low. Hence the association between contango and high correlations.
Note: hedge funds, speculation, yadda yadda yadda have nothing to do with this.
Kemp does note that there is physical tightness that does explain the backwardation:
Overlaying all these broader factors are continuing problems with production of the four North Sea crude streams (Brent, Forties, Oseberg and Ekofisk) that physically underpin the Brent futures prices. BFOE crudes remain in short supply, keeping the market in a steep backwardation, with futures prices tending to rise sharply in the run up to contract expiry.But then he discards this fundamental fact, and mounts his favorite hobby horse of bashing hedge funds and speculation.
Note even in this paragraph there is a telling piece of information that contradicts his view: “with futures prices tending to rise sharply in the run up to contract expiry.” Uhm, that’s exactly when hedgies and other speculators are liquidating-selling-their nearby contracts and rolling them into the deferred months. This should put downward pressure on nearby prices, if the speculators were really in command. Completely inconsistent with his assertion that hedge funds are driving the disconnect between spot and futures.
Kemp also makes a comparison to spot price and curve movements in 2008 to more recent movements. But as I also show in my book, to explain commodity price dynamics you need multiple shocks of differing persistence. Curve shape is driven mainly by transitory shocks: that’s what inventory is used to smooth out. The level of the curve is largely driven by persistent, business-cycle type shocks. This means that conditioning on price levels alone is insufficient to make an apples-to-apples comparison. The 2007-2008 boom was driven more by long run, secular factors-namely the Asian/Chinese growth boom. This resulted in a rise in the price level and only a modest increase in backwardation. That is completely different from current conditions-hence the different behavior.
Similarly, the differences between high correlations pre-2010 and low correlations now are readily explicable. The market was much more abundantly supplied in 2009-2010 due to the severe economic contraction following the financial crisis, and as a result, the market was in contango most of that time-at times in a “supercontango”. Again, one would expect this to be associated with high spot-futures correlations....MORE
Just so you don't get too hyped up with anticipation Metallgesellschaft is a topic of especial interest.
In the meantime here is Pirrong's "Metallgesellschaft: A Prudent Hedger Ruined , or a Wildcatter on NYMEX?".
And here is Merton's "Metallgesellschaft and the Economics of Synthetic Storage"
See also: "Maturity Structure of a Hedge Matters: Lessons from the Metallgesellschaft Debacle" for a very solid, non-ideological discussion of the Metallgesellschaft trades.
Professor Pirrong was one of the academics who saw no evidence of speculation driving the 2008 oil price spike and subsequent collapse. Market participants who were on the other side of his bet won big.
$147 to $33 in under six months.
Yeah I got your long run, secular factors.
On the other hand Prof. Pirrong is pretty good on the effects of storage in commodities markets, an aspect of the biz that can be very, very profitable.
