Wednesday, September 3, 2014

Bloomberg's Matt Levine Talks Goldman Sachs and Aluminum

Dizzynomics alerted us to to the dismissal on Aug. 30. More interesting was her piece immediately preceding the aluminium  post on "Muscle Economics"
Here's more detail, from Bloomberg:
The Goldman Sachs Aluminum Conspiracy Lawsuit Is Over
Let me tell you about aluminum. Aluminum is a metal that is used to make beer cans, and also for some other things. You might want to buy aluminum for either of two reasons:
  1. to take that aluminum and turn it into beer cans, or
  2. for "financial purposes."
One big financial purpose is to hedge your future plans to make beer cans: You think aluminum looks cheap today, so you buy some aluminum to lock in your costs. But there are other possible financial purposes. Maybe you are hedging some risk in some other commodity that is correlated with aluminum. Maybe you are just speculating on the price of aluminum. Whatever. Financial purposes are broad; the point of this category is that you want exposure to the price of aluminum, as opposed to an actual pile of aluminum to be fed into your beer-can-making machine.

Similarly, you might sell aluminum either because it just came out of your aluminum mine1 and you want to get rid of it. Or you might sell it for financial purposes, hedging your future aluminum mining or whatever.
So there are sort of two markets for aluminum.2 One is, like, A digs aluminum out of the ground and sells it to B to make beer cans. The other is, like, C and D speculate with each other on the price of aluminum. These two markets serve different, though obviously related, purposes. The beer-cans market is about putting a big hunk of metal on a truck and delivering it to the gate of your factory, where you will turn it into beer cans. It is concrete and specific and local: You need a specific amount of aluminum, in a specific shape, at a specific place and specific time.

The financial market is about figuring out the price of aluminum, balancing worldwide supply and demand, moving aluminum to its highest and best uses by trading away arbitrage opportunities. It abstracts away from shapes and places and times and just trades aluminum generally. So everyone agrees that there's a thing called The Aluminum Price, and it's the price of a standardized amount of a standardized grade of aluminum delivered to an abstract location.

How do you deliver actual metal to an abstract location? Well, you put a bunch of aluminum in special warehouses around the world, and everyone agrees that the insides of those warehouses constitute Abstract Aluminum Space. So if you buy aluminum for hedging or other financial purposes, then what you have is not a lump of aluminum on a railroad siding by your factory, but rather a claim on some aluminum that lives in Abstract Aluminum Space. And when you later want to close that position and take the gain or loss on your financial investment in aluminum, you sell the claim on to someone else. You never bother moving actual lumps of metal around; you just trade the abstract claims.3
 
Of course, you cannot make actual beer cans with abstract aluminum, and for the abstract market to be useful in setting the price of aluminum, there needs to be some interchangeability with the actual-lumps-of-metal market. There is, but it's annoying. If you've bought abstract aluminum, you can ask to get the actual underlying aluminum. The seller will give you what is called a "warrant," which entitles you to take out a particular amount of aluminum out of the network of warehouses that constitute Abstract Aluminum Space. But he doesn't have to give you a very convenient warrant: If your factory is in Detroit, he can give you a warrant for metal in Barcelona.

And once you have the warrant, it's not very convenient to get the aluminum out. The Abstract Aluminum Space warehouses exist not to facilitate industrial processes, but to facilitate abstraction. What that means is, basically, it takes a really long time to get aluminum out of them. A forklift driver will work with less urgency if he is an agent of abstraction than if he is an agent of industry.

But this shouldn't bother you. You bought the abstract aluminum for financial purposes. Let's say you bought it in January to hedge your aluminum-price exposure. In September, when you're actually going to make beer cans, you don't take your aluminum out of the abstract system and have it delivered to your factory in Detroit. Instead, you sell your abstract aluminum to lock in the profit or loss on your hedging trade, and you buy actual aluminum for delivery to your factory in Detroit. The abstract aluminum remains in the abstract system, and you've just used it for its price. You buy your actual aluminum from an aluminum smelter, or from a warehouse that isn't part of the abstract system....MORE
Previously the New York Times did a 100,000 word piece (okay, maybe not that long but it did run to 5 pages) which we linked to in "UPDATED: 'How Goldman Made $5 Billion By Manipulating Aluminum Inventories (and Copper is Up Next)'"

By the way, Izabella did not use the 'aluminium' spelling, that was me remembering a U.S. metals trader in Russia who had taken the extra 'i' on as an affectation.