When Commodities Collapse, Find A Hedge
“I used to make a phone call with a very thin dime, now I can’t afford to even call to get the time”
—Prince Charles and The City Beat Band
Many times, economic and financial market concepts seem really complicated and difficult to understand for the average citizen. However, if we have a discussion with friends in a bar or a restaurant, many understand the basic principles of commodities. And when we talk, we frequently debate on the challenges of supply and demand. Everybody more or less gets the idea of a finite resource and that price inflates when demand rises and reduces when supply is plentiful. On top of it, because we like conspiracy theories, we add assumptions of what producing countries’ governments secretly think, what the real strategies in the global geopolitical landscape are, and how they affect pricing.
Commodities are much simpler than derivatives or equities.
The key to the definition of a commodity is that it is a basic resource which is used as a raw material for trade to exchange goods and services; as everyone understands the basic principles of their value, commodities many times work as money. However, commodities are used mainly as input to create a final product with higher value which will be sold at a profit.
It seems simple. But for financial markets, it is not. Commodities are also financial products, and have complicated structures that allow traders to buy and sell them as many times as needed. It is necessary for commodities to have a specified minimum standard, usually known in the market as basis grade.
Financial markets have broken down the historical barrier between producers and consumers of commodities by providing liquidity and flexibility. A large vessel carrying crude is bought and sold to different owners a few times in the course of the same trip from one port to another. Financial markets have diversified the uses and value of commodities and multiplied demand as these commodities became a trading opportunity and an investment. Transactions would not have to be physical, and millions of tons of any given commodity were traded in seconds.
Furthermore, the futures contracts exceed by many times the physical market.
Chris McMahon1 explains it very well:
“Exchanges would always prefer cash settled over physical delivery because it is much easier. Physical delivery requires a tremendous amount of work.... It’s a real nightmare.
For more than 100 years the basic premise of a futures contract was unchanged. It was a legally binding agreement to take, or to make, delivery of a prespecified quantity and quality of a commodity on a predetermined date at a predetermined location. By tying the futures contract to an actual, physically deliverable product, the integrity of the contract was backed up by underlying physical goods, ensuring that the market universally agreed to the fairness of the price. This allowed hedgers and speculators to more realistically take on and lay off the risk of production and purchase because the price of the futures contract would closely track the price of the physical commodity.
As contracts approach settlement, there are a series of notices to which traders must respond if they intend to take, or make, physical delivery. But most traders simply close out the positions by purchasing offsetting contracts.
By having the physical delivery aspect of the contract, it forces the prices to converge. That function forces cash and futures to be equal on that settlement day.
The exchange does not set the settlement prices. The settlement price of the physically delivered futures energy contracts is decided during the last 30 minutes of trading on the final trading day, and that price is used to determine margin calls and invoice prices for deliveries. In contrast, the cash settled contracts settle on a futures price on the fourth business day before the 25th, hence the name ‘penultimate,’ and never go to delivery.”
The reader may have heard numerous times that speculators and traders decide the price of a commodity by dealing on massive figures of financial instruments instead of buying and selling physical commodities. But that is not true; what they buy and sell are financial complex products linked to the price of the commodity in the physical market. The oil producer in Jeddah is not subject to the wave of speculation; that wave of speculation happens depending on what demand there is for the product in the physical market.
What Is the Price of Oil?
Or any commodity that trades in U.S. dollars, for that matter.
There is the nominal price and the real price. The first is what you discuss at dinnertime with friends and family. The second is the same price adjusted for inflation, caused by devaluation.
As all commodities trade in U.S. dollars, when the U.S. central bank devalues and increases money supply dramatically, commodities rise in nominal terms, not necessarily in real terms.
In fact, the casual dinnertime conversation about commodities and the fascinating conspiracy theories about geopolitical secret agendas are immediately killed by the real price argument. Bummer.
“Oil prices are at all-time high because of Saudi agendas, or conflicts, or China”... oops. Oil prices in real terms are at the same level as they were in 1978. Bummer.
Tim McMahon at InflationData.com2 analyzes real and nominal prices for oil frequently. He states:
“Starting in 1946 the inflation adjusted price of oil was $18.03 per barrel. After climbing sharply for a couple of years, it stayed relatively steady and in fact steadily declined in inflation adjusted terms until 1973. From there prices exploded until 1980 when the bubble burst and prices returned to ‘ normal’ however they were much more volatile from then on.
The major peaks occurred in December 1979 at $119.33, October 1990 at $62.59, and June 2008 at $139.05 (all inflation adjusted to 2016 dollars). Another interesting item to note is that the average price has been increasing. The average for the entire period from 1946 to present is $42.54.” “Adjusted for inflation the 1979 $38 peak oil price is the equivalent of paying $119.33 today (meaning Oct 2016).”
A real party breaker. Most of the stories about geopolitical conspiracies and the amazing science fiction theories about the end of oil (called peak oil) vanish when you understand that the vast majority of boom and bust shocks in the King of Commodities, crude, have been—yawn—monetary changes.
Hola, Mr. Fed
Yes, there have been price spikes due to fundamental aspects. Oil crises from OPEC cuts, supply affecting wars ... all of it is there. And in real terms oil has appreciated since 1980. But the big monsters in the room dictating price are called Mr. Federal Reserve and the mighty U.S. dollar.
Once you understand money supply as a deciding factor for commodity pricing, the complaints about speculators and evil manipulators disappear.
More importantly, once countries and central banks understand that it’s the reserve currency and its effect that matters the most, it is easier to make a fundamental analysis of other real variables that affect the price, and whether those trends are sustainable or just mirages.
Unfortunately, many, even knowing this reality, make the mistake of believing that “this time it’s different.”
If countries had taken the tsunami of dollars generated by massive monetary manipulation for what it was—a mirage—it would have been much easier for them to understand the inevitable collapse when the seemingly endless flow of cheap dollars finished.
Preparing for a bubble is difficult. A rising wave of liquidity is very tempting and many people become very rich quickly. The perverse incentives to allow everyone to believe the trap are enormous.
Boom and Bust
The commodities boom and bubble was born before QE, but reached phenomenal heights with it. The fact that it started earlier does not mean it is not due to “expansionary policies.” The commodities supercycle started at the beginning of the new millennium, just in time to fill the void created after the colossal tech-stock bubble burst of the1990s, with massive interest rate cuts to “stimulate the economy” and survive the bust of a bubble with a new—and seemingly more credible—one.
As Keith McCullough3 always says: “There is a difference between a unicorn and a bubble. A bubble, at least for a short period of time, is something real, tangible. Unicorns don’t exist.” The tech bubble came from the belief in unicorns. The commodity bubble had a certain fundamental reality to it, at least for a while. To the tangible fundamentals, in order to fuel the bubble, the market added the “peak” concept. Consumption was so out of control that we would run out of oil, gas, and other commodities sooner than any substitution could appear. To justify that “bubble argument,” the market added another bubble: the perennial and unstoppable growth of China.
Of course, all those bubble-justifying arguments were presented with tremendous “scientific” studies and alarmist conclusions. A great business for those involved. But all of them ignored reality. Cycles happen; efficiency is a bitch, and it erodes Excel spreadsheet demand models; technology leads to new discoveries and better and more diversified production.
The biggest enemy of a bubble estimate is an engineer.
Commodities had been in a steady bear market since the early 1980s and were virtually ignored by investors in favor of rapidly rising stocks. Energy products and precious metals started showing definite signs of life again in 1999, but the real commodities boom began in earnest in November 2001, just as the Federal Reserve’s aggressive interest rate cuts aimed to stop the post–tech crash recession on its tracks.
Commodities prices, as measured by the Continuous Commodity Index (CCI), rose a staggering 275 percent since the start of their bull market in November 2001, against a 25 percent increase in overall inflation as measured by the CPI.
What is impressive about this commodities bull market is not just the magnitude of the price increases but also the sheer breadth of commodities involved, from Malaysian palm oil and rare earth metals to sulfuric acid and uranium, with virtually no commodity missing out on the bounty. Thank you, Federal Reserve.
While the global financial crisis of late 2008 resulted in a 48 percent plunge in commodity prices, they staged a quick and powerful recovery, rising 112 percent from the depths of the crisis to a mid-2011 peak that surpassed the prior 2008 high by over 10 percent.
A massive bubble, inflated by ultralow rates, burst and created a financial crisis, and the solution was to ... fuel the bubble again.
At this point, there is an important thing to say. Mainstream economics and most academia deny the existence of bubbles. However, there are relevant studies that analyze how they are created, almost invariably, from the perception of low risk, and the idea that valuations and fundamentals have changed to a new paradigm.4 Some papers even find bubbles a great way to go from financial crises to growth, as if the crises were not generated by the bubbles themselves, and the exit is weaker growth.5
Like all bubbles, the commodity bubble of the 2000s started as a legitimate economic trend6 and evolved into a “new paradigm”—the “fundamentals have changed” speculative mania.
A critical component of every bubble is a convincing underlying story with widely acceptable elements of truth to be believable not only in the minds of the otherwise intelligent and well-educated people who control market-moving amounts of capital ... but also of their clients, media, and analysts.
The elements of truth responsible for the justifiable or “nonbubble” portion of the commodities price boom were: underinvestment in natural resource productive capacity during the 1980s and 1990s; the 2000s’ U.S. dollar bear market; the fundamental shift in the economy of China, India, and other emerging markets; population and middle-class growth; climate change and extreme weather; geopolitical turmoil; and the increased diversion of agricultural commodities for use in biofuels.
Some legitimate portion of the increase in commodities prices since 2001 can certainly be explained by the aforementioned fundamentals, but it is also important to realize that most were also exaggerated and magnified to adapt to the ever-rising price discourse. Furthermore, when some of those factors—supply, China, technology—ended being questioned, others would be further exaggerated. Peak oil worked wonders to help this and the “next year” fallacy we mentioned with hockey stick estimates.
“The only cure for high prices is ... high prices.”7
As high prices eventually encourage more supply to enter the market, they push prices down again. And this supply comes to the market following the belief in endless growth in China, emerging markets, and so on.
Prices are viewed as a reflection of a reality and a future that is unquestionable, without discerning whether the price formation is following supply, demand, and inventories. One of the indicators that the bubble was exactly that, was the fact that supply kept rising and inventories building while demand growth estimates were revised down every few months between January predictions and December reality.
Record-high commodities prices led to ambitious investment plans, such as projects in Quebec and Canada’s multibillion investment and the decision to open its vast Northern region to mining development—an area twice the size of France with an abundance of iron, nickel, and copper ore deposits. From Australia to Brazil, Russia to Madagascar, new and massive development projects went rapidly into Final Investment Decision (FID) and capex. China’s growth and “endless thirst” for commodities justified even the most challenging of economics. Investments in resource exploration, mining, and development exceeded $1.5 trillion a year. Ten times more, in real terms, than historical averages.
Record food prices incentivized the planting of new farm fields, causing a global wheat supply glut to swell to its biggest in a decade. While the rise of China is commonly cited as a reason for rising food prices, China could meet its own demand for food and even become a significant food exporter. Chinese interests have also started to unlock Africa’s abundant undeveloped agricultural potential using modern farming techniques.
Dollar Collapse, Commodity Boom, Then Bust
The strongest driver of the commodities bull market was the 40 percent decline in the U.S. dollar’s exchange rate versus its basket of currencies since 2001.
The next main catalysts for the second phase of the commodities bubble (2009 to 2013) was the launch of the Federal Reserve’s QE programs.
But by QE3, the third phase, the carry trade—“long commodities and short dollar”—was disappearing. Like all bubbles, the mirage of the exaggerated fundamentals was rapidly fading, and the reality of oversupply was becoming more evident.
Estimates of real demand started to come down aggressively, and with them the world GDP growth expectations. Supply kept rising and thousands of projects with questionable economics kept adding production because they became sunken costs and producers needed to generate cash, not returns over cost of capital.
The collapse in commodities was as quick as the rise, and its force came as a surprise even to the analysts and economists that predicted the burst of the bubble. I wrote The Energy World Is Flat in 2014 with the view that oil prices would fall from nearly $100 to half, and prices crashed to lows of $25–$30 a barrel.
Like the bubble, fundamentals were exaggerated and misunderstood. But after an entire generation of traders had been raised on the belief that commodities could only go up, the fall was more severe as few could discern real fundamental value as the bottom approached.
To find real value we must understand real monetary bubbles and money supply.
Those that analyzed the economy and the fundamentals of commodities understanding the peaks and bottoms of fundamental supply and demand cycles were able to pick great opportunities and, more importantly, avoid the magic ideas of new paradigms and endless inflation.
The opportunity that the end of the commodity supercycle provided was enormous, as long as governments, investors, traders, and citizens sobered up and understood that the analysis we had made for almost two decades was sugarcoated by the placebo effect of monetary policy.
We cannot just complain about these policies. They have been going on for centuries. There is always a government or a central bank that will believe that this time they will get away with inflating assets and destroying currencies with no consequence. But they always fail. We, as investors, economists, and analysts need to understand that these policies will create shorter and more abrupt cycles, be intelligent enough to ride them while the wave is rising, and be prudent enough not to believe what is simply unbelievable: that this time we have found the recipe to mitigate and offset any economic cycle. It is simply untrue.
1 Futures Magazine July 2006.
2 Oil Prices in Inflation Adjusted Terms, October 2016, inflationdata.com
3 Hedgeye CEO.
4 Bubbles, Financial Crises, and Systemic Risk. Markus K. Brunnermeier, Martin Oehmke. Columbia. 2010.
5 Economic Growth with Bubbles. Alberto Martin and Jaume Ventura. 2011.
6 Bubbles, Rational Expectations and Financial Markets. Olivier J. Blanchard, Mark W. Watson, 1986.
7 The Cure For High Prices Is ... High Prices—Leigh Drogen, Blog. 2011.