Category Archives: commodities

The uncertain future of natural gas

Today is the official release event for the MIT study on the Future of Natural Gas. It’s a wide ranging study examining the role of natural gas in meeting future energy demand under carbon dioxide emissions constraints, and recommending appropriate policies–both for the US government and for industry. I was a member of the study group producing the study. I’ll let the full length study speak for itself on the many different issues it addresses. I want to use this blog post to expand on one specific point which is the huge uncertainties we face in charting any path forward as manifested in the fluctuating price of natural gas.

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When a hedge becomes a risk: The recent rally in corn prices.

Commodities markets have been quite agitated in May. The tremors felt on May 5 have not dissipated and recent data on the US economy, the risks of inflation in China’s and the protracted debt crisis in the EU left many traders wary. Prices of precious metals, industrial metals and oil have all dropped. So far, grains, led by corn, have held their value pretty well.

Corn is now being planted to be harvested in August. Weather is the main factor affecting the progress of planting and yields (#bushels per acre), and consequently a key driver of prices for new corn. Estimates indicate that the planting season is behind schedule, and that flooding of the Mississippi has destroyed some fields. Lower expected yields and acreage put further strains on an already historically tight ratio of stocks-to-usage – a measure of supply and demand.

Presumably these facts should have a greater impact on the incoming crop season (new corn). Yet, the recent sharp rally in corn prices occurred in nearby contracts (July futures) rather than in December futures contracts. Why is old corn more bullish than new corn?

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The cloud in silver pricing

On Thursday, May 5, commodities markets fell sharply. On that day alone, the DJ-UBS index of commodities prices lost 4.7 per cent. The rout is said to have started in the market for silver, but rapidly spread to a wide range of commodities.

Silver is used for commercial purposes. Recently, however, the metal has been trading predominantly as a speculative asset. A lot of people now associate silver with the role traditionally given to gold as a store of value against the erosion of fiat money. As such, the price of silver, instead of reflecting the value of the stream of income derived from the traditional commercial uses, is driven by changing beliefs about grand macroeconomic events. This is how silver has gone up by more than 70 per cent in just three months, between the end of January and April 29.

Silver prices halted their rapid ascent with an abrupt fall of 28 per cent in the first week of May. Fundamentals can hardly explain such a violent reversal. Searching for an answer, many pointed their fingers at the Exchange, which raised margin requirements on futures positions four times for a total increase of 61 per cent since April 25. Three increases happened in just five trading days. The argument goes like this: many investors, surprised by the repeated large margin increases were unable to quickly arrange financing of the margin and were forced to sell their positions, driving the price down. This selloff may have been aggravated as other investors panicked. Some complain that the Exchange was deliberately, and unfairly, trying to push prices down. Others use the occasion to press the political case in favor of more aggressive use of margin requirements as well as position limits to stop speculators from inflating the price in the first place.

The events of the last couple of weeks in the silver market are a useful opportunity to briefly review the role of margin requirements and what is known about their impact on trading and prices. Continue reading

Phew, that was close!

In September 2008, Constellation Energy, a major electric utility in the US, was on the verge of bankruptcy—see my analysis here. That rang alarm bells throughout the territory covered by the PJM Interconnection, one of the largest electric power marketplaces in the world, stretching from New Jersey, Pennsylvania and Maryland in the east to Illinois in the west. Because of Constellation’s many transactions in the PJM market, a default by Constellation could have saddled PJM with an unpaid bill of more than $100 million. No one knew what might have happened next, especially since this incident was happening just as the global financial crisis was threatening the economy everywhere. Would liquidity in the electricity market dry up? Would buyers and sellers come forward with bids for the coming days transactions? Would the PJM market itself survive? If the market was in jeopardy, how would the supply and demand of electricity in this vast region be matched? Who would dispatch the many generators, and with what authority? How would prices be set? The chaos that followed the collapse of the California Power Exchange in 2000 provided one somber scenario, despite the fact that there was a much longer advanced warning for that collapse.

Fortunately, Constellation did not go bankrupt and we’ll never know exactly what the consequences would have been.

Fortunately, too, that didn’t stop the Federal Energy Regulatory Commission (FERC) from taking notice of this close call and identifying necessary changes in the credit system to minimize the chance of a similar event wreaking havoc on the electricity system in the future.

In January 2009, FERC organized a technical conference to analyze the credit issues and identify measures that ought to be considered. This initiated a long period of discussion among the many stakeholders, including electricity suppliers, local public utilities, cooperatives, and financial players. Continue reading

Margins & End-Users #4: The Hidden Cost of Credit in Non-margined Derivatives

When an end-user posts margin on a derivative, the cost of posting the margin is easy to identify. For example, if the margin is funded by drawing down on a line of credit, interest is paid on the credit line. The end-user also earns money on its margin account, so the net cost is the difference between the two cash flow streams. The size of the difference will vary through time and depending upon circumstances. For example, if, as time progresses, the market moves against the end-user, the margin account will be drawn down so that the difference between the two cash flow streams grows.

What about when a dealer bank sells a derivative and forgoes any requirement that the end-user post margin? Some people think the end-user is getting a better deal. If, as time progresses, the market moves against the end-user, it will accrue a liability with the dealer bank. But the end-user doesn’t pay any interest on this liability. So, these people evidently believe, the end-user is getting credit for free.

Actually, the dealer bank is not foolish enough to open a derivative trade with an end-user forgetting about the possibility that the end-user might accrue a liability. The dealer bank does charge for this credit. But the charge is not separately itemized anywhere. Where is it? It’s in the bid-ask spread. When the dealer bank sells the derivative, the terms of the sale bake in a profit. If the derivative is not margined, so that the dealer bank may end up extending credit it will set a wider bid-ask spread and bake in a larger profit.

Just because the price of credit is never separately itemized is no reason to believe the end-user isn’t paying the price.

Can Goldman Sachs’ Financial Engineering Make It A Synthetic End-User?

Oil Daily, a publication of the Energy Intelligence group, had a story yesterday authored by Gregory Gethard about a deal between the refining company Alon USA and Goldman Sachs’ commodities trading arm, J. Aron. The headline reads: “New Goldman Sachs US Refinery Deal Sets Alarm Bells Ringing”.

What is the structure of the deal, and what are the alarm bells about?

First, to the structure… According to the story, the refiner, Alon, agrees to purchase from Goldman 70,000 barrels of crude oil per day for use in its Big Spring Refinery in Texas. Goldman, in turn, purchases from Alon the refined products it produces. Goldman also pays to lease the storage facilities at the refinery. The sales are all made at market prices. The deal runs at least through May 2013, and potentially into 2016. These general terms of the deal were outlined by the refiner in an 8K filing with the SEC. A similar deal had been executed between Alon and Goldman in mid-2010 for product at Alon’s Krotz Spring refinery in Louisiana, as reported in a company 8K filing with the SEC. An article on by Pauline McCallion describes that earlier deal and the motivations for it.

What are the results of the deal? How does it restructure risk?

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Realism’s Beachhead

The Wall Street Journal’s Andrew Peaple uses this morning’s Heard on the Street column to address the demand by some derivative dealers for a broad exemption to the new Dodd-Frank clearing mandate. The issue is how to deal with companies that operate both types of businesses–an end-user business focused on producing physical products, and a financial business including derivatives dealing. The law already exempts the former–under certain circumstances and provisos–but the whole point of the law is to bring the latter under appropriate regulation. What to do about companies that do both?

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The Exxon Puzzle

Exxon doesn’t use derivatives. At least not many of them. This is in strong contrast with a number of other oil majors that make active use of derivatives—for example, BP and Shell.

This fact is a real puzzle for those who argue that companies should use derivatives to hedge the financial risks coming from their physical business. Since we are among the advocates of hedging, we take the puzzle seriously. We’ll come back to that shortly.

This fact also stands as a rebuke to some of the opponents of reforming the OTC derivatives markets who misrepresent the connection between derivatives trading and the physical business of many end-user companies. More on that later, too.

First, the numbers. Although it is well known within the industry that Exxon avoids using derivatives, it’s nevertheless worthwhile to see how this fact is manifested in the reported financial statements. Here’s a condensed version of Exxon’s 2009 balance sheet with the derivative portion highlighted:

The net derivatives position equals approximately 4 one-thousandths of 1% of Exxon’s equity. [One has to be cautious about using a net liability figure, since this can underestimate the significance of the derivatives position. But our understanding of US accounting rules (aided by unnamed sources with actual knowledge of accounting) is that if the gross positions had been material, Exxon would have had to disclose them. That, plus other knowledge of Exxon, leads us to believe this net figure is probably not misleading.]

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ADM: World’s Most Admired Food Production Company… and Banker

The Archer Daniels Midland company issued a press release Thursday announcing that Fortune magazine has ranked it the world’s most admired company in the food production industry.

By the way, alongside all of that food production they do, ADM has a financial subsidiary. Not that they hide it. It’s right there on the web-site under the tab “Financial Subsidiaries”.



Correction: The original version of this post used the phrase “Derivatives Dealer” in the title instead of “Bank” and said that ADM’s financial subsidiary “deals derivatives.” Both ADM’s website and its 10K straightforwardly declare that ADM operates a financial subsidiary, and the services offered clearly touch the derivatives markets. But the term ‘dealer’ is term of art, even if one that has different meanings in different contexts including now a legal context. I have no personal knowledge of ADM’s specific activities beyond the website or 10K, so it was sloppy on my part, and potentially misleading, to attach the specific term ‘derivative dealing’ to the broad category of financial services ADM offers. I owe thanks to the pair of readers who called my attention to this. Since the original purpose of the post was to highlight the fact that a number of end-users operate financial businesses alongside their physical business, and since the specific type of financial activity is irrelevant to that point, I corrected the phrasing of the post.

A Useful Distinction on the End-User Exemption

Gregory Meyer at the Financial Times does some helpful reporting on the different strategies being pursued by commodity companies in the fight over the regulations being written to implement the Dodd-Frank reform of the OTC derivatives markets. Companies including Cargill, Shell, Hess and Land O’Lakes produce, process, and ship physical commodities, and they trade financial derivatives to hedge commercial risk stemming from that business in the physical commodities. These are all activities covered by the end-user exemption written into the legislation. But many of them also operate a swap dealer business, selling financial derivatives to other companies, making financial markets, and betting money on their own proprietary trading portfolio. This is the activity that the legislation did not exempt.

Most of the public debate has been been framed by companies like Shell which have been pushing a false choice on regulators. Because they own some businesses producing physical commodities, they want the regulators to designate them in toto as an end-user, exempting them entirely from the regulations that cover swap dealers. They run a swap dealing business, but they are asking the regulators to ignore it because it is housed inside a company that also produces physical commodities. (See my post on Shell here.)

This is the dangerous loophole I was referring to in the quote in Meyer’s piece. Once written into the regulations, any financial firm could take advantage of it by starting a physical business alongside its financial business.

It’s as if a cell phone company wanted exemption from cell phone regulations because it’s product contains a camera and so is not a cell phone. The regulator should not care about the camera. They should care about the cell phone. If the product makes calls on a cellular system, it’s a cell phone and, in that capacity, it should be subject to the regulations governing cell phones. What else the product does is beside the point.

On the same principle, the same regulations should apply to swap dealer businesses, whether they come as a stand-alone business or wrapped together with a physical commodity business operated under the same corporate parent.

Until recently, Shell and similarly situated companies have refused to acknowledge any of this, and they have had some success in framing the public debate as if a company was either (i) in the physical business — aka an end-user, or (ii) in the financial business — aka a swap dealer. They have refused to acknowledge that a company can be both, and they hoped to shape the regulations to align with this unreal framework.

Along comes Cargill to finally acknowledge the obvious. Cargill is a big end-user. And Cargill runs a swap dealer business. They do both. Cargill’s realism is a breath of fresh air.

Cargill has its own lobbying agenda, which is to avoid a potentially dangerous consequence of Shell’s false dichotomy. After all, if a company can only be one or the other, there is a danger that some end-users with a swap dealer business will be labeled a dealer and not an end-user. Then the regulations will apply not only to the company’s dealing activities, but also to the company’s commerical hedging activities. That’s what Cargill wants to avoid. It wants the regulator to make a distinction between its swap dealer business and the rest of its business. As Gregory Meyer reports, “Cargill said the new capital rules should apply only to its swap dealing division.”

How to write the regulations to respect the distinctions within a company is a difficult task. But we can only get started if we begin with a realistic perspective. In that respect, Cargill has done the public discussion a useful service.

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