Saturday, November 01, 2008

Forwards, futures, onwards...

I am not going to argue Dave Justus’ remark on whether the trading of futures and other commodity wagering “stabilises markets” or not. He can do that if he wishes.

There is one small part where he is right. There is much where I think he is quite wrong.

The derivative trading and arbitrage processes do have “beneficial” effects between markets. If a price difference for a tradable commodity exists between two markets (NY and London for example) then traders will buy in the cheap market to sell on the higher priced market. That small part of the process is as DJ says.

I must point out that in the whole process of derivative trading, arbitrage and cross trading is just a very small part of the whole process.

Other than that, Dave’s extrapolation and Mises in particular are long on propaganda and short on true analysis.

If one takes the trouble to view commodity markets objectively, and forward/futures trading in particular from the wider POV, a different picture emerges. It is, regretfully, not what the like of Dave, or Al, or Mises want you to hear. Well, not quite as baldly as I state it, though it is hinted at.

I will try to work down through the levels of complexity as simply as I can.

The process of wagering, sorry, forward or future derivatives –

1. For a specified standard commodity,
2. for a standard quantity
3. At a specified future date
4. Deliver and settle for an agreed price.

Now as far as I am concerned, and while Mises does cover the point briefly, and Wikipedia and other sources give emphasis to the “discounting” process, those last two words are the most critical of all.

When that future matures, there will be one winner (either buyer or seller) and one loser. Who wins and loses is not critical to the debate. The important fact, inescapable fact, is that the price on that derivative becomes the cost to the buyer.

Six months out from the Hurricane Season, traders are betting the probabilities of a stormy or not season, and the likelihood of supply interruption. When, six months later a Cat 5 hurricane does start advancing toward the Gulf of Mexico all of the traders factor into their wagers the likely (possible) impact that storm might have on oil supplies. A lot of damage is going to mean higher prices until repairs are made, facilities reopened and production is restored. If the damage does not occur, then someone is going to take a bath. The dickering over probabilities and pricing is the fundamental of forwards and futures trading.

Lying under that comparatively simple strata we start getting into the darker realms of hedging, and short selling.

If a trader is prudent, he will self-insure (carry the potential liability for losses) in part, and will seek to pass on the rest of that risk to other (willing) traders. This hedging process is rather like sticking a large sum on the nose of a horse with one bookie, then going around the corner and placing smaller bets against that horse with other bookies. Yeah it costs a bit, but this is the secret of derivative trading. It is the process of sharing risk across the market, while preserving as much as possible of potential profits on one’s own book.

Hedging is not a difficulty at this level, but short selling can be. That takes us to the next level of this Dantean Inferno.

Short selling is not difficult to understand. The trader sells commodity that he has borrowed from another trader. Not difficult; there is documentation, principal in the form of commodity, interest paid on the value of that principle. The security for the “loan” is paper written by the trader.

Now, consider that a “good” trader is not likely to enter a forward or future contract without having first lined up a few other ducks. The cost of the interest on the hedge, the commissions incurred, the risk factors all have been well set out and considered.

Together, the sum of all of those constitutes the Margin that the trader hopes to gain through his top level wager.

But wait, there’s MORE!!!

Let’s peek into the murk on the next level of this Inferno.

Remember that “short selling” is in effect using someone else’s commodity to secure the hedge or the basic forward contract.

But what to do if the product can not be bought at a price giving a suitable margin, or is simply not being sold at the price you are offering?

Look out for the streakers folks, ‘cos here comes the “naked short selling”.

The trader is now selling “non-existent commodity”. Well it does exist, but not on his books. He just has to get it together before settlement date, or he has to sell his forward contract, or he has to suck his very burnt fingers or combinations of all three.

Of course, if the market price does not exceed the future price of his contract he could do quite well out of his bet / wager / contract, thank you!

There is one winner and one loser in this whole process. If the trader is the loser, he can attempt to recover his losses on one contract with winnings on others. If the buyer is the loser, then his recovery comes from passing the higher price on to the people who buy the commodity from him. Eventually, and this is “trickle-down economics” at its best, the poor little guy at the bottom of the heap pays the price – whatever it might be.

That price does include the original production (well-head if it is oil) cost, plus the producer’s margin, plus the margins for all of the speculators and traders between there and the refinery, plus the refinery’s costs and margin, plus the refined product can be traded in the same way as the crude with all the margins added in there ad nauseum.

What do you buy for your gallon of gas?

The retailer’s margin – in NZ it is said to be about 2c/litre.
Government taxes. In NZ said to be about 45% of the total price.
The transport cost from supply storage to retailer.
The cost of storage.
The cost of transport from refinery to storage.
The refiners costs.
Cost of transport from wellhead to refinery
Production costs at wellhead.
Extraction royalties and duties
Research, prospecting, drilling, and extraction costs

Plus, in the midst of all that, is the profit (or losses) taken by the people who trade little pieces of paper with “O I L” written on them. Mind you, you can buy little pieces of paper with “R W C” on them. You will even find futures contracts based on the value of the DOW at the end of a day’s trading, or to buy and sell a currency.

If you own a piece of paper that says “BRENT LIGHT CRUDE, 1 Barrel” then six months or so ago it could have been worth about USD130. That would be about 65 cents per gallon. That “market price” is quoted on the London Exchange (ICE) and represents the forward price for the “current” block of that commodity. As I understand it, there is a standard monthly maturity for settlement and delivery. Now the market is quoting USD60.29 or 30 cents per gallon.

All of the costs I have listed above are predominantly unchanged. So, where does the difference go?

This is the point that I contend. It is the point that the likes of Mises, the “free-marketers” and the rest would prefer not to talk about.

That difference might end up with reduced profits along that chain. But in my opinion, that possibility is minimal because the long-term loss of profitability leads to only one thing – extinction. If you look at the oil industry that is something that is not likely to happen (to the whole industry, not individual players) any time soon.

But by far the greatest part of that fall in cost content is the direct result of the fall in the volume of forward and futures trading. With the withdrawal of credit, the speculators are unable to back their wagers with your money and mine. The true value of short sale commodity scrip is being critically examined. Trades are being done far more directly from well-head to refinery to wholesaler to retailer.

And that, dear reader, is the basis for my contention that the argument put up by Dave the Justus is counter-intuitive, even just plain wrong!

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