Jim Chanos is a China bear. He mentions something in this interview to keep in mind: There are many powerful interests on the inflation balance: Bernanke and his printing press, the dollar carry trade, China’s current account surplus along with its underwater/grasping Nomenklatura and out of control mercantile trading structures.

According to Jim Chanos, Chinese manufacturing business can be added to this group:

Sez Chanos via Mike Shedlock:

“China is building US-priced condos where the average income is $3500 per person.“

Margins on Chinese companies are razor thin. If China hikes rates substantially most companies in China will lose money. Chanos thinks they already are. “Every company we have looked at has accounting issues. The lower you get in the story the more interesting it becomes.”

Chanos notes the China economy is largely a real estate bubble on a Pharonic scale.

“China probably will  build 12  to 15 million residential units this year. Put that in perspective, at the top of the market in the States in ’06 we built  two and a half million units …”

Yowzah!

Industrial output and returns constrain the ability of the Establishment to raise rates to combat inflation. China’s business cannot afford deflation, This is another vote for more BPOC printing and more under- the- table lending along with an even more pronounced PR campaigning pimping China’s inflation fighting.

Meanwhile. looking back over some of the interesting articles about futures trading activity during the Great Oil Price Spike period of 2008. A lot of interesting stuff was going on:

The estimable Yves Smith (Susan Webber) noted distress among grain farmers who could not find storage because the grain storage companies were unable to inexpensively hedge in the futures markets:

Since 1959, grain producers have been able to hedge the price of their wheat, corn and soybean crops on the Chicago Board of Trade through the use of futures contracts, which are agreements to buy or sell a specific amount of a commodity for a fixed price on some future date.

More recently, the exchange has offered another tool: options on those futures contracts, which allow option holders to carry out the futures trade, but do not require that they do so. Trading in options is not as effective a hedge, farmers say, but it does not require them to put up as much cash as is required to trade futures.

These tools have long provided a way to lock in the price of a crop as it is planted, eliminating the risk that prices will drop before it is harvested. With these hedging tools, grain elevators could afford to buy crops from farmers in advance, sometimes a year or more before the harvest.

But that was yesterday. It simply is not working that way today. (2008)

Futures, for example, are less reliable. They work as a hedge only if they fall due at a price that roughly matches prices in the cash market, where the grain is actually sold. Increasingly — for disputed reasons — grain futures are expiring at prices well above the cash-market price.

When that happens, farmers or elevator owners wind up owing more on their futures hedge than the crops are worth in the cash market. Such anomalies create uncertainty about which price accurately reflects supply and demand — a critical issue, since the C.B.O.T. futures price is the benchmark for grain prices around the world.

Two outcomes: one is a transfer of funds from the producer to futures’ traders which explains the divergence @ settlement as well as market volatility. The other is that the market pricing ability vanishes as participants make bilateral trades off the exchanges.

Here’s another futures market tale from Chris Cook by way of the The Oil Drum. Chris ran the International Petroleum Exchange before it morphed into the Intercontinental Exchange (ICE). He knows where the bodies are buried. A lot of information is packed into this article which is worth the read:

The founder entrepreneur behind the Intercontinental Exchange (ICE) is Jeffrey Sprecher – the current CEO – who saw early the potential of screen trading for energy. He acquired the US-based Continental Power Exchange in 1997 as awareness of the Internet began to spread, and everyone grabbed for market platform territory, with Enron Online leading the way.

But my understanding is that the Continental Power Exchange would in all likelihood have gone the way of most Internet start ups had Gary Cohn of Goldman Sachs and John Shapiro of Morgan Stanley not had dinner and agreed to set up an exchange. Their two firms put up the initial capital, and their stroke of genius was to offer to the other founder members – BP, Deutsche Bank, Shell, Soc Gen and Total – an inspired deal. In exchange for providing liquidity these traders would receive equity in the exchange, alongside Sprecher’s Continental Power Exchange, which was the other founder.

At a stroke ICE was created and had transcended the Liquidity/Neutrality paradox of the Internet: if a platform is neutral, then it’s not liquid: and if it’s liquid, it’s not neutral. By 2001 things were really cooking; other trader/shareholders had joined ICE (having had to buy in); but the key was to actually reach the thousands of participants out there who were the actual “end users” of the market.

An approach to acquire NYMEX was rejected, since NYMEX membership was dominated by independent “locals” who were and are in competition with the investment banks as financial intermediaries. However, in July 2001 ICE acquired for a pittance the International Petroleum Exchange – which was set up and owned by brokers – having made the IPE an offer they couldn’t refuse ie “….accept this offer, or we take our business elsewhere”.

Since then, the ICE has extended beyond energy into other markets, but its core business remains energy.

The Brent Complex

The “Brent Complex” is aptly named, being an increasingly baroque collection of contracts relating to North Sea crude oil, originally based upon the Shell “Brent” quality crude oil contract which originated in the 1980s. It now consists of physical and forward BFOE (the Brent, Forties, Oseberg and Ekofisk fields) contracts in North Sea crude oil; and the key ICE Europe BFOE futures contract which is not a deliverable contract and is purely a financial bet based upon the price in the BFOE forward market.

There is also a whole plethora of other “OTC” contracts involving not only BFOE, but also a huge transatlantic “arbitrage” market between the BFOE contract and the US West Texas Intermediate contract originated by NYMEX, but cloned by ICE Europe.

North Sea crude oil production has been in secular decline for many years, and even though the North Sea crude oil benchmark contract was extended from the Brent quality to become BFOE, there are still only about 70 cargoes, each of 600,000 barrels, of North Sea oil which come out of the North Sea each month, worth at current prices about $2.5 billion. It is the price – as reported by Platts – of these cargoes which is the benchmark for global oil prices either directly (about 60%) or indirectly (through BFOE/WTI arbitrage) for most of the rest.

So it will be seen that traders of the scale of the ICE core membership wouldn’t really have to put much money at risk by their standards in order to move or support the global market price via the BFOE market. Indeed the evolution of the Brent market has been a response to declining production and the fact that traders could not resist manipulating the market by buying up contracts and “squeezing” those who had sold oil they did not have. The fewer cargoes produced, the easier the underlying market is to manipulate.

Continues Cook:

The key point to understand is that for a deliverable futures contract like NYMEX’s WTI, the futures price converges on the physical price, and not the other way around. What matters in terms of manipulation is the exercise of control over physical oil in tank or in transit, in order to be in position for delivery in accordance with exchange rules.

For six years I oversaw the trading and delivery cycle of the IPE’s deliverable Gas Oil contract and can categorically say that neither IPE nor the London Clearing House saw any reason to even consider position limits other than in the month of delivery itself. Even were the Clearing members to be negligent or mad, IPE took care to ensure that any of their clients who still had contracts open were in a position to make or take delivery in accordance with the rules. I knew that all of the action in what was occasionally Europe’s biggest game of “chicken” was taking place in the physical market between the consenting adults whom I had on my speed dial.

I have no doubt that the manipulation of global energy prices which is taking place does so not on exchanges, but in trading within the Brent Complex where the key transactions take place on the telephone or – in a modern twist – in the instant messaging chat-rooms to which most of the negotiations have migrated.

Some of the resulting contracts are registered and cleared by ICE Europe and elsewhere, but most remain open bilaterally between seller and buyer. So most of the huge volume of transactions which take place in ICE Europe and NYMEX are in fact “hedges” of the risks taken on by financial intermediaries in these opaque off-exchange transactions. The futures markets are the tail, not the dog: the problem is that the tail can be seen, but the dog is invisible.

Does this sound familiar? Keep this in mind when you consider what is happening on the COMEX, in gold and silver markets. Continues Chris:

A combination of market hype, the opacity of the Brent Complex and the relatively small scale of trading of the benchmark BFOE crude oil contract enabled the long run up in prices, and several observers believe that the dramatic spike to $147.00 per barrel was the specific outcome of the collapse of SemGroup which that company’s management subsequently blamed mainly on Goldman Sachs.

For those interested in the history there is Cook’s TOD article along with FBI Director Louis Freeh’s report on Semgroup’s activities. Trading entity Semgroup was the target of Goldman- Sachs and its trading entity J. Aron during the spike. Semgroup folded in 2008, just before the peak in June of that year. Did Goldman price- fixing contribute to Semgroup’s failure? Did Goldman fix prices so as to topple Semgroup?

Meanwhile: we have another ‘Blast From the Past’ by way of the estimable Steve Waldman who examines ‘renting’ a commodity and ‘convenience yield’. Back in 2008, every finance analyst was interested in commodities and energy, even Paul Krugman! Sez Waldman:

Suppose someone offered to buy your vacuum cleaner today for $100, and sell it back to you next week for $80, with no risk of wear or breakage. Would you? It would depend how much you value the use of your snorter. If you refuse, we might infer that a week’s access to the pleasures of vacuuming is worth 20 bucks to you. We call that value of temporary use a “convenience yield”. It’s as if having the vacuum cleaner around pays you $20, even if no cash changes hands. Maybe we observe negative forward yields on oil because the smell of oil in the morning is priceless to guys in cowboy hats. (Or not… see below for a more plausible account of oil’s “convenience yield”.)

Get the idea? Waldman is confusing so let me clarify: if YOU buy/sell back MY vacuum cleaner I get the $20! If you don’t, I don’t. What Waldman calls convenience yield I call ‘rent’. Yes, you can rent my vacuum cleaner for a month for twenty bucks.

Nobody is going to pay me $20 to hang onto my own vacuum although someone might pay me $20 to allow them the right to access my vacuum during any given month’s period.

Get it? Convenience yield is the option value … of vacuum cleaners!

Basically, CY is the call option price of any given month’s crude futures contract. It’s a call option as the bias is on the ‘buy’ side, that is, a discounting of future prices rather than a premium. The CY is ‘factored in’ alongside the markets’ contango or backwardation.

What Waldman poses is a preference for the ‘now’ that amounts to persistent discount of future crude relative to crude in hand. In other words, ‘convenience yield’ is not just rent or access but also a form of cash preference as expressed as an options price. You want your good now and will pay — in the form of discounted futures prices — for the privilege of getting your good now. What is the yield on such an ambiguous good?

From Jan 1986 through May 2008, oil futures have reflected a convenience yield of 8% per year on average. (This is in rough agreement with the overall mean of 0.021% per day calculated here by Milonas and Henker, see Table 3.)

Suppose that the current convenience yield is about 8% and three month interest rates are about 2%. (Today, they are about 0.5%: steve from virginia.) Then a one-year futures contract should be about 6% cheaper than spot, and a four-month-out contract should be about 1.4% cheaper than a one-month-out contract (reflecting 3 months of storage). At the end of May, the 4-month-out contract was in “backwardation”, but was only 0.5% cheaper than the 1-month, still too expensive given the convenience yield. Oil dudes could have earned (on an annualized basis) about 3.6% more than the risk free rate (about 5.6% overall) buying high and selling low, but enjoying the privilege of storage. Now that oil is in gentle contango (as of June 17, the 4 month contract costs about 1% more than the 1 month), buying forward and storing looks like a really fantastic deal.

What is this “convenience yield”? Is it real? It seems like it must be, the economics of an 8% return aren’t subtle in the data. But when I first encountered this idea, it baffled me. So instead of talking oil, let’s talk hotels.

Suppose you have a hotel, it’s morning, and you’ve got a room that isn’t yet booked for tonight. Empty rooms end up costing you about $10 a night, considering your rent, maintenance, utilities, etc. But, you estimate there’s about a 50% chance that a weary last-minute traveler will come by and pay your walk-in rate of $150 for the room. So, the risk-neutral expected value of your empty room is $65 [(150 ÷ 2) – 10]. You’re risk-averse, not risk neutral, though. You’d accept a certain $60 rather than a 50-50 chance of losing $10 or earning $140. That $60 is the “convenience yield” on your empty room, it’s what having a room empty, in case opportunity strikes, is worth to you.

Okay, questions? Yes, Waldman has a ‘thing’ about cowboy hats. Yes, read the entire article, Waldman always has something interesting to say and is witty, as well!

Why ‘rent’ oil? The obvious answer is to sell short. However, selling a futures contract IS selling short. This would not represent an 8% bias as there are an equal number of longs! Does oil ‘rent’ or option value represent an excess of short- selling ‘demand’? Hmmm … Chris Cook, again:

It appears to me that what has been occurring in the oil market may have been that – through the intermediation of the likes of J Aron in the Brent complex – long term funds have been lending money to producers – effectively interest-free – and in return the producers have been lending oil to the funds. This works well for as long as funds flow into the market, or do not withdraw in quantity, but once funds withdraw money from the market, there is a sudden collapse in price.

A combination of market hype, the opacity of the Brent Complex and the relatively small scale of trading of the benchmark BFOE crude oil contract enabled the long run up in prices, and several observers believe that the dramatic spike to $147.00 per barrel was the specific outcome of the collapse of SemGroup which that company’s management subsequently blamed mainly on Goldman Sachs.

What Chris means is the producers have been renting their vacuum cleaners to the funds to allow the funds to create synthetic or ‘phantom’ positions that allow control of the underlying price. We see the same activity taking place in precious metals as well as in the long Treasury bond that we discussed last week.

What the 8% convenience yield partially represents is a ‘volatility premium’ that intermediaries pay to keep control of volatility. Since futures cannot determine final price, what traders on that market CAN control is volatility prior to the final price being set. Volatility is useful!

🙂

High volatility is harsh and profitable to grain traders who can use it to bankrupt grain elevators and farmers and push trades off the exchanges. Low and comforting to oil producers who love the high prices but don’t want to rock the boat for political reasons – or generate a devastating spike.

As if the super- high prices aren’t devastating enough …

NEXT: the story that gold is telling.