Commodities take another beating: What is driving the volatility and what does it mean for the stock market?
MAY 12, 2011
Commodities fall as China hikes reserve requirements, futures margins are raised, fear over end of QE2 grows
Commodities such as gold, silver, oil, natural gas, copper, etc. were once again in retreat mode yesterday. Even today, commodities took a beating this morning before ralying later in the afternoon. I wrote about what may have sparked the initial sell off last week, but I think it's worth re-examining this as it has significant implications for the direction of Canada's commdity-heavy stock market.
I have long been warning about the risks in the commodity markets as China (the largest purchaser of commodities) has sought to rein in its problems with rising inflation, and as speculation in commodity futures has grown as the fear of future inflation has mounted. There's little doubt in my mind that the long-term prospects for commodities are excellent, but that doesn't mean that there isn't necessarily some major froth in the market at the present time. Interestingly, China has once again raised reserve requirements at their banks in order to reduce the amount of credit being generated and tame rising inflation. This is a tightrope act for sure: If credit expansion and inflation can't be contained, civil unrest will likely follow....but tightening too quickly leaves the economy at risk of a hard landing which, as explained in a recent TD report, would be detrimental to the global economy and Canada's in particular.
I believe that the recent pressures exerted on the commodity markets are the result of two major factors: margin hikes at the futures exchanges and a spreading concern about what the end of QE2 means for risk assets, which we know have been highly correlated to the expansion in the balance sheet of the US Federal Reserve. The Fed balance sheet has expanded as it has purchased US bonds in order to keep interest rates low and provide an additional measure of liquidity to capital markets.
The margin hikes have been what have had the greatest impact in pushing the price of commodities down. And that in itself is a great indication of the level of speculation that exists in commodities markets today. I've often discussed how the Commitment of Traders (COT) reports issued weekly by the Commodities and Futures Trading Commission (CFTC) gives insights into the speculative positions that exist in various commodities. It's perhaps worth explaining this concept a bit more. So what is a futures contract and why have margin requirement changes led to a sell off in commodities?
What is a futures contract?
A futures contract is nothing more than an agreement between two people to trade a particular asset at a specified price at a later date. Most futures contracts are for commodities such as oil, gas, sugar, corn, gold, etc, though active markets exist that trade in all sorts of other futures such as stock market futures, interest rates, currency exchange rates, etc. In the case of commodity futures, essentially one person agrees to buy a given amount of that particular commodity at a later date for a specified price, while the other party agrees to sell it to them on that later date and for the specified price. The person who has sold the contract and has an obligation to sell the product at a later date is said to be in a "short" position, while the person agreeing to buy the product is said to be in a "long" position. Note that for every short position there is an equal and offsetting long position.
Futures contracts are often used by companies to ensure a profit at a later date. For example, a mining company that has stable production may want to offer to sell their product someone at a later date at a certain price. This ensures the company a profit even if the price of the product drops between now and when they actually mine it. That's just one simple example. The point is that futures markets serve an extremely important function for many businesses. But they can also attract speculators.
People who may want to profit from rising commodity prices can also participate in the futures markets. Since futures contracts are primarily used as a means of hedging (or guaranteeing a profit/preventing loss) most futures contracts settle in cash. Even though the actual futures contract is for one party to buy the commodity at a later date and for the other to sell it to them, that typically doesn't happen. Instead, the cash typically trades hands. It works like this:
Imagine a silver miner enters into a futures contract with another company that uses silver in an industrial process. Both companies are trying to protect against fluctuations in silver prices in order to ensure profit: The silver miner does not want the price to fall, while the other company does not want it to rise. Since both companies are profitable with silver at current prices, they both want to ensure that they can buy/sell the silver at a future date at the current price.
They enter into a futures contract for 1 million ounces of silver at a price of $35/ounce to be delivered in six month's time. This contract is legally binding. In six month's time, no matter what the price of silver is, the miner is obligated to deliver one million ounces of silver to the other company at the negotiated price, while the other company is obligated to buy it.
In practice, the silver is often not actually delivered. Often the two sides to the contract are separated by great distances, so it makes sense to buy/sell from someone nearby. So at the end of the six months, one company pays the other the difference between what the current price of silver is and the price stipulated in the futures contract. For example, the contract was for 1 million ounces at $35/ounce. So one company is obligated to pay the other $35 million for 1 million ounces of silver. If at the end of the six months, the price of silver has risen to $40 an ounce, rather than deliver all the silver, the companies can settle for the difference. In this case, since the price has risen, the mining company will pay the other company $5 million (the difference between the $35/once agreement price and the $40/ounce current price times the 1 million ounces).
Note what just happened: The silver miner wanted to be able to sell their product for a guaranteed price of $35/ounce and the other company wanted to be able to buy it for that price. However, had they not entered into the contract, the silver miner would have been able to sell their one million ounces of silver for $40/ounce, netting them $40 million, but the other company would be out an extra $5 million if they had to buy that silver in the open market. So, in a sense, the silver miner is up $5 million and the other company is down $5 million. But since they both wanted to guarantee the price at a later date, the silver miner pays their 'extra' $5 million to the other company to even things out.
Conversely, had the price fallen to $30/ounce, the other company would have paid the mining company the $5 million. Hence, no matter what the price of silver is at the end of the contract period, the mining company is guaranteed a $35 million profit (no more and no less), and the other company is guaranteed a $35 million expense (no more and no less).
Futures contracts can be entered into on margin, meaning using borrowed money. This is a big part of the appeal for speculators. However, there has to be guarantee that either side of the transaction has the money to cover their cash obligation at the expiry of the contract. In the example above, someone must ensure that the $5 million is transferred between the parties. (The example above is actually not a good example of this concept since futures exchanges often waive the margin requirement for commodity producers since they have the actual commodity in hand....but hopefully you get the general idea).
The amount of customer leverage allowed by the exchanges depends on the volatility of the commodity in question. During periods of heightened volatility (frequent, extreme moves upwards or downwards), a great deal of money is gained/lost on each contract every day. During these periods of unusually high volatility, the exchanges will often raise their margin requirements to protect all parties and ensure that the contracts can be settled in cash.
When the markets raise their margin requirements, participants on both sides (longs and shorts) have to make sure that they have adequate margin levels. This can be done by depositing additional cash or by closing out the position.
Closing out a position:
Since the contract between the two parties can't be broken, if one party is forced to close their position, they must actually enter into a second contract to offset the first. Here's a simple example:
Party A enters into a futures contract with Party B. The contract is for the delivery of 1000 barrels of oil in six month's time where Party A is required to deliver the oil and Party B is required to purchase it for $100/barrel. Party B will profit if the price of oil rises since their cost is fixed at $100/barrel. Party B is trading on margin. If the price of oil falls rather than rises, Party B will be forced to pay Party A the difference at the end of the contract. As it falls, Party B's margin level shrinks and they must put more money into their account.
Similarly, if the exchanges raise the margin requirements, both Party A and Party B will have to ensure that their accounts have adequate margin. Imagine now that the exchanges raise their margin requirements as they have frequently over the past few weeks. Imagine also that Party B, a speculator, cannot meet the margin call. That is, they don't have the money or are unwilling to put more money at risk. They now have to close out their position. To do so, they have to enter into a second, offsetting contract. Since the original contract is for them to purchase 1000 barrels of oil, they have to enter into a contract where they now are the seller of 1000 barrels of oil to a third party, Party C. Both contracts have to have the same expiry date.
Since Party B now has obligations to buy 1000 barrels of oil from Party A and to sell 1000 barrels of oil to Party C, their position is now closed. Essentially it is now Party A selling 1000 barrels of oil to Party C at the expiration of the contract. However, since the price of oil has fallen, Party C was only willing to buy the oil at $90/barrel. Even with their position closed, Party B is out $10,000 (a loss of $10 per barrel x 1000 barrels) since Party A was promised $100/barrel and Party C has only agreed to pay $90/barrel. Party B must pay the difference.
What happens now when many speculators employing leverage are on one side of a trade? As we have seen recently with silver, the results can be dramatic. Since the margin requirements apply equally to both the long positions and the short positions, there should be no huge movement in prices provided the use of margin is equal (i.e. there is a comparable amount of leveraged speculators betting that the commodity will rise and that it will fall). But if too many speculators believe the same thing and have employed margin to gain exposure, there can be drastic moves in the pricing of the commodity as people seek to close their position.
In the case of silver, it is now obvious that a huge amount of leverage had been employed by speculators looking to profit from the rise in silver prices. They were "long" silver. They stood to gain when prices rose since they had entered into contracts to purchase it at a set price. When margins were raised, it forced many of them to close their positions by taking the opposite position (i.e. to agree to sell silver). That means they needed to find a buyer. But with so many of them forced to find a buyer, and with so few buyers, the price that the buyers were willing to pay plunged. As the price of silver plunged, it forced more margin calls, which were forced to close their position, etc.
The primary lesson here, once again, is that when many people are convinced that something is a sure thing, it inevitably proves to be otherwise. This is the lesson from the third primer on mass psychology. For the record, I still believe that silver represents a good long-term investment, but the level of speculation was clearly getting ridiculous. Parabolic moves in asset prices, be they the price of silver or the price of a detached home in Vancouver, never end well.
The other important lesson, which I have discussed before, is that when large speculative positions exist in a commodity, the result is increased volatility and a good chance that the commodity will move in the opposite direction. In other words, if people overwhelmingly believe it will fall, it is more likely to experience a violent rise at some point. The same is true in any asset market. When the majority of participants believe that an asset will rise/fall in value and have positioned themselves to profit from this, there are few remaining on the opposite side of the trade. This is not a good sign, and it is true in stocks and commodities as well as real estate, currencies, and bonds.
In commodity markets, we can get an idea of the level of speculation by reading the Commitment of Traders Reports by the CFTC, but we can only find out which side was betting on leverage in the aftermath of a substantial margin increase.
I think this the primary reason why commodities fell earlier this week and last. Of note, if margins are raised in one commodity, it can still result in price pressure on other commodities if leveraged speculators who have positions in more than one commodity choose to close out another position and keep the position open in the commodity that just experienced the margin hike by transferring money between accounts. So while silver was under the gun last week, the margin calls in silver may have forced some traders to close positions in other commodities to keep their silver positions open....meaning the pressure was felt other commodities.
With regards to the commodity-heavy TSX, I think there will be unusually high volatility until people have a better feel for how the end of QE2 will affect risk assets and interest rates. The net speculative long positions in most commodities are at very high levels. I do wonder how many of these positions will consider bailing as the end of QE2 draws near.
Finally, if you want an interesting read on the how the end of QE2 and other factors might affect the stock market in the US, check out Jeremy Grantham's latest quarterly letter. For those not familiar with the name, Grantham is a highly respected fund manager and strategist. Though his calls have often been too early (a topic he openly discusses in the letter), he is nevertheless one of only a handful of analysts and managers who avoided the Japanese equities meltdown in the late 80s, the worst of the tech meltdown in the late 90s and into 2000, as well as the housing fiasco in the US. The man's position is worth reading.