(Originally published here.)
Over the weekend, the New York Times ran a long investigative story explaining something that market insiders have known for years: Keeping industrial metals in warehouses can be profitable. It can be even more profitable if — like Goldman Sachs, J.P. Morgan Chase and Morgan Stanley — you own the warehouses and can sell the metals in the futures markets.
As Bloomberg News explained, this has led to complaints from commercial users of metal, including manufacturers of canned beer and soft drinks. They claim that the banks have been unfairly squeezing metals supplies, driving up consumer prices.
These complaints aren’t necessarily wrong — but they miss the broader point. Hoarding large stockpiles of physical commodities and selling them in the future usually isn’t attractive, because it’s usually easy to get a better return by putting cash in the short-term money markets — especially after accounting for storage costs. The banks wouldn’t have found this strategy attractive if it hadn’t been for the broader environment created by institutional investors (pension funds, sovereign wealth funds, endowments and the like) and monetary policymakers.
Izabella Kaminska of the Financial Times has been writing about this for a long time. Over the past few days she did us all the favor of writing three detailed explanations of what happened and why it was profitable. She also pointed out, two weeks ago, that this problem may soon disappear all on its own, given Goldman’s and JPM’s plans to sell their metal warehousing subsidiaries.
For most of history, commodity futures traders could be divided into three groups. The producers — farmers, oil majors, miners — are always selling futures. Commercial commodity consumers — airlines hedging fuel costs, manufacturers buying steel and aluminum, food companies buying wheat and pork bellies — are always buying. Both the consumers and the producers can adjust how much they choose to buy and sell in advance, according to their own estimates of future supply and demand. At the same time, the prices they observe in the market tell producers how much to manufacture, and consumers whether it is worth investing in ways to reduce their need for raw materials. Then there are traders and speculators, who make it easier for the consumers and producers to reach the best prices.
The relatively recent concentration of savings in large institutions, which were increasingly afraid of inflation and looking to diversify their portfolios, upset this balance. While some of the big savers decided to buy actual timber forests, gas fields and copper mines, many preferred to just buy futures contracts for commodities without ever actually taking physical delivery. That helped push futures prices systematically higher than “spot” prices. At the same time, interest rates fell close to zero across the rich world once the crisis of 2007-08 hit. The returns from owning cash were suddenly so low that “commodity financing” became relatively compelling.
That’s why the banks bought the warehouses and why they were able to make money through a somewhat complicated set of trades that may look to outsiders like a scam. It’s hard to blame them for exploiting the opportunities created by an unusual set of circumstances that, fortunately, are already ending.
(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)