The Senate Banking Committee is tackling a provocative and timely topic on Tuesday. The issues up for debate: whether banks should be allowed to control power plants, oil refineries and commodities warehouses – as opposed to simply making a market in the end products via trading.
It’s a timely subject because the Federal Reserve announced Friday it would be reviewing a 2003 decision that allowed banks to own such assets – and because of a newly published New York Times investigation that suggests that we’re all paying a premium for the aluminum in our cans of soda and our cars because Goldman Sachs took advantage of new rules that enabled it to own commodity warehouses and acquired a commanding position in that business in North America.
The fireworks started even before the hearing did. Three of the scheduled speakers filed written statements that argued, in some cases in almost hyperbolic terms, that banks should be banned from that business as a danger to the system. In the words of the testimony submitted by Joshua Rosner of research firm Graham, Fisher & Co., “electricity users appear to pay more because of Wall Street involvement, aluminum for airplanes and soda cans costs more, and some say gasoline at the pump costs more – without any measurable benefit to anyone but the banks.”
Wow. Those are strong words, but in response, they invite one of those pesky and inconvenient facts: Correlation is not causation. Just because hemlines have risen during bull markets doesn’t mean that you should run out and buy the S&P 500 after noticing that designers have opted to bring back the mini skirt. What sets commodity prices is what dictates every other kind of market price, too: the relationship between supply and the demand. So what Rosner is arguing is that the banks, through their ownership of some of the assets associated with commodity supplies, have consciously manipulated those supplies to create an artificial market price, from which they benefit at the expense of the rest of the market.
That’s not out of the question. It’s entirely possible that bankers can run amok in the commodities markets just as they have done in creating securities stuffed with subprime mortgages, or underwriting IPOs for tech companies with no profits and almost no revenues, or in flooding the market with inappropriately priced junk bonds. Perhaps the battle being waged between the Federal Energy Regulatory Commission (FERC) and the bankers at JPMorgan Chase over the bank’s alleged misdeeds as it tried to generate a profit from some power plants in its portfolio is an example of that.
But, as Randall Guyin, head of the financial institutions group at law firm Davis Polk & Wardwell wrote in his own testimony, banning an entire range of activities because of the misdeeds of a handful of participants – misdeeds, moreover, which appear to have been caught by the appropriate regulators – isn’t a reason to throw out the benefits that banks can bring to the commodities markets. At the time the rules were changed, the move made sound economic sense for plenty of reasons. (Those reasons related to the arbitrage opportunities created by a pricing pattern called contango: a pattern in which the future price of a commodity is higher than its spot price. The reverse of this is known, suitably enough, as backwardation.)
Certainly, history has demonstrated that rogue traders in the commodities markets haven’t belonged to banks. When the Hunt brothers tried to corner the market in silver in the 1970s, driving its price up from $11 to about $50, they weren’t bankers or owners of a bank. When Yasuo Hamanaka tried to pull off the same coup in the copper market in the mid-1990s, causing his own metal trading firm to lose more than $2.5 billion and triggering a plunge in the metal’s price that affected the industry for years, he wasn’t working for a bank and only a fraction of his trades were routed through banks, with many more going through specialized metals trading firms.
If you want the real skinny on what’s up now with Goldman Sachs, metals trading and warehouses, I’d urge you to take a deep breath and dive into the work of Izabella Kaminska at FT Alphaville, whose detailed and authoritative accounts of just what is going on and why banks like Goldman are interested in owning metals warehouses and have a vested interest in keeping aluminum in them are perhaps less simple to follow than the Times analysis, but impressive and far more thorough.
The bottom line is that you may want to question some of the London Metal Exchange rules that call for a certain amount of a commodity stockpile to be moved in and out of a warehouse, even when the customers who have deposited the metal don’t have buyers for it at a price they are willing to accept. You may also want to question the degree to which speculation has crept into commodities markets, making them more volatile and at times, according to some traders, less reflective of what is going on in the “physical market.” But the bottom line is that there is little evidence at this time that a buildup of inventories in these warehouses is a sign of Wall Street trying to control or corner the aluminum market, even if banks do try to use the information they have about inventory levels – and their ability to reflect how those inventories are seen by the market – to establish trading positions.
1. Warehouse stocks account for only 5 percent to 10 percent of all aluminum that is traded (hardly enough to set a price), but it is owned by the consumers: merchants, industrial companies or others. It’s not owned by Goldman Sachs or its divisions.
Goldman may want customers to deposit metal in these warehouses, whether to earn fees on it (the simplistic view) or to use it as collateral for securitized products. It may offer incentives to keep the metal in the warehouse, resulting in the bizarre shuffle of aluminum bars from one location to another, as described so vividly by the Times.
But while the bank owns the warehouses, it would be foolishly uneconomic for it to consistently bid up the price of aluminum in order to persuade customers to keep it there. Goldman doesn’t get to decide when to release it on to the market, or under what terms.
If there were demand for the aluminum in the broader market, you can bet it would be leaving and if it didn’t do so promptly, the LME would view this as affecting the integrity of its own market and take appropriate action. But that demand simply isn’t there. Bringing us to…
2. The price of aluminum isn’t high; it’s heading back toward cyclical lows. The spot market price was around $1.35 a pound five years ago; today it bounces around 80 cents a pound. Yes, it doubled from its post-crash lows of just under 60 cents a pound to more than $1.20 in the spring of 2011, but it has been declining since then.
When you see that pattern, think “China,” not “Goldman Sachs”; the sharp slump corresponds quite neatly with the deceleration in the growth of the Chinese economy and thus with the country’s need for raw materials. A similar pattern has been seen in steel, concrete and other materials. Throughout that period of slow and recovering prices, warehouse inventories climbed, logically enough: producers wanted to wait until it was clear that the new demand levels were lower to scale back production, meaning there was more unsold inventory to stuff away in those LME warehouses.
3. The warehouses themselves don’t set prices, or they do only in environments where prices are rising rapidly and the owners of the inventory hold on in search of higher and higher payments. As the LME itself says, very few contracts that it trades result in physical delivery from a warehouse – it’s a “market of last resort.”
The vast majority of metals trading takes place on a dealer/producer (e.g., Alcoa) and dealer/consumer (e.g., Coca-Cola) basis, and even then, a lot of it involves hedging by the buyers, who want predictability in their budgeting and are willing to pay for it in the shape of prices slightly above the spot market. Odds are that many companies that buy aluminum are paying a premium to the spot price for that reason, not because of any alleged warehouse shenanigans.
There are times to be worried about what is going on in the commodity markets: when prices surge inexplicably, or a new counterparty with mysteriously deep pockets emerges, or a quirky price pattern takes hold, such as the backwardation that accompanied rising prices during Yasuo Hamanaka’s prolonged attempt to corner the copper market.
None of those seem visible right now. Looking at the markets today, we see a slump in the spot price of aluminum – logical in the context of IMF and World Bank outlooks for global growth – and a corresponding rise in warehouse stocks of the metal, as well as the beginnings of restructuring initiatives on the part of manufacturers like Alcoa. (That’s why the company had such a big second-quarter loss.) There may be room for criticism about LME warehouse rules that permit banks to treat stocks in the ways described by Kaminska, but whether this rises to market manipulation is highly questionable.
Banks have been trading commodities for as long as financial institutions have existed, with the Medicis getting involved in all kinds of raw materials, from gold to alum. Banning them from these related businesses is far from guaranteed to prevent abuses (after all, the biggest manipulator of the electricity markets hasn’t been JPMorgan Chase but Enron) and would remove liquidity from the markets.
If Goldman Sachs didn’t have exposure to aluminum in the form of the warehouses, perhaps it would be less willing to structure commodity-linked loans for clients, or offer its investors securities whose value is tied to commodities. I’d like to think that Senate policymakers will bear in mind the unintended consequences of their policy decisions, just as I hope that Wall Street bears in mind the unintended consequences of its own business decisions.