The role of dark inventory in the commodities bull run of 2008 | FT Alphaville

The role of dark inventory in the commodities bull run of 2008

We’ve argued before that the 2005-2007 commodity bull-run could have been the product of an unwitting self-manufactured squeeze, as the industry rushed to monetise as much inventory as possible to benefit from higher than usual interest rates and as inventory levels dropped. (All pretty much unwittingly, of course.)

As prices increased, the economy choked.

But here’s an interesting addition to that view by way of Ing-Haw Cheng and Wei Xiong in a paper on the financialization of commodity markets. As the researchers note it’s entirely conceivable that as the economy began to choke from 2007 onwards (and in some cases even earlier), what appeared to the world to be tight inventory levels justifying higher prices, were in fact sufficient stores given the demands of the system at the time.

The final price hike therefore may have had little to do with insufficient supply, and more to do with the speculative inflows from other classes seeking diversification and principal protection in the wake of the housing asset collapse.

From the authors:

While no one doubts the importance of the theory of storage, the dramatic increase in oil prices during the first half of 2008 presents a challenge for studies which attribute it to a rise in fundamental demand. Although strong oil demand from emerging markets such as China drove prices to high levels before 2008, oil prices further increased by 40% in the first half of 2008 before peaking at $147 per barrel in July 2008. During this period, oil inventory did not spike, leading many to conclude that the price increase during this period was driven by strengthening demand as it was before 2008.

However, major world economies such as the U.S. were falling into recession in late 2007, with the U.S. beginning its recession in December 2007 (as marked by the NBER). The S&P 500, FTSE 100, DAX, and Nikkei equity indices had peaked by October 2007; with the collapse of Bear Stearns in March 2008, the world financial system was facing imminent trouble. Growth in China was also slowing: year-on-year growth in China’s GDP peaked in mid-2007, and the Shanghai CSI 300, MSCI China, and broader MSCI Emerging Markets equity indices peaked in October 2007.

With the benefit of hindsight, it is difficult to argue that the growth of the emerging economies, themselves slowing, was strong enough to more than offset the weakness in the developed economies to push up oil prices by over 40% in half a year. The puzzle is then how perceptions of demand could have strengthened in early 2008. Explicitly accounting for the informational role of commodity prices helps solve this puzzle. In early 2008, agents in the economy could have reasonably interpreted the large increases in futures prices of oil and other commodities as positive signals of robust commodity demand from China and other emerging economies. In fact, the large commodity price increases even motivated the European Central Bank to increase its key interest rate in March 2008. The large increases of commodity prices in early 2008, a portion of which may be attributable to investment inflows into commodity markets coming from the declining real estate market (Caballero, Farhi, and Gourinchas, 2008), may have temporarily distorted people’s expectations of global economic strength and thus commodity demand by distorting price signals.

The point basically is that commodity traders missed the influence of speculative inflows into their asset class because relatively stable inventory levels obscured the supply picture, disguising the demand destruction which was taking place.

In our opinion, this may have happened because the market didn’t understand that when demand destruction is accompanied by a falling interest-rate environment — as well as a speculative crash in an alternative asset class — capital flows can incentivise overproduction to satisfy collateral needs. In other words, the market effectively ends up pre-paying for volumes that are surplus to actual demand. Excess unencumbered inventory fails to show up in the system immediately, meanwhile, because of the way it has been commissioned: by means of the futures market.

Since the market is rewarded for overproducing by the speculatively influenced futures market, it willingly absorbs the excess supply (without any spot price impact) for as long as it is expected to carry that excess volume over to the futures delivery date.

Only when the futures that hedged the production oversupply expire does the market feel the full penetration of those excess volumes. When that happens, prices correct sharply and cartels are forced to take offsetting action.

So while speculative inflows don’t necessarily stop supply and demand balancing in the end, they can delay or obscure the price balancing process in such a way that distorts the market for longer and makes it more volatile.

A similar argument can be made today about prime housing stock. Are prices really rising because of a lack of supply? Or are they rising in response to financial collateral needs, which are disguising the real-world demand destruction that is taking place at those price levels.

If there are lessons to be learned from 2008, it’s that if and when the encumbered stock is unencumbered and/or if additional supply (created to cater to what was construed to be real world demand but is really financial demand) hits the market in a way that shows up a slew of empty property inventory, prices could collapse much in the same way.

For now, just like in 2008 with commodities, we are still being mislead by the idea that emerging market (and especially Chinese) demand will keep prices supported no matter what. We are also failing to grasp the difference between real end-user demand and financial collateral demand, and why it is so important in determining fair value.

Related links:
Dark inventory, death of a city edition – FT Alphaville
The rise of the real collateral ‘mining’ business – FT Alphaville