Commodities and Their Derivatives

You'll remember that my March 12 blog entry consisted of a discussion of what is to become the fourth chapter of my proposed book as represented in the table of contents I provided in this blog on December 10, 2010. Now I move to the fifth chapter, about commodities and their derivatives.

This will make five points.

1. definition of terms

A commodity in the sense significant for this book is a physical (and usually a fungible) item of commerce. It is distinct from intangible goods such as patent rights, or a share of equity in a company. It is also usually distinct from any complicated manufactured item, such as a custom-built hot rod. Foods, metals, and natural fibers are all commodities.


2. Brief history of the derivatives exchanges

Commodity futures are the paradigmatic "derivatives." Birth of the Chicago Board of Trade. The CME and a cross-time rivalry. Imitators and developments.

3. Federal regulation up to 1974

Federal regulation of futures contracts began with the Futures Trading Act of 1921. Declared unconstitutional by SCOTUS later that year. How this decision was circumvented and the regulatory system established. Why it took another 50 years for the system to crystallize into the CFTC.

4. the OTC derivatives market and its challenge to the exchanges

One distinction between OTC and exchange trading involves the margin requirements of the latter: performance bonds that market participants must post, in amounts that vary in a way based on the risk and volatility of the product. In the OTC market there have long been no rules, so the parties negotiate their own collateral arrangements. Dodd-Frank. What happens next?

5. It is time now to deal with the spectre of speculation.

Speculation is not gambling. Why not? Because gambling creates its own risk for the sake of the game. A gambler puts money on how a pair of dice will land. Nobody would even bother rolling those dice unless somebody was putting money on them.

What about sports gambling? The game exists independent of the risk. We might suppose that basketball games will continue to take place even in a (hypothetical) world in which gambling on basketball comes to a quick and complete end. But the game itself is not a risk for the folks in Vegas putting their money on the line. It becomes a risk when they decide to accept that risk, both for the chance of profit and for the thrill.

How is that different from financial and commodity speculation? Consider orange juice futures, the subject of a memorable Eddie Murphy and Dan Ackroyd collaboration. These risks are not optional. Anyone investing in an orange grove, in the expectation of selling the fruit of his labors to the OJ market is taking enormous risks. The “dice” are meteorology on the one hand and fickle breakfasting-consumer preferences on the other. The producers can only hedge these risks to the extent that speculators are willing to take it from them.

6. Our first look at the CBOT/CME merger of 2007. We'll come back to this.

Contango: 2011 Edition

Regular readers may remember that every year at this time I do some basic arithmetic regarding contango.

As a refresher, contango is the discount you can get on a non-perishable commodity by virtue of your willingness to accept delivery at once, or (stated inversely) the extra payment you make if you want the seller to hold it for you for some interim.

One would naturally expect this discount to be closely related to the costs of storage space. After all, if I buy crude today and tell you to deliver it six months from now, you have to keep it somewhere during the interval, and pay the maintenance on the storage facilities. If I take delivery now but I don't use it over the six months, then the cost of storage falls on me.

So: a year ago I simply measured the per-barrel price for March delivery (which was $74.14) against that for August delivery ($77.08) and extrapolated that into an annual rate. The five month delay in delivery cost the buyer $2.94 at that time, which extrapolated into an annual figure would have been $7.06 or about 9.5% of the price of the barrel.

Checking the figures a year later ... the price of a barrel was $89.58 for March 2011 delivery last time I checked. Never mind the question of why that has gone up. I'm focusing on just one piece of the puzzle now. The price for August delivery was $94.49. That's a difference of $4.91 for storage. This annualizes to $11.82, which is roughly 12.5% the price of a barrel.

Why is contango on the increase? I might like to suggest that this confirms that the market is signalling a recovery soon. People are willing to pay to store the crude NOT because the costs of carry have gone up dramatically but because speculators would rather have crude oil several months from now than now. And they'd rather have in six months from now because they are getting signals that people are going to be driving more, the wheels of industry are going to be turning ... good times will be back. At least to some degree.

But then ... I'm still uncomfortable. After all, forgetting speculation, the simple cost-of-carry sort of contango might have increased to 38% annually. Why not? Maybe all the easy storage spaces are all used up, and it takes extra expense to bring new storage space on line (marginalism, anyone?) and THAT is leading to a sizeable discount for anyone who will take the stuff out of the marketers' hands quickly.

All this is making my head hurt. Enough!