The Wall Street Exodus From Natural Resources

by: Matt Geiger

Summary

Wall Street is Leaving the Commodity Space.

Silver Price Fix Ends in August.

Wall Street is a Barometer for Contrarians.

Over the past twelve months, an unmistakable trend has taken shape - large banking interests are distancing themselves from the commodity/resource markets. This has only accelerated in the first half of 2014 - where we have seen Morgan Stanley, Barclays, JP Morgan, and Goldman Sachs sell their physical trading groups. Additionally, we will witness the dissolution of the century-old Silver Fixing Index in August 2014, with the Gold Index likely to follow. I will first describe this phenomenon and the likely catalysts for this "Wall Street Exodus". I will then speculate on the longer-term impacts of reduced Wall Street influence on commodity prices and the resource markets in general.

Timeline:

2010-2011: 43 Complaints Filed Against JP Morgan For Silver Manipulation

March 2013: Case Against JP Morgan Is Dropped

December 2013: Deutsche Bank Exits Commodity Trading

December 2013: Volcker Rule Is Passed

April 2014: Volcker Rule Goes Into Effect

April 2014: Barclays Withdraws From "Most Global Commodity Activities"

May 2014: Goldman Sachs Puts Metals Warehouse Up For Sale

May 2014: Barclays Fined By British Regulators For Gold Manipulation

August 2014: Dissolution Of The Silver Price Fix

The imminent folding of the The Silver Price Fix is particularly interesting news. This arrangement has been setting the price of silver for over 117 years. Before the news, HSBC, Deutsche Bank, and Bank of Nova Scotia served as the three market makers for the international price of silver. Every day at noon GMT the members would meet and decide the silver price for the day. It is fascinating that in this world of electronic trading, old-fashioned market making still serves important functions in the financial world. However, in the case of the Silver Fix, Deutsche Bank was forced to withdraw from the arrangement after repeated regulatory investigations for precious metal price manipulation. The 3 price setters will continue to function as normal until mid-August, where a new electronic system will be implemented. (On July 11, CME/Thomson Reuters were chosen to run the new price setting system.) It remains to be seen whether the new electronic price setting system will be more or less amenable to manipulation. I could certainly see it going both ways.

Both the dissolution of The Silver Price Fix and the likely dissolution of The Gold Fix (which currently has 5 banks serving as market makers) reduce banking influence on commodity prices. Additionally, it is evident from the above timeline that Wall Street is also abandoning in droves commodity prop trading, commodity warehousing, and various other resource-specific functions. The twin forces of this decreased banking presence are (NYSE:A) the Volcker Rule and (NYSE:B) reduced volatility/attention on the resource market in general.

The Volcker Rule's intention is to ban proprietary trading within commercial banks. (Proprietary trading is where deposits are used to trade on the bank's account - a practice that can be both lucrative and risky.) The rule, named after former Fed Chairman Paul Volcker, was first introduced in 2009 in response to the financial crisis beginning in 2007. After three years of tinkering, the Volcker Rule was eventually passed as part of the Dodd-Frank Bill in December 2013 and went into effect in April 2014. There is no doubt that the Volcker Rule has reduced Wall Street's influence over both commodity prices and resource equities. Due to the inherent volatility, these markets in particular have always been a favorite place for prop traders to speculate. A case in point is the resource mania we saw in 2005-2007, which coincidentally was also a time period where prop trading went rampant within Wall Street banks. Even though the Volcker Rule has only been implemented within the past few months, it has had an effect for multiple years on Wall Street's resource presence. The mere possibility of the bill has set compliance officers scurrying, and prop trading (both resource-specific and in general) is in major decline.

The resource market of today is far different from what we have witnessed over the past decade. Gone are the days in 2007 and 2008, where the price of oil dominated the front page of the New York Times. Instead, commodity price volatility is at 10-year lows in many major commodities. Additionally, investor interest in resource equities is at historic lows. This may be an ideal occasion to be investing in select resource equities, but it is certainly not a great time to be a resource-focused banker. This low interest and low volatility have certainly contributed to the Wall Street exodus.

In the immediate term, there haven't been major effects from the developments described above. However, in the medium to long term (let's say 2-5 years), there will be multiple results from a reduced banking presence in the commodity/resource sphere. The first effect is that money is currently going from "weak hands to strong" and will continue to do so for some time. Wall Street in general is a "weak" shareholder, lacking both patience and dedication once the going gets tough. However, these flaky shareholders continue to sell their resource equity shares and future contracts to "strong" investors (such as the Partnership) that have patience and conviction in the long-term resource story. This process always occurs as bear markets bottom and ultimately results in more efficient allocation of capital to quality projects. This is in stark contrast to what we see (and will continue to see) in the tops of bull markets - where almost any project can receive funding, regardless of the quality.

Additionally, while Wall Street in general is a fickle group, it is consistent with the fact that big banking interests will always go to where the money is. As evidenced by the low volatility and low investor interest, the money has clearly gone elsewhere in the case of resources. However, sometime in the next 5 years the story will change and resources will become "hot" once again. When that happens, Wall Street will come back. And when they come back, they will come back en masse. (With or without the Volcker Rule - Wall Street will find a way to gain exposure.)

Wall Street is a foolproof barometer for contrarian investors. When Wall Street vacates a certain industry en masse, it is a sign that bargains are to be had. The key factor is patience, as these bargains will often take years to reach fair value. Conversely, as Wall Street enters an industry in full force, the prudent investor exercises increasingly greater caution. I look forward Wall Street's next swing to exuberance regarding the resource market, because this will result in both higher share prices and possible exit points for Partnership holdings. In the meantime, the current negativity gives me confidence that now remains an excellent buying point for carefully selected resource equities.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.