Commodity Conundrum Solved: The Hidden Parameter in Interest Rates

The commodities we are concerned with here are those with potentially very low storage costs. Minerals, when kept in the ground, have a storage cost next to zero. I observed a strong link between the evolution of the market price of minerals and the slope of the yield curve. The slope of the yield curve indicates the preference of the market between short-term assets and long-term assets.

Attention: My model says a yield curve is normal if the differential between long-term rates and short term rates pay exactly for the interest risk (market indifference). It is steep if the differential between long-term rates and short term rates pay more than the interest rate risk (market preference for long-term assets). It is inverted if the differential doesn't pay for the interest rate risk. As a result, a yield curve may have a positive slope and still be inverted, contrary to the general perception.

When the yield curve is inverted, because of profit maximization, Miners & Drillers, as a group, prefer hoarding a higher proportion of their minerals in the ground (their preferred short-term assets) rather than extracting them and investing the proceeds in long-term instruments. Hence, the marginal cost of extraction of minerals becomes irrelevant to their market price as miners stop maximizing their output under the constraint: Market Price - Their Marginal Cost of Extraction > 0 . Reminder: the

Chart of the Slope of the Yield Curve

click to enlarge all images

Profit maximization would have them trying to retain a higher proportion of their minerals in the ground rather than extracting them. The quality of the index, the slope of the yield curve, is superior to any other known system.

Need for a Global Parameter: The price of minerals has grown unabated since the yield curve started being inverted with acceleration when the Federal Reserve started increasing short-term rates from 1%. At that time, long term interest rates were so low that the yield curve became inverted when the short term rates reached 2.5% All of the minerals have grown together, which cannot be explained by the growth of the marginal price of extraction alone; no price increases have caused the price of any mineral to stop its growth as a result of an increased investment in exploration.

Chart of Oil and EuroDollar

Chart of Gold and EuroDollar

This correlated increase in the price of minerals must be caused by a global parameter. Harvard Economics Professor Jeffrey Frankel, in Monetary Influences on Commodity Prices, a summary of The Effect of Monetary Policy on Real Commodity Prices, made the hypothesis that a decrease in real interest rates ("real" rates exclude inflation) increases the demand for storable commodities. However, during the increase of short-term rates from 1%, under the chairmanship of Alan Greenspan, inflation didn't grow as fast as short-term rates and still minerals kept growing. Storable from an industrial point of view should be different than from an economic point of view: if you need to build a Fort Knox, hire people to handle your stock and guard it; your cost might be higher than any expected revenues. Storage outside the ground would not be economically viable as the cost of storage would be added to the interest rates; under this assumption, the only storable commodity would be minerals. The low interest rate argument doesn't hold as you can always sell the commodity on futures markets and earn the short-term interest rate. As a result, there is an implied short-term interest rate embedded in a commodity.

My Hypothesis is Different

The Hidden Parameter: Interpretation of the Yield Curve

A normal yield curve means that the market is indifferent between long-term and short-term assets (neutral monetary policy). A steep yield curve means that the markets prefer long-term assets over short-term assets (accommodative monetary policy). An inverted yield curve means that the market prefers short-term assets rather than long–term asset (restrictive monetary policy).

Financial decisions are always about choices: If you consider the minerals as short-term assets, you come to the conclusion that miners, confronted with an inverted yield curve, would prefer to hold minerals The shape of the yield curve is paramount in any financial decision, rather than long-term assets.

“Inventory accumulation is likely to continue unless demand rises, output declines, or we run out of storage capacity.” (Remarks by Chairman Alan Greenspan on Energy before the Economic Club of New York, NY, New York, May 20, 2005)

Hence, miners would keep a higher proportion of their minerals in the ground where storage is infinite and almost free to them (for a miner, the best short-term asset is minerals in the ground, so selling them in order to buy short-term financial assets is simply not relevant), rather than sell them and invest the proceeds in long-term assets. Because of their self-restraint on output, hence on supply, they generate as the commodity price rises, which is compounded with the increase in their unrealized revenues. That behavior need not be conscious but is probably the result of the propagation of arbitrages through the different financial markets, among them the cash and derivative markets on fixed income securities and the cash and futures markets for minerals.

Circumstantial evidences: How else would we understand that, over such a short period of time, the cost of oil was multiplied by 5, with a low depletion of the proven reserves? How else would we understand that all the minerals saw their costs rising in the same period with a next to perfect correlation? It cannot be explained by the growth of the marginal price of extraction alone: no price increases have caused the price of any mineral to stop its growth as a result of an increased investment in exploration.

Reminder: the Marginal Cost of Extraction does not include fixed cost (i.e. exploration cost, cost of an offshore platform, etc...). How else would you explain the fact that the rise of minerals started shortly after the rise from 2.5% of short-term interest rates by the Federal Reserve? At the same time, the yield curve was under the influence of the famous Greenspan Conundrum, which caused the inversion of the yield curve.

Term Structure of Forward Prices: In their work, Equilibrium Forward Curves for Commodities, Bryan R. Routledge & Duane J. Seppi & Chester S. Spatt charted the forward curves for high and low demand for commodities.

Term Structure of Forward Prices of Commodities

With high demand and increasing prices, the slope of carry rate is negative and the implied interest rate decreases, which suggest that the yield curve is decreasing: it is coherent with a reversed yield curve. With low demand and decreasing prices, the slope of carry rate is positive and the implied interest rate decreases, which suggest that the yield curve is increasing: it is coherent with a normal or steep yield curve.

Price movements: Should the yield curve on the U.S. dollar return to normal, as it did on Monday, March 13th, the miners would stop hoarding their reserves in the ground and the prices should go down in the direction of their marginal cost of extraction. Should the yield curve stay normal or steep for a protracted period of time, the price of commodities would reach its marginal price of extraction. According to my hypothesis, that price must be much lower than the expectation of all market participants. Because most of the hedge funds holding are outside the ground, they are not constrained by the marginal cost of extraction; should the price of mineral go down, we should see some overshooting, in particular in minerals with low industrial use: gold and silver.

Graph of the Normal Slope vs. Short-Term Interest Rate

My model of the yield curve comes from empirical observations over a 14 year time span. It is backed by a modified work of one of the most respected and reliable academics in the field of mathematical finance. The modification was simply the relaxation of one parameter which the researcher himself didn't use in his other related work.

The Minerals Paradox: A restrictive monetary policy increases the price of minerals, including oil, and participates in the building up of inflation.

Conclusion

Precision of the Model: The precision of my model of the yield curve varies from 1 basis point to 5 basis points. A change of one basis point around the normal curve means a movement of several dollars of the price of the minerals in one direction or the other.

Timeliness: The reaction of the mineral markets to a twist of the slope of the yield curve around its normal value varies from instantaneous to one hour.

Measure of the Quality of the Decision: The steeper or the more reverse the slope of the yield curve, the more stable the price movement. In that sense, it can allow for safer trades and to calibrate the size and risk of their exposure. Because short-term yields and long-term yields have a high correlation, the dynamic of the slope of the yield curve is slow, which allows the trader to make better decisions with less pressure.

Asymmetry of the Price Movements: My model implies that when the curve is normal or steep, the fall of the price is much faster than the rise of prices when the curve is inverted.

Higher Limit of Mineral Prices: Under this framework, there is no theoretical higher limit of the price of the minerals, however, should the yield curve become normal or steep, the fall of the price would be accelerated by the difference between market price and marginal cost of extraction.

Caveat:

"Risk management involves judgment as well as science, and the science is based on the past behavior of markets, which is not an infallible guide to the future." (Remarks by Chairman Alan Greenspan, Risk Transfer and Financial Stability, To the Federal Reserve Bank of Chicago's Forty-first Annual Conference on Bank Structure, Chicago, Illinois (via satellite), May 5, 2005)

Funds liquidations: My model supposes that the market is driven by the miners. If the market falls sufficiently in order to cause wide fund liquidations, it stops working; the funds don't have a zero cost of storage and they are not governed by the shape of the yield curve. Hence, the market can fall with a reversed yield curve. The model will return to its operational work on any significant technical rebound. In that case, the trader must use his own judgment and try to gauge the size of fund liquidation.

Large positions: A trade when the yield curve is normal is rewarding, but the risk to see the yield curve revert to inverted can be sudden: it is not fit for large positions.

Connected markets: The ethanol, and in a lesser proportion, corn and wheat markets, because of the agricultural surface they displace, have some positive correlation with the market for minerals; however, my experience tells me that fund managers should stick to minerals where the connection with the slope curve is the strongest.

Portfolios: In order to shield from specific risk when a particular mineral price is influenced by some random news, it is advisable to use a portfolio of minerals rather than one specific mineral.

References:

• Equilibrium Forward Curves for Commodities by Bryan R. Routledge, Duane J. Seppi & Chester S. Spatt.
• The Effect of Monetary Policy on Real Commodity Prices by Jeffrey Frankel
• Monetary Influences on Commodity Prices by Jeffrey Frankel

Comments

[Polaris]

I found your analysis totally flawed but very entertaining. It seems that along with all other US econometricians you start from the ingrained conceit even hubris concerning the $US and that the world economy is somehow still controlled from the Fed Reserve. It is not. It has not been so controlled for well over a decade.

Your logic is flawed. Yes the inexorable rise in commodity prices seems to coincide to the decline and fall of the $US. But a statistical correlation does not prove cause and effect. It is a pity that economists are not scientifically trained.

Now be sensible take out gold from the analysis – it is a barbaric metal of little or no industrial use – just a speculative hedge against the US$. Look at the other economically important commodities.

What we are witnessing is a total change in the global market dynamics; starting with the fall of the Iron Curtain, the consolidation of East and West Europe, the rising strength of the Euro and most importantly the industrialisation of China and India. Concomitant with this has been the start of the decline of the influence and economic importance of the USA.

You only have to look at the demand for iron ore as an example, ignore the price for a moment. The demand has been growing exponentially since 1999/2000. This growth is largely fuelled by the industrialisation of China. This has absolutely nothing to do with the decline in value of the US$. In fact the US contributes less that 3% to the demand for iron ore annually.

The importance of the US to the global economy has been declining for over a decade. It has been accelerated by the mismanagement of the Fed by Greenspan and by the criminal activities of the Wall Street traders. But it was inevitable anyway.

Economists must learn to look to the future and not the past.

I leave you with a quote from Fredrick Nietzche:

“The present is as much determined by the future as it is by the past”

[thomas728]

Polaris.......Read the piece again.Your brief counter is from a
fundamental view while Mr.Hamou is trying to relate to two movements apart and, of course, effect.

Mr.Hamou may be on to something but the piece lacks any real
testing from past action.

Me ? Where there is a crying need for any product you can
throw hypothesis out the window.

[Georealist]

This article (and its reasoning) is really the poster child of why mathematical analyses of complex, value laden phenomena like markets (ALL MARKETS, regardless of product rendered) is utterly useless! The idea that the Federal Reserve and interest rate curve fluctuations affect a worldwide infrastructure buildup is almost beyond arrogance.
Oil (and nat gas) for instance operate under a set of development criteria that are only incidentally influenced by yield curve attributes. Have you heard of Peak Oil? or Peak Production? or the costs of finding new oil/gas? or delievering those commodities?
Heaven help us you don't tackle the CPI and tell us gold/silver miners make decisions based on its published movements!

[Shalom Hamou]

To Polaris

I never mentioned the value of the USD as a parameter of my model.

It is probable that there is a link between the yield curves and the value of currencies and it is the object of my next work.

The question of increasing demand is not something I discount, what I questioned is the increase of the Marginal cost of extraction and the decrease of demand

[Shalom Hamou]

To polaris

Whatever the demand the classical hypothesis is that the price of a mineral is its marginal cost of extraction.

under that hypothesis any producer would maximise his production under the constraint of his marginal cost of extraction.

I doubt the marginal cost of extraction of gold is 1000 USD or the marginal cost of extraction of oil is 120 USD

[Shalom Hamou]

To georealist,

The proven reserves are such that we have at least for another 30 years of production, Peak Oil is a theory that doesn't even evaluate the cost of extraction. It is on of those Malthusian theories that are around since Malthus invented them.

[Skjellifetti]

This just looks like a restatement of the classical economic theory used to explain finite resource extraction rates. If you are the owner of a finite amount of a resource sitting in the ground, at what rate should you mine the resource in order to maximize your long-run discounted profits? If you sell a marginal unit today, you can put the proceeds in a bank and earn an interest rate r. If you hold the unit in the ground, and sell it tomorrow, you have lost r unless the price of the unit increases by the same amount. All that the author is saying is that interest rates have a powerful effect on the owner's decision to sell the marginal unit today or tomorrow. Polaris and Georealist are quite correct in that the demand curve is the other half of the equation and is necessary for understanding why tomorrow's price may not be the same as today's. Shalom is correct, too, in that extraction costs change through time as does demand since higher prices are a powerful incentive for developing substitutes for any product.

[Shalom Hamou]

to Skjellifetti,

The difference with what I say and what you say is that I am saying that there is an expected short-term interest rate build in commodities as a result of their forward term structure.

So the factor in making the decision to extract the marginal unit today or tomorrow is function of the difference between short-term rate and long-term rates.

[dlaw]

I'm sure that, at some level, your thesis explains some thinking in the commodities market. The elephant in the room, however, is your implicit assumption that owners of minerals should NOT take advantage of today's high prices and sell product.

You should have seen the flaw of your model when you wrote this: "Under this framework, there is no theoretical higher limit of the price of the minerals."

In other words, your model suggest that mining firms are always willing and able to become sitting-around-and-doing-nothing firms with no negative effect on their business, because they have this perfect asset in the ground. Thus the price will go to infinity if the yield curve is bad.

You'll realize this is wrong when you ask yourself why people issue short term debt when the market is clearly over-valuing short-term debt. They know they'll be able to borrow more cheaply very soon, and yet the price of short-term debt doesn't go to infinity. Why are they not willing to shut down *their* businesses until the cost of financing gets cheaper?

You think you've discovered something because of this "next to zero" storage cost. But money not borrowed in a poor interest rate environment has a *negative* storage cost. Yet people do it.

You've also completely forgotten the futures market. Since the very point of the futures market is to smooth cash prices, one way they do that is to tempt producers into locking in a profitable price. They who produce the very commodities you discuss feel - unlike you - that they cannot be sure about price direction. Do you have any evidence that mineral producers suddenly stopped trying to lock in profits with hedges? No, you don't.

That's because in the real world, not everything is a bond. A mineral in the ground is dirt. A miner not in the business of collecting money for looking at a screen, she is in the business of making dirt into something useful.

There's this thing called the "real economy" where people do material work and produce things for each other. Look into it.

[dlaw]

Also, I think you'll find that, for example, copper companies tend not to move all - or even most - of the proceeds they make into long-term instruments. Rather, as efficient stewards of capital they favor what they judge to be a higher return in - and this may surprise you - the copper business.

It's called "alpha", Mr. Hamou, and whereas in finance you may (or may not) have it, in copper, they do.

[Shalom Hamou]

to dlaw,

Your remarks are interesting and numerous:
"
You say:

"The elephant in the room, however, is your implicit assumption that owners of minerals should NOT take advantage of today's high prices and sell product."

High in economy is not compared to yesterdays price, which you can't act on but with regard to tomorrows prices. The Miners have two choices: Mining today and invest long-term or Mining tomorrow and invest an profit from the expected short-term yield implied by futures and forward prices.

you say:

"You should have seen the flaw of your model when you wrote this: "Under this framework, there is no theoretical higher limit of the price of the minerals."

In other words, your model suggest that mining firms are always willing and able to become sitting-around-and-doing-nothing firms with no negative effect on their business, because they have this perfect asset in the ground. Thus the price will go to infinity if the yield curve is bad."

I am not saying that they are sitting-around-and-doing-nothing I am saying that they extract at a lower rate than output Maximization would suggest.

You say;

"You'll realize this is wrong when you ask yourself why people issue short term debt when the market is clearly over-valuing short-term debt. They know they'll be able to borrow more cheaply very soon, and yet the price of short-term debt doesn't go to infinity. Why are they not willing to shut down *their* businesses until the cost of financing gets cheaper?"

It is the FED that create this distortion in prices, it is taking off liquidities out of the system, or more exactly diminishing money supply: the FED never look to maximize its profit.

You say:

"You'll realize this is wrong when you ask yourself why people issue short term debt when the market is clearly over-valuing short-term debt. They know they'll be able to borrow more cheaply very soon, and yet the price of short-term debt doesn't go to infinity. Why are they not willing to shut down *their* businesses until the cost of financing gets cheaper?"

Business have to borrow they can't close down, they are faced with the borrowing cost today. However they can chose between borrowing short-term or long-term. Individual businesses do chose to borrow short term because they have some expectations or because the Market won't let do so. The Market as a whole, in that configuration, prefers to borrow long-term rather than short-term. This is the way monetary policy influence investments decisions.

Shutting down a business is never a possibility, and by definition, they usually earn more than interest rates.

If people know to make one thing they usually continue to do that thing even if it is not profitable or optimal.

An example of that irrational behavior was what the financial industry did as yield curve was inverted: their optimal behavior would have been to stop making long-term loans. however they looked for something which was long-term and provided an expected return that would pay for the interest rate risk: mortgage backed securities. Not only did they buy all there was to buy their pressured their providers to sell them more. The providers provided them with sub prime or Alt-A products.

"Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."
The General Theory of Employment, Interest and Money (1935)

It does not mean that men don't make rational choices about present value maximization, it means that they are constrained i doing so.


You say:

"You've also completely forgotten the futures market. Since the very point of the futures market is to smooth cash prices, one way they do that is to tempt producers into locking in a profitable price. They who produce the very commodities you discuss feel - unlike you - that they cannot be sure about price direction. Do you have any evidence that mineral producers suddenly stopped trying to lock in profits with hedges? No, you don't."

I have not forgotten future Markets, I use them to explain the expected short-term return, but if long-term return is to low to compensate the Market for interest risk they tend, as a result from Market arbitrages, to extract less and enjoy the implied short-term returns rather than extract and invest the proceeds in long-term assets.

My assumption is that the Market does not have expectation about future prices, otherwise the Market would be at a different price today.

The Market as a whole does not lock in profit with hedges, some do and some don't the result is today Market price. Individual entities have expectations about the future evolution of the price of the minerals, the Market don't.

I am not saying that miners look at the prices of bonds, in fact they don't. The cause of their actions is a complex arbitrage that take place between fixed income instruments and their derivatives and the Minerals an their derivatives.

Miner are into the business of making dirt into something useful but doing that they mak choices which maximise under constraint their profit.

[dlaw]

Mr. Hamou,

Thanks for your response and your work. I didn't mean to be harsh.

I think you've made a valuable contribution but the problem is very much one of scale. I have no reason to think that the dynamic you describe is not involved in the thinking of the market. I think it would represent a very interesting case for a trade in a more settled market. I also think that you may inadvertently have hit on something deeper and more dramatic going on in forex - but that's a side issue.

But the article you're responding to (given your title) makes a compelling case about unregulated long-only players and reminds us that we have "been here before". As we all know, markets can easily become detached from the underlying economics of what they are meant to price - and quite often do. Unregulated markets where information-flow is even less are even more vulnerable.

The shape of the gold and oil curves alone certainly indicate to me that something "behavioral" is probably going on and probably beginning to predominate in the market. I am also becoming "bearish" on commodities (medium term, depending on your definition) but because I feel I see the evidence of "herding" behavior. Mind you, I accept the argument that there has been an increase in world demand and that demand would push prices up steadily over time, but that kind of background absolutely sets the stage for speculative excess.

Have you ever considered *reversing* your thesis? Could it not be that what you are observing - particularly in the gold market - represents money flows that have become so large they are beginning to influence credit market behavior? Central banks act in ways that are discontinuous, of course, but they are also reactive.