Shalom Hamou's  Instablog

Abstract:

This article is an updated version of an article that was published in Seeking Alpha. I have updated  and clarified certain definitions. The relevance of that article in todays' Market justify this updated publication.

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 shape of the yield curve.

The slope of the yield curve indicates the fair valuation or not of the price of short-term assets compared to long-term assets.

I am going to show that the shape of the yield curve is a first order parameter of the evolution of the price of minerals.

When the yield curve is inverted, because of profit maximization, Miners & Drillers 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.

Prevailing Theory:

According to the prevailing theory the Market price of a mineral is its marginal cost of extraction: the cost of extraction of the most expensive unit that find its way on the Market.

Reminder: the Marginal Cost of Extraction does not include fixed cost (i.e. exploration cost, cost of an offshore platform, etc...).

If that was true then the marginal cost of extraction would have risen has much as $140!

In order to account for that unexpected behaviour people have invoked the concept of peak oil or the possibility that minerals would behave like stocks and would discount some future value, without even trying to find out what those future value were.

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.

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 prices 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.

Financial decisions are always about choices:

The shape of the yield curve is paramount in any financial decision, rather than long-term assets.

Miners and drillers who contrary to the bankers have no vested interest in buying long-term assets, prefer short-term assets to long term assets when the yield-curve is inverted.

If you consider the minerals as short-term assets, you come to the conclusion that confronted with an inverted yield curve, would prefer to hold minerals in the ground, their most profitable short-term assets. It create a rise in the price of minerals which comfort them in their behaviour.

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 behaviour 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.

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.

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

Conclusion

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:

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 judgement 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.

There are some striking conclusions that can be driven from this discovery and they explain some of the paradox of economy. They are the subject of the following paragraph:

✔ The Barbaric Relic: Why the Gold Standard Can't Work.

✔ OPEC & Oil.

✔ The Paradox of Stagflation.

References:

The Effect of Monetary Policy on Real Commodity Prices by Jeffrey Frankel

Monetary Influences on Commodity Prices by Jeffrey Frankel

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