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Dark Inventory - and the death of markets

by ChrisCook Tue Oct 25th, 2011 at 06:57:49 PM EST

The premise of this article is that equity and most commodity markets have become completely perverted by the entry into the market of a new breed of fund investors.

On the one hand there is a market behaviour issue - ie the presence of passive 'inflation hedger' participants who are aiming to avoid loss, rather than actively seeking transaction profit.

On the other hand there a newly observed phenomenon - Dark Inventory - which is essentially the Dark Matter in the market universe outside the visible market solar systems.

The bottom line is that market participants who believe that market prices are actually set by producers and consumers are unaware that financial supply and demand are sending false signals.

These traders and speculators are being ruthlessly culled, as they were in 2008, by those who know where the treasure is buried - no prizes for guessing who - and a major, possibly epochal collapse in prices is imminent which could well have far-reaching  consequences.

We live in interesting times.

Dark Inventory, and the Death of Markets

The collapse of Lehman Brothers in October 2008 is already recognised as a crucial point of Peak Credit. But the intervening three years now appear to show that it may have been the point at which the current generation of markets died.

The response of the US government to the Credit Crash was firstly to reduce interest rates to zero and secondly to create trillions of new dollars and inject them into the financial economy by buying government and other debt - so-called Quantitative Easing (QE).

The reaction of investors, who rightly feared inflation, was a rush to buy anything but dollars. A huge wave of investment poured into a new generation of funds such as Exchange Traded Funds (ETFs) and Index Funds which invest directly in equity and commodity markets.  

These 'inflation hedger' investors are not greedy speculators aiming for a quick transaction profit but the complete opposite: they are risk averse investors who simply wish to preserve the value of their assets over the medium and long term.

Dark Inventory
At least one investment bank realised long ago that inflation hedgers who invest in commodity funds provide a source of cheap, even free, funding to commodity producers.  The creators and issuers of these funds enabled investors to effectively lease or take temporary ownership of commodities in warehouses; tanks; and even in reservoirs still in the ground.  

The flow of funds into commodity markets inflated two commodity price bubbles, the first in 2008 and the second, since 2009. These bubbles benefit producers to the detriment of consumers.  It is ironic that the very same investors attempting to hedge or avoid inflation are actually responsible for causing it.

This is bad enough, but arguably even worse than this has been the effect of these funds on the very fabric of the markets themselves.

In the same way that private financial networks provide Dark Pools of liquidity outside the transparent exchanges, so it is that in exchange for a dollar loan, title to large amounts of producer and other inventories has opaquely passed to investors.

This Dark Inventory is, as the name implies, visible only to the issuer, and market participants who have knowledge of its existence have an advantage compared to the majority who are blissfully unaware.

Caveat Vendor
For intermediaries, transparency is the enemy of profit, and the presence of Dark Inventory in the market has enabled massive new profit opportunities for those in possession of what is euphemistically called asymmetric information.

By way of example, a great deal of money appears recently to have been made in the trading of physical oil, because other market participants who were selling forward physical Brent/BFOE oil contracts did not realise that the buyer had already contracted to repurchase the Dark Inventory it had leased out in the first place. The hapless sellers who were therefore 'squeezed' were then obliged to buy oil expensively to satisfy their forward sale contractual commitment.

Such losses made by the consenting adults in the wholesale oil market, will not be mourned by many, but the underlying reason for losses should be a cause of concern for all.  The presence of market participants who are motivated by the avoidance of loss, rather than the generation of profit - and asymmetric knowledge about the Dark Inventory thereby created - has completely changed market dynamics to the extent that markets are no longer fit for purpose.

ETFs are actually killing the markets in which they participate

Market Cardiac Arrest
The following 'screen grab' shows two market prices over the period from 2005 to date. The upper market price is the US S & P stock index futures price, while the lower price is that of Units in the enormously successful exchange traded fund (SPY) which tracks the S & P Index and allows investors to obtain exposure to it without actually buying the shares themselves.

It is quite striking how the regular pulse-like oscillation in the Unit price was disrupted during 2008, as the S & P index fell sharply, and then flat-lined from 2009 onwards as QE pumped up US share prices.

While the S & P  index itself was re-inflated by investors with QE money, the SPY market essentially went into cardiac arrest. It has become a playground firstly for the authorised participants who create, issue and manage Unit redemption and maintain the Dark Inventory of assets which underpin the Units, and secondly for the High Frequency Trading (HFT) automated trading algorithms which provide so-called liquidity.

So much for the purely financial markets of the S & P Index and SPY.  In the real world of commodity markets the bubble inflated by inflation hedging investors - which has been responsible for a massive transfer of wealth from commodity consumers to producers - now appears to be on the verge of collapse.  

Cui Bono?
Who benefits from high commodity prices?  It's the producers, stupid.

If the history of commodity markets shows us anything it is that if producers can support prices at high levels then they will.  The tin crisis of 1985 and Hamanaka's ten year manipulation of the copper market are good examples.  What has changed is that commodity producers have become able to use inflation hedging investment to monetise their inventory.

What we have been seeing since 2008 has been the creation and maintenance of correlated commodity price bubbles caused by the creation of Dark Inventory by ETF and Index Fund issuers. Producers lent commodities to the funds; in return, the funds lent dollars to the producers; and those market participants who know where the Dark Inventory treasure is buried make fortunes.

The darkest of all Dark Inventory is in the oil market, and here, if my analysis is correct, a long-standing market manipulation on a cosmic scale about to end.

Printing Oil
The oil price bubble culminating in 2008 was a purely private affair.  The origins may lie in the long-standing collaboration between BP and the ground-breaking GSCI fund originated by Goldman Sachs - two market players who were joined at the head for 12 hugely profitable years.  At least one industry observer considers that the relationship between BP, who are structurally 'short' of crude oil,and the GSCI fund, which is structurally long, may have initiated both Dark Inventory, and the marketing triumph of inflation hedging.

Other private market participants subsequently caught on, and also attracted risk averse investors - who are completely unaware of the true risks they run - to fund Dark Inventory.  But there is a limit to the availability of private sector oil for leasing to funds, and from 2005 onwards an unsustainable bubble was inflated. This was ramped up by massive and shameless hype: during this period there was little market news which was not interpreted by analysts as being bullish for the oil price.  

But eventually oil price increases lead to a fall in demand, and after a speculative or manipulated (according to who you believe) spike to $147/bbl  the bubble inflated by Dark Inventory collapsed to $30/bbl in late 2008 as fund money pulled out.

But it was not long before money poured into the oil markets again.  In order to accommodate the demand for oil to lease there was only one possible candidate - Saudi Arabia, who like all producers was hurting badly from the price collapse.  It appears clear that a geopolitical Grand Bargain was struck between the US and the Saudis which was aimed at keeping the oil price pegged between levels which are not so high as to be politically dangerous in the US, and not so low as to be politically dangerous in Saudi Arabia.

In March 2011 two market shocks disturbed the unstable Saudi/US equilibrium. On the supply side, Libyan oil supply fell to a trickle,and on the demand side, Fukushima led to Japan requiring carbon-based fuel to replace nuclear.  True speculators poured in to the market which duly spiked to well over $120/bbl - threatening politically dangerous gasoline prices in the US.

As all this was going on, the Federal Reserve Bank switched off the QE money pump.  What this meant for the oil market was that new Dark Inventory stopped being created.  Meanwhile, producers are continuing to sell their own inventory at inflated prices, and take windfall dollar profits out of the markets.  The funds which actually own Dark Inventory have massive unrealised losses which they can avoid only if physical demand picks up; QE and financial demand restarts; or they can find a greater fool to buy their Units.

So the new buyers necessary to keep the market price inflated in future have withdrawn  This led to future prices sagging below current prices, a state of affairs known as a Backwardation.  Moreover, recent market turmoil has seen a stampede back to the dollar. In September, $9 billion was withdrawn from commodity markets by index funds. The collapse of commodity prices in late 2008 was associated with just such an outflow of commodity market fund money.

Goodbye to All That
A collapse in oil market price is imminent, and quite probably also a collapse in other commodity markets and even equity markets.  In the Alice in Wonderland market of Dark Inventory, market participants mistake apparent demand for real demand.  

So if a market participant buys Brent/BFOE forward contracts, physical market traders may be blithely unaware that the buyer is ending a lease agreement and repurchasing oil they have already sold.  So traders are suckered by illusory market demand into a forward sale, and then find themselves 'squeezed' and having to buy back their contracts at a loss, which 'pops' the price briefly upwards.

The recent rapid rise in equity prices, may well be a similar pop in price as speculators who are essentially right too soon, are losing money to better placed market participants.

If markets collapse as I expect, this will mark the definitive end of the current generation of markets, and perhaps constitute a necessary step on the path to a new generation of networked and resilient markets where middlemen transition to a role as market service providers.  

But that is another story: the Market is Dead: Long Live the Market!

(Published with kind permission of Asia Times)

Another brilliant article, Chris.  Well done.  You are becoming quite the Guru. I like the concept of dark inventory as applied to financial markets and your elucidation of how financialisation obscures genuine supply and demand and therefore prices in the real world.

While I agree that commodity prices are likely to fall in consequence of the collapse of a financially engineered bubble in commodity prices, I find it harder to see how this will play out in equity markets.  Of course commodity producers like oil companies will fall, but will many other "real economy" companies (who require commodities to produce their goods) not benefit?

Index of Frank's Diaries

by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Wed Oct 26th, 2011 at 07:56:49 AM EST
Thanks, Frank

Indeed falling prices are desirable on the face of it. But of course if oil prices fall and re-establish their historic relationship with natural gas then people will go back to wasting both.

Carbon energy prices - not complete bollocks CO2 emissions prices - are veering (to the benefit of the middlemen) between upper (seller's market) and lower (buyer's market) price trends.

The requirement is for a stable mid-price line, with the surplus value divvied up between the producer and the consumer.

That is what Senegal's President Wade was after with his Wade Formula

In order for this to be achieved, a new market architecture is necessary.  I am working on just such a gas market initiative. I'm in Tehran again all next week, for instance.

When the oil market blows up, which is only a (IMHO short) matter of time, then the end users might come to realise that the middlemen should be servants, not masters.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Oct 26th, 2011 at 09:56:21 AM EST
[ Parent ]
When the oil market blows up, which is only a (IMHO short) matter of time, then the end users might come to realise that the middlemen should be servants, not masters.

In The WestTM that is the sort of heresy and blasphemy that could get you our equivalent of Salman Rushdie's fatwa.  

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Oct 26th, 2011 at 03:30:54 PM EST
[ Parent ]
Then let's say service providers........

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Wed Oct 26th, 2011 at 04:06:43 PM EST
[ Parent ]
I can't see oil prices collapsing. Insofar as they still have us by the short and curlies from a supply point of view, they can just cut down supply if the price slips to unacceptable levels. As long as the customers keep paying...

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II
by eurogreen on Wed Oct 26th, 2011 at 10:27:04 AM EST
Sure, and the long term price is therefore up.

But what everyone is missing that is that if financial inventory - ie the economic interest in oil - is dumped, then the market price WILL collapse irrespective.

We have already seen that happen once already in 2008, but on a much smaller scale

This market is going to crash (if it hasn't already started), and yes - if nothing were to change, then the Grand Old Duke of York might conceivably be marched all the way up the Hill again.involving only private inventory. The KSA cannot catch this falling knife, I think.

This time, I think that crash will be on such a scale, and the regulatory disaster will be so great - it could extend to the loss/meltdown of a clearing house - that common sense will prevail as between producers and consumers.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Oct 26th, 2011 at 11:00:18 AM EST
[ Parent ]
not that it will affect prices at the pump, which are always going up irrespective of the price of oil

keep to the Fen Causeway
by Helen (lareinagal at yahoo dot co dot uk) on Wed Oct 26th, 2011 at 01:17:11 PM EST
It seems clear that at various levels of rise and fall in the price of oil, many different scenarios might be triggered. Working out how these scenarios might interact would require an as-yet unbuilt model.

Energy is so central to a mobile society that price changes resonate deeply throughout the economy - enough to radically alter private, corporate and state behaviour.

In Finland I could foresee, if a steep pump price rise occurred, a rapid drop in car use and a move to public transport. Operators would also have higher costs, but much higher passenger numbers. Same for trains. Car driving would be reserved for trips that can't be achieved by public transport.

One aspect I have mentioned before is that cellulose-based plastics processes have been around since the 30s and the last 20 years has seen many innovations in cellulose packaging, such that it can substitute for almost any oil-based plastic packaging capability. These products have not been widely used because they are marginally more expensive than oil-based - but that differential could easily change.

Kareline", for instance, is a Finnish natural fibre composite that can be injection moulded - and recycled.

The rapid fall in newsprint sales and falling sales in coated printing papers has meant that Finnish plantation forests are being added to at the rate of 70 million cubic metres a year. That fibre will supply a whole new industry. Or that's the theory - according to my inside sources.

You can't be me, I'm taken

by Sven Triloqvist on Wed Oct 26th, 2011 at 03:46:22 PM EST
Well, Nokia was a paper company innit?

It'll be interesting to see where the others end up....

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Oct 26th, 2011 at 04:08:23 PM EST
[ Parent ]
The generally accepted view among the young IT entrepreneurs I know is that the infrastructure (ecosystem) of knowledge and skills that built up around Nokia since the 80s has enormous national value even without Nokia. This know-how infrastructure is not limited to coding: it includes all the logistic, marketing, design, project management and integration skills that can be applied across a wide range of products and services, including public services. Not to mention Angry Birds :-)

My current clients include a digital locking company, an iphone/iPod aps start-up, a digital marketing agency that includes 70 brilliant coders, and a large financial processing company, and I am mostly dealing with contacts who are in the 35-40 age range, i.e. the Nokia generation. These companies are all imperfect, but at least they recognize their imperfections.

You can't be me, I'm taken

by Sven Triloqvist on Thu Oct 27th, 2011 at 03:41:59 AM EST
[ Parent ]
Sweden had some cellulose-based plastics industries - I think it was in the late 40ies or in the 50ies. There was a fair amount of instead-of-oil-research during the war and with the post-war boom some of this got applied.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se
by A swedish kind of death on Thu Oct 27th, 2011 at 08:33:02 AM EST
[ Parent ]
Hum ... I think your thesis on the Dark Inventory is possible correct, but Oil may not be the best example.

For starts there hasn't been any relevant change on physical demand, at least yet. Further economic recession in the OECD may change this but until then, I'm doubtful.

Secondly, I'd note that Brent futures are showing a clear backwardation structure. This hints at strong physical demand, and some degree of scarcity.  

You might find me At The Edge Of Time.

by Luis de Sousa (luis[dot]a[dot]de[dot]sousa[at]gmail[dot]com) on Wed Oct 26th, 2011 at 04:32:48 PM EST
You're missing the point, I'm afraid.

The existence of dark inventory means that the backwardation is misleading anyone - ie most people in the market - who thinks about the market only in terms of consumption and production.

This backwardation is only a sign that forward prices are below current prices. and says nothing about consumption and production.

In fact, the market is over-supplied, and evidence yesterday of that is the weak 'crack spread' ie demand for gasoline, and the falling demand for other refined products such as propane and napththa.

What has happened is that the economic interest in oil has become detached from the actual supply of oil.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Oct 26th, 2011 at 05:50:05 PM EST
[ Parent ]
...and by the way, the fact that inventories are falling is what you get in a backwardation - inventory holders get rid as fast as they can....it's a variation on debt deflation.

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Wed Oct 26th, 2011 at 05:52:26 PM EST
[ Parent ]
Ok Chris so you are saying that the futures structure is being manipulated by these dark forces. While I can see this perfectly happening with commodities like precious metals, this can't be done without using physical stocks. In our case we need to have these obscure speculators accumulating incredible volumes of oil somewhere; not impossible but technically improbable.

You might find me At The Edge Of Time.
by Luis de Sousa (luis[dot]a[dot]de[dot]sousa[at]gmail[dot]com) on Fri Oct 28th, 2011 at 02:43:55 PM EST
[ Parent ]

As I have been saying throughout, I do not characterise the investors who fund 'Dark Inventory' as speculators.

In my view a speculator is someone prepared to put his dollars at risk in search of a transaction profit.

These investors are the complete opposite of speculators - they are risk averse, and aim to avoid loss over the medium and long term.

And in my view, the people who are accommodating these investors by leasing inventory to them are producers - private (eg BP) and State (the Saudis?) who have enormous amounts stored for free in the ground.

This has been going on for years, but Shell - who have been doing it since 2005 - are the only one to be transparent about leasing their inventory.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Fri Oct 28th, 2011 at 09:26:33 PM EST
[ Parent ]
It becomes feasible if the producers are simply not producing.

That is, people are beginning to realise (since we are beginning to see the end of oil production within one or two infrastructure lifetimes), that oil-in-the-ground has value - being able to pump in 2050 might be more valuable than pumping today and buying stuff with the proceeds.

I'm not wholly convinced that this is malignant, actually.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu Nov 3rd, 2011 at 11:49:07 AM EST
[ Parent ]
Except that most oil producing countries need the proceeds right now. An exception is Norway - I recently asked a Norwegian I was talking to on the train why they put their money into unreliable investments rather than just leave the oil in the ground until it is worth more. The best she could come up with was that they were being nice to the rest of the world who need it.
by gk (gk (gk quattro due due sette @gmail.com)) on Thu Nov 3rd, 2011 at 01:36:33 PM EST
[ Parent ]
I would guess that the institutional interests of Statoil are a big part of it.

It might also be a sensitive question politically, the right-wing lunatics in Norway Fremskrittspartiet - Breiviks pals - does not only want to throw the foreigners out, "spend the oil money" is their solution to almost everything. Reducing the oil pumped and thus the amount of oil money might look sensible enough then, but politics is a sensitive game.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Thu Nov 3rd, 2011 at 06:05:33 PM EST
[ Parent ]
Except that most oil producing countries need the proceeds right now.

What Chris is postulating is that the oilcos have found a way to get paid for the oil without the hassle of pumping it out of the ground.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu Nov 3rd, 2011 at 08:46:53 PM EST
[ Parent ]

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