City Tech Assistant Professor of Business Lucas Bernard was interviewed earlier this fall by Deutsche Welle, the German equivalent of BBC or National Public Radio, on the financial aspects of commodity trading. Although prompted, in part, by news that Goldman-Sachs was involved in “warehousing” aluminum to avoid pricing regulations, the interview focused on the financial aspects of commodity trading that are not obvious to the casual observer and that can go beyond the simple supply-demand models most frequently used to organize thinking about these phenomena.
Says Professor Bernard in comments for this article that echo much of his Deutsche Welle interview, “The popular notion of commodities trading is something between that portrayed in the Frank Norris novel The Pit, which is about wheat traders in late 19th century Chicago, and the macho images portrayed in the popular film The Deal of young, high-testosterone trading ‘jocks’ in expensive suits and private jets and corruption set in the high-stakes world of corporate investment and international oil trading. While both of these clichés are surely aspects of markets, they are by no means the bulk of them. Instead, modern commodity markets are shaped by a variety of other forces.
“First,” notes Professor Bernard, “modern commodity markets have more in common with the fruit vendors we see on the streets than with the reckless risk takers of Hollywood imagination. Just like fruit vendors, financial firms make much of their money off the buy/sell spread of their goods, investment-related products of one sort or another which they hold in inventory. Just as the fruit salesman buys fruit at a low price in order to sell it at a higher price, companies like Goldman-Sachs buy financial instruments at one price in order to sell them at a higher price.
“But both the fruit vendor and the financial company,” Professor Bernard adds, “run the risk of not being able to sell their entire inventory. The fruit vendor, may ‘hedge’ his or her bets by making a deal with a smoothie operator, who agrees to take delivery of the vendor’s damaged fruit at a reduced price. Similarly, the financial company must also hedge its position. However, because of the complexity of financial products, there are a great many more options available. Thus, a considerable amount of trading involves the balancing and rebalancing of financial products, which includes commodity-related products, in order to hedge inventory. In fact, the famous Black-Scholes pricing model derives from exactly this observation: that market makers need to maintain neutrality with respect to market forces on their inventory. Occasionally, this hedging involves taking physical delivery of commodities.”
Professor Bernard says that as financial companies are dealers in commodity futures, forwards, options and other products deriving their values from commodities, termed “derivatives,” again, as in the hedging scenario, they must sometimes take delivery of physical product. There are many legal and logistical complexities involved in commodity trading. For example, the Jones Act requires that shipment of goods between U.S. ports be handled by ships that were built in the U.S.A and that fly the U.S. flag. As a consequence of the recent boom in domestic shale gas, a market opportunity for American shipbuilders has, thus, resulted. Regulations such as these constrain the transportation of commodities in non-obvious ways and can impact prices.
“In addition,” Bernard goes on to say, “as was the case with mortgages and, in general, with defaultable obligations, e.g., bonds, complex securitizations and structured financial vehicles have injected a myriad of further intricacies into the commodities industry. For example, future-flow securitizations may be built to use the forward receivables of commodity producers as collateral for loans at below sovereign rates. As many commodity producers are legally located in ‘stressed’ countries where high yields are demanded on their country’s general obligations, these agreements allow for sustainable borrowing on behalf of the producer. However, tranche-holders may enter into complex positions in these instruments, which may impact on commodity prices, again in non-obvious ways.
“Some journalists,” Professor Bernard concludes, “have a tendency to fail to realize that many complex phenomena cannot be easily popularized for the casual reader. This is why newspapers tend not to discuss the latest developments in solid-state physics or non-linear partial differential equations. But the same is true of modern structured finance and the macroeconomics of global warming. As a result, isolated facts are ‘cherry-picked’ and presented out of context in the press. Sometimes, there is no shortcut to the truth, and even the ‘truth’ may be a bit more involved than one would expect.”
Professor Bernard is co-editor of a forthcoming new book, The Oxford Handbook of the Macroeconomic of Global Warming (Oxford University Press, 2014), with Willi Semmler, Henry Arnhold Professor of Economics at The New School for Social Research of New School University New York. The book analyzes the macroeconomics of global warming, especially the economics of possible preventative measures, adaptation, various policy changes, and the potential effects of climate change on developing and developed nations.