BP – The clock has already started

What happens if BP goes bankrupt in the next few months? Setting 20 billion aside in a private deal with the White House surely won’t survive a judges review. What about paying out small claims to thousands if not tens of thousands of shrimp boat captains and motel operators? Will they be clawed back? How can they not be? What will that do to the small business owner? And what about all of their bilateral trades? I am not sure people realize just how many trading shops that could ensnare.

I am not a bankruptcy attorney and this is not my area of expertise, but I did trade through a number of counter-party bankruptcies and I know how hairy things can get. I can see it now – Florida vs bondholders vs shareholder lawsuits vs their NYMEX FCMs and banks vs gulf residents – a legal battle royal if their ever was one.

No judgments here – only a question.

How easy it all used to be

Commodity traders and analysts are finally waking up to the reality that their jobs were a lot easier five years ago. Back then, strong research could model supply curves with a fair degree of confidence. Analysts argued about the start date of new mines, new wells, and new cargo ships, but from where we stand now, all of that seems a bit quaint. Demand was very well understood; small variances between 1.4% or 1.6% demand growth were standard arguments but no one really put in significant time or energy on the demand side of things. Everything was correlated to GDP or Industrial Production and that was simply a plug in number take from the various macro analysts. One of the only true variables at the time was weather. Energy and Ag lived and died by short and medium term changes to a model run, to a tropical cyclone warning, or to slight changes in the patterns of El Nino and La Nino. The one-sidedness of the forecasts were remarkably similar to those of the housing market.

Somewhere about 2006, things started to change. The appearance of Chinese demand caught many analysts napping and gave rise to many of the winners and losers we know today. Massive changes in investment sentiment pushed the long only ETF and index business on to the forefront. The dollar weakened. Interest rates in the US were moderately low, but Japan remained near zero and inflation started popping up in the emerging markets. This all culminated in the demand driven orgy, or FORECASTED long-term demand driven orgy, that dominated the early summer of 2008. Expectations out of the BRIC nations stoked fears of food and energy shortages while overloaded transportation systems, natural disasters, and rationing added to woes from the supply side. From there, it’s easy to look back and say that the crash in resource prices was obvious to see, but it happened fairly quickly and many were caught wrong footed. Equities crashed, GDP started dropping, and a number of large industrial commodity consumers were going bankrupt.

So where does that leave us today? On the currency side, it’s anyone’s guess. Yuan, the Euro, the Yen, and others are moving around ferociously. Long term expectations of deflation, hyperinflation, or both are common forecasts. Rates are low and the flight to safety trade is still dominating long-term bond prices. On the demand side, forecasts for GDP in the US, Euro zone, and Asia are all over the map. As for the supply side, several years of uncertainty and fears of new taxes have clearly clouded the investment picture and these multi-year decisions can not be sped up or canceled easily.

All in all, modeling the commodity markets used to be a fairly calm and simple thing where the majority of action came from trading around weather events (once you had done a bit of home work). Today, any proper forecast has huge caveats and very wide price distributions. Volatility is deservedly higher than normal. All in all, it’s a great time to trade the markets, but an extremely difficult one to “invest” in.

Fingerprints? Feels like I’ve played this game….

I noticed something familiar in the markets action the last few sessions but I just couldn’t put my finger on it until today. I had seen this before. Or at least I had seen this market action played out before. A dozen times even, but I never thought I would see in the indexes. This is exactly the action I saw repeatedly play out in small commodity markets that were notoriously controlled by a few strong traders with a limited form of market power. I am not a conspiracy theorist. I am not claiming these markets are being “manipulated”, only that the action shows the mark of a strong bear intelligently squeezing out other shorts, churning profits on the way down, and limiting up moves through heavy market making practices.

Lets say you have a solid bear position on, but you don’t have the patience to just sit back and wait for the market to unfold. What can you do? A lot actually, especially in a market with a number of weak (or weakened) players. First, assume a fairly large short position. This would have to be a significant size for the market, but not maxed out, as you would need room to add to it,  so lets say, 50% of max size.  From there, when the time is right and the downtrend gets momentum, add a new position in slightly out of the money puts. Now the game is on. Start with the after hours market. Sell quickly, especially in the later hours when volume is very light. Press on through the morning, especially from 5-630am so people wake up with a sense that things are weak. From there the ball gets rolling – delta hedgers start hedging, people start jumping on board. Especially people with momentum following systems. And I get the feeling these guys make up a big part of the market today.

Market opens down big; you push a little, getting a bit extended on your short, but that’s ok.  After a solid move, you start slowly covering. No jumping, no gapping, no out of control runs, just a solid two way keeping the market in check.  A short covering where you cover your overnight shorts, extract value from trading around your options, and end the day with the same base short position, only this time with a little more money in your pocket and hopefully a few other shorts who’ve been ridding your coat tails shaken out.

It’s really not as hard as it sounds. It doesn’t work in a very liquid or deep market, but I don’t think we have that anymore. I am not sure what made me put everything together, and I really have to wonder if someone could actually do this in the major  markets, but I see fingerprints of a strong trader moving the market lower, while squeezing profits out.

Boot-strapping, RVs, and Making Markets

…a simple discussion of market making and how volatility and the lack of market makers lead to $0.01 prices

For many years I was a market maker in the commodities space, specifically in the electricity markets. Producers, consumers, hedgers, and speculators all would contact me for quotes on numerous locations and forward delivery dates, which often enough were not quoted elsewhere. What’s a good sell side market maker to do? You make a price and hope your curves are close enough that you don’t get killed. How did I formulate a market for a utility customer looking to buy, lets say for example, 2011 delivery for the Month of May peak hours into Boston? To be honest, a lot of boot strapping and prayers that correlations will hold up.

Power for delivery in Boston, is a basis to the primary regional market for New England, in this case called MassHub. MassHub is often priced as a spread to New York – Zone G (essentially the Hudson valley) or the Mid-Atlantic market known as PJM. Power in Boston is also heavily correlated to the delivered price of gas in the city known as Algonquin (which is itself based on other gas locations). The price for May 2011 is also closely associated with the price of May 2010, April 2011, and June 2011, and to a lesser extent, May of 2012. Markets are usually most liquid in the front of the curve, so everything starts there. You can easily see this by looking at trade volumes for any futures contract, and see how the volume drops considerably after the first few months of delivery. These other similar markets allow me to “bootstrap” a curve from the relative value versus other products.

From a combination of cross commodities spreads and ratios, combined with historical spread settlements, traders gain confidence that when they sell power for Boston delivery in May of 2011, they can go out, buy some PJM for May 2010, buy a NY-G May 2010/2011 time spread, and perhaps buy a similar amount of Q2’11 NYG/MassHub spread. Add in some gas basis spread to get from PJM to NY-G and perhaps a power spread to get from MassHub to Boston, and you are nearly home. Seems like a lot of trades to make a deal, but it’s these kind of market makers and spread traders that support a huge marketplace with several dozen locations across 15-20 years of delivery. Does it make sense that 2010 June natural gas delivered to Houston is the basis for 2022 power delivered to Cincinnati? Not really, but through dozens of traders spreading across regions, times, and products, the market works as a giant interconnected web of spreads all holding each other up.

At the end of the day, traders “Mark the Book”, and by that I mean they enter their estimates for market curves several years out, on a month by month basis, for often several dozen locations. Are there visible quotes on the screens or exchanges or in the OTC broker market to validate these curves? Often not. Most of the exchanges and brokers rely on yesterday’s spread differences or spread markets.

What happens during times of volatility when some of the spread traders pull their markets or widen them considerably across all of the spreads? Bid/offers become scarce. If someone has to sell, because they were tapped on the shoulder or something changed in their other positions, there may not be a “rational” market. If someone had to sell something at “market”, and there was no one willing to spread into the position, then technically there may not be a bid at all. Rationally, someone should have bid for Accenture against a spread to the futures or some other stock, but those spread offers were not there. Sounds a lot like of what happened yesterday when the NYSE was on “pause” and the other exchanges found themselves with no rational bids.

Market fundamentals, price momentum, historical cash settles, the size of the order and the nature of the counterparty all clearly contribute to any price, but at any instant, the current prices for associated markets matter the most. If the price of the first delivery month of natural gas disappeared, I would not be able to calculate any ratios of power to gas and most likely not be able to get any other power prices to spread to. Lacking that information, I might bid $0.01.

An interesting quote…

Michelle Obama’s Strange Message

Maybe I am just a bit paranoid, but the quote written on the journal that Michelle Obama gave to Laura Bush give me chills when I read it.
 ”There will come a time when you believe everything is finished. Yet that will be the beginning.”
If that’s not a weird, anti-establishment slogan with a ring of social reengineering to it, I don’t know what is.

China growth…a thing of the past? Looking to electricity demand for clues

Chinese electricity growth and GDP growth had a .99 correlation from 1991-2007. Last year, electricity growth was 5.5% while GDP was up 9.5%. In January Chinese electricity growth was DOWN 13%. The first two weeks of Feb did rebound to be slightly positive, but the January number is truly staggering. There might be some effect from the holiday calendar, but it is a YOY analysis so the effect should be negligible. 1st quarter GDP numbers wont be available for a few months, but I don’t’ think you need to wait that long to draw some scary conclusions. While I have long doubted the official Chinese numbers on both statistics, it is a relationship that makes sense and should be followed.

Great news for coal and America? Strip mining is back!

Did anyone really think they could keep King Coal down? After environmentalists won a court case virtually ending the practice of “Mountain Top Mining”, leave it to the appeals court to come through and save the day. For those unaware, you actually need a special permit (“404″) to knock off the top off of a mountain, use the debris to fill in the valley below, and mine the freshly unearthed coal. Who knew?

The 4th Circuit Court of Appeals just overturned the previous court ruling that halted the issuance of 404 permits which put into question the future of mountain top mining in Central Appalachia.

What it means? Cheaper coal prices, which the industry needs right now to stay competitive with all of the funding for renewables and things like carbon credits. It also means they can close some of the more expensive, more dangerous underground mines. I guess thats a good thing. But it also means more valleys will be filled. Oh, and there may be some ground water issues but we’ll have to wait and see on those.

World steel production in free fall

Jan 09 down 24% YOY and 38.8% excl. China.

China was up 2.4% YOY and now represents an astounding 48% of world wide steel production. The U.S. is sitting at roughly 5%.

Other key stats include:
Brazil down 45.6% YOY
Japan down 37%
EU down 46%
Rus&ukr down 47%

Case-Shiller Dec Data – Down Everywhere

Todays release of the Dec 2008 Case Shiller home indices showed little relief for home owners. Large monthly drops across Phoenix (>5%), Las Vegas, and Miami overshadow the more important changes in the numbers. The average New York City price had its largest drop and largest % drop since the index was created. The exceeds November’s numbers, which also were records at the time.

For the largest 10 and largest 20 city indices, the monthly declines continues to be greater than 2% per month.

Global Steel ex China looking weak

Global Steel Production:  In December, Non-China steel production showed both a monthly (down 13.8%) and yoy decrease (down 35.4%) as expected.  China’s crude steel production was up 10.9% from November, though full year 2008 was only up 1.7%.

The fact that world wide steel production ex China was down 35.4% over dec 2007 is truly amazing. Coking coal prices tripled for most mills through the third quarter of ’08 so perhaps you can blame some of the decline on a rise in costs, but one would have expected to see that effect starting as early as August. Additionally, by Dec8, shipping and spot market prices had dropped the net price back from 375/t to 175/t which should have spurred some demand. 

Full year production worldwide was only down 1.5%, but the comps are about to get very ugly over the next few months. I don’t see how the global steel conglomerates can survive after their frenzied acquisition binge of the last few years. The Chinese growth numbers cannot be overlooked and do represent some positive developments, but I take long-planned government spending with a grain of salt.

TAYM