Nothing new under the sun, warehousing edition As they say on Battlestar Galactica, "all this has happened before and all this will happen again." It turns out similar activities and concerns were very much rife in the grain markets in the 1920s as well. Here follow some wonderfully evocative of today snippets from the 1921 Federal Trade Commission report on the grain trade: In Chicago, while the public warehouse operators are forbidden by Illinois law from storing their own grain in the public bins, the operators are in every instance large merchandisers of grain, and by a technical compliance with the statutes are able to derive appreciable benefits from the operation of these houses. That is, over 30 per cent of the total capacity in the United States is operated under State license but in practice is used primarily for private account. That is, the elevator operator being forbidden from storing his own grain in the public warehouse which he operates, employs a buyer, who in effect acts as a broker, to purchase the cash grain "to go to store." With this understanding, the elevator operator sells such a buyer 50,000 bushels of cash wheat, for example, at one-eighth of a cent and carrying charges (storage, insurance, etc.) under the market for the prevailing option and at the same time buys from him a future for the same quantity of grain at the market price of the same option All elevating and carrying charges attaching to the grain prior to date of delivery on the future are in effect paid by the elevator operator. But the elevator will earn a carrying charge if the spread between cash and future prices shows the latter at a premium. It is only under such circumstances that the elevator has an inducement to send grain to store for a considerable period. IK - i.e. this only works during a contango. The elevator operator recovers the grain for merchandising purposes by taking deliver on the future contract and removing the grain from store; or he may accept the warehouse receipts on the delivery and pass them on in fulfilment of sales of futures just as if he had previously been the legal owner of the grain in public store. It appears that the practice of selling "to go to store" sometimes enables an elevator operator to make delivery on sales of futures to better advantage than if he were obliged to bid for contracts in the pit. Public storage is sometimes used by the public-elevator operators by mutual exchange of storage, each operator storing a certain quantity in the other's public warehouse. This is apparently not commonly practiced, however. A Chicago grain merchant stated the case in 1918 as follows: The entrance of the public elevator proprietors into the grain merchandising business has had several effects. First, it has destroyed the ability of grain receivers to store grain in public elevators in competition with the proprietor-merchandiser who has no storage to pay except to himself and in many cases has practically no costs of storage due to the very favourable leases of elevator property from railroads. This situation has developed to such an extent that I believe over 99 per cent of the grain stored in public elevators is owned by proprietors of such elevators. In reality the so-called public elevators have become private, but with all the privileges given to public elevators under the law. However, as already shown above and in Volume II of this report, the decrees of the Illinois courts granted a perpetual injunction against Chicago warehousemen from storing their own grain in the public bins; and subsequent to this ruling there was a considerable decline in the elevator storage space operated for public account. The operators of public warehouses, however, instituted practices whereby the ruling of the courts has been effectively evaded ever since the final decision. The principal method employed has been for the operator to sell grain from his private elevator to another trader under the agreement that the grain is "to go to store" in the public warehouse which the seller operates; deducting from the prevailing future price a margin sufficient to cover the buyer's expenses for storage and to allow him a small brokerage in compensation. In summary, it is generally understood and admitted by the trade in Chicago that the public storage facilities at that centre for many years have been largely utilised by the operators either directly or indirectly for their own private merchandising process. This does not mean that they have, strictly speaking, a proprietary interest in the grain sold to be stored in their public elevators; but rather that they are able to arrange for and direct the movement of their own cash grain into the public warehouse which they operate. As long as these warehouses are operated by dealers in grain and as long as storage charges remain at the present level the natural result will be concentration of the control of actual grain in the hands of the elevator operators because only such operators can profitably accumulate a large line of grain. This situation gives to the large elevator merchandisers practical control of deliverable grain at the terminal markets, facilitates the manipulation of futures, and has doubtless been at times responsible for the failure of the cash and futures markets to move in harmony. The possible remedy for this situation suggested by the circumstances is to make it practicable for grain dealers not operating elevators to store grain in public elevators in competition with the large merchandisers. To accomplish this would require a reduction in storage charges. The existing situation tends to choke the normal channel of connection between the cash and futures markets, to foster in the latter market "technical" conditions and price movements not related to the demand and supply situation for actual grain, to give to powerful integrated concerns additional opportunity for manipulation, and to impair the usefulness of the futures market for hedging purposes. In the modern incarnation, the role of public storage proprietors is being played by banks that have the ability to own warehouses. The incentives are also being heightened by zero rates and even greater premiums than those outlined above. There's another part of the commission report which explains the actual mechanics of the carry trade, emphasising that the operators do not take price risk as a result of the structure of the trade. The purpose is to earn the spread, rather than to speculate. There's also an interesting chapter on financing and collateral, in which the operators come to evoke the role of modern non-bank trading companies who regularly engage in credit intermediation with entities which would otherwise not get favourable lending rates. Another worthwhile reference to how public warehouse operators, as a result of the large inventories they gather, can influence spot and future prices to their own benefits by shifting those sums around. This gives a clue to the real purpose and interest of so-called commodity shuffling between warehouses, especially from private to public stock. Here's the chapter: Private elevator companies with houses that are "regular" under exchange rules are often in position to influence the course of the futures market through their control of a large quantity of deliverable grain. A large elevator, or a group of elevators, may make heavy deliveries on the first day of a delivery month with a view to such manipulation. By this manoeuvre, long buyers of futures who do not wish to bother with the cash grain will be impelled to sell hastily, thus depressing the current-delivery future price relatively to the price for the next delivery of futures. The elevators will then by able to transfer their open hedges to the next delivery on the basis of a profitable spread between the two options, buying in the current option and selling the next option. They may also be able to buy back the cash grain at a sufficiently depressed price to give them a larger carrying charge. Similarly, if the elevators withhold delivery on a large block of open future sales until the end of the delivery month, smaller traders may become apprehensive and start selling for fear of a reaction when delivery is made. A large elevator company is usually on the alert for opportunities to make profits by spreading between options, and is sometimes in position to make such opportunities. The elevators with large stocks of grain hedged and storage available for additional supplies have advantages over speculators not so equipped; and if such elevators operate together they may sometimes control the local situation. The main thing to note is that these tactics are used by operators precisely so that they don't have to speculate on the underlying price of the commodity. Most of the time, consequently, such companies care little about the outright "flat price" movement of a commodity. The money is made from anticipating changes in curves and spreads, mostly as a result of changing supply/demand imbalances in specific locations - some of which, it has to be said, can be influenced by trading entities directly. In that sense, these parties - the equivalent of modern trading companies or warehouse-owning banks - are anything but speculators. To the contrary, they take advantage of speculator mispricing on account of their better understanding of the true inventory, supply/demand fundamentals. The interesting thing about the report is that it shows little or nothing changes over time in commodity markets. None of this is new, and none of this is exceptional. What is clear is that the public becomes more interested in such tactics whenever they orientate towards pushing prices up rather than down, or away from the usual flux they are in. And yet long-term shifts to the upside, which involve a lot "sell to store" activity, are much more likely to be motivated by superior returns which can be extracted from speculators - due to a lack of better positive yielding options in financial markets - than the underlying fundamentals themselves. At that point, operators do have an expressed interest in portraying the markets as being tighter in the future than they really are. Hat tip to the Streetwise Prof for drawing our attention to the report. Related links: Let's count the copper with dust on it - FT Alphaville The curious case of un-cancelled warrants - FT Alphaville Commodity encumbrance and Joseph's storage play - FT Alphaville The dawn of systemically important commodity traders - FT Alphaville The "Tin Man" and the "Johor shuffle" - FT Alphaville