FT Alphaville " Commodity encumbrance and Joseph's storage play It could be that a major commodity story is about to go mainstream. We are, of course, talking about the issue of financialised commodity inventory and the impact it has had on the supply and demand picture, by taking inventory off-market and off-balance sheet. Last week Oleg Deripaska revealed his concern over the financialisation of physical aluminium. He called for output cuts, effectively to take the place of funded "dark" inventory, in order to bring the market back to equilibrium. Then Reuters reported at the weekend that Chinese banks and companies -which had tried to seize commodity collateral which had been pledged for loans, now defaulted upon - had found the metal in question never existed. This, they noted was the case of "ghost inventories": Chinese authorities are investigating a number of cases in which steel documented in receipts was either not there, belonged to another company or had been pledged as collateral to multiple lenders, industry sources said. Ghost inventories are exacerbating the wider ailments of the sector in China, which produces around 45 percent of the world's steel and has over 200 million metric tons (220.5 million tons) of excess production capacity. Steel is another drag on a financial system struggling with bad loans from the property sector and local governments. Now on Wednesday we have the following story, also from Reuters, describing similar goings on in the lead market: Commodity traders Glencore and Trafigura are keeping most of Europe's stocks of spare lead out of the market's reach, pushing up premiums for a metal dogged by global surplus and anaemic demand growth in Europe. Since mid-May, more than 61,000 tonnes of lead has left London Metal Exchange (LME) monitored warehouses in Italy and Spain. Trade sources said the material has been moved to Antwerp, where Trafigura subsidiary NEMS owns 13 storage facilities. The metal has yet to reappear on LME data, however, leaving the total stocks on which industrial users can draw as a last resort down at just 39,025 tonnes, versus some 110,000 tonnes this time last year. As Reuters notes, the problem is that as far as the market is concerned the "dark inventory" - even if it exists in the physical realm - is out of the reach of market traders and end users. Because the commodity in question is encumbered, the overall effect is that the remaining available market is squeezed, both in terms of available supply and liquidity. It's very much like when the ECB takes periphery bonds that no-one else wants off market - into own endless reserve pit - in order to corner support the market. The ECB essentially becomes the market. And... via commodity encumbrance, those players who actively store or finance the storage effectively become the commodity market in their own right as well. It's easy to wonder, but... what would be the upside? Eventually that inventory has to be released, right? As FT Alphaville has discussed at length already it all comes down to curve structure. Though, at this point, we should emphasize that we're not having a go at the normal practice of storing commodities during times of transitional surplus. So-called "contango-trades" are and always have been an acceptable commodity market strategy, which hail back to biblical times. Note, after all, the story of Joseph... (via Wikipedia): Joseph was called for, and interpreted the dreams as foretelling that seven years of abundance would be followed by seven years of famine, and advised Pharaoh to store surplus grain during the years of abundance. It's understandable, because for most of living memory it's been impossibly hard to forecast commodity demand to the tee. To limit volatility and the risk of future scarcity, surpluses have been used as a type shock-absorber for the system to help the system adjust supply sensibly over the longer term. But not everyone in the market is an altruistic Egyptian regent with access to the predictive power of Joseph. The market accordingly needs incentives to store during a time of abundance. Incentives which have come to be generated by the financial market, thanks to the wisdom of group-based investor expectations. It's investors who thus assess the degree to which today's abundance is transitional or not, and decide to what degree inventory should be held back (and encumbered) for future use. If investors feel today's abundance will shortly be replaced by scarcity, they incentivise the market to store today's surplus, usually by promising producers a premium for the right to access that supply at a later date. In today's world this is accomplished by a futures market that's in contango. On the contrary, when the market is gripped by scarcity, investors encourage producers to sell everything they've got today on the expectation that the market will take measures to add to supply over time. In today's world this is accomplished by a futures market that's in backwardation. The problem we have today is that investors have potentially over-estimated the period of abundance. They are waiting and waiting for scarcity to materialise, but to no avail. The risk for producers comes if and when these very same investors begin to change their viewpoint. And this, arguably, is what is happening now with the emergence of backwardation in many markets. What this transition means is that rather than incentivising stores to be held back to cover periods of anticipated scarcity in the future, investors are now incentivising producers to deplete stores as quickly as possible. But not because there is a current scarcity and because the market will add to capacity overtime, but because measures have to be taken to cut abundance through output and capacity cuts. It's a rebalancing of a different sort. One which will no doubt dent income at many global commodity producers, which accounts for the reluctance to comply and the ongoing want to add to inventory regardless. Inventory stockpiling is only delaying the inevitable, a fact which Oleg Deripaska for one now recognises. In Joseph speak... it's like the seven years of famine never arrived. But because Joseph doesn't want to be sent to the stocks, he's doing his best to keep Pharaoh of the opinion that future scarcity is right around the corner. Though don't get us wrong. We're not saying the risk of commodity scarcity has been fully eliminated. But it is possible that the rise of information technology, the internet of things and 24-hour commodity tracking more generally has made us a lot better at adapting to supply and demand changes, that we just don't need the spare inventory we once did to shock absorb the mismatches. Related links: Storage play by Glencore, Trafigura pushes up lead costs - Reuters Slumping trade growth - and more oil Jedi mind tricks? - FT Alphaville Scarcity amid plenty, oil edition - FT Alphaville The oil-bound - FT Alphaville This entry was posted by Izabella Kaminska on Wednesday, September 19th, 2012 at 13:10 and is filed under Capital markets, Commodities. Tagged with aluminium, commodities, deripaska, lead, oil.