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)

