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    Capital Markets | 6 min read

    If You Can't Beat Them, Join 'Em

    “After all, we are not communists” – Don Emilio Barzini, The Godfather Part One

    As we enter the most confusing investing chapter in The Great Pandemic, I’ve been thinking a lot about what are some good, or maybe even great, investments to take advantage of the current dislocations as well as the ones to come. I have been thinking of this since a strange thing happened to copper on the London Metals Exchange (LME) back in the month of October.

    The amount of copper in LME Warehouses available to trade dropped 124,200 tons as of September 30, 2021, to 14,150 tons on October 15, 2021, an astonishing 89%. That has never happened before in such a short amount of time. Nearly all the LME warehoused copper resided in LME designated warehouses located in Rotterdam, Netherlands, and Hamburg, Germany at the end of September. In just about three weeks, it was nearly all cleared out. The abrupt move caught anyone needing to buy copper for near delivery short and severely out of luck while whoever owned spot copper was left very happy. The cash to three-month spread for LME copper went from eight as of September 30 to 257 on October 15and then a jaw-dropping 1,103 on October 18. The next day Bloomberg News reported:

    Trafigura Group, the world’s top copper trader, said it’s been withdrawing stocks from the London Metal Exchange to ship to customers in under-supplied physical markets and it communicated the trades ahead of time to the bourse. Bloomberg reported on Tuesday that Trafigura had ordered significant volumes of copper from LME warehouses over recent weeks, helping to drive down available stocks to the lowest since 1974 and pushing a key spread to the highest on record.

    Trafigura immediately denied that anything untoward had happened, stating again that they were pulling metal out of the warehouses for end users. Magically, the day that Bloomberg broke the story, the cash to three-month spread dropped back to 338 (69%). As of November 15the spread is now at 32 (down 97% from the high). Meanwhile, copper is slowly being added back to the LME warehouses, about two to three thousand tons a day. What might have happened other than a handful of entities hoarding over 100,000 tons of copper in three weeks? 

    LME storage or stock numbers for the eight major industrial metals, (primary aluminum, aluminum alloy, American automotive aluminum, copper, lead, nickel, tin, and zinc) is public information. With the right data provider, like Bloomberg, you can see every day what the amount of all the metals mentioned above are in each LME warehouse in the world. Within the warehouses, if a metal is spoken for but still in the warehouse and theoretically available to trade (think of it as the float), it is labeled “On Warrant."  When metal is labeled “Off Warrant,” its owner has communicated to the warehouse that it wants its metal from the warehouse. That metal is no longer part of the float. End users and traders of industrial metals watch these numbers every day. When they saw that copper "on warrant" went to "off warrant" to the tune of 124,000 tons in three weeks panic and the short squeeze mentioned occurred.   

    Therefore, if you own your own warehouses that are not part of the LME and you have the ability to move large amounts of metals on your own, you can notify the LME warehouses that you are moving your metal, which makes it go from On Warrant to Off Warrant and presto, a short squeeze panic. It just so happens that Trafigura has all these capabilities to do such a thing.

    The main point here is that companies like Trafigura that can physically store vast amounts of commodities like copper, have the logistical infrastructure to move those commodities where they want to without having to involve any outside parties, and has the ability to trade those commodities is usually going to win in normal times. In crazy times like these, operations such as Trafigura play the game like Alabama playing against Southern Mississippi, every day. Glencore is also a major commodity-focused firm. They also own the commodities; they own storage throughout the world, and they have the logistical infrastructure and know-how to move it. In fact, up until 2017 Glencore owned a vast network of LME warehouses until they, along with Goldman Sachs and JP Morgan, were sued in 2013 for warehouse tomfoolery. Owning the metal and the LME warehouses to go along with a major trading operation is a neat trick. 

    And then, there is oil and gas. In March 2021, Bloomberg News had a fascinating piece titled “Big Oil Secret World of Trading”. The article highlighted the oil and gas trading businesses of Royal Dutch Shell, BP, and Total. From the article:

    In an average year, Shell makes as much as $4 billion in pretax profit from trading oil and gas; BP typically records from $2 billion to $3 billion ­annually; the French major Total not much less, according to people familiar with the three companies. In the case of BP, for instance, profits can equal roughly half of what the company’s upstream business of producing oil and gas makes in a normal year, such as 2019. In years of low prices, like 2016 or 2020, trading profits can far exceed those of the production business. Last year, both BP and Shell made about $1 billion above their typical profit target in oil and gas trading.

    The CEO of Royal Dutch Shell perhaps summed it up best when he presented his massive oil and gas trading operation’s earnings in July 2020:

    “That’s no ordinary trading. That is actually optimizing market positions that we know better than anybody how to take advantage of. It actually makes the magic.”

    That’s enough for me; I would like some magic too! Think about what happened on April 20, 2020, when May 2020 WTI crude futures went to negative $37 a barrel. The story was that many unfortunates found themselves having to take delivery of crude at the same time the storage capacity in Cushing, Oklahoma the main storage facility of WTI crude had no more room at the inn. Was this the complete truth? I think partially, but not the whole truth. Certainly, if you were one of the big players and you owned a large amount of storage at Cushing, you were in the nexus of information in the middle of chaos as well as in control of a sizeable amount of physical storage capacity. That kind of knowledge and capacity could make you a lot of money.

    WTI crashing below zero was not a big surprise to everyone as many made a fortune that day including a small group of oil traders in London known as Vega Capital. Vega made $660 million on the day WTI went negative. If you stop and think about it, which not many people seem to have done, for Vega Capital to make $660 million in one day they would have had to take an awful lot of risk, meaning that if they were wrong about their bet for a complete one-day historic collapse they would have lost tens of millions. These blokes were certainly great oil traders but trading with their own capital, it is hard to imagine that they had enough capital for counterparties to trade the kind of size they traded that day. The whole thing is very fishy. Vega had to know something that only a select few knew and it is hard to imagine Vega being able to make such outsized bets without somebody bigger staking them.

    If you believe as I do, that the next 18 months or so will see tremendous volatility in commodities where information is more key than ever, then you want to be placing your bets on the global giants that have that information as well as the ability to act before everyone else finds out. While Trafigura is private, Glencore is not. Total is not public but Royal Dutch Shell and BP are.

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    © 2020 SWBC. All rights reserved. Securities offered through SWBC Investment Services, LLC, a registered broker/dealer. Member FINRA & SIPC. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor, registered as such with the US Securities & Exchange Commission. SWBC Investment Services, LLC is under separate ownership from any other named entity. SWBC Investment Services, LLC a division of SWBC, is a nationwide partnership of advisors.

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    John Tuohy

    John Tuohy is CEO of SWBC Investment Services, LLC, a Broker/Dealer and SWBC Investment Company, an SEC Registered Investment Advisor (RIA). In his role, John is responsible for identifying, developing, and executing the division's strategic plan and all business development, sales, and marketing activities.

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