Goldman Sachs and the Aluminum Warehouses: Part 3

Facts matter: Sign up for the free Mother Jones Daily newsletter. Support our nonprofit reporting. Subscribe to our print magazine.


Why does Goldman Sachs own a big aluminum warehousing business that it deliberately runs poorly? Yesterday I suggested that Goldman couldn’t possibly have any interest in the warehousing business per se, so instead their interest must have something to do with trading profits to be made by controlling and manipulating physical stocks of aluminum.

Today, Izabella Kaminska of Alphaville confirms that this is the case. But how and where does Goldman make money? I can’t pretend to follow every twist and turn of Kaminska’s explanation, but here’s my take on the basics.

Suppose that aluminum sells for $1,800 per ton on the spot market, but a contract for December delivery sells for $2,000. There’s a moneymaking opportunity here: buy the aluminum now, warehouse it, and simultaneously forward sell it at a premium. As long as your storage and financing costs are low, you’re guaranteed to make money.

This condition is commonly called contango, and it’s not unusual in commodities markets. Goldman was able to profit from this—their financing costs were already low, and buying the warehouse business provided them with low storage costs—but that’s not the whole story. It turns out that lots of Goldman customers wanted to get in on this action too, but they were limited by the fact that contango plays were a big drain on their balance sheets. To help out, Goldman “created a business in freeing up the balance sheets of those firms which were encumbered by large but clearly profitable contango trades, by financing these trades and taking them off-balance sheet in return for some of the contango margin.” In other words, Goldman helped its customers expand their trading positions in return for a cut of the profits. Owning the warehouses was key to this.

There are six paragraphs of detailed explanation that follow this, and I might as well just fess up that I don’t understand them. Click the link if you’re more finance savvy than me and want to know more. The end result, says Kaminska, was “the mass encumbrance of physical commodities for the purpose of collateralising implied future demand from retail and pension funds — which would otherwise take the shape of a much less tangible and uncollateralised futures investment.”

Roger that. In any case, Kaminska suggests that this would basically be OK except that:

  1. The process creates the means by which speculation does end up driving and influencing physical prices (rather than being priced off physical realities)
  2. There is a fiduciary issue because banks have an incentive to maintain the illusion of physical scarcity to mislead investors. This is so that pension and institutional money keeps flowing into commodities so that synthetic yields can be extracted from the flows to be handed over to the sell-side and/or commodity industry. It is, in effect, a stealth yield transfer from those who have been sold the myth that commodities are a viable (and scarce) asset class to those who have too many commodities to sell. Further perpetuated, we should add, by the myth that commodities can protect wealth from inflation.
  3. The dark inventory hoards can be used to the trading advantage of the banks.

Point 3 has to do with the practice of reclassifying inventory as either public or private. By manipulating apparent inventory levels, Goldman and its customers can benefit when markets are in contango and when they’re in the opposite, or backwardation, state:

When it suits an institution to benefit from a move towards backwardation, public inventory will be taken dark, and positions established to benefit from an apparent destocking effect — even though the collateral is not heading to market at all. When it suits an institution to benefit from a move towards contango, dark inventory will be taken public, presenting the appearance of a sudden surplus and glut in supply (even though the glut was always there).

This is the other reason why owning warehouses became so appealing. It’s much harder to keep inventory out of sight of public eyes if you’re dependent on the LME warrant system or third-party providers.

Bottom line: you just knew that this whole thing had to be some insanely complicated trading ploy, and you were right. It’s complicated enough that I still don’t really understand the details. In a nutshell, though, if you control the inventory of a commodity, you can make a lot of money. Speculators have known that for a very long time, but the old, crude days of simply cornering a market are gone. These days, markets are manipulated in much more sophisticated ways. As always, though, you and I are the ones who pay the price.

REAL QUICK, REAL URGENT

Minority rule, corruption, disinformation, attacks on those who dare tell the truth: There is a direct line from what's happening in Russia and Ukraine to what's happening here at home. And that's what MoJo's Monika Bauerlein writes about in "Their Fight Is Our Fight" to unpack the information war we find ourselves in and share a few examples to show why the power of independent, reader-supported journalism is such a threat to authoritarians.

Corrupt leaders the world over can (and will) try to shut down the truth, but when the truth has millions of people on its side, you can't keep it down for good. And there's no more powerful or urgent argument for your support of Mother Jones' journalism right now than that. We need to raise about $450,000 to hit our online fundraising budget in these next few months, so please read more from Monika and pitch in if you can.

payment methods

REAL QUICK, REAL URGENT

Minority rule, corruption, disinformation, attacks on those who dare tell the truth: There is a direct line from what's happening in Russia and Ukraine to what's happening here at home. And that's what MoJo's Monika Bauerlein writes about in "Their Fight Is Our Fight" to unpack the information war we find ourselves in and share a few examples to show why the power of independent, reader-supported journalism is such a threat to authoritarians.

Corrupt leaders the world over can (and will) try to shut down the truth, but when the truth has millions of people on its side, you can't keep it down for good. And there's no more powerful or urgent argument for your support of Mother Jones' journalism right now than that. We need to raise about $450,000 to hit our online fundraising budget in these next few months, so please read more from Monika and pitch in if you can.

payment methods

We Recommend

Latest

Sign up for our free newsletter

Subscribe to the Mother Jones Daily to have our top stories delivered directly to your inbox.

Get our award-winning magazine

Save big on a full year of investigations, ideas, and insights.

Subscribe

Support our journalism

Help Mother Jones' reporters dig deep with a tax-deductible donation.

Donate