the Wealthy Canadian

Yesterday I discussed the difference between spot and futures pricing and how things work in a normal, contango, market.  Today I will look at what happens when things are not ‘normal.’

The difference between the spot and futures price is called the basis.  In a normal market there are adequate supplies of the underlying asset for every futures contract (i.e., every delivery month) and the basis reflects a premium on the futures contract (for the cost to carry).  For a better explanation, see yesterday’s post

Occasionally the futures price will drop below the spot price which is said to be an inverted market.  Of course, such a simple term would not be fun, so I present to you… (drum roll please), “backwardation.”

Normal market = contango
Inverted market = backwardation

Backwardation may occur for a number of reasons:

• Seasonal fluctuations of asset.  In the winter, the demand for heating oil increases but by the spring the demand will have waned so the futures price will not increase.
• A sudden lack of the asset.  When a refinery breaks down the supply of gas starts to drop and the price goes up, but generally the refinery will be operational again in three months so the futures price doesn’t need to increase.
• Asset does not store well.  Gold keeps well in my basement, oranges don’t.  If the oranges are ripe now then it would be better to own the physical asset.
• Asset is difficult to short sell.  Assets that are hard to short are generally those that meet the above conditions as well.

In an inverted market people prefer to own the physical asset.  If I need oil to heat my house then I would place a high value on owning the asset during a blustery Canadian winter.  The value placed on the commodity is known as a convenience yield.  Isn’t it convenient that I actually own oil now so that I can use it to heat my home and I won’t freeze.

I used to hear about futures prices and think that if March Gold Futures were trading at some price then come March the price of Gold should, reasonably, be that price.  That is not actually the case.

You can buy gold in one of two ways.

1. In the cash market, where you will pay the spot price.
2. In the futures market where you will pay the futures price.

The cash market is similar to a jewelry store.  You can go buy a gold ring today, pay cash for it and give it to your girlfriend immediately.

The futures market is sort of like going to the jeweler and saying that you will need to buy a gold ring in about three months time.  You don’t need it today, but you want to buy it today, just to make sure that you know what price you will have to pay and that they will have it for you.  What price should the jeweler sell the ring to you for?  The same price as the spot price?  No.  Remeber that the jewelry store will have to:

• store the gold for you (they promised you that exact amount and quality of gold so they have to make certain they have it when you go to collect),
• finance the cost they paid for the gold (they aren’t doing well enough to promise everyone a gold ring on the promise that they’ll buy it in the future)
• insure it (if it goes missing they still have to pay for it)

All of those are called the “cost of carrying” the physical asset.  Add all of those costs up and it may cost an extra $10/ month for them to hold onto the gold for you.  You agree because you cannot afford to buy the ring today.

Therefore,  in a normal “cost of carry market” the price for the gold ring in three months time will be the spot price plus the cost of carrying.  This normal market also has the fancy term , “contango.”

As the time goes by the futures price and the spot price will converge.  It costs 10 bucks per month to store it, so a three month agreement will cost an $30 over the spot price, but a two month agreement will only cost $20, one month is only $10, or you can buy it today without any carrying charges.

Of course, that is not always the  way it works.  Sometimes speculators get in the game, or there is a sudden shortage (or abundance) of gold, and the spot and futures prices will deviate from this contango pricing.

I’m seeing a lot of good comedy about the folly of our ways but no one states it so simply as Scott Adams:

Brilliant.

Of course, hindsight and all that… A few years ago it may have looked differently

Invest in high risk cattle, they’re only high risk because of an outbreak of Mad Cow disease.
Buy the entire herd to minimize your risk of one bad cow
There’s no way that the entire herd will be affected… diseases don’t spread like that, and we can still sell the beef after we kill the cow, anyway. So, there really is no risk

Corporate welfare vs. Corporate social responsibility

In North America,
* the banking sector has been failling, yet reportedly, the top execs are still making multi million$ in compensation.
* the auto industry is on the brink of collapsing in on itself after years of what I suggest is due to both poor management and design
* both sectors are going to get boatloads of taxpayer cash

In Japan,
* Toyota claims that they will not lay anybody off, instead they spend any downtime by (re)training their employees. They can do this because their management has a fifty (yes, 50!) year plan. not a five quarter plan.
* Japan Airlines CEO Haruka Nishimatsu, after giving many employees a buyout package, eliminated his executive perks and reduced his salary to $90,000 USD.

Watch the CNN report below.

And now for something completely different…

Jack and Gilles went to the Hill to try to crush the Tories.
Stephane’s the man to lead the plan,
And Michaëlle gets to decide the outcome.

Global economic crises abound and we don’t have a functioning government!  I cannot claim to understand all of the inner working of our political system.  However, it seems that the past two weeks has been all about power and nothing about actually governing.

When the going gets tough the… the feds stop working.

Anybody ever notice that Stephen is remarkably close to Stephane?

I apologise for sounding acerbic but this is getting tiring.  Hey, didn’t we just spend $300 million to form this government? And isn’t this their first week of “work”?  I like the Conservatives and their economic ideals… but I didn’t think that this is what they meant when they said “small government.”