“Pozsar proceeded to speculate on a tsunami of margin calls for market participants long physical commodities and short futures,” I wrote, on March 5, following the largest weekly gain for commodity prices in recorded history.
At the time, Vladimir Putin’s star-crossed misadventure in Ukraine was just days old and the incomparable Zoltan Pozsar was busy warning that if the rally in raw materials was one for the history books, “so the margin calls must be historic too.”
He was right. Shortly thereafter, the margin calls began, and they were indeed acute. The LME “Big Shot” fiasco broke the nickel market (literally) and echoed in JPMorgan’s first quarter results.
Having successfully telegraphed one of the most dramatic episodes in the long and storied history of the commodities trade, Pozsar quickly moved on to bigger and “better” things, where that means declaring the dawn of a “new monetary world order” and inaugurating “Bretton Woods III“.
Jerome Powell and his colleagues aren’t on board with any (tall) tales about the demise of dollar dominance in global trade and finance, but researchers at the Dallas Fed essentially rewrote Pozsar’s margin call note this week. It’s worth highlighting if for no other reason than the version penned by Jill Cetina, Matthew McCormick and Pon Sagnanert is more accessible — it’s written in English, not Pozsarian.
“Derivative hedges for firms that are long the underlying commodities… have liquidity implications for firms using them,” Cetina wrote, adding that,
While the two positions net out in an economic sense, the cash flows aren’t offsetting. For example, a commodity trading firm may buy a physical commodity and then also expend cash on a derivative hedge against falling prices. However, if commodity prices rise, the derivative position taken to guard against a price decline loses money. Margin calls from the derivative counterparty may follow, requiring that the trader/producer provide additional funding of the hedge and further draining cash. More broadly, the financing needs for global commodities increase significantly as prices surge. When prices of commodities rise quickly, not only do the prices of goods rise, but also the associated price volatility increases the size of margin calls. The rapid price increases across a range of commodities means that trading firms need additional credit to finance not only the goods they purchase, but also the margin they must post.
That speaks to the peril inherent in a correlated surge, something Pozsar emphasized (“Russia and Ukraine export pretty much everything imaginable,” he wrote, in the same early March note).
As Cetina went on to write, firms that find themselves caught out in the storm may feel compelled to protect themselves with options, which sounds good in theory, but it just means taking on more derivatives exposure. Effectively, the idea is to pay margin calls on short futures positions with profits from long calls.
Cetina pointed to elevated open interest in OTM crude options. “While some of the growth… may reflect market views about the future path of prices, some of this activity may also come from firms seeking to minimize the liquidity strains associated with other derivative positions,” she said, before noting that all of this points to higher financing needs, and thereby pressure on banks to extend more credit.
Of course, the more volatile the market, the more nervous banks will be, especially considering the current environment also involves Treasury sanctions. If sufficient financing isn’t available, intermediation will suffer, which could push prices higher still in what the Dallas Fed researchers called “a negative feedback loop.”
Last week, Ukraine begged Vitol, Glencore, Trafigura and Gunvor to “terminate” business with the Russian fossil fuel industry. Although commodity trading houses reiterated they’d halt new business with Russia, most intend to fulfill existing contractural obligations. On Thursday, Vitol said it would stop trading Russian oil entirely by the end of the year.
Cetina went on to note the obvious: The whole point of sanctions is to reduce intermediation in the market for Russian energy, and in the event sanctions eventually ensnare foreign subsidiaries of Russia’s state-run producers, they could be unable to “meet physical delivery or derivative obligations,” with knock-on effects for European utilities and refineries.
The Dallas Fed research piece cautioned that the European utility sector could suffer the same fate as electricity producers in Texas during the February 2021 deep freeze, when providers were “forced to make expensive purchases in the spot market for natural gas or were unable to produce and deliver electricity that they had sold forward in the derivatives market.” Recall the infamous chart (below).
During that highly unfortunate episode, some Dallas residents received electric bills in excess of $15,000. As one Army veteran told The New York Times amid the freeze, “My savings is gone. There’s nothing I can do about it, but it’s broken me.”
Is that what’s coming for Europeans? Maybe. That’s essentially the debate in Brussels. If Europe voluntarily cuts itself off from Russian gas, the Kremlin loses a crucial revenue stream. Putin would have virtually no incoming hard currency. Moscow would be in trouble. But so would European households. Germany is the key.
Finally, Cetina, McCormick and Sagnanert warned that “since foreign banks’ commodity financing is often US dollar-denominated, disruptions in commodity financing can weigh on offshore dollar liquidity.”
As Pozsar wrote six weeks ago, “commodities are collateral and every crisis occurs at the intersection of funding and collateral markets.”
I found out about the problem described by M. Cetina in the included quote the hard way in my younger days. I had enjoyed a nice run up in the market but the pundits were all forecasting a downdraft. I didn’t want to sell and cede my hard-won capital to the IRS and I did want to protect my gains so I worked with my advisor to develop an affordable, though a bit costly, hedge to protect my gain. Well, the market didn’t fall, my hedge moved against me, of course, and expired leaving me to eat a loss on the hedge. That was a real loss, like an insurance premium is a loss, and even though the market rise gave me unrealized gains equal to the loss on the hedge, the net effect was zero on the books but I lost the benefit of the gain and I would have had to do what I didn’t want to do in the first place, sell stuff or kiss the lost cash goodbye. What I learned that the cash mismatch in hedging, especially for retail punters such as myself, means hedging needs to be done in other ways. Thanks for the reminder, really.