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It is not an exaggeration to compare the complex derivative strategies surrounding resource inventories to the U.S. subprime mortgage crisis. We're not kidding. Mining companies are using inventories in the same way investment banks used mortgages, the complexity level is exceedingly high and, like the banking crisis, the scale of speculation is hidden from normal accounting procedures.
The bulk of the work here has been done by Izabella Kaminska from the Financial Times who describes the phenomenon on her personal Tumblr account. In simple terms, resource companies are "financializing" their inventories – using physical assets as collateral to implement hedge fund-like derivative strategies.
For instance, a copper miner could realize revenue by selling call options for a fee to a metals-based ETF. This revenue is higher than the yield the mining company would receive for selling physical assets and investing the proceeds into government bonds. If the ETF wants to exercise the option at expiry, the miner would basically hand over a portion of inventory at the agreed price. By doing this, the mining company is hedging the value of its inventory – locking in a minimum price – which seems completely reasonable.
Ms. Kaminska describes the potential problem:
"But what [miners who sell options] really have is counterparty exposure on their hedges, not a safe 'state guaranteed' asset at all. If and when commodity prices fall, the people on the other side of those hedges will be more and more out of the money. They will either close out (which will impact the price of new hedges) or have to deliver margin.
"If and when they are caught out they will have to raise $$$$ to maintain those commodity positions. If they can't they will be forced to close out, realizing losses – stemming from failed promises that commodities would definitely outperform in the long run.
"In the end you will get the very same situation plying out as with subprime."
More than 40 per cent of the S&P/TSX composite index is composed of energy and mining stocks, so it's hard to image a more important issue for Canadian investors. At the very least, as the unwinding of this strategy occurs and resource inventories can no longer be used as the spine of a hedge fund, they will be released into the market and depress global commodity prices. The disaster scenario would prompt a messy unwind of both futures positions and physical inventories at the same time, creating a rapid downward spiral for commodities.
There is no way to know the extent of the potential problem. According to Ms. Kaminska, the mining companies hold these positions under the accounting category "cash and equivalents" and there is no way to break them out to assess liability.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow