Gekko - effects of Sumitomo Corp.'s copper futures scandal - Column

National Review, July 15, 1996 by John Dizard

I DIDN'T think I'd be vindicated quite so soon on my call on the copper market, but there you are. Once again, we see how people can ignore what's going on right in front of them. Sumitomo's market manipulation, which Gekko first began to report in July of last year, was known to the major players in the market. Yet they were somehow able to compartmentalize the knowledge and act as if this were a normal market.

Instead, as we now see, it was one where the biggest player was willing to accumulate $2 billion - plus in losses to paint the tape. The story isn't over, however. Sumitomo supposedly is long as much as 2 million tons of copper, which is about 20 per cent of a year's world production.

Interestingly, it isn't the major copper-mining companies who will take the first hit on the old income statement. Over the past couple of years, they knew that with copper trading far above its cost of production and true equilibrium value, they had better lock in their excess profits while there were still dealers and banks prepared to believe in the Easter Bunny.

So the copper companies went to the major copper-trading houses and a number of the major international banks and contracted to lock in a minimum price on their production over a couple of years. The dealers sold them puts, which gave the copper companies the right to sell their production at a certain minimum price if the unthinkable should happen and the price of copper were to fall to 90 cents or below. Which it has done.

Now the trading houses and banks, being incredibly smart people, knew that they were assuming some risk here. But they also figured that they could reduce that risk to a calculated minimum through "dynamic hedging," or selling on the way down. Their models, based on historical data, showed that that would be no problem.

What those models ignored was what happened in other markets where everyone decided to do his dynamic hedging, or selling, all at the same time. They crashed as liquidity dried up. For example, "portfolio insurance" programs in the October 1987 U.S. stock-market crash, and the emerging-markets bonds derivatives in early 1994. But the hope among the traders writing the puts was that they would get their bonuses paid out before anything happened, and many of them were probably right.

There were some people in the perhaps not much loved New York hedge community who could see that the Copper Emperor of Japan had no clothes. They bet heavily against the whole inflated copper game, and have booked good profits on their short positions. But reportedly, some of the short sellers, who believe that copper will continue to go down from here, have been getting calls from central banking officials trying to persuade them to cover their short sales sooner rather than later.

This would have the effect of at least temporarily propping up the price of copper and allowing certain banks to get out of their long positions at a lower loss than they might otherwise. This is consistent with the Federal Reserve philosophy that unlike other institutions, banks and perhaps some securities dealers must be protected from the consequences of their stupidity. We should all have such rich, indulgent, powerful uncles.

Hats should be tipped, by the way, to mining analyst Lianne Baker of Salomon Brothers. She was a lonely voice of reason and sound analysis in the copper market when the bulls were in charge.

Speaking of markets where people might be kidding themselves just a bit, at least in the short term, consider the Russian equities market. Back at the end of May, shares of Lukoil, the most widely traded Russian oil company -- the Exxon of the East, as it were --were going for around $6 a share. Toward the end of June you could consider yourself lucky, I guess, to have an order filled at around $11.30 a share.

The more feverish outside speculators might want to keep in mind that there's a banking crisis ready to kick in not long after the electoral process is over. Thanks to the Western taxpayer, the crisis in state finances and the banking system has been put off until after the elections, but some time later this year the crunch will come. What's interesting is that Russian stock-market operators don't bother to dispute this. They just think that it doesn't really matter, that values are so compelling in Russia that a banking "consolidation" not dissimilar to the one we had in 1932 - 33 shouldn't really slow down the market. Oh. Okay.

Grant Noble, a commodities player in Lake Forest, Illinois, has had a number of interesting calls in the markets he follows. Right now, he thinks that the best way to fade the conventional wisdom is by going long the March soybean contract and short March corn.

"I think that the market has overestimated the degree to which farmers have decided to switch out of corn and into beans," Grant says. "They're looking at how wet the weather's been, and how much later you can plant beans. But the price of corn has been so high that there is a huge incentive to plant corn, which I think is what has happened. My belief, based on both the fundamentals and the technicals, is that by the spring, beans will roughly double, and corn will go up maybe 50 per cent."