Why Subsidize Speculation in Commodities?

If you follow me on Twitter @ElliotTurn, you know that commodities have been a big point of interest of late.  I’ve been spending some time trying to distill whether the driver of the commodities bull market for the last decade has been US monetary policy or China’s rapid acceleration in growth.  The answer to that question has significant implications for several different types of investments today, and is really just an interesting and important point in understanding today’s macroeconomy.  But today, with commodities a hot-topic and tax day quickly approaching, I want to take a glimpse at commodities through a different lens entirely.  With oil prices rising quickly in the face of our largest build in crude oil inventories since 2008, there are obvious questions being raised about the impact of speculation in commodity markets (see here for a good look at the question).  After all, how can something go up in the face of an overabundance of supply?  Rather than try to answer the question of how much of a premium in commodity prices is driven by speculation, to this too, I want to take a different angle altogether.

Whether one agrees or disagrees with speculation being a factor in commodity markets, I think we can all agree that such activity should not be subsidizes no matter what.  Yet, that is exactly what our tax code does—it incentivizes speculation in commodities over speculation in any other market.  Even more, speculation in commodities is a great way to guarantee a lower tax rate than the general income tax, when compared to any other profession in America.  There is a hot debate over carried interest, yet this loophole is at least as egregious. 

Broadly speaking, we are in a state of heightened global macroeconomic volatility, and that alone does yield way to increased volatility in demand and pricing for resources; however, that does not explain some of the radical swings in commodities ranging from oil to palladium to gold in recent times.  Since the 2003 Bush Tax Cuts, long-term capital gains are taxed at a 15% rate, while short-term capital gains are taxed as general income, at a 35% rate.  These capital gains apply to most forms of investment income; however, they do not apply on gains in futures contracts–the principle way in which commodities are traded.  Futures contracts, as prescribed by Section 1256 of the tax code, are taxed with a blended rate of long and short-term gains: 60% long-term capital gains and 40% short-term.  The blended rate results in an effective tax rate of 23% on income derived from futures/commodity trading (check out this site for more information on trading taxes).

In essence, the tax code promotes short-term speculation in commodities markets, and it does so in several ways.  People who are speculating in commodity future markets are inherently short-run, and care far more about the discount on the short term capital gains tax rate than they do the increased cost of long-term commodity ownership.  Whereas a short-term equity speculator is taxed at the general income rate, a commodities/futures speculator is taxed at 23%.  The consequences of this are two-fold: first, there is an economic incentive for speculators to ply their craft in commodities markets as opposed to equity markets, and second, speculators desire volatility in the short-run in order to maximize their capacity to make money, such that there is a serious misalignment of incentives between speculative market participants and the purpose of commodity markets. 

The goal of commodity futures markets is to provide a venue through which buyers and sellers of raw materials can share some of the risks in price fluctuations and both can secure some sort of certainty for longer-term budgetary purposes.  Fundamental commodity market particpants are not necessarily trying to make money on each transaction, but rather their aim is to gain security in price on both sides of the equation in order to more efficiently plan and manage their business.  Because this is the existential purpose of commodity markets, it should be noted that volatility poses dangerous risks to the players who need smooth functioning in these markets most. 

Meanwhile, short-term transactions that result in realized gains in commodity markets are not done with the intention ever taking or giving delivery of the underlying goods themselves.  Rather, these transactions are done for the purpose of realizing a gain off of changes in price.  These transactions require inefficiencies between supplier and buyer PLUS volatility in order to generate a profit.  In seeking volatility, such transactions promote yet further volatility.  Because of this fact, volatility and market dislocations lead directly to more opportunities for speculative gains.  Pushing such actors into commodity markets creates a situation where volatility becomes a self-fulfilling prophecy for the benefit of a significant portion of market participants, but a detriment to society at large. 

Speculative traders do play an important role in that they provide liquidity for the true suppliers and consumers of commodities; however, there is no reason for the government to provide a direct subsidy in inducing speculators to prefer commodity rather than any other market.  And there’s really no reason that speculators who engage in these markets for a living should pay a lower tax rate than any other hard working American.

Since markets like these are zero-sum, where one actor must inherently make money at the expense of another, there is unquestionably at least some coefficient of a speculative cost in the price of commodities.  No one these days is seriously concerned about a lack of liquidity in commodity markets, if anything we as a society acknowledge the abundance of this liquidity between the proliferation of commodity-based ETFs.  While we can’t necessarily weed out all speculation from these markets, we can realign the incentive structure to be symmetrical with every other profession in our country.  This is a question to which both Democrats and Republicans should be able to find some common ground.

Why Italy Doesn't Worry Me

With Greece once again making front-page headlines, the attention, as it often does, is seeking the “next crisis.”   Just like this Summer, to many the next phase involves the inclusion of Italy in the Euro-induced panic.  Why Italy?  Many of the reasons are obvious: Italy is carrying a $2.1 trillion budget deficit accrued over years past (all dollar figures cited throughout are Euro’s converted into dollars at today’s $1.324/€1 exchange rate), the country is infamous for a perpetually corrupt economy, and the nation’s politics are equally dysfunctional.  In many respects, Italy remains a pseudo-fascist state, where government and business are largely intertwined and collectively unproductive. Yet despite these notorious problems, Italy does not concern me, as much of the crisis argument for the country hinges on the manipulation of numbers while willfully ignoring the rich assets the country possesses. 

This past summer, yields on Italian bonds surged above 7%.  This forced long-time Silvio Burlesconi, a man who survived numerous scandals, to finally depart leadership, and drove the European Central Bank (ECB) to buy Italian debt on the open market to help drive down yields.  In fact, it was the spread of contagion to Italy that provoked the more acute phase of this Summer’s Euro crisis that ultimately drove the European Union to embrace a fundamental rethinking of the Maastricht Treaty.  Italy entering the crisis faze was (and remains) concerning because of its size relative to Greece.  To make matters worse, Italy needs to refinance over $300 billion of its legacy debt in 2012, an amount which in and of itself is nearly as large as Greece’s entire deficit.  By that token, as the Forbes article linked to above suggests, “Italy is too big to bail out.”  Fearmongerers love using size to their advantage as it relates to the Italy “problem,” but they equally love ignoring size when the topic becomes the relativity of Italy with Greece, so let’s take a deeper look.

Let me start with this caveat: this is not an argument for or against privatizations in Italy, or anywhere else for that matter.  I am merely going to lay out a few of the assets that the Italian government positively owns, in order to highlight my belief that this is a crisis of liquidity and not one of solvency, and as such, it is very much a transitory event  as it pertains to Italy.  In the future, I will be sure to discuss my beliefs on the Euro as a currency in more depth, for that will shed further light on my argument that Italy is not a concern in the first place.

Italy vs. Greece—Some Relativity

What makes matters appear far worse than they actually are for Italy is the frequency with which people are stacking the country’s $2.1 trillion deficit against Greece’s $456 million deficit to highlight the “greater magnitude” of Italy’s problem.  To the lazy eye this looks frightening, yet it’s not— the fearmongerers are intentionally aiming their appeal towards the lazy eye.  What they don’t want you to know is that Italy’s GDP dwarf’s Greece’s (Italy’s is greater than $2.1 trillion, while Greece’s is a mere $329 million).  Further, these numbers are solely looking at accrued deficits from years past and in no way reflects the fact that Italy is running a SURPLUS (yes you read that right) of approximately 0.8% of GDP this year, while Greece is in a tailspin.  Quite simply, the situations are not analogous.  It is merely the size of Italy combined with the “what if” that drives the fear, whereas in Greece the problem is fundamental and existential as it pertains to the country’s continued inclusion in the Eurozone. 

A Wealth of Assets in Italy

Let me start with a question: which country in the world has the third largest gold reserves after the U.S. and Germany? 

Clearly the answer I’m getting at is Italy.  Italy has immense gold reserves that serve no functional purpose for the country at this point, especially since they themselves are not sovereign over their own currency.  At today’s price of ~$167/ounce, Italy owns $14.4 billion worth of gold.  This alone accounts for 6.9% of Italy’s budget deficit.  The concern that Italy’s deficit will persist in perpetuity is a core argument of the fearmongerers, therefore the value of using that gold to pay down the deficit is far greater than the value of the actual gold itself.  Viewed as a perpetual obligation at Italy’s present 5.5% interest rate on the 10 year note, the paying down of $14.4 billion of debt amounts to a net present value of a $262 billion gain.  I like to think of the benefit this way because Italy is carrying a primary surplus right now, and as such, dropping its perpetual debt burden substantially alters the country’s present and future outlook for the better.  The cost-to-carry of the debt instantly drops, as should concerns over refinancing 14% of the country’s outstanding debt during the course of 2012. 

Now let’s get to where Italy really has substantial wealth—public ownership of corporate enterprises.  In the time leading up to World War II, the fascist regime of Benito Mussolino used the government as a means through which to build corporate Italy.  While fascism was defeated in World War II, the legacy of government intertwinement with business in Italy never ceased.  In fact, it was the primary method through which Italians rebuilt and moved forward in the aftermath of the War, with some generous help from Uncle Sam in the form of the Marshall Plan.  Largely due to this history and a dose of corruption, the Italian government continues to own substantial business interests within the country.  Below is a select sample of a few of these interests.

First up is Poste Italiane, the Italian “post office.”  I say post office in quotes, because while the company does postal services, it is not your run-of-the-mill post office.  Poste Italiane operates several lines of businesses including logistics (which does have a natural connection to package delivery), financial services, insurance, phone calling cards, and even semi-conductor manufacturing.  In 2011, Poste Italiane brought in $28.9 billion in revenues and had nearly $2.5 billion in operating income.  Further, the European Union has rules and restrictions on post offices, and is trying to liberalize and even phase out some of the government postal services themselves.  As is typical for Italy, the country has been slower than slow in pursuing these liberalizations, as evidenced by this quote from the Consumer Postal Council: “The target date for full liberalization had been postponed several times [by the European Union], and Italy took full advantage by refusing to liberalize its market ahead of schedule.”  Why does this matter?  Well again, an interest in a profitable business like Poste Italiane could easily be worth $25 billion on the private market (this is a rough earnings power valuation of a company generating $1.5 billion in sustainable EBIT). 

Luckily for Italy, Poste Italiane is just the tip of the iceberg for government ownership of industry.  The Italian government is also the full owner of Fincantieri, the largest ship-builder in the Mediterranean.  While the company is not nearly as profitable as Poste Italiane, the state ownership is notable, for why does the Italian government even have the full ownership of a company that today is known for being the premier manufacturer of luxury yachts in the world?  At one point in history, Fincantieri served a purpose for the government in manufacturing military vessels, yet now the company is better known for building super-yachts for Europe’s elite playboys to cruise the Italian Riviera and the Amalfi Coast.  Fincantieri suffers from government’s inability to efficiently manage the business as is evidenced on its 4% operating margin on over $3.5 billion in revenues.

One of the prizes of Italy’s ownership interests in corporations is Eni, a publicly traded conglomerate with a market cap of $91 billion today.  The government owns 30% of the company, a stake worth $27.3 billion on the open market.  Eni, an integrated energy company involved in exploration and production and the delivery of oil and natural gas, makes $21.3 billion in operating profit and over $8.3 billion in net income.  As of today, the company is valued near the low-end of its five year trading range, and outside a crisis environment could be worth far more down the road. 

Lastly, let’s briefly talk about Italy’s public interest in broadcast and media.  In my opinion, this is a pretty big no-no for a liberal democracy to begin with, especially in light of the fact that the recent Prime Minister owned the largest private media empire in the country, while pulling the strings at a substantial state-run enterprise.  In essence, the media and the government were inseparable, and this helped Burlesconi consolidate his grip on power for so long.  This is a greater than $3 billion in revenue business, that includes ownership over Cinecitta, the largest cinema studio in Europe, and the crown jewel of Mussolini’s propaganda initiatives during World War II.  Many a great Sofia Loren films, and more recently Gangs of New York and The Life Aquatic were filmed there  It’s no wonder that outsiders view Italy as helplessly corrupt.   Needless to say, there is tangible asset value here, that given the need, Italy could monetize in order to bring their debt burden under immediate control.

In Sum:

I have outlined approximately $73.2 billion dollars of tangible value (or 3.4% of the deficit) that Italy could monetize should the need arise, and this is far from an exhaustive list (please note that the $73.2 billion figure counts Italy’s gold value at $14.4 billion, and not the more generous $262 billion benefit the country would gain from removing a perpetual liability from its balance sheet, as would be the case with any of these other valuable assets).  In addition to gold and corporate interests, the country owns billions of dollars worth of real property. While this would not extinguish all liabilities entirely, even the most gloomy of observers doesn't think that is what's necessary.  The key is to restore the debt to what the market perceives to me a manageable level, which in and of itself will drive down yields and make the cost of carry that much less.

Despite these facts, fear itself is contagious and that is clearly evidenced by the concern over the country in debt markets today.  Italy is not running a deficit as of today, and as I have highlighted above, the country owns substantial assets.   I cannot help but think that one catalyst for the contagion of fear is the market trying to force the country’s hands into privatizing these aforementioned lucrative assets.  In past debt crises around the globe (Latin America serves as an outstanding case study), substantial state owned assets were privatized in order to cover public borrowings.  In the process, many profited directly by positioning for a crisis and then deployed their gains along with those who stayed on the sidelines in order to make substantially more money in scooping up newly private assets at dirt cheap prices.  To many, a crisis is an opportunity and that is precisely how Carlos Slim became the wealthiest man in the world.