Following the Money: How Goldman Sachs Manipulates Commodity Prices

Once again, maybe for the last time, Senator Carl Levin and the Permanent Subcommittee on Investigation has demonstrated how government, and the legislative branch in particular, can work in the public’s interest regardless of partisanship.

Yesterday’s hearing laid out a complex system of price manipulation in which Goldman Sachs appears to have pocketed huge sums by marrying aluminum derivatives and warehouses. The public was the victim.

The scam described by the Senator is a clever and diabolical hustle. It is based on the London Mercantile Exchange (or “LME”), the international price-clearing organization that until recently was owned by a club of market players, including Goldman. Any company can order up aluminum from one of the LME warehouses around the world. They can also go directly to smelters and other suppliers and often do so, but the LME source always provides a baseline price of last resort that shapes the negotiation with direct suppliers.

The regional LME warehouse price is determinative of marginal aluminum prices. If an aluminum derivatives trader could control the price or, most importantly, know ahead of time the direction of price movements, it could make a fortune.

Enter Goldman Sachs, which bought up LME aluminum warehouses sufficient to control 85% of the warehoused aluminum in the US, mostly in the Detroit region. What remained for Goldman was how to use this position to squeeze the market.

Prices paid by aluminum consumers are made up of two components—the base price applicable around the world and the regional “premium” for storage and transport. The premium is like the shipping and handling charge when one orders online. When a consuming company negotiates with a smelter, the discussion is over the premium and the LME fallback was an amount equal to two weeks of storage, the average time it took to get the aluminum out of a warehouse, plus trucking cost. 

Historically, the premium was around 5% of the all-in price.

It was clear that if the average storage time at the LME warehouses could be extended, the LME premium (the baseline in all negotiations) would have to cover more storage fees for aluminum sourced from LME warehouses. And this would change the negotiation of prices from direct suppliers like smelters. The all-in price for aluminum could be put on an upward trajectory without the underlying aluminum price changing at all.

And if Goldman’s traders knew of this in advance they could load up on physical aluminum and ride the price up. They could also enter into derivatives that would increase in value along with prices synthetically increasing their aluminum holdings by multiples.

Once Goldman got control of the warehouses, average storage periods pending delivery out (the queue for shipment to consumers) started to increase. The queue started at a few weeks and has increased to 665 days, almost 2 years. The storage fees for that extended period increase the price of last resort against which the whole markets bargains. Up goes the aluminum price, affecting everything from car prices to the price of a cold Coors. 

There was nothing apparent in the marketplace that could have caused this to happen; the main thing that had changed was that Goldman’s subsidiary controlled warehousing.

The cause seems to have been the way Goldman’s subsidiary ran its business. The process of shipping out seemed to just slow down. But LME had rules to prevent warehouses from hoarding. The rules required designated warehouses to ship a minimum of 1500 tons per month ship from facilities (recently this has been raised to 3000 tons). Goldman seems to have treated this as a maximum, targeting minimum compliance. And then they manipulated this maximum. First, they consolidated several of the warehouses in the Detroit area into integrated operations so that the 1500 ton minimum applied to a larger warehouse capacity.

But this was not enough. Owners of the stored aluminum were provided incentives to cancel their arrangements and move their aluminum to another Goldman warehouse, some as close as 200 yards away. They received a substantial credit for new storage so it predictably turned into an absurd shell game. This was the “merry-go-round of metal” made famous by a forklift operator interviewed for news accounts. Why did this nonsense persist? Maybe because the shell game involved the shipping out of aluminum, even if it was being shipped 200 yards and put back in the queue.

All of this caused a shipping backup and a two-year queue. And importantly it increased the average storage fees and the premium. In fact the premium rose from 5% of the all-in price to 20%, translating to billions over time.

Goldman asserted at the hearing that the premium increase made no difference in the all-in price, claiming that any increase in premium would cause the base aluminum price to go down. It is hard to see how this is true, and Senator Levin was severely skeptical. 

Experts testifying at the Permanent Subcommittee hearing agreed that the Goldman argument made no sense.

A more plausible analysis is that the increasing queue and the skyrocketing premium drove up the prices of Goldman aluminum holdings. Goldman could multiply those profits by anticipating the price rise based on knowledge of the plan by making bets on rising prices in the derivatives markets.

This may not be the biggest profit grab extracted by Wall Street in recent times. The aluminum market is no where near the size of the LIBOR interest rate market or the currency markets, both of which have drawn settlements in lieu of fines for manipulation and profit. But if this apparent scam is what it appears to be, the complexity and planning and the audacity of the whole thing is chilling.

All of these manipulations have an important thing in common: the real victim is the public. These financial institutions seem to have no moral compunction against increasing profiting from manipulative contrivances at the expense of American households. What do the individual traders think? That no one gets hurt?

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