[A-List] Reconnecting to the real economy

["Michael Keaney" <michael011@xxxxxxxxxxx>]

Real-world thinking that comes from inside the box
By John Dizard
Financial Times: May 28 2007

In the New York-London metroplex we're very, very good at coming up with
innovative products such as arbitrages between options and forwards on
indices of baskets of collateralised debt obligations comprised of
credit default swaps on other CDOs against the underlying asset.

The fundamental strategy, to separate ourselves as much as possible from
the real economy, is working quite well, as reflected in our local real
estate markets.

Even so, from time to time, it's useful to look down from the
pressurised cabin, even to land and make a first-hand assessment of what
is going on where things are produced. It can be particularly useful at
possible turning points in the economy, when the aggregated, adjusted
numbers we see in the centre of the world don't tell us enough about
prospects in the real world.

I spent a few days in Texas last week, out in oil and gas country and in
Houston. While Texas is anomalous, heavy with years of energy profits,
the people there are close to actual production of goods and services.
Houston's trading community, which at the beginning of this decade was
over-concentrated in a few large companies, has evolved and diversified.
The Enron traders who weren't caught up in criminal or civil cases make
up an influential (and more careful) diaspora. I don't know if they have
a secret handshake, but they do a lot of business with each other and
have accumulated a lot of new capital.

One such group has been doing a lot of work trading the inefficiencies
of the forest products market. Enron itself did this before the end and
the strategy was one of the ones that worked pretty well right up to
when the parent's credit disappeared. The big E would go to, say,
newsprint buyers, who apparently are naive about financial matters, and
sell them 10-year supplies. Then they would hedge out the price risk of
the energy embedded in the newsprint, along with the price risk of the
pulp and any other hedgeable risks they could identify. They were left
with a high yield synthetic bond, financed with Enron's investment grade
paper. When the rating went away, so did the trade.

Enron's forest products people were on the street with the tumble-weed.
But the company's implosion left more risks unhedged by producers and
consumers out there: meat for speculators. You can see this even now in
over-the-counter markets for the forest product complex which, unlike
most metals and energy products, are backwardated. That is, the spot
prices are higher than prices in the months further out. That used to be
the case for better known commodities before excessive capital from the
funds and institutions was thrown at the sector.

Before Alan Greenspan was known for making scary speeches and collecting
huge advisory fees, market people knew he spent a lot of time looking at
the market for cardboard boxes. Most things you use are put in a
cardboard box at some point, and box use, production, inventories and
pricing are, therefore, useful indicators. What is the box world telling
us?

According to my Houston traders, not encouraging things. The
conventional line from the Federal Reserve and the economy bulls is that
the US housing market may be weak but it is beginning to stabilise, and
that the rest of the economy is continuing strong. The overall recovery
in growth the Fed expects later this year would make a rate cut
inadvisable.

But the box story is not quite so bullish. My trader says: "Box demand
has been weak for the past five months or so. In April, supposedly you
saw an uptick on a year-on-year basis but, on an average weekly basis,
it was still in decline. There was one extra shipping day in April 2007
compared with April 2006 and, if you take that out, box shipments
actually declined this April.

"Also, when we talk to people in the field about what is going on now,
they say that they are not seeing any great increase in demand and that
there is no way that the producers will be able to get the increase in
the containerboard price they are trying to impose."

Still, the market for boxes and the containerboard used to make them is
finely balanced. Hesitant producers and consumers are keeping low
inventories, which helps to prop up prices. And there is a trend to
"consolidation" in the containerboard industry, which means that a
smaller number of producers may, in the future, be able to use market
power to keep up prices even in a weak environment.

"One trade we're looking at is buying the back months in
containerboard," the trader says. "It's so backwardated that you could
see a fall of $40 a tonne in prices [a typical decline in a recession]
and your forward purchase would still not liquidate negative [be
unprofitable]."

So is that our future: stagnant to falling real demand but sticky,
cartel-like prices and opportunities for a few traders of inefficient
markets?

Sounds a lot like the 1970s. Not like what we're seeing discounted in
the equity markets.


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