Philip Manduca, Head of Investment of the ECU Group, discusses Greece and the very severe implications of what the final outcome will look like. “Trichet said the Greeks are crooks, and they’ve been lying about the numbers. There is a deeply embedded corruption within the Eurozone. Combined with the endemic European socialism and there is just no way you are going to get spending cuts and tax raises and maintain a GDP that makes any sense of the percentage aspect of debt to GDP. So the whole show is wrong. This is an intractable situation, this is going to continue on and on. The only hope for the Eurozone, and the Euro as a currency, is that someone takes the spotlight soon, and that may be the United States.” courtesy ZeroHedge

Here is our take on the current situation in the Eurozone:

German Exports

The German government needs to save the Euro at all costs, even if that cost is the wealth of its citizens. As exporters to the rest of Europe, Germany cannot let its trade partners wither as Greece currently is; it would spell disaster to their own economy and the Euro’s demise. They must bail out Greece.

Public Disconnect.

The German people do not want to bailout Greece. This political pressure puts the government in a bad position. While they EU members debate the “ifs” and “hows” of the bailout, the market is punishing them. Delay in action almost always results in a worse situation. We are witnessing this currently in the Euro swoon. The lost confidence and lack of decisiveness will make the bailout in whatever form it comes more expensive. This is a situation where what is in the best interest of Germany is not perceived to be in the best interest of its people. But it is nearly impossible to make the tragic alternative to not rescuing Greece clear to millions of people. What to do?

Choices and Consequences

• Single Lender Bailout- is not going to happen. Politics will prevent it, and a direct loan to Greece is too obvious a risk for any nation that makes the loan.
• IMF Money- spreading the pain seems logical. This also gets the US involved. For every dollar the IMF gets around 20 cents is from the U.S. tax payer. This shows major weakness in the EU and may spell the end anyway, to be dependent on outside help.
• Devaluation- the Eurozone lends Greece money and then starts printing, devaluing the currency. The wealth of all the stronger economies are depleted to rescue Greece and sure to follow Portugal, Spain et al.

Devaluation will happen. Perhaps it will be in conjunction with an IMF assist, but it will happen. Anything else in full measure is the end of the EU era.

• Saves trading partners
• Politically better- the tax on citizens is stealth at least in the short run
• Puts the onus on the U.S.

If we are right, the US will have the problem. It must also devalue to remain competitive globally selling goods and services.

Bailed Out EU Countries Will Short the $U.S.

Countries like Greece and Portugal will issue as much dollar denominated debt as is possible. If you believe the U.S. will also devalue to remain competitive, then the benefit to dollar-denominated bond issuers is two-fold. They borrow strong dollars now. They’ll pay back the debt with devalued ones after the U.S. prints more dollars.

Race to the Bottom

Assuming that the EU and the US both will devalue their currency to lessen their debt burden, who do you think would win a race to the bottom? We think the U.S. wins hands down. Here is why: the EU has unified monetary policy, but not fiscal policy. It is much easier for the U.S. to coordinate fiscal policy to weaken its currency than it is for the EU, with its national interests. You cannot tax a Frenchman to fix a bridge in Italy (yet). But you can raise the whole nation’s federal taxes to bail out California.

We think that regardless of the situation in the future, gold is a better investment vehicle than most other assets. As an inflationary hedge, it will increase in value as a proxy for the US Dollar. In a deflationary environment, gold may not appreciate, but it will outperform relative to financial investment vehicles and most other currencies.

“The US faces rapidly rising inflation or deflationary recession: credit cycles (and this one is extreme) always end in a deflationary bust – this is the lesson of the Kondratieff Cycle. The Fed will most likely try to defy economic gravity using increasingly inflationary means. Gold is the only asset to outperform in periods of either uncontrollable inflation or deflation: the US economy is on a knife-edge between the two.” – Redburn Partners, November, 2007.ⁱ

U.S. Economic Outlook

Where we are

It’s been well documented where we are and how we got here. Here is our own two cents worth: Easy money and credit, poor regulatory decisions, irresponsible buyers and sellers, and other enabling factors have all contributed to the situation. As a culture, we have been cashing in on the hard work of generations before us. The American dream has morphed into a feeling of American entitlement. But we do not pass judgment. This is how the emotional component of economic cycles works.

It is our analysis however that the structural issues precipitating the 2008 crisis and its aftermath have remained unresolved. Simultaneously, the growing cultural austerity of our populace will be a great impediment to reflating a consumerist economy in the United States and other western economies.

Why the situation will persist

Many Cassandra-ish reasons can be made why we are all doomed. To be clear, we do not feel that way. The U.S. just has to retool how it generates income to remain competitive.ⁱⁱ That said, here are three major reasons we feel the U.S. economy will go nowhere significant in its current state. We are still a credit driven economy, consumers will not spend like they did in years past even if they could, and China is not ready to pick up the U.S. spending slack.

Still a Credit Driven Economy

There will be no real recovery until the economy retools itself from a consumer driven one to a capital expenditure one. This means an end to credit as a means to buy things, which won’t happen until the fed stops reanimating the easy-money cadaver.

David Roche, former Head of Morgan Stanley Research and Global Strategy, and currently president of Independent Strategy:

“…none of the core problems that caused the credit crisis have been addressed. Credit crises end when the economy starts to grow without credit. This can happen because, in a credit contraction, the price of assets and goods and services can fall dramatically. Households lose about 20% of their wealth. But if the price of things (either stuff in the shops or investments) falls by more than the combined contraction of wealth and income, they have become cheaper in terms of the ability of most households to buy them. Those with money do so. They don’t borrow to buy or invest but they have the cash. Those that don’t are still busy paying down their debts.  But the ‘haves’ can have enough purchasing power to move the economy off the bottom. This sort of recovery is self-sustaining.”ⁱⁱⁱ

Governments react to grass roots changes, they are not proactive. Thus, they are totally behind the curve. While this administration is busy giving easy credit to banks in the hopes it will trickle down to the public, the public has put itself on an easy-money diet. The banks aren’t helping either; they are offering to lend only to those who do not need it. The fed is just getting gamed, and monetary policy will not alter the changing habits of Americans. The credit driven method of growing this economy is dead.

Consumer Sea-Change

Consumers will resist returning to looser spending habits and will not be the engine of growth for the U.S. economy moving forward. High debt, wage pressures from a globalizing work force, and a moral rethinking of consumerist attitudes all contribute to this. It is our analysis that those who want credit cannot get it, while those with ample credit loathe to use it. No one is spending.

Roche again: “The savings deficit countries (the US, the UK) must see a return to thrift (which will cap consumer spending). One driver of higher household thrift in deficit-ridden countries is that households and corporations realise that the wrecked balance sheets and budgets of the government sector can only be paid for in one way, down the road — with their money.”

If we are wrong and these changes do not take hold in the consumer psyche we will have a consumer-lead recovery. This is merely a can kicked down the road to the next deflationary debacle. It only affects the timing of our investments, not the choices. Deficit spending cannot be sustainable forever.

Chinese Spending will not save us

We believe the view held by some that the Chinese consumer will be a driver in this recovery is not happening anytime soon. The reasons are numerous.

• China’s recent stimulus package was intended to gear up for more export growth, not domestic consumption.
• It is a political issue for their government to let standards of living grow too much, as it will invite progressive reforms and social unrest. People will know what they’ve been missing once they see the potential.
• China, like most Asian economies after their own currency crises, is an inflation hawk. They will seek to cool down their economy more aggressively than most hope.
• Fear of a rollback to a Maoist regime still weighs on many people. These citizens keep their wealth portable, and live within their means.
• China is deepening relationships with LATAM countries to export goods, seeding the next big consumerist economy potentials.

Maybe next generation folks. That said, if we are wrong and China does become a buyer of finished goods and services, U.S. inflation will explode.

What the Gov’t has done thus far

Up to now the U.S. government has embarked on a reflation attempt which will either fail and end in a deflationary crisis on par with 2008, or it will succeed and slip into an inflationary environment. The stimulus is a temporary measure at best and will only serve to delay deflationary pressures without fundamental changes in our behavior. It’s a circle of hardship. We don’t judge current actions as right or wrong. We just seek to anticipate what comes next and hopefully profit from them. And we think the choices available to the government from here are quite limited.

Government Choices Moving Forward

Not much of a choice

What must be done to combat our current paralysis and its effect on the U.S. government’s ability to repay its own debt?

Choices are limited with regards to the debt: Restructure it or devalue it. Restructuring is essentially defaulting and letting the deflationary forces run their course, and devaluing the debt consists of monetization.

U.S. Monetary and fiscal policy will continue to be geared towards devaluing its debt. Even with these attempts, more deflationary events are likely. The Greek crisis is an example. The alternative is a deflationary depression that will wipe out tax revenues entirely.

The U.S. monetary recipe

In short order we think the following will be their policies for the next several years.

• Monetary policy will remain much easier than the conventional wisdom due to a backlash against government stimulus spending. Low rates will be all they have left to make it work.
• Fiscal policy in the form of another Quantitative Easing (QE2) will be put on the table, but will have a tough chance of passing due to a trickle up of austerity from the public to its elected representatives (witness the Mass. election and the populist rhetoric to cut spending).
• Taxes will go up. No surprise here. It has already started. Wealthy families will be taxed directly, and the rest of the country will be via the companies in their portfolios getting taxed at higher rates.

The global situation does not help matters, and will only force the U.S. hand.

Economic nationalism

As a consequence of globalization, our economies are more tied together than ever. One of the factors that brought about the great depression was a nationalistic backlash against trade. The result of which was countries pulling in the reigns, drying up liquidity, and consequently deflating asset prices even more. Governments are resisting this urge today, and have learned the lessons of the past. But, banks may not care so much.

As global credit risk causes lending institutions to decrease international loan exposure, banks begin to repatriate their money and lend more locally. This is an economic nationalism, and can have the same effect as the political ones did in the 1930’s. Governments have little choice but to engage in competitive devaluations in an attempt to stave off the effects of these (localized) lending practices.

Race to the bottom

In order to attract trade away from competing countries, it behooves most governments to opt for a weaker currency. If every country knows this, then we have a prisoner’s dilemma situation. We believe there may be less honor among governments than among thieves, and a race to the bottom will be the result. Such a situation may be good for the winning individual country, but it is bad for the group and citizens everywhere. In this case, global inflation is the outcome. The countries with the most to lose are those with the most debt, and the least flexibility to deleverage. They must devalue fastest.

^iv

Conclusion

• Governments almost always choose devaluation- it is better politically, and is consistent with the kick-the-can down the road mentality of short term outlooks, limited to reelection time horizons. Some end up defaulting regardless.
• Fiscally taxes will go up, there may be a QE 2 but most of the work will remain monetary policy.
• We will either get deflation resulting in inflation or inflation resulting in deflation, but we will get both.
• 1970 Chevy Malibu carburetor analogy- the U.S. economy is an old car with a sticky carburetor. The fed’s foot has been on the gas and will continue to be until the spring loosens and the intake opens (inflation) or the spring breaks (deflation) and the intake snaps shut. Either way, the fuel system has to be fixed, because that spring is going to break soon regardless.

The only thing that remains is what to invest in, and to either time the market or just diversify risk.

Investment Choices

Moving forward we think inflation and deflation are both a risk to the markets and that the golden age of capitalistic monetary management is over. We like real estate in countries with little or no leverage on their balance sheets (personal or government), especially LATAM and Caribbean countries that may benefit not just from growing credit cycles but from an influx of wealthy U.S. and European retirees. We like seats on agricultural commodity exchanges, and we are buyers of gold in spread, physical and option form.

Before we go further, we’d like to lay out our definitions of inflation and deflation.

Inflation

Inflation is a function of monetary policy. All monetary systems can experience inflation, but paper money is most inherently prone to it. The two most popular and conflicting definitions of inflation are Keynesian and Austrian.

To oversimplify it: Keynesians believe inflation is largely demand-based and occurs when prices increase. Austrians see inflation as strictly a function of money supply, and increasing prices are merely a symptom of the problem. Either school of thought works here.

Deflation

Deflation is closely tied to fractional reserve banking. At its worst, it ends with runs on banks. People and institutions would rather have currency jingling in their pockets due to its scarcity than a debt from someone to give us money at a later date. During a panic, that is exactly what happens. Depositors see their money as a loan to their respective bank and call in the loan.

Both of these have horrendous implications for citizens. In a deflationary situation; cash is king, and everything else deflates as the word says. In an inflationary devaluation; cash is trash because purchasing power is destroyed and assets must keep pace with inflation just to justify ownership.

It is also important to note that to the degree that one approach is chosen, the other will surely follow as a reactionary result unless our economic engine replaces consumption with creation as its primary fuel.

Gold

We like gold in a domestic inflationary environment for obvious reasons. But we also feel it will hold its own against other currencies. Gold is money, that is all. And as a store of value, it will compete with paper currencies more and more. We also believe as do others, it will increase in an almost Giffen Good manner moving forward.

Gold is also subject to fractional reserve banking. We have seen firsthand what happened in 1997 when Warren Buffet decided to take delivery of silver. The result was a backwardated spread market equal to a $40% yield annually. Unallocated gold accounts where investors have claim to a pool of vaulted gold can be subject to the same risk.

We like gold in a deflationary environment as well. Everything drops in a deleveraging, deflationary period to be sure, except currency. Gold will also most likely drop. But it will suffer the least of other assets for a couple reasons. It is money and can be easily quantified as such. It’s portable. Finally, gold is internationally recognized and understood.

We believe this all ends in a deflationary collapse and healthy economic retooling. Gold may end up being the tallest pygmy in a deflationary environment. To date we have implemented our spread strategy. We expect to accumulate a physical position over the next 60 days.

Vince Lanci
Managing Partner
vlanci@echobay.com

The information, opinions, scientific data, quantitative and qualitative statements contained in these reviews have been obtained from research, trade and statistical services as well as other sources believed to be reliable. The information, opinions, rankings or recommendations contained in these reviews are submitted solely for advisory and informational purposes. Echobay Partners Ltd. opinions and estimates reflect current judgment; they are neither all-inclusive nor can they be guaranteed to be complete or accurate. The opinions expressed are our current opinions as of the date appearing on the review only. Our analysis is subject to possible change without notice.

i Mylchreest, Paul. “Gold War.” Nov. 2007. Redburn Partners.

ii Easier said than done.

iii Roche, David. “De-lipsticking the pig.” Aug 2009. Global Markets.

iv Gross, Bill. “The Ring of Fire.” Feb 2010.

The Over-the-Counter Markets must evolve into a hybridized exchange model to satisfy the regulatory and business issues they are currently facing. They must provide regulators a window into their business and a way to gauge risks on both counterparty and settlement basis.

Successfully done, this will not only satisfy regulators and market participants, but transform the current OTC business model from a sunset industry to one of accelerated growth. Key to their success is clearing fungibility, market structure, and appropriate technology. The energy markets offer examples of one path to a successful evolution for OTC participants.

What OTC Venues Offer

The OTC Markets problems are many and well known. Among them are: counterparty risk, subjective portfolio valuations, and systemic market risk. But the OTC execution model offers value despite the outcries of its detractors.

One-price liquidity, minimal information leakage, and structured deal pricing are some reasons for the persistence of OTC trading and good reasons why regulated exchanges have yet to co-opt their liquidity pools.

• One-Price Liquidity: An institutional investor may value the time he must spend tallying the various partial fills he gets more than the 2 cents he paid over the exchange advertised price. Equally important, it minimizes information leakage which could hinder the fill.
• Information Leakage: the longer a large order rests in the market, the more potential for competitors to move the price away from the clients order price. Good OTC brokers use discretion and one-price liquidity to minimize this problem.
• Structured Deals: institutional clients do not want a la carte pricing for trades involving multiple instruments as in Options. Electronic platforms do not offer this effectively yet.

The Problems Exchanges Face

The government, the public, and much of the investment community are up in arms about the Over-The-Counter markets. So what is taking so long? In much or the OTC world, the liquidity pool and clearing are fragmented. Additionally, banks are the main liquidity providers of the OTC markets and are not too excited to give up those franchises. A prime example is the CME-Reuters FXMarketspace venture that failed in part due to the lack of bank participation.

What must they do? They must leverage their inherent advantages: mitigating counterparty and settlement risk, while removing the perceived advantages that the OTC enjoys. If they can do this without fragmenting their sources of liquidity, they will succeed. Marketmakers and gatekeepers must be incentivized to participate without compromising market integrity. Regulators must work closely with exchanges and understand the complexities of the dilemma. When it comes to marketplace liquidity, five million “one-lot” orders on an exchange can be as bad as three banks trading five million contracts in a dark pool.

Market Structure and Technology

There is one market that is successfully transferring OTC volumes to accredited exchanges while preserving its liquidity pool. It is the Energy market. Energy is enjoying secular growth while keeping its OTC volumes. Both major exchanges, The CME and The Intercontinental Exchange (ICE) are successfully replicating their OTC business onto regulated electronic platforms. Two major factors in determining their success are Market Structure and Technology. The CME has focused so far on Market Structure, while until recently ICE focused on Technology. Both have been successful.

The CME inherited the Clearport product from its Nymex acquisition. Clearport is the clearing mechanism that Nymex smartly advanced post Enron’s collapse as an alternative to bilateral credit. It addresses the OTC from a Market Structure approach. Its main advantage is its removal of counterparty replacement risk.

The CME’s Clearport product is slowly but surely replicating the whole of the OTC bilateral market onto an accredited regulated platform. But the CME is going further. Wherever it can, it seeks to replicate benefits of OTC trading in its futures business, while enabling fungibility on its clearing side. Block trading in futures negates the OTC one-price liquidity advantage, while CME readies its own front end for Clearport products. Despite having top tier technology, the front end screens will come last when it comes to OTC Energy. They are being careful not to fragment the energy market liquidity.

ICE on the other hand, leveraged its technology to create an ECN type screen where price was transparent but counterparty privacy was preserved until after the trade. This was especially effective since all its trades were bilateral initially. Now ICE owns its own clearing house and has effectively gone from an unregulated dark pool to an Exempt Commercial Market. Their early model sought to disintermediate the OTC broker with electronics, and they were quite successful in the Natural Gas Swaps market. Now ICE sees the limitations of a disruptive approach and is embracing FCMs as gatekeepers to volume growth. Additionally, they have implemented YJ Trader, an Instant Messaging technology that tries to mimic the current flow of options business, rather than disrupt it.

The Hybrid Exchange Model

Hallmarks of an OTC market successfully evolving into a regulated trading venue are varied. CME used a cooperative model, while ICE used a disruptive one. What is and will be consistent across the board are fungibility of products, centralized clearing, and adaptive market structures using appropriate technology to model information flow.

Those OTC dark pools that do not become a part of regulated exchanges will most likely themselves become exchanges.

Prior to this he was portfolio manager at CiSEnergy, LP a profitable derivative fund out of New York. He founded and was president of Berard Capital Management, a commodity market making firm from1993- 2004. He began his career as a Commodity Derivatives trader on the floors of the Nymex, Comex, and Nybot exchanges working for Cooper Neff and Associates.

As of July 7, 2009, UNG issued all of the remaining outstanding units to its Authorized Purchasers. As a result of these issuances, UNG will temporarily suspend the issuance of additional Creation Baskets until the SEC declares effective the registration statement on Form S-3 (333-159772) which was initially filed on June 5, 2009 and registers an additional 1,000,000,000 units. This registration statement is currently subject to review and comment by the SEC, the Financial Regulatory Industry Association (“FINRA”) and the National Futures Association (“NFA”).

UNG Market Cap of NYMEX Open Interest

Whether this suspension of new issues is temporary as stated or of a more permanent nature one cannot know for sure. But it does raise several questions worth answering.

• What effect will this have on the commodity?
  Answer: lower prices
• How will this affect the tracking relationship between UNG and Nat Gas?
  Answer: most likely it will trade like a closed end fund
• What about the Contango?
  Answer: less contango
• What are the implications to the ETF and commodity industry?
  Answer: the honeymoon is over

What effect will this have on the commodity?

Commodity ETFs were created in response to increased demand from the retail sector for commodity based vehicles in which they could invest. They provide a way for smaller investors to participate in the commodity markets without “worrying” about margin calls associated with trading the bigger physical contracts listed on the commodity exchanges. They are an attempt by Wall Street Investment banks to brand a previously unbrandable product, a finite commodity that is in the public domain. In a sense, Stock Exchanges and IBs essentially were securitizing commodities and listing them.

This is all well and good. There was a demand at the retail level and the commodity exchanges were unable to accommodate it. Entrepreneurial firms filled the need. The net result was a significant increase in incremental commodity demand from the public. Since most public participants play solely from the long side, their net effect on the markets have been bullish. The issuance of new shares (called Creation Baskets) is accompanied by purchases of the physical commodity. Without this retail business, there is one less buyer of Nat Gas and the overall effect is bearish on the product.

Conclusion: Absent all other factors in the commodity markets, Nat Gas will decline with less investor interest.

How will this affect the tracking relationship between UNG and Nat Gas?

If new-share issuance is permanently ended, then UNG will exhibit much of the behavior of a Closed End Fund (CEF). These vehicles rarely trade at the same price as their NAV. When they trade higher, it is almost always due to pent-up incremental demand and a lack of alternate choices to gain access to the underlying asset, as was the case for Emerging Market CEFs in 2008. In short, their assets are hot investment items and the CEF is the only vehicle for getting into the asset.

More often CEFs trade lower than their NAV. This can be for many reasons. The most theorized is that a CEF’s discount is a comment on management’s ability and the fees the fund charges. Basically, it can be deduced that CEFs trade at a discount because the market is efficient. While open-end funds do not because they are forced to trade at NAV. Why these discounts are not arbitraged out of the market is something that has been debated for years to no good consensus.

Conclusion: UNG price will fluctuate above and below the NAV of its portfolio. In a secular bull market for commodities (with good salesmanship) it will trade at a premium. In a disinvestment period, it will trade at a discount. There may also be short squeezes as shares are retired.

What about the Contango?

A lack of incremental retail investor interest is bearish for the commodity itself. It also follows that less open interest continually rolling over its position is bearish for the contango in that commodity. With less committed longs, there are less longs rolling over. This translates to a smaller discount of the prompt future to the second month future. Smaller open interest translates to less of a distortion during roll over periods. What is also of interest is the effect on the professional trading community.

Conclusion: UNG’s effect on the market contango will diminish over time and it will lessen.

Rollover Arbitrage

Securitization is one of the tools in which Wall Street produces profits. An early successful attempt at doing this in commodities was the GSCI. Clients of Goldman Sachs could buy a basket of commodities in private transactions and participate in commodity markets with minimal hassle. Buyers never had to rollover their expiring futures, Goldman did that for them. The GSCI was a huge success with Goldman clients in part because of this low maintenance quality. But as the GSCI grew in terms of open interest, so did its effect on the markets it was long.

The bylaws of the GSCI mandated that the positions had to be rolled over during a 5 day period. This more effectively systematized the fund’s management and made it less susceptible to rogue trading decisions. This automation made it clear what investors were getting into and made for an easier marketing pitch. What it also did, was remove much of the tactical value a trader adds in not telegraphing what he intends to do. So, the market always knew what the GSCI had in its poker hand, and it always knew when they would fold.

Knowing that the GSCI had to roll over a massive long position, traders would begin to position themselves to take advantage of that just prior to the actual roll-over. There were several ways they could do so, but the simplest was to simply put on the position that Goldman would be executing and hope that when the GSCI rolled over, they would be able to exit the trade at a better price. For example:

The GSCI fund is long front month futures. Next week, it will have to roll these into the second month to maintain its position and not have to take delivery. A hedge fund or local might sell the front month and buy the second month in a spread. A few days later, GSCI does the same thing, but because it has significant size, and must liquidate in a small time frame, it inevitably distorts the contango for a short period of time. The local hopefully takes a small profit.

This was not without risk to the local or hedge fund. It assumed several things. It assumed that the GSCI client base would not be liquidating its positions. It assumed that there were no other physical market effects that offset the roll, like a refinery fire or a war. It also assumed that Goldman was powerless to protect itself and its clients. Goldman was not powerless and did things to help mitigate the rollover risk, but there was almost always someone playing this in some way. Usually, the arb backfired when too many people were front running the roll-over and created an “over subscription” effect.

The UNG Roll

The same type of arbitrage happens in UNG and other commodity based ETFs. The fund manager has to roll his Natural Gas position. Professionals position themselves in anticipation of the event. They short the spread, play the UNG directly against the Nat Gas future or initiate some other cash-and-carry type position. These strategies all have term-structure risk and are not manipulation. But in the end, it is the public that suffers, even as they are the ones who are buying the commodity. Limited fungibility and captive order flows create what is essentially a regulatory arbitrage opportunity.

• Limited fungibility: professionals with balance sheets can play both markets, individuals cannot
• Captive Flows: UNG must roll, and in doing so it creates a potential distortion in the financial carry from front to second month expirations.

This ends up being a tax on the individual investor because of the uneven playing field. Cross regulatory conflicts and securitizing a finite commodity create the environment for systemic risk. Open-end ETFs are essentially derivatives of their respective commodities. As derivatives, their market cap could actually grow to be bigger than the above ground supply of the commodity to which they are tied.

As the public’s appetite for commodity ETFs grows their capital flows distort and make more volatile the actual price of the commodity in reference to its supply and demand fundamentals.

Conclusion: by effectively converting the UNG to a closed-end fund, rollover arbitrage will become a much riskier play. The mechanical nature of the UNG rollover will continue to exist. But if no new shares are created and existing shares begin to be retired, then the risks associated with this trade will increase.

What is next?

We suspect UNG has gone closed-end to preemptively address political issues with commodity speculation. We believe the fund’s next step is to get its open interest down as a percentage of Natural Gas. Once management decides what percentage of open interest is acceptable (or allowed) it will more than likely retire shares (and sell Nat Gas) in orderly fashion to get to those levels. Perhaps new shares would be issued when open interest gets under a certain level.
But in their current state, ETFs with mechanical rollovers distort the carry and storage aspect of commodities. This adversely affects the fundamentals of the commodity. Because money can move faster that it takes to build new storage facilities, the contango never rebalances itself with new buyers. Finally, it serves as a “Contango Tax” on the long term owner of an ETF and the retail public in general. ETFs are trading vehicles, not investment vehicles.

Reality Check

UNG has not converted to closed end. They merely suspended the creation of baskets. They have also filed for a billion new shares. So it stands to reason that they will begin creating new baskets at some point in the near future. Practically speaking, if there is demand for these securities then they will be issued. And for those people who think that this product and others like it may be a political football, we say this: if the SEC says stop creating new shares, this product will just pack up and go list itself in another country.

There are three essential elements of any business transaction: Content, Clients, and Connectivity. This model is even more relevant to the Exchange industry and its offspring, the Broking industry.

• Content – people need what the Exchange has to sell, namely hedging and speculative tools.
• Clients – captive clients are even better, which near monopolies like Exchanges have.
• Connectivity – this is technology; phones, IMs, ASPs, and Web Based Platforms.

Liquidity Creates Liquidity

All brokers possess these 3Cs in some form. Their Content is the markets they show clients. Their Clients are not captive, but every broker has one or two on which it can count. An improvement in their Content (markets) gets more Clients, and vice-versa. This Content-Client feedback loop can create a self-sustained liquidity cycle that is hard to beat.

There are a couple problems with its reliability however. For one; clients blow up, move on, retire, or simply get eclipsed by a competitor. For another; Brokers are essentially independent contractors hanging their hats where ever the best deal is. The problem is people. You cannot systematize or scale them. and that is why a brokerage firm without technology is worth historically 2x revenues.

Connectivity and the Network Effect.

It is the 3rd “C” that changes an business’s trajectory. Improve how your client connects with the content, and your business breaks out of its cyclical nature and becomes a growth stock.

Good technology creates its own self-sustained liquidity cycle in the form of a Network Effect. Once a Network reaches critical mass, it becomes a must-have tool for market participants. Obvious examples are Telephone and Instant Messaging.

Can a broker afford to be without either of these?

In the Energy Broking business new connective technology is being implemented right now. Just because it isn’t being used by everyone doesn’t mean it won’t be someday. We all didn’t wake up one day and en masse decide to use IMs to transact business. The same is true with Electronic Communication Networks (ECNs). It will take a while for the tipping point to be reached within these networks. But ECNs will eventually break up the more fragile Content-Client based networks. The degree to which an individual ECN reduces communication friction and facilitates transactions will determine if it succeeds.

And electronic incumbency is the hardest network to break.

Branded for Potential

As a part of its increased oversight in the Exempt Commercial Market (ECM) space, the CFTC has required ECMs to register with it. Pay close attention to the electronic ECMs. Those with order flow have the potential to become a regulated dark-pool, in essence an exchange. The ones without order-flow, just old technology in a year or two.

Here are a few electronic ECMs listed without further comment alphabetically:

• Chemconnect
• HoustonStreet Exchange
• ICAP (3 systems)
• ICE
• International Maritime Exchange
• Natural Gas Exchange
• NetThru Put
• Parity Energy
• Spectron Live
• TFS Energy
• TradeSpark

We’ll try to take a look at some of these in the coming weeks.

So far this year, natural gas has experienced none of the strength that Crude has. This can be attributed to several things. Not the least of which is a lack of speculative activity from the financials. Indeed, the global deleveraging has caused trading firms to pull in the reins on all but the most liquid assets traded.

We discussed this with some industry participants. Commercial and financial people were asked: Heating oil companies, business owners, brokers and a Washington PR firm. We were surprised to find a decent size minority bullish in the intermediate term. Here is what we came away with.

And Our Survey Said….

Right now Natural Gas has a couple things working against it. Gas is pricing demand destruction on the back of this deflationary recession. It also has a fresh source of low cost supply from Shale in places like the Marcellus deposit. And there is a lot more shale out there.

To put in a decent bottom, the market needs a reduction in CAPEX by producing firms. This has already started at the margin, but more has to happen.

One decent indicator is west coast production. Many small and mid size producers cannot turn a profit with Gas in the $2.00 area. That would put Henry Hub between 2.75 and 3.15. That is the opinion of one 25+ year industry veteran at a New York hedge fund.

One voodoo witch doctor (AKA a technical analyst) thinks that Natural Gas will put in an L shaped bottom with a rally when Crude gets back in the $60 dollar range. By the way, he is bullish oil as well and he has good tea leaves.
Natural Gas is also a widow maker. Natural Gas likes to take out a major bullish player before it rallies. Bullish players like Amaranth, Mother Rock, BMO, and several recent fund blow ups fit that bill. Did FC Stone’s recent situation qualify? We will see.

Obama Isn’t a Coal Fan

Another bullish factor is the political atmosphere in DC towards coal. President Obama administration’s aggressive anti- coal stance is well known. This can only help Natural Gas as more power generation changes over from coal.

Late last year, Obama said the following: “So if somebody wants to build a coal-powered plant, they can. It’s just that it will bankrupt them because they’re going to be charged a huge sum for all that greenhouse gas that’s being emitted.”

Once this banking crisis is over, the administration will probably resume its aggressive stance to putting coal power plants out of business. Nat gas will get major breaks and be incentivized to produce power. Cap and Trade credits are the beginning.

Choices

So, if you are bullish how can you play it? ETFs are the current rage for commodity investment. The risk here, as in the USO oil ETF, is the carry. “Do not buy futures or a physical ETF”, says an ETF trader. The back part of the curve is too steep and the seasonality will kill you. “If you think USO carry is bad, you ain’t seen nothing until you’ve seen Natural Gas seasonality.”

Another’s advice was to look for pure play producers or an Industry ETF in the equity sector. MLPs are a good start. They must return up to 90% of their profits to shareholders. But beware, MLPs’ are very sensitive to Tax policy changes. The key is what piece of production you get. MLP choices cover pipelines, exploration, different locales, and combinations of the above. The other factor is management’s philosophy on hedging. If they hedged and how they hedged should be considered.

Some legendary investors feel the same way about MLPs. Last we checked, Leon Cooperman’s Omega fund owns several pipeline MLPs. Seth Klarman owns a few as well. And of course, T. Boone Pickens has bought T.V. time extolling Natural Gas’ virtues. This sector has gotten beat up along with the broader market. We guess dividend security is something to consider. “Long puts anyone?”

And every day the debt is not written down creates an opportunity cost for the economy to recover. This is trading 101. Cut your losses or miss the next opportunity while you are treading water. I know something about denial and treading water.

We All Pay Some Way

When a person cannot afford to pay their bills but hasn’t declared bankruptcy it does not matter. They are effectively bankrupt . No one will extend them credit and they cannot create demand as a consumer. Although they retain the pride of not being declared bankrupt officially, they are as much practically. The longer they live in this state of denial/hope that things will turn around, the longer they will suffer the loss of missed opportunities that may come their way.

The psychological damage is significant as well. Denial creates rationalization, repressed emotions and other things. Coping mechanisms are used to balance the cognitive dissonance, elaborate rationalizations are constructed, etc. It ends with thumb sucking and vodka.

Now substitute the word “company” or “business” for person in the first sentence. The idea is scalable. Our banks and government are in denial.

Raises for Everybody!

What we need to do is either make more money or pay less interest. Raise income or reduce debt payments.

Make more Money:

• Raise income- fat chance real income will go up. Moving right along….
• Print More Money- give everybody a raise on paper.

Lessen Debt Service:

• Restructure the Debt- lessen the payments, everybody walks away miserable but alive.
• Print More Money- cheapen outstanding debt by devaluing it.

Seeing a pattern here? How does the government raise incomes, lessen debt service and maintain its denial? By printing more money. It has to happen, it is happening and it will continue to happen.

GM as a Proxy for Fiscal Prudence.

Watch GM. If they come to a successful deal on a restructure, then we are on the right track. Because as GM goes, the U.S. still goes. If they do not come to terms, then we may be in a banana republic for some time.

Inflation How?

We feel here that even though there will be a lot of fresh cash, inflation will not be a factor at first, due to the lack of money velocity.

No matter how much money the banks are given, they won’t lend for the following reasons:

1. They don’t know what their assets are worth and must shore up balance sheets.
2. They know more bad news is coming in the form of a Commercial Real Estate collapse.
3. Their models for credit assessment of individuals are broken. TRW, Equifax are no different than Moody’s and Ambac. The credit bubble must deflate at an individual level.
4. Anyone worthy of lending to is not interested in borrowing because growth prospects are dim. They are pulling in the reins because there is no domestic demand.

In the first leg of a dollar devaluation, there will be a big fear of inflation. That will be unfounded. The devaluation process will simply slow or stop the deflation at first. Bonds will probably remain strong and the inflation bull’s expectations will be dashed. In the next leg of the devaluation, when countries begin to repatriate their own currencies to heal themselves, we will begin to see real inflation.

The Trade

We are doing nothing except putting money aside for more bad news and have done so for the last 6 months. Smaller banks are offering 3% liquid CDs. We bet that gold would have dropped by not buying it, but were wrong. Most likely we will buy a dip to the 750 area if it comes. Finally, we are shorting the dollar scaling in right now. We are also long the AUD for reasons unknown to us. Except that we think commodities will rally and the dollar will drop, so maybe the AUD benefits. I have a call into Jim Rogers on this one, lol.

We hope to be buying stocks in 2010, starting with Brazil and India.

Hope without action is denial. Denial leads to economic paralysis. Economics is an imperfect science, but it is a science nonetheless.

[Image: Courtesy of the Fark community]

How to trade that piece of wisdom? Here is what we are doing in our P.A.s.

1. Get Long -As we approach those previous bottoms we are buying and averaging in on a long S&P position.
2. Triple Bottom Establishment. If there is a bounce after we are in, we will sell scale out.
   2b) if the market trades thru our buys and makes new lows, then we puke, reverse and go directly to number 4
3. Sell Weakness- We will go short the market on new lows, with objective stops determined by previous hourly highs.
4. Schadenfreude- we do not tell our friends if we are right.
5. Corollary- market should not look back for a while. But the longer it remains under the level, the bigger the rally when it finally breaks thru. Start buying later in the year and early next year.
6. Caveat- Remember that we are not technicians , just arbitrageurs with a gambling problem. This is our strategy and we do not recommend it to anyone at any time for any reason.

NEXT WEEK, Continuation of OTC Brokerage Industry Analysis.

Here’s what will happen:

1. Horizontal consolidation- independent brokers in the fragmented OTC industry will not be able to maintain profit margins against bigger firms. First, individual shops will roll up to mid-size independent firms. Then, mid-size firms will roll up to bigger OTC shops (witness Choice’s actions this past year)
2. Cost Reductions- back office redundancies in acquired firms will be removed. Then less profitable individual producers will be let go.
3. Value Added Partnerships- the remaining firms will seek to add value either by creating technology or partnering with a firm that has it.
4. Hybrid Exchanges- the smarter firms will then morph from dark pool operators into regulated OTC firms. All others will begin to see their volumes slowly decrease as regulatory issues hamper their business.
5. Vertical Consolidation- bigger firms seeking exposure in energy will buy Order Flow, Data, and/or Technology to create their own full service Energy Brokerage divisions. Their preference will be to buy a company that has all three already. Banks and exchanges will be the most likely buyers. Banks need to replace the business they lost from the CDO/credit debacle. Exchanges because it makes sense. Exchanges are big brokers. Why not buy and lock in order flow?

Why It Will Happen:

Economics – There’s a lot of fat in OTC brokerage. Margins for Voice brokers are in the 20% area. Electronic brokers are in the 40 to 50% area. This is incentive enough for an equity broker to step in and take market share.

Technology – the OTC market is a closed, opaque business. Technology creates operating efficiency which pairs well with an open architecture business model. In short; tech creates more money from more clients with less overhead.

Regulatory – In general, the government reacts slowly to macro trends in business. But when they move, they all but close the lid on competing business models. In this case, they are reacting to the credit crisis that stemmed from the CDO market collapse. Regulatory agencies have no choice but to oversee the situation now.

Setting the Table:

Those are the macro trends that are changing the business. That is just the beginning. In the next stage: economics, technology, and regulatory factors will specifically target the OTC to get with the program or lose out to exchanges.

And So it Begins:

Here are three specific developments that have come across our table in the last month alone.

1. Clients are Demanding Compliance – Soon, if you are a broker and want to trade with a major bank, you will have to be NFA registered, Series 3 licensed and most likely have had a background check done by that client. The brokers without these will watch their client universe shrink considerably.
2. Enter Bloomberg – The brokerage business model centers on four services: Execution, Liquidity, Data, and Technology. Firms like Bloomberg and Reuters, already possessing Technology and Data can easily create the Execution and Liquidity piece and become formidable competitors to OTC brokers as well as Exchanges. In fact we are pretty sure Bloomberg is making a move to do this right now. We expect they will announce a JV with one or more OTC brokers and begin offering execution services on their screens. They already have the eyeballs, it makes sense. (You want fries with that shake sir?). Other competition will come from the Equity side soon thereafter.
3. The CFTC – They are now proposing specific changes to regulate OTC electronic platforms. This is their proposal to regulate all OTC electronic trading platforms. At first glance it may seem to have no effect on the voice-broker population. But that is a mistake. This plays right into point number one above. “If you aren’t regulated, we cannot trade through you.” It only highlights brokers as unregulated participants.

A land grab is about to take place, where banks, exchanges, tech and clearing firms all seek to protect their current franchises while growing their business.
Those that understand these changes can stay ahead of the curve. There are 2 groups:

1. Brokers who have developed good technology (real ECNs, not a computer with a hamster on a wheel inside) to ring-fence their business, and
2. Exchanges who are willing to be regulated by the CFTC. The rest may have to charge their last remaining client $25,000 per lot to survive.

Next Up:

• Who the likely winners and losers are.
• Marketmakers face the same fate.

For more information, contact Vincent Lanci at (212) 223-1000.

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