World Markets Under Pressure—Anatomy of a Squeeze

September/October 1993 

Market squeezes—the nemesis of commodities traders and exchanges—can and do occur for a variety of reasons. Here's a look at some explanations and examples.

squeeze \'skwez\ vb: to exert pressure, especially on opposite sides; to extract or emit under pressure; to get by extortion; to cause economic hardship.

As those commodities traders who have been through market squeezes will likely tell you, this unsavory definition from Webster's Ninth New Collegiate Dictionary comes close to capturing how they feel when futures markets act contrary to their expectations. In fact, while the Webster's definition certainly isn't focused on commodity market forces, it seems almost more relevant to the market than the more benign listing found in Wolff's Guide to the London Metal Exchange, which describes a squeeze as "pressure on a particular delivery date which makes the price of that date higher in relation to other dates."

Regardless of its exact definition, the word "squeeze" is one of those loaded terms that commodity exchange officials throughout the world avoid when discussing spot or future price discovery systems. The concern, some traders contend, is that "squeeze" suggests something unethical or illegal, hinting at subtle or even blatant market manipulation. And "manipulation" is considered such a dirty word in commodity exchange lingo that doesn't even include it in its glossary of commodity market terms, though a publication by the Mid America Institute for Public Policy Research (Chicago) does, calling it "the consequence of an exercise of market power [monopoly or monopsony on a product or market influence] in futures markets."

Loaded term or not, commodity exchanges and traders have indeed been squeezed at many times in the past, and very few can be tagged as attempts to consciously influence prices for purely speculative gain. Unusual price spikes unrelated to supply-and-demand fundamentals have occurred on the London Metal Exchange (LME) (London), the Commodity Exchange Inc. (COMEX) (New York City), the Chicago Board of Trade (CBOT) (Chicago), and other exchanges, with many of these ups and downs attributed to strikes, weather, political unrest, business fears—real or imagined—and a host of other innocuous factors. The usual explanation is simply that "the market is being temporarily squeezed" and, generally, the story ends there. Still, there have been times when commodity prices have been squeezed by the action of a few, apparently solely looking for speculative gain.

The Secretan Affair

One of the first reported instances of such a squeeze occurred on the LME soon after it introduced a copper contract for trading and hedging purposes in 1883. The contract was based on refined copper bars from Chile, which were, for a time, the only material accepted against the contract. Because of this narrow physical market, Pierre Secretan, manager of the Societe des Metaux (Paris), reckoned that by buying up existing LME stocks during a period of weak demand and falling prices, other buyers would be forced to come to him—and pay his price—when demand for copper again moved ahead.

Secretan formed a buying syndicate backed by French bankers and managed to gain control of around four-fifths of the world's primary copper production. True to his expectations, the price of copper doubled between 1887 and 1889, and copper consumers started to buy red metal once again, mainly to replenish stocks in what was then a fast-rising market.

Not surprisingly, higher copper prices attracted numerous other sources of refined and secondary copper to the LME, which reacted in self-defense by allowing other brands of copper to be delivered to its warehouses. This move forced the Secretan syndicate to step up its buying to maintain control of the market, but escalating LME stocks and declining demand due to higher prices eventually forced one of the syndicate's supporting banks into bankruptcy. As a result, the syndicate stopped buying spot copper and copper prices immediately fell, ending Secretan's domination of the market.

The Infamous Silver Conspiracy

Probably the most famous squeeze in history was the futile attempt by the Hunt family of Texas to corner the silver market between 1979 and 1980. In this case, manipulation was clearly the operative word.

As the story goes, Nelson Bunker Hunt's fascination with silver began in the mid-1970s when he bought several million troy ounces (t.o.) and watched prices soar from around $3 per t.o. to more than $6. To keep prices up, Hunt and his brothers continued to expand their holdings while also looking for additional investors, reportedly contacting the Shah of Iran, Prince Faisal of Saudi Arabia, Philippines President Ferdinand Marcos, and several other powerful international personalities—many of whom joined in the formal silver buying plan.

The intrigue deepened when the silver market took off in 1979. Silver prices rose from $6 per t.o. in early January to $10 per t.o. by August, peaking in January 1980 at $50.35 per t.o. During this time, a Bermuda-based company controlled by the Hunts bought massive quantities of silver—something like 28 million t.o. At the rate they were buying, it seemed they would eventually own virtually all the world's silver. And though it didn't turn out quite that way, at their peak, the Hunts and their partners had joint holdings in silver positions worth approximately $16 billion.

In addition to buying futures contracts, the Hunts and their cohorts were taking delivery of bullion to dramatize their commitment to silver, loading truckloads of the metal onto 747s and DC-10s flying from New York City to Zurich, Switzerland. This practice of taking deliveries—a digression from the normal paper-only futures transactions—placed the sellers of silver contracts at potential financial risk, as they would have to buy and deliver huge quantities of bullion if the Hunts demanded delivery on their contracts. Because of this financial exposure, several large brokerage firms and, consequently, several large U.S. banks faced potential ruin, including Bache Halsey—the Hunts's principal New York City brokers. Rumors were also circulating on Wall Street that Merrill Lynch and Shearson were in trouble.

At the same time, COMEX and the CBOT initiated liquidation-only trading, meaning that market participants could only sell silver, not buy it. Since speculators weren't allowed to add to their positions, the price of silver quickly fell under the weight of heavy selling, plunging to $10 per t.o. in March 1980. That same month, when the Hunts failed to meet a $135 million margin call from Bache Halsey, their conspiracy crumbled and many lawsuits followed over the next eight years.

The story basically came to an end in 1988, when the Hunts filed for bankruptcy protection after a federal jury awarded Minpeco S.A., a Peruvian minerals concern that sued the Hunts, more than $197 million in damages, while also finding the three Hunt brothers—Nelson Bunker, William Herbert, and Lamar—guilty of conspiring to corner the world silver bullion market.

Tin's Turn

Tin has also been the subject of several noteworthy squeezes, with the last one occurring in 1985. For 29 years, from 1956 to 1985, the price of tin was controlled to a large extent through intergovernmental supply agreements formed by an international tin council composed of more than 20 nations. While the system appeared to work for a while, council participants eventually deduced that if tin prices could only be maintained through continuous buying and inventory building—which, in turn, was pledged as collateral for further loans for additional metal purchases—someday something would have to give. If council participants didn't buy, prices would surely fall and the collateral would be insufficient to cover the outstanding loans.

As it turned out, the council ultimately suspended its tin purchases in 1985 because it simply ran out of funds. The result was tin's virtual collapse, which took years to resolve and prompted the LME to remove tin from its trading list from 1985 until June 1989.

The Options Game

Like the previous examples, most squeezes fall under the heading of bull market squeezes, or attempts to control supply by purchasing as much available material as possible. But thanks to the twists presented by futures options, there have been instances in which sellers of options—both puts and calls—have been subject to both bull market squeezes and the rarer bear market squeezes.

Call options—the right to buy a futures contract at a specified price—for example, figured heavily in last year's zinc market, and as recently as May there was talk of the potential for a nickel squeeze to develop in late 1993 because of the options market. This talk emerged based on this scenario: Despite oppressive nickel supply-and-demand fundamentals through May, the May spot price for nickel was $100 per metric ton (mt) higher than the November-December 1993 futures contract price, creating a backwardation. This backwardation coincided with the buildup of a large number of call options for November, which, if exercised, would present the potential for heavy buying of nickel contracts, thus creating a squeeze. Traders were also reporting an increase in calls held by aluminum producers at mid-year, a result of their plans to cut production in 1993.

Copper, meanwhile, provides examples of how put options—the right to sell a futures contract at a specified price—can figure into squeezes. In late 1991, for instance, LME copper was reportedly being squeezed, as the premium paid for copper for immediate delivery rose $130 per mt above the three-month quote, thus drawing attention to itself. Traders were quick to blame a large foreign copper producer that allegedly controlled an estimated 30 to 60 percent of LME-registered warehouse stocks and that reportedly was financing these stocks by granting, or selling, put options. The producer's underlying assumption, of course, was that copper prices weren't going to fall, so it viewed its act of selling puts as a generally bullish outlook for copper. On the other side, buyers of the put options were purchasing the right to sell as a type of relatively inexpensive insurance should prices indeed fall.

But as copper prices, in fact, weakened, the foreign producer started buying up physical metal heavily in hopes of bolstering the market and making the put options held by other market participants financially unattractive to be exercised. Copper prices indeed firmed in late November, prompting LME officials to put a limit of $25 per mt on the backwardation as a signal that the party was over for all participants who looked to make extra profits by buying more copper. With the price advantage gone, holders of copper—including the producer that started it all—began releasing metal onto the market, and the squeeze eased. In hindsight, traders contended that the foreign producer's actions were extremely unorthodox, with one remarking that the producer "attempted to fight the market by buying copper when it should have been selling."

More recently, the copper market demonstrated how a squeeze can arise when grantors of put options sell into a falling market. This scenario played out like this: Brokerage firms that had sold puts to copper producers discovered that as copper prices weakened in 1993, they had to begin selling futures contracts to cover the outstanding puts that appeared likely be exercised, which would leave them long in a falling copper market. This kind of selling, prompted by attempts to cover one's position, tends to feed on itself, creating a snowball effect by initiating more and more futures selling by the grantors the closer the put option comes to its stated strike price. In this case, substantial tonnage was involved and some brokerage houses were indeed squeezed as they were hit for repeated margin calls on the put options. Exacerbated by the selling initiated by the options market, copper prices dropped sharply in what traders described as a classic bear market squeeze.

Battling the Big Squeeze

While it is rare for squeezes to be the result of intentional market manipulation, exchanges have several techniques at their disposal to counter such challenges when they arise. The most straightforward measure is to establish a position limit, and the LME, COMEX, and the CBOT have the authority to determine how much of a backwardation can exist, thereby effectively preventing traders or speculators from amassing huge positions, as occurred with copper in 1991. Exchange officials and others can also bring civil and/or criminal actions against market manipulators, as occurred in the Hunt silver debacle.

Careful contract design can also help reduce the potential for market manipulation, with one option being the broadening of delivery specifications. In this case, the more delivery options available to suppliers—by increasing the number of locations where short traders can deliver, increasing the number of deliverable grades, or even increasing the time requirement for delivery—the less likely the market will experience a squeeze. The Secretan syndicate, for example, was doomed once the LME allowed other brands of copper to be delivered against the contracts written. And aluminum traders note that the growing number of LME warehouses around the world, including the United States , lessens aluminum's chances of being squeezed.

The LME, COMEX, and the CBOT are quick to react to actual and potential manipulation-related squeezes for one primary reason: Maintaining market integrity, order, and confidence is paramount for the long-term survival of commodity exchanges. And though there's no way to control all economic factors, and thus no way to create a "squeezeless" market, the exchanges and other market participants are satisfied to succeed in keeping the market in relative balance. •

Market squeezes—the nemesis of commodities traders and exchanges—can and do occur for a variety of reasons. Here's a look at some explanations and examples.