Major bank profits are up. Way up.
Goldman Sachs Group Inc. (NYSE: GS) just reported that its first-quarter earnings nearly doubled to $3.46 billion, the investment-banking giant's second-most-profitable quarter since going public a decade ago.
And Bank of America Corp. (NYSE: BAC) reported that its earnings for the first three months of the year rang in at $2.83 billion.
For all three of these banking giants, the first-quarter results blew past analyst expectations. Their stock prices? Approaching levels not seen since the start of the financial crisis. In fact, JPMorgan's stock is within 10% of its five-year high.
Major bank profits are zooming – despite the fact that U.S. consumers are struggling to repay loans.
So how are these guys pulling this off? Well, if you dig, you'll find that the bulk of major bank profits are coming from stronger trading revenue and other segments that are enabling the largest banks to overcome weakness in the lending area, which decades ago was the banking sector's bread-and-butter business.
If you dig deeper still, as I've done, you unearth one of the key reasons these banking behemoths are booking such massive profits. They've been moving enormous amounts of capital into one area of the market.
I'm talking about commodities.
Banks Bet Big on Resources
With major resources like oil, gold, silver, copper, and countless other commodities reaching decade-long highs – and even all-time records – in just the last two years, you can see why the world's biggest investors are so taken with this sector.
A recent survey of institutional investors showed that nearly two thirds plan to raise exposure to commodities. According to Barclays Capital (NYSE ADR: BCS) "investors expect commodity returns to be robust over the next five years and plan to continue raising their exposure to the asset class to new highs."
For the big investment banks, the gravitational pull of commodities is evidenced by their escalating commitments. In the next two years Merrill Lynch (now part of Bank of America), plans to grow its commodities team by 25%.
In just the past year, Deutsche Bank AG (NYSE: DB) has launched 11 new commodity indices, three new commodity mutual funds, and one new commodity exchange-traded fund (ETF). Societe Generale SA (OTC ADR: SCGLY) has nearly 400 commodity professionals expecting to double revenue over the next two years.
Barclays Capital set up a shipping division one year ago to support physical trading in oil. Credit Suisse Group AG (NYSE ADR: CS) has an alliance with secretive trading house Glencore International AG (the world's largest) in order to uphold its large presence in the physical-commodities market.
I could go on and on with details about the burgeoning importance this has for major bank profits. But let me give you one statistic that really cuts to the bottom line: Today, four of the largest U.S. banks have upwards of $4 trillion riding on commodities-related investments.
But there's more at work here than just hiring staff and grabbing a seat aboard the secular natural-resources bull.
Most investors continue to have concerns about a weak economic recovery, the threat of a double-dip recession, and even speculation of deflationary risks – which is probably one reason that stock-market volume remains so low.
And yet, in the face of all that worry and fear, an intense level of confidence – if not a downright bullish conviction – seems to permeate the investment banks' upbeat forecasts for gold and oil.
Gold was trading at about $1,150 an ounce this week while the so-called "black gold" – crude oil – was trading at about $84 a barrel.
Goldman Sachs, for instance, is calling for gold to reach $1,350 an ounce in 2010 and $1,425 an ounce by 2011. It's also forecasting oil to be trading in a range of $92 a barrel to $97 a barrel within three to six months. It's even predicting an oil shortage for 2011, and is calling for oil – the so-called "black gold" – to reach $110 per barrel by then.
For its part, Barclays believes oil will bump up against the $100-a-barrel level before the year is out, and even sees crude prices reaching $140 within the next five years. Bank of America expects oil to exceed $105 this year, and is forecasting $150 within four years.
So how are these investment banks able to make such bold predictions about rocketing prices? How can they be so confident?
There's only one answer: They're taking tangible steps to gain control over commodities supplies – essentially guaranteeing that prices go higher.
Control + Confidence = Profits
My knowledgeable Money Morning colleague Martin Hutchinson has effectively analyzed the implications of hedge funds making investments in "physical commodities" in order to counter potential regulatory moves by the U.S. Commodity Futures Trading Commission (CFTC), which is looking to introduce "position limits" into the futures markets.
Given what hedge funds are doing, it's not surprising that the big banks and investment banks have been lurking close behind.
Already Goldman, Morgan Stanley (NYSE: MS) and JPMorgan Chase control 120 million barrels of oil. But only JPMorgan has supertankers and storage tanks in strategic locations around the globe, which enables it to hold millions of barrels of oil off the market.
JPMorgan and Goldman have begun taking physical delivery of gold when their futures contracts mature. Last August, Morgan Stanley got the okay to trade with Dubai Gold Securities, which will allow it to take physical possession of the gold.
Earlier this year, Goldman and JPMorgan each bought established metals-warehousing facilities. Goldman purchased Metro International of Detroit for $550 million, and JPMorgan bought Henry Bath of the United Kingdom as part of a larger $1.7 billion acquisition. According to industry insiders both deals were done at a premium.
These steps are all aimed at helping ensure the investment banks' $4 trillion "commodities trade" goes their way.
Here's what I mean: By taking physical commodities off the market while demand is on the rise, they're only going to exacerbate supply shortages.
And that's precisely the point.
Physical supplies are limited, so when a ship full of ore is purchased by a bank and held "off the market," that can send serious supply shocks through a particular industry. In terms of "gaming the trade," the inventory can be sold for profit and repurchased later with the intention of benefiting from a subsequent rise in price.
But if you analyze this transaction in isolation, it's clearly a one-way bet: When an institution buys the physical commodity, its objective is clearly to unload that inventory at a later date and at a higher price – most likely much higher.
Keep in mind that a physical inventory of crude oil or gold isn't at all like a share of stock or a futures contract – the latter two of which are highly liquid and very easy to sell: For an actual commodity, it takes time to find a buyer.
Intuitively speaking, that brings us to a very clear bottom line. When an institution buys and holds a physical commodity, there's a very clear belief, confidence or conviction: The price is going to rise – probably by quite a lot.
Only industrial players that use a particular commodity as a raw material, which they intend to consume in the process of creating another product (crude oil becomes gasoline, or iron ore becomes steel, for instance). They certainly don't want to overpay, but securing a supply of that commodity is essential to doing business.
As the banks take physical delivery of oil they know its price will rise significantly, so they can "double up" and even simultaneously "paper trade" futures for additional profits.
In fact, banks are helping ensure higher prices by effectively limiting the supply of that commodity.
But, being ever the innovators, banks have figured out a still-more-effective way to profit from supplies that fall short of the market demand. And this is something you're almost certainly never going to read about in the mainstream financial press.
Let me explain.
Hoarding Resources – While They're Still in the Ground
One of the shrewdest methods to expand control over a commodity is to buy saurian-sized resource deposits while they're still in the ground – for just pennies on the dollar.
As the price of an underlying commodity continues to rise – as has been the case during the current secular bull market for commodities – the value of that asset increases at an exponential rate. That's because the cost to control the asset is minuscule in relation to its value.
Interestingly, you don't even have to extract the resource. You can just hoard it. In other words, you can just sit on it, leave it in the ground, and wait for its "spot price" to rise.
You even avoid the burden of storage costs.
I have to hand it to the investment banks: It's a brilliant strategy.
Provocatively, investors can now obtain valuable insight into how this strategy's being applied.
Fallout from the financial crisis forced some banks to become bank holding companies, which requires the quarterly filing of a special form, known as FR Y-9C, which provides a glimpse into which sectors are gaining favor.
Other standard quarterly reporting reveals the banks' equity holdings. Analyzed together, these two filings show that banks are becoming significant players in resource equities, and specifically in the junior resource space.
It's easy to see why.
Numerous junior and mid-tier resource companies, with in-ground "inventories," trade at market-cap valuations at barely 10% of their total net asset value. The attraction is irresistible.
How About a '10-Bagger' Return?
Despite the increasing involvement of banks in the natural-resources sector, it's the exploration companies – and producers that continue to explore – that stand to be one of the most explosive ways to generate wealth.
The reason is simple. Although exploration remains a riskier business, when you hit paydirt the return can be as much as 100 times the amount being spent.
For example, when drilling for oil or natural gas, a $10 million exploration budget could generate $1 billion or more worth of hydrocarbons in the ground.
Now that's what we call financial leverage.
But there are ways to dramatically minimize the potential risks normally associated with these investments. An oil-and-gas company that's already producing has better odds of finding more valuable assets on its current property. And those firms that maintain healthy cash balances and that possess little or no debt will achieve better market valuations.
Make no mistake, opportunities abound, but recognizing that commodities are a favored sector is not enough. Understanding which commodities are undervalued at a given point in time – and researching the best-managed and most-undervalued plays – can yield explosive results. The returns can sometimes reach 10 times, or even 15 times, the original investment.
So as you peruse recent headlines describing how the world's largest investment banks are reporting record profits, are roaring back to record level profits, remember that some of their methods aren't overly sophisticated – they're just not mainstream.
And keep in mind, too, that natural-resource stocks – no matter if they are small-, medium-, or large-cap in nature – are a growing and highly effective part of those profit-making strategies.
It's all about confidence … and control.
And in the commodities sector, banks right now boast both.
[Editor's Note: Investments in commodities or natural resources – such as the ones that banks are right now making in a big way – can easily generate returns of 15 times your money … or even more.
That's the kind of financial leverage that can transform a simple $5,000 investment into $75,000.
As part of his Global Resources Alert advisory service, veteran analyst and commodities expert Peter Krauth has devised a strategy that will let virtually any investor outsmart Wall Street and hitch a ride on this commodities-profit train. But there's a catch: You need to act before May 10, when the data-rich report that's the key to this strategy becomes available.
News and Related Story Links:
J.P. Morgan Chase profit jumps 55%
- Money Morning Special Report:
Low Stock Market Volume: It's Even Weaker Than You Think
- Money Morning Special Report:
Hedge Funds Take Direct Stakes in Commodities … Should We Be Wary?
- Money Morning News Analysis:
Goldman's First-Quarter Profit Doubles to $3.46 Billion, Even as its Fraud Probe Takes on an International Twist
- Commodities Futures Trading Commission:
Official Web Site
- Dubai Gold Securities:
Official Web Site
- Commodity Online:
Morgan Stanley to redeem Dubai Gold Securities
Gaming the System
- Federal Reserve:
Form FR Y-9C
About the Author
Peter Krauth is the Resource Specialist for Money Map Press and has contributed some of the most popular and highly regarded investing articles on Money Morning. Peter is headquartered in resource-rich Canada, but he travels around the world to dig up the very best profit opportunity, whether it's in gold, silver, oil, coal, or even potash.