Streetwise Professor

October 28, 2014

Convergence to Agreement With Matt Levine

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 10:10 am

Matt Levine graciously led his daily linkwrap with a response to my post on his copper column:

It’s not that hard to manipulate copper.

Craig Pirrong, who knows a lot more about commodities markets than I do [aw, shucks], objects to my take on copper. My view is sort of efficient-markets-y: If one person buys up all the copper in the LME warehouses and then tries to raise the price, the much much greater supply of copper that’s not in those warehouses will flow into the warehouses and limit his ability to do that. And I still think that’s broadly true, but broadly true may not be the point. Pirrong quite rightly points out that there’s lots of friction along the way, and the frictions may matter more than the limits in actual fact.

. . . .

So there are limits to cornering, but they may not be binding on an actual economic actor: You can’t push prices up very much, or forvery long, but you may be able to push them up high enough and for long enough to make yourself a lot of money.

I agree fully there are limits to cornering. The supply curve isn’t completely inelastic. People can divert supplies (at some cost) into deliverable position. The cornerer presents the shorts with the choice: pay me to get out of your positions, or incur the cost of making delivery. Since those delivery costs are finite, the amount the cornerer can extract is limited too.

I agree as well that corners typically elevate prices temporarily: after all, the manipulator needs to liquidate his positions in order to cash out, and as soon as that happens price relationships snap back. But that temporary period can last for some time. Weeks, sometimes more.

What’s more, when the temporary price distortions happen matters a lot. Some squeezes occur at the very end of a contract. This is what happened in Indiana Farm Bureau in 1973. A more recent example is the expiry of the October, 2008 crude oil contract, in which prices spiked hugely in the last few minutes of trading.

The economic harm of these last minute squeezes isn’t that large. There are few players in the market, most hedgers have rolled or offset, and the time frame of the price distortion is too short to cause inefficient movements of the commodity.

But other corners are more protracted, and occur at precisely the wrong time.

Specifically, some corners start to distort prices well before expiration, and precisely when hedgers are looking to roll or offset. Short, out-of-position hedgers looking to roll or offset try to buy either spreads or outrights. The large long planning to corner the market doesn’t liquidate. So the hedgers bid up the expiring contract. Long still doesn’t budge. So the shorts bid it up some more. Eventually, the large long relents and sells when prices and spreads get substantially out of line, and the hedgers exit their positions but at a painfully artificial price. I have documented price distortions in some episodes of 10 percent or more. That’s a big deal, especially when one considers the very thin margins on which commodity trading is done. Combine that price distortion with the fact that a large number of shorts pay that distorted price to get out of their positions, and the dollar damages can be large. Depending on the size of the contract, and the magnitude of the distortion, nine or ten figures large.  (I analyze the liquidation/roll process theoretically in a paper titled “Squeeze Play” that appeared in the Journal of Alternative Investments a few years ago.)

But this is all paper trading, right, so real reapers of wheat and miners of copper aren’t damaged, right? Well, for the bigger, more protracted squeezes that’s not right.

Most hedgers are “out-of-position” they are using a futures contract to hedge something that isn’t deliverable. For example, shippers of Brazilian beans or holders of soybean inventories in Iowa use CBT soybean futures as a hedge. They are therefore long the basis. Corners distort the basis: the futures price rises to reflect the frictions and bottlenecks and technical features of the delivery mechanism, but the prices of the vastly larger quantities of the physical traded and held elsewhere may rise little, if at all. So the out-of-position hedgers don’t gain on their inventories, but they pay an inflated price to exit their futures.

This is why corners are a bad thing. They undermine  the most vital function of futures markets: hedging/risk transfer. Hedgers pay the biggest price for corners precisely because the delivery market is only a small sliver of the world market for a commodity, and because the network effects of liquidity cause all hedging activity to tip to a single market (with a very few exceptions). Thus, the very inside baseball details of the delivery process in a specific, localized market have global consequences. That’s why temporary and not very big and localized are not much comfort when it comes to the price distortions associated with market power manipulations.

 

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Gunvor Cutting Back in Russia: Jumping or Pushed?

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 9:14 am

Gunvor announced plans to sell assets in Russia:

Oil trading house Gunvor is seeking to cut exposure to Russia by selling assets in the country which had long been one the main generators of its growth and profit before the United States imposed sanctions on its co-founder.

. . . .

Now the company, led by the veteran Swedish oil trader, is looking to rebalance its asset portfolio and divest a significant part of business in Russia to acquire new assets in Europe, the United States, Asia and South America.

“Since a significant portion of our investments are in Russia, over time Gunvor will be looking to sell selectively part of those assets. We do not expect this will have any impact on our existing trading activities in Russia,” the company said on Sunday.

I am somewhat amused by the statement that the company “expect this will have any impact on our existing trading activities in Russia,” because it is well known that it has been cutting back on these activities for some time.

Some obvious explanations include a genuine desire to rebalance its asset portfolio, a need for cash due to persistent suspicions about the company leading to constraints on its ability to access the credit markets, and a desire to put paid to those suspicions by cutting back exposure to Russia.

Knowing the way Russia works, I would advance another hypothesis for Gunvor’s actions. It has been told to sell out, because someone covets those assets, and because after Timchenko’s departure (and Putin’s being cashed out?) the company has lost its krysha. Russia is the country of “nice little port you have here. It’d be a shame if something happened to it. Or to you.” When you have something that somebody important wants, you’d better say da! and accept the price offered without complaint. Just ask Vladimir Yevtushenkov.

One of the assets that Gunvor is selling is its stake in the port in Novorossiisk. Wouldn’t you know who expressed an interest in acquiring a stake in the the port there? Yeah. Igor. And Rosneft has oil trading ambitions, and the Ust-Luga port on the Baltic could fit quite nicely into that.

So keep an eye on who buys. Given that this is hardly a peachy time to sell assets in Russia, given the country’s growing economic isolation and the fear of further sanctions, Gunvor’s announcement is quite telling. The buyer is likely to be Russian, and the set of possible buyers is quite limited, which means that Gunvor is not likely to get top dollar for these assets. If Rosneft or another national champion with close connections to Putin ends up being the buyer, my suspicions that Gunvor was pushed out of Russia will be largely confirmed.

Someone at Gunvor told the FT that Russia was “Gunvor’s heritage, not its future.” That’s definitely true. The only question is why. I strongly suspect this is not totally voluntary, and to the extent that it is, it reflects Gunvor’s judgment that the legal and economic and political risks of operating in Russia are no longer worth the candle.

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October 27, 2014

Who You Gonna Believe? Dr. Barry or the US Army?

Filed under: Economics,Politics — The Professor @ 5:43 pm

From day 1 of the Ebola episode in Dallas, the administration has been adamantly opposed to travel bans and quarantines, especially of health care workers who have been to West Africa. When New York and New Jersey implemented quarantines, the administration leaned on governors Cuomo and Christie very hard: Cuomo relented considerably. The administration argues that imposing restrictions on returnees from the Ebola-stricken region will impede efforts to control the outbreak there.

I’ve expressed skepticism about those arguments, but if you don’t give me any credence, what about the US Army?:

The U.S. general appointed to oversee America’s fight against Ebola in West Africa has been quarantined in Italy with at least 10 other Americans upon returning from the disease-stricken continent.

Major General Darryl A. Williams, who was appointed head of the U.S. command center in Liberia that coordinates the response to Ebola, was isolated along with several other Americans over the weekend, CNN reports.

The General’s “plane was met on the ground by Italian authorities ‘in full CDC gear,’” a U.S. official was quoted as telling CNN.

Williams and the others will now be monitored for 21 days at a U.S. military compound in Italy, according to the report.

To steal a phrase, the US military is pretty much the ultimate reality-based community–except when political pressure gets too hard to bear. But in most matters of life and death involving its areas of competence, the military doesn’t bend to political fashions, especially progressive ones. It balances risk and reward, based on its best understanding of the facts (which is often imperfect, admittedly) and decides accordingly.

So for the Army to decide, in the face of the obvious potential for fierce disagreement with the administration, that quarantine is the right thing to do, you can be pretty sure that decision is the result of a sober appraisal of the situation. Indeed, the willingness to buck administration preferences gives you an indication of the strength of the Army’s convictions.

The US military has always been more serious and squared away and apolitical with regards to biological and chemical threats. It should be assigned primary responsibility in dealing with the situation in the US too, but turf wars have ruled that out. (Hot Zone describes the turf fights between CDC and the Army during the Clinton administration during an episode involving infected monkeys in Virginia.)

The Army action is basically calling bull on the administration’s frantic anti-quarantine position. Between Dr. Barry and the US Army, I know whom I trust more.

That said, there are smart ways of doing a quarantine, and dumb ways. The measures initially adopted by New York and New Jersey seem to be  ham-fisted. The quarantined nurse in NJ has something of a legitimate beef (mixing meat metaphors!), although her claims that quarantines are totally unnecessary for returning health care workers comes off as entitled and clueless, especially given the infections of health care workers here in the US and Europe, and the large numbers of deaths among such workers in Africa. One would think that someone who is  selfless enough to risk contracting the disease in Africa would be willing to take prudent precautions to prevent it from spreading at home.

The Army way seems to be the right way. A special facility, outside the US, where those working in the afflicted region are quarantined  in a comfortable, secure facility before returning to the US.

@libertylynx pointed out to me that quarantine can be a financial burden and family hardship on aid workers, many of whom are missionaries without substantial financial resources. That problem is easily solved, as it involves only money, and not a lot at that. There is a way of balancing the need to attract people to West Africa to fight the disease, and limiting the possibility that they can spread the virus back to the states on their return.

Put differently, the cost of compensating the workers for the burdens of a quarantine pales in comparison with the cost of dealing with an outbreak in the US. Even if the probability that  returnee would spread the virus is small, given the huge cost of a US outbreak and the huge benefit of attracting workers to fight the disease the affected region, it is cheap at twice the price (or much more) to compensate them for the time and hardship a quarantine imposes. Pace Adam Smith: compensating differentials in action.

That said, the Army’s action speaks many volumes. It is saying that from a medical perspective, quarantine is a prudent measure. If the administration is concerned about deterring the travel of needed workers to Africa, the costs of that prudence can be easily paid. Rather than stubbornly fighting quarantines and travel bans, the administration should focus its efforts on designing and getting passed financial compensation measures that balance risk and reward.

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Matt Levine Passes Off a Bad Penny

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 5:36 pm

Bloomberg’s Matt Levine is usually very insightful about markets, and about financial skullduggery. Alas, in his article on developments in the copper market, Matt is passing off a bad penny.

The basic facts are these. A single firm, reportedly well-known (and arguably infamous) metals trading fund Red Kite, has accumulated upwards of 50 percent (and at times as much as 90 percent) of copper in LME warehouses that is deliverable against LME futures contracts. Such an accumulation can facilitate a corner of the market, or could be a symptom of a corner: a large long takes delivery of virtually the entire deliverable stock (and perhaps all of it) to execute a corner. So the developments in LME copper bear the hallmarks of a squeeze, or an impending one.

What’s more, the price relationships in the market are consistent with a squeeze: the market is in backwardation. I have not had time to determine whether the backwardation is large, controlling for stocks (as would occur during a corner), but the sharp spike in backwardation in recent days is symptomatic of a corner, or fears of a corner.

Put simply, there is smoke here. But Matt Levine seems intent on denying that. Weirdly, he focuses on the allegations involving Goldman’s actions in aluminum:

Loosely speaking, the problem of aluminum was that it was in deep contango: Prices for immediate delivery were low, prices for future delivery were high, and so buying aluminum and chucking it in a warehouse to deliver later was profitable. So people did, and the warehouses got pretty jammed up, and other people who wanted aluminum for immediate use found it all a bit unsporting.

. . . .

The LME warehouse system is an interesting abstract representation of a commodity market, but you can get into trouble if you confuse it with the actual commodity market. One example of the trouble: Goldman and its cronies were accused of manipulating aluminum prices up by putting too much aluminum in LME warehouses.

Well, yes. But the point is that there are many different kinds of manipulation. Many, many different kinds. An Appeals Court in the US opined in the Cargill case that they number of ways of manipulating was limited only by the imagination of man. Too true. The facts in aluminum and the facts in copper are totally different, and the alleged forms of manipulation are totally different, so the events in aluminum are a red herring (although it is copper that is the red metal)

Levine also makes a big, big deal out of the fact that the amount of copper in LME warehouses is trivial compared to the amount of copper produced in the world, let alone the amount of copper that remains in the earth’s crust. This matters hardly at all.

What matters is the steepness of the supply curve into warehouses. If that supply curve is upward sloping, a firm with a big enough futures position can corner the market, and distort prices, even if the amount of copper actually in the warehouses, or attracted to the warehouses by a cornerer’s artificial demand, is small relative to the size of the world copper market.

Case in point. In December 1995 Hamanaka/Sumitomo cornered the LME copper contract holding a position in LME warrants that was substantially smaller than what one firm now owns. Hamanaka’s/Sumitomo’s physical and futures positions were small relative to the size of the world copper market, measured by production and consumption. But they still had market power in the relevant market because it was uneconomic to attract additional copper into LME warehouses.

Another example. Ferruzzi cornered the CBT soybean contract in July, 1989, owning a mere 8 million bushels of beans in Chicago and Toledo. But since it was uneconomic to move additional supplies into those delivery points, it was profitable for, and possible for, Ferruzzi to corner the expiring contract.

World supply may have an effect on the slope of the supply curve into warehouses, but that slope can be positive (thereby creating the conditions necessary to corner) even if the share of metal in warehouses is small. The slope of the supply curve depends on the bottlenecks associated with getting metal into warehouses, and the costs of diverting metal that should go to consumers into warehouses. These bottlenecks and costs can be acute, even if the amount of warehoused metal is small. Diverting copper that should go to a fabricator or wire mill to an LME warehouse is inefficient, i.e., costly. It only happens, therefore, if the price is distorted sufficiently to offset this higher cost.

Levine ends his post thus:

One example of the trouble: Goldman and its cronies were accused of manipulating aluminum prices up by putting too much aluminum in LME warehouses.The worries about copper — that it could be cornered, pushing prices up — stem from there being too little copper in those warehouses. Both of those things can’t be true.

Yes they can, actually. Different commodities at different times with different fundamental conditions are vulnerable to different kinds of manipulation. It is perfectly possible for it to be true that aluminum was vulnerable to a manipulative scheme that exploited the bottlenecks of taking the white metal out of warehouses starting some years ago, and that copper is vulnerable to a manipulative scheme that exploits the bottlenecks of getting the red metal into warehouses now. No logical or factual contradiction whatsoever.

I know you are better than this, Matt. Don’t let your justifiable skepticism of allegations of manipulation make you a poster child for the Gresham’s Law of Internet Commentary.

 

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October 24, 2014

Someone Didn’t Get the Memo, and I Wouldn’t Want to be That Guy*

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 9:23 am

Due to the five year gap in 30 year bond issuance, in mid-September the CME revised the deliverable basket for the June 2015 T-bond contract. It deleted the 6.25 of May, 2015 because its delivery value would have been so far below the values of the other bonds in the deliverable set. This would have made the contract more susceptible to a squeeze because only that bond would effectively be available for delivery due to the way the contract works.

The CME issued a memo on the subject.

Somebody obviously didn’t get it:

It looks like a Treasury futures trader failed to do his or her homework.

The price of 30-year Treasury futures expiring in June traded for less than 145 for about two hours yesterday before shooting up to more than 150. The 7.3 percent surge in their price yesterday, on the first day these particular contracts were traded, was unprecedented for 30-year Treasury futures, according to data compiled by Bloomberg. Volume amounted to 1,639 contracts with a notional value of $164 million.

What sets these futures apart from others is they’re the first ones where the U.S. government’s decision to stop issuing 30-year bonds from 2001 to 2006 must be accounted for when valuing the derivatives. The size and speed of yesterday’s jump indicates the initial traders of the contracts hadn’t factored in the unusual rules governing these particular products, said Craig Pirrong, a finance professor at the University of Houston.

“That is humongous,” said Pirrong, referring to the 7.3 percent jump. “We’re talking about a move you might see over weeks or a month occur in a day.” Pirrong said he suspected it was an algorithmic trader using an outdated model. “I would not want to be that guy,” the professor said.

Here’s a quick and dirty explanation. Multiple bonds are eligible for delivery. Since they have different coupons and maturities, their prices can differ substantially. For instance, the 3.5 percent of Feb 39 sells for about $110, and the 6.25 of 2030 sells for about $146. If both bonds were deliverable at par, no one would ever deliver the 6.25 of 2030, and it would not contribute in any real way to deliverable supply. Therefore, the CME effectively handicaps the delivery race by assigning conversion factors to each bond. The conversion factor is essentially the bond’s price on the delivery date assuming it yields 6 percent to maturity. If all bonds yield 6 percent, their delivery values would be equal, and the deliverable supply would be the total amount of deliverable bonds outstanding. This would make it almost impossible to squeeze the market.

Since bonds differ in duration, and actual yields differ from 6 percent, the conversion factors narrow but do not eliminate disparities in the delivery values of bonds. One bond will be cheapest-to-deliver. Roughly speaking, the CTD bond will be the one with the lowest ratio of price to conversion factor.

That’s where the problem comes in. For the June contract, if the 6.25 of 2030 was eligible to deliver, its converted price would be around $142. Due to the issuance/maturity gap, the converted prices of all the other bonds is substantially higher, ranging between $154 and $159.

This is due a duration effect. When yields are below 6 percent, and they are now way below, at less than 3 percent, low duration bonds become CTD: the prices of low duration bonds rise less (in percentage terms) for a given decline in yields than the prices of high duration bonds, so they become relatively cheaper. The 6.25 of 2030 has a substantially lower duration than the other bonds in the deliverable basket because of its lower maturity (more than 5 years) and higher coupon. So it would have been cheapest to deliver by a huge margin had CME allowed it to remain in the basket. This would have shrunk the deliverable supply to the amount outstanding of that bond, making a squeeze more likely, and more profitable. (And squeezes in Treasuries do occur. They were rife in the mid-to-late-80s, and there was a squeeze of the Ten Year in June of 2005. The 2005 squeeze, which was pretty gross, occurred when there was less than a $1 difference in delivery values between the CTD and the next-cheapest. The squeezer distorted prices by about 15/32s.)

The futures contract prices the CTD bond. So if someone-or someone’s algo-believed that the 6.25 of 2030 was in the deliverable basket, they would have calculated the no-arb price as being around $142. But that bond isn’t in the basket, so the no-arb value of the contract is above $150. Apparently the guy* who didn’t get the memo merrily offered the June future at $142 in the mistaken belief that was near fair value.

Ruh-roh.

After selling quite a few contracts, the memo non-reader wised up, and the price jumped up to over $150, which reflected the real deliverable basket, not the imaginary one.

This price move was “humongous” given that implied vol is around 6 percent. That’s an annualized number, meaning that the move on a single day was more than a one-sigma annual move. I was being very cautious by saying this magnitude move would be expected to occur over weeks or months. But that’s what happens when the reporter catches me in the gym rather than at my computer.

This wasn’t a fat-finger error. This was a fat-head error. It cost somebody a good deal of money, and made some others very happy.

So word up, traders (and programmers): always read the memos from your friendly local exchange.

*Or gal, as Mary Childs pointed out on Twitter.

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October 19, 2014

It *Was* Too Quiet Out There

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis — The Professor @ 5:28 pm

Four weeks ago I gave the keynote talk at Energy Risk Asia in Singapore. My talk was a look back at commodity market developments in the past year, followed by a look forward.

The theme of the look back was “A Perfect Calm.” I noted that volatility levels across all markets, not just commodities, were at very low levels. Equity vols, as measured by the VIX, had been in the 10 percent range in August and had only ticked up to around 12 percent by late-September. Commodity volatilities were even more remarkable. Historically, the low level of commodity volatilities (the 5th percentile) have been around the median of equity vols and well above currency and bond vols. During the first half of the year, however, commodity vols were below the 5th percentile of equity vols, and below the 95th percentile of currency and bond vols. Pretty amazing.

I argued that this reflected a happy combination of supply and demand factors. In energy and ags in particular, abundant supplies put a drag on volatility. But volatility from the demand side was low too. The low VIX levels are a good proxy for macro uncertainty, or the lack thereof. Put both of those together, and you get a perfect calm.

But perfect calms are the exception, rather than the rule. The last slide in my talk looked forward, and cribbed a movie cliche: It was titled “It’s Quiet Out There. Too Quiet.” I noted that periods of very low volatility frequently bear the seeds of their destruction. When risk measures are low, firms and traders lever up and increase position sizes. A bit of economic turbulence increases volatilities, which leads to breaches in risk limits, which forces deleveraging and reductions in positions. This tends to lead to reduced liquidity, exaggerated price moves, yet higher volatility, leading to more deleveraging and repositioning, and on it goes. That is, there can be a positive feedback loop. Transitions from low to high volatility can be very abrupt.

It looks like that’s what has happened in the weeks since my return. Equity markets are down substantially. Commodities, notably energy, have slumped: Brent is down to around $88. Volatilities have spiked. The VIX reached over 31 percent last week, and the crude oil VIX went from about 15 percent at the end of August to over 37 percent last week.

The spark appears to have been mounting evidence of a slowdown in Europe and China. Ebola might have been a contributing factor in the last week or two, but in my view the economic weakness is the main driver.

I admit to being like the title character in My Cousin Vinnie. He had difficulty sleeping in the Alabama country quiet, but slept like a lamb in a raucous county jail. Times like these are more interesting, anyways.

So it turns out it was too quiet out there.

And remember. Today is the 27th anniversary of the ’87 Crash (one of the formative experiences of my professional life). Octobers are often . . . interesting (the most dangerous word in the English language). So the markets bear watching closely. If you aren’t interested in them, they may well be interested in you.

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October 14, 2014

The IEA Has Identification Issues: Econ 101 Fail

Filed under: Commodities,Economics,Energy — The Professor @ 1:39 pm

The IEA’s most recent report includes this gem of an analysis:

Recent price declines have sparked speculation about their potentially supportive impact on demand. The price elasticity of oil demand tends to be asymmetric in nature: oil demand falls on high prices more easily than it expands on lower prices. Looking at the last five incidences of crude oil price declines of 15% or more over a four‐month period (as occurred, at the time of going to press, June‐through‐ October), only in one case (in 2006) was a noticeable uptick in demand seen.

The immediate impact tends to be weakening demand reducing oil prices, as opposed to lower prices triggering additional deliveries, which is very much lagged. The dramatic price decline of late 2008/early 2009, for example, was not followed by a noticeable uptick in global oil demand growth until 2H09, many months after prices had started to rebound. Oil price changes will naturally affect demand differently depending on whether they are themselves supply‐ or demand‐driven. The price drop in 2008 was overwhelmingly demand led, whereas recent declines appear to have been largely in response to rising supply. Nevertheless, recent price movements are not expected to significantly lift demand in the short term, especially since crude price drops are not fully carried through to retail product prices.

That sound you just heard was me doing a I-coulda-had-a-V8 head slap.

Um, the IEA is making the most basic error possible: mistaking a fall in quantity demanded (consumed) for a fall in demand. A decline in demand (i.e., a movement in the demand curve) leads to a decline in price and quantity. This is exactly what happened in the episodes the IEA discusses: the 2008-2009 episode is the most severe example. Demand fell precipitously due to the financial crisis and subsequent Great Recession. This cratered prices, and also led to a decline in consumption.

Prices and consumption move inversely when there is a move along the demand curve. This occurs due to a supply shock.

This is Econ 101 textbook stuff, people. It has an name: identification. You can identify a demand curve only by holding it fixed and moving the supply curve. If the demand curve is moving around, you can’t identify a demand curve from price and quantity movements.

Hell, the IEA even recognizes this problem: look at the second paragraph. But if they recognize the problem in the second paragraph, why did they write the first paragraph? And this asymmetry in elasticity stuff? What, did the IEA have an acid flashback of a 60s textbook’s analysis of Sweezy’s Kinked Demand Curve?

I would seriously question whether the current price drop is totally supply driven as well. Chinese demand appears to have dropped steeply, and the European economy is slowing notably: Germany in particular has hit a rough patch.

So the IEA fails Econ 101, but we’re supposed to take seriously its analysis of more complex issues?

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October 13, 2014

Russia in a Nutshell: Three Stories That Convey Important Truths About an Aggressive, Mendacious, and Economically Weak Empire

Filed under: Commodities,Economics,Energy,Military,Politics,Russia — The Professor @ 2:43 pm

A quick rundown on some Russia stories. Three stories that encapsulate important truths about an unhappy country that seems intent on forcing others to share in its unhappiness.

First, there was a lot of attention paid to Putin’s announcement that 17,000 soldiers would be withdrawn from Rostov, on the Ukrainian border, to return to their bases. The reactions are a combination of poor memory, ignorance, and wishful thinking. Poor memory because something similar happened in the spring, which didn’t preclude an invasion in the summer. Ignorance, because if you are aware of Russia’s conscription cycle, you are aware that the fall 2013 conscript class is due to be mustered out, and units must return to their bases to discharge last year’s class and induct and train this year’s. That’s what happened in the spring. This ignorance is inexcusable now, as it was written about in the spring, notably by Pavel Felgenhauer: I wrote about it here as well. Wishful thinking, because everyone is grasping at the hope that Putin will back down from the Ukraine battle. As if.

There is no news here. This is an artifact of Russia’s conscription system. Period. Watch for new training exercises in a few months, and the deployment of units to the Ukrainian border again, once the new conscripts are integrated into their units.

Second, Russia will sign several intergovernmental agreements with China when Premier Li visits next month. One of them is an agreement to export gas from Russia to China.

I know what you’re thinking: “Wait, didn’t they sign that deal to huge fanfare back in May?” Apparently not:

Russia has prepared intergovernmental agreements to sign during Chinese Premier Li Keqiang’s visit to Moscow next week including one on a $400 billion natural gas deal agreed in May, Russia’s deputy foreign minister said.

Russian gas exporter Gazprom and China National Petroleum Corp (CNPC) have agreed that Russia will supply China with 38 billion cubic metres of gas starting from 2019.

Yet on Friday Gazprom said an intergovernmental agreement between Russia and China required for the plan to come into force had not yet been signed.

Russian Deputy Foreign Minister Igor Morgulov told Chinese state news agency Xinhua that governmental agreements including one on gas were ready for signing during Li’s coming visit.

“They include an intergovernmental agreement on natural gas supplies via an “‘eastern’ route,” he said. [Emphasis added.]

Proving yet again that announcements from the Russians about any deal should be treated with extreme skepticism. They are the masters of vaporcontracts.

The Russians are touting various deals with the Chinese as proof of their invulnerability to western sanctions and pressure. The feebleminded believe this. In fact, Russian desperation is palpable: the fact that they hyped the gas non-deal is a perfect example of this. If you don’t think that the Chinese are aware that they have the whip hand here, and are flogging the Russians for all it is worth, please contact me. I’ve securitized some bridges, and I’m sure they’d be perfect for your portfolios!

Third, the Russians are in full paranoid mode over the decline in oil prices. Brent is down to $88/bbl, which puts Urals at about $86. Speaking of 86, they are having flashbacks to 1986, when the Saudis flooded the world with oil. This began the fatal crash of the Soviet economy (described well in Gaidar’s book, Empire).

The vice-president of Russia’s state-owned oil behemoth Rosneft has accused Saudi Arabia of manipulating the oil price for political reasons. Mikhail Leontyev was quoted in Russian media as saying:

Prices can be manipulative. First of all, Saudi Arabia has begun making big discounts on oil. This is political manipulation, and Saudi Arabia is being manipulated, which could end badly.

Er, this is way different from 1986. At most, the Saudis have increased output only slightly (about 100kbbl/day): in ’86, they more than doubled output. The Saudis are just acknowledging market reality. Demand is weak,  supplies from the US are growing, and Libya is coming back into the market. Put those  things together, and prices are inevitably going to fall. The Saudis can see the writing on the wall, and their market share is sufficiently small that unilateral reductions in their output are not economically rational. Funny, now that I mention it: Saudi market share is about the same as Russian market share. The Russians produce up to capacity, because that is profit maximizing. Yet they expect the Saudis to cut back output? Of course they do! The Saudis should sacrifice their own interests to bail out the Russians! Of course they should!

Leontyev seems to be vying with the Gazprom guy Komlev to see who can make the most idiotic statements about world energy markets. Something that commentor Ivan passed on suggests that as idiotic as Komlev was, Leontyev has him hands down. The Rosneft spokesman also blamed low oil prices on ISIS selling oil at a “triple discount.” Hilarious! World oil prices are determined in the world market. ISIS has to sell at a huge discount because it is politically radioactive, and because it cannot access world markets directly. Those to whom it sells pocket the discount to adjust for the risk of dealing with a political leper (a radioactive leper!-I’m not mixing metaphors), and sell at the world price. The world price is determined by world output, not the price of the first sale. If anything, ISIS is propping up prices by reducing output in Syria (not a big deal) and threatening output in Iraq (a bigger deal).

Together, these three stories convey important truths  about Russia. And truth is ugly indeed. An aggressive, economically tottering empire dependent on commodity rents, and constitutionally unable to tell the truth or deal with reality.

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You Might Have Read This Somewhere Before. Like Here.

The FT has a long article by John Dizard raising alarms about the systemic risks posed by CCPs. The solution, in other words, might be the problem.

Where have I read that before?

The article focuses on a couple of regulatory reports that have also raised the alarm:

No, I am referring to reports filed by the wiring and plumbing inspectors of the CCPs. For example, the International Organization for Securities Commissions (a name that could only be made duller by inserting the word “Canada”) issued a report this month on the “Securities Markets Risk Outlook 2014-2015”. I am not going to attempt to achieve the poetic effect of the volume read as a whole, so I will skip ahead to page 85 to the section on margin calls.

Talking (again) about the last crisis, the authors recount: “When the crisis materialised in 2008, deleveraging occurred, leading to a pro-cyclical margin spiral (see figure 99). Margin requirements also have the potential to cause pro-cyclical effects in the cleared markets.” The next page shows figure 99, an intriguing cartoon of a margin spiral, with haircuts leading to more haircuts leading to “liquidate position”, “further downward pressure” and “loss on open positions”. In short, do not read it to the children before bedtime.

This margin issue is exactly what I’ve been on about for six years now. Good that regulators are finally waking up to it, though it’s a little late in the day, isn’t it?

I chuckle at the children before bedtime line. I often say that I should give my presentations on the systemic risk of CCPs while sitting by a campfire holding a flashlight under my chin.

I don’t chuckle at the fact that other regulators seem rather oblivious to the dangers inherent in what they’ve created:

While supervisory institutions such as the Financial Stability Oversight Council are trying to fit boring old life insurers into their “systemic” regulatory frameworks, they seem to be ignoring the degree to which the much-expanded clearing houses are a threat, not a solution. Much attention has been paid, publicly, to how banks that become insolvent in the future will have their shareholders and creditors bailed in to the losses, their managements dismissed and their corporate forms put into liquidation. But what about the clearing houses? What happens to them when one or more of their participants fail?

I call myself the Clearing Cassandra precisely because I have been prophesying so for years, but the FSOC and others have largely ignored such concerns.

Dizard starts out his piece quoting Dallas Fed President Richard Fisher comparing macroprudential regulation to the Maginot Line. Dizard notes that others have made similar Maginot Line comparisons post-crisis, and says that this is unfair to the Maginot Line because it was never breached: the Germans went around it.

I am one person who has made this comparison specifically in the context of CCPs, most recently at Camp Alphaville in July. But my point was exactly that the creation of impregnable CCPs would result in the diversion of stresses to other parts of the financial system, just like the Maginot line diverted the Germans into the Ardennes, where French defenses were far more brittle. In particular, CCPs are intended to eliminate credit risk, but they do so by creating tremendous demands for liquidity, especially during crisis times. Since liquidity risk is, in my view, far more dangerous than credit risk, this is not obviously a good trade off. The main question becomes: During the next crisis, where will be the financial Sedan?

I take some grim satisfaction that arguments that I have made for years are becoming conventional wisdom, or at least widespread among those who haven’t imbibed the Clearing Kool Aid. Would that have happened before legislators and regulators around the world embarked on the vastest re-engineering of world financial markets ever attempted, and did so with their eyes wide shut.

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October 7, 2014

The Crude Export Ban: Moot For Now, But That’s Not Necessarily a Good Thing

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 7:55 pm

Markets are wondrous things.

Consider the crude oil market. Remember the debate about the US crude export ban? Well, in a few months, that has turned out to be a moot issue. Due to the collapse of demand in Europe, and the freeing up of Nigerian supplies formerly exported to the US, price relationships have changed dramatically. Whereas Louisiana Light Sweet had recently traded at a big discount to Brent, it is now at a sufficiently high premium that it is economical to import Brent to the US, especially to the East Coast. Jones Act tankers expected to take crude from the Gulf to the East Coast are swinging at anchor because it is now economical to feed the EC refineries with Brent.

What’s more, the US crude glut fattened domestic refining margins. So how did US refiners respond? By increasing capacity, and reducing maintenance schedules by 30 percent. This has increased the demand for domestic crude, which has in turn helped close, and at times reverse, the US price discount. This investment in capacity and adjustment of maintenance schedules is arguably inefficient: it’s better to direct some of the crude to underutilized European refineries than to expand refining capacity in the US. But the point is that this inefficiency is attributable to inefficient laws: the laws on oil export have stood still, but the markets have moved on to mitigate the damage.

Meaning at present, price differentials are such that it would not be profitable to export crude even if it were permitted.

This may be true now, but of course it is not destined to be true forever. Therefore, it is still desirable to eliminate the ban, if only to eliminate the incentives to use scarce resources to take advantage of the price distortions that the ban can sometimes cause.  The ban might be a moot issue for now, but that’s not necessarily a good thing.

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