Streetwise Professor

October 3, 2015

People. Get. A. Grip: Glencore Is Not the Next Lehman

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,History,Regulation — The Professor @ 6:53 pm

There is a lot of hysterical chatter out there about Glencore being the next Lehman, and its failure being the next Lehman Moment that plunges the financial system into chaos. Please. Get. A. Grip.

Comparing the firms shows there’s no comparison.

Let’s first talk size, since this is often framed as an issue of “too big to fail.” In November, 2007, Lehman’s total assets were $691 billion. As of August, Glencore’s were $148 billion. Lehman was about 4.5 times bigger. Moreover, Glencore’s assets include a lot of short term assets (inventories and the like) that are relatively liquid. Looking at Glencore as a $100 billion firm is more realistic. Lehman was much bigger.

Then let’s talk leverage. Lehman had 3 percent equity, 97 percent debt. Glencore about one third-two thirds. Stripping out the short term debt and short term assets, it’s about 50-50.

Then let’s talk off-balance sheet. Lehman was a derivatives dealer with huge OTC derivatives exposures both long and short. Glencore’s derivatives book is much smaller, more directional, and much in listed derivatives.

Lehman had derivatives liabilities of about $30 billion after netting and collateral were taken into account, and $66 billion if not (which matters if netting is not honored in bankruptcy). Glencore has $2 billion and $20 billion, respectively.

Lets talk about funding. Lehman was funding long term assets with short term debt (e.g., overnight repos, corporate paper). It had a fragile capital structure. Glencore’s short term debt is funding short term assets, and its longer term assets are funded by longer term debt. A much less fragile capital structure.  Lower leverage and less fragile capital means that Glencore is much less susceptible to a run that can ruin a company that is actually solvent. That also means less likelihood that creditors are going to take a big loss due to a run (as was the case with Lehman).

As a major dealer, Lehman was also more interconnected with every major systemically important financial institution. That made contagion more likely.

But I don’t think these firm-specific characteristics are the most important factors. Market conditions today are significantly different, and that makes a huge difference.

It wasn’t the case that Lehman failed out of a clear blue sky and this brought down the entire financial system through a counterparty or informational channel. Lehman was one of a series of casualties of a financial crisis that had been underway for more than a year. The crisis began in earnest in August, 2007. Every market indicator was flashing red for the next 12 months. The OIS-Libor spread blew out. The TED spread blew out. Financial institution CDS spreads widened dramatically. Asset backed security prices were plummeting. Auction rate securities were failing. SPVs holding structured products were having difficulty issuing corporate paper to fund them. Bear Sterns failed. Fannie and Freddie were put into receivership. Everyone knew AIG was coughing up blood.

Lehman’s failure was the culmination of this process: it was more a symptom of the failure of the financial system, than a major cause. It is still an open question why its failure catalyzed an intensified panic and near collapse of the world system. One explanation is that people inferred that the failure of the Fed to bail it out meant that it wouldn’t be bailing out anyone else, and this set off the panic as people ran on firms that they had thought were working with a net, the existence of which they now doubted. Another explanation is that there was information contagion: people inferred that other institutions with similar portfolios to Lehman’s might be in worse shape than previously believed and hence ran on them (e.g., Goldman, Morgan Stanley, Citi) when Lehman went down. The counterparty contagion channel has not received widespread support.

In contrast, Glencore’s problems are occurring at a time of relative quiescence in the financial markets. Yes commodity markets are down hard, and equities have had spasms of volatility lately, but the warning signs of liquidity problems or massive credit problems in the banking sector are notably absent. TED and OIS-Libor spreads have ticked up mildly in recent months, but are still at low levels. A lot of energy debt is distressed, but that does not appear to have impaired financial institutions’ balance sheets the same way that the distress in the mortgage market did in 2007-2008.

Furthermore, there is not even a remote possibility of an implicit bailout put for Glencore, whereas it was plausible for Lehman (and hence the failure of the put to materialize plausibly caused such havoc). There are few signs of information contagion. Other mining firms stocks have fallen, but that reflects fundamentals: Glencore has fallen more because it is more leveraged.

Put differently, the financial system was more fragile then, and Lehman was clearly more systemically important, because of its interconnections and the information it conveyed about the health of other financial institutions and government/central bank policy towards them. The system is more able to handle a big failure now, and a smaller Glencore is not nearly as salient as Lehman was.

In sum, Glencore vs. Lehman: Smaller. Less leveraged. Less fragile balance sheet. Less interconnected. And crucially, running into difficulties largely by itself, due to its own idiosyncratic issues, in a time of relative health in the financial system, as opposed to being representative of an entire financial system that was acutely distressed.

With so many profound differences, it’s hard to imagine Glencore’s failure would lead to the same consequences as Lehman. It wouldn’t be fun for its creditors, but they would survive, and the damage would largely be contained to them.

So if you need something to keep you up at night, unless you are a Glencore creditor or shareholder, you’ll need to find something else. It ain’t gonna be Lehman, Part Deux. But I guess financial journos need something to write about.

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September 28, 2015

Regulation Confronts Reality In the Commodity Markets. Reality Is Losing.

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Financial crisis,Regulation — The Professor @ 6:36 pm

Following the commodities markets today was like drinking from a fire hose. Many big stories, with “up” and “down” being the operative words. Alcoa split up. Shell announcing that it was giving up on its Arctic plans after its controversial test well failed to find commercially viable reserves. Oil price down around 3 percent, etc.

But the biggest news items were Glencore’s continuing downward spiral, and ESMA’s release of its technical recommendations for application of MiFID to non-financial firms, including commodity firms.

Glencore’s stock was down hard at the open, and at one point was down 31 percent. It’s CDS are now trading up-front (always a bad sign), and the spread widened from an already big 550 bp to 757 bp. At conventional recovery rates, this gives a (risk neutralized) probability of default of better than 50 percent. The Biggest Loser was Glencore’s CEO, Ivan Glasenberg, AKA, Ex-Glencore Billionaire.

The CDS are now trading wider than when Glencore had it s last near-death experience at the height of the financial crisis. Arguably the firm’s situation is worse now. It cannot attribute its woes to stressed financial market conditions generally, in which pretty much everyone saw spreads blow out to one degree or another. This is unique to it and the mining sector. It is a verdict on the firm/sector.

Moreover, in 2008 the firm was private, and Glasenberg and the other owners were able to stanch the bleeding by injecting additional capital into the firm. The ominous thing for Ivan et al now is that they tried that again a couple of weeks ago (along with announcing other measures to reduce debt and conserve cash) and it only bought a temporary respite before the blood started gushing again.

Moreover-and this is crucial-Glencore 2015 is a very different creature than Glencore 2008. It was more of a pure trader then: it is a mining firm with a big trading arm now. This means that its exposure to flat prices (of coal and copper in particular) is much bigger now. In fact, most commodity firms saw little drop off in profits in 2008-2009, and several saw profits increase. The fundamentals facing trading firms in 2008-2009 were not nearly as bad as the fundamentals facing mining firms today. That’s because their flat price exposures weren’t large, and margins and volumes (which drive trading profits) are not as sensitive to macro conditions as flat prices. Given the lack of any prospects for a rebound in flat prices, Glencore’s prospects for a recovery are muted.

Some tout Glasenberg et al’s trading acumen. But it is one thing to be able to sniff out arbs/relative mispricings and structure clever trades to exploit them. (Or to hold one’s nose while doing deals with dodgy regimes around the world.) It is something altogether different to predict where prices are going to go. Glencore made a bet on China, and now that bet is not looking good. At all.

In a nutshell, this is pretty much out of Glencore’s hands. It is along for the ride.

The irony here is that Glasenberg sold the Xstrata merger and the new business model as a way of using the less cyclical profitability of the trading venture as a way of dampening the cyclicality of the mining operation. As it is developing, an extremely adverse cyclical downturn in the mining operation is impairing the viability of the trading operation. How the trading operation can flourish within a financially distressed corporation is an open question. Maybe the company will have to pull an Alcoa, and separate the trading from the mining operations, to keep the latter from dragging down the former.

A key takeaway here relates to the other story I mentioned: ESMA’s release of its recommendations regarding the application of MiFID to non-financials. The objective is to mitigate systemic risk. I was always skeptical that commodity traders posed any such risk (and have been making that argument for 3+ years), and so far the Glencore meltdown is supporting that skepticism. There has been no evidence of spillovers/contagion from Glencore to financial institutions, or to the broader market, a la Lehman.

But ESMA has proposed Technical Standards that would impose the full panoply of CRD-IV capital requirements on commodity traders (and other non-financial firms) that cannot avail themselves of an exemption (on which I will say more momentarily).

  1. If firms cannot make use of an exemption under MiFID II, capital requirements under the new banking regulatory framework will apply to them. This new framework consists of Regulation EU No 575/2013 (CRR) and Directive 2013/36/EU (CRD IV), repealing Directives 2006/48/EC and 2006/49/EC. While CRD IV is addressed to CAs and includes, inter alia, qualitative provisions on the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP), the new CRR imposes quantitative requirements and disclosure obligations pursuant to Basel III recommendations on credit institutions and investment firms, including own funds definition, minimum own funds requirements and liquidity requirements. However, under Article 498(1) of CRR, some commodity dealers falling within the scope of MiFID are transitionally exempt from the CRR’s provisions on own funds requirements until 31 December 2017 at the latest, if their main business consists exclusively of providing investment services or activities relating to commodity derivatives.
  2. Moreover, firms falling within the scope of MiFID II will be considered to be financial counterparties rather than non-financial counterparties under Article 2(8) of EMIR. Therefore, they will not be able to benefit from the clearing thresholds or the hedging exemption available to the latter under Article 10 of EMIR. An additional consequence of being classified as a financial counterparty will be that the trading obligation (i.e. the obligation to trade derivatives which are subject to the clearing obligation and sufficiently liquid on trading venues only, cf. Article 28 of MiFIR) would apply in full without being subject to a threshold.

So, even if you aren’t a bank, you will be treated like a bank, unless you can get the exemption. Apropos what I said the other day about impoverished carpenters, hammers, nails, etc.

To get an exemption, a firm’s non-hedging derivatives business must fall below a particular threshold amount, e.g., 3 percent of the oil market, 4 percent of the metals market. ESMA recommends that hedges be determined using EMIR criteria. The big problem with this is that only months ago ESMA itself recognized that the EMIR framework is unworkable:

  1. It appears that the complex mechanism introduced by EMIR for the NFC+ [Non-Financial Company Plus] classification has so far led to significant difficulties in the identification, monitoring and, as a consequence, possible supervision of these entities by their competent authorities.
  2. As a result, in the context of the revision of EMIR, ESMA would see some merit in the simplification of the current framework for the determination of NFC+.
  3. One route that the Commission may wish to explore is to move from the current two-step process (Hedging/Non Hedging and clearing threshold) to a one-step process, where counterparties would qualify as NFC+ when their outstanding positions exceeds certain thresholds per asset class, irrespective of the qualification of the trades as hedging or non-hedging. This idea is further developed in Section 4.2 which addresses the way in which NFCs qualify their transactions as hedging and non-hedging.

In other words, ESMA judged that it is impossible for regulators to distinguish firms’ hedging derivatives from its speculative ones. Given these difficulties, just a few months ago ESMA recommended jettisoning the entire mechanism that it now proposes to use to determine whether commodity firms are exempt from MiFID, and the associated capital and clearing requirements.

Makes perfect sense. In some universe.*

At the very least the ESMA plan will impose a huge compliance burden on firms who will have to justify their categorizations of derivatives positions as hedges or no. Given the complexities of risk management (e.g., managing risk on a portfolio basis means that saying what trade is a hedge is difficult, if not impossible, the rapid and frequent adjustments of positions inherent in most trading operations, etc.) this will be a nightmare.

So the good news is: You can get an exemption from capital and clearing requirments! Yay!

The bad news is: The entity proposing the exemption says that the process for getting the exemption is unworkable, and you’ll have not just a compliance headache, but a compliance migraine.

So at the very same time that the financial travails of a big commodity firm cast serious doubt on the systemic riskiness of these firms, European regulators advance regulations intended to fix this (non-existent) problem, and are doing so in a way that they themselves have cast serious doubt on.

Put differently: regulation is confronting reality in the commodity markets at this very moment, and reality is coming off second best.

* It also hardly inspires confidence that ESMA fails basic arithmetic. Note that the threshold in oil is 3 percent, then consider this from its Briefing on Non-Financial Topics: “If a firm’s speculative trading activity is less than 50% of its total trading, it may be MiFID II exempt providing its market share is less than 20% of each threshold in the market share test e.g. 0.8% for metals, 0.3% for oil etc.” Um, last time I checked .2 x 3%=0.6%, not 0.3%.


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September 26, 2015

Capital My Boy, Capital: Or, the Day of the MiFIDs

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics,Regulation — The Professor @ 6:42 pm

As the EU’s Markets in Financial Instruments Directive II (“MiFID II”) slouches towards its destiny in Brussels, one of the last items on the agenda is capital requirements for commodity traders. It appears that the entity responsible for providing technical advice to the European Commission, European Securities and Markets Authority (“ESMA”–my God when it comes to acronyms the US military has nothing on the EU) is like the proverbial poor carpenter who owns only a hammer, so that everything looks like a nail. Or in ESMA’s case, that every firm that intermediates looks like a bank, and must be regulated accordingly, including through capital requirements. Thus, firms that serve as intermediaries in physical commodities are likely to be subject to the same type of capital requirements as firms that engage in financial intermediation, like banks, and be forced to hold a higher proportion of equity in their capital structures than they currently do.

This raises the question: what “market failure” (to use a shorthand that I dislike but which gets at the basic idea) justifies the regulation of the capital structures of firms?

One can make the case for banks and some other financial intermediaries. Banks have fragile capital structures because they engage in liquidity and maturity transformations that make them vulnerable to runs. Runs on a particular institution can impose costs on other institutions, and the resulting financial crises can have devastating effects on the broader economy. The effects on the broader economy occur because financially impaired banks cannot produce their most valuable output, credit, and contractions of credit can cause a broad downturn. Banks don’t internalize these effects, and thus may choose capital structures that are too fragile. Capital requirements can ameliorate this externality.

Commodity trading firms intermediate, but they are totally different than banks. I set out the reasons in detail in this white paper (sponsored by Trafigura*-with bonus video!). A few of the key points. Commodity trading firms (“CTFs”-hey, I can play the acronym game too!) aren’t too big to fail because they aren’t that big, by comparison to banks in particular. More importantly, they don’t have fragile capital structures because although CTFs transform commodities in space, time, and form, they don’t engage in financial transformations in maturity or liquidity like banks do. They aren’t even that highly leveraged, in comparison to European banks in particular. Further, whereas a bank can’t produce its main product (credit) if it is financially distressed, the human and physical assets of a commodity trading firm can continue to transform commodities even if the firm is financially distressed: it can operate under insolvency protection or its assets can be spun off to another firm.

This is not to say commodity trading firms can’t go bust. They can: we might see that in a big way if Glencore’s travails worsen. It is to say the fallout will be limited to their creditors and shareholders, and will not be the catalyst for a financial crisis.

Consequently, there is no justification for regulating the capital structures of these entities. But Europe, in its wisdom, apparently thinks otherwise.

The numbers are big. Based on public data from 2010-2012 for five big European energy companies with trading arms alone, I estimate that the additional equity required is in the vicinity of $120 billion with a “b”. Smaller entities will take smaller hits, but it will add up and probably put the final number in the $150 billion-$200 billion range. Some Swiss entities won’t be hit directly on their main trading businesses, but they have derivatives affiliates in the UK that will be. They might decide that the weather is better elsewhere.

The big driver in the number is the Operational Risk category, which is based off 15 percent of revenues averaged over the last three years. This number is big for commodity traders because they buy and sell a lot, which generates revenues that typically dwarf their incomes (because margins are on the order of 1-2 percent).

Operational risk is a catch-all category that encompasses things other than price and credit risks, such as rogue trader risk (of which there was an example just this week), a systems failure that results in a loss, etc. Yes bigger firms with bigger revenues are likely to have bigger operational losses, but these risks don’t scale with commodity firm revenues.

I have been told that there is whispering in Brussels against these numbers, because they are based on revenues derived when oil was north of $100/bbl. At lower prices, the operational risk charge will be smaller.

Thanks for proving my point, you whisperers! Please speak up, so everyone can hear!

Operational risks are more related to the scale of the physical business (e.g., the number of barrels traded)  which is much more stable than the price of oil. So a revenue-based operational risk charge expands and contracts like an accordion with the price of commodities, but the operational risk that the charge is supposed to absorb doesn’t fluctuate nearly so much. Given the costs of increasing equity, it is likely that firms will hold equity based on high commodity price-based revenues, leading to equity capitalization that is excessive in most environments. (Well, since the regulation generates no meaningful benefits, any requirement is excessive, but it will be extremely excessive given the way it is set up.)

You might say: “Who cares?” After all, in a Modigliani-Miller world, capital structure is irrelevant. Requiring firms to issue more equity and less debt doesn’t impose costs.

Yes. In a Modigliani-Miller world, which, like the Coase world, points out the things that must be true for the irrelevance result to hold. A theoretical world, in other words, not the real world we live in.

Firms care about capital structure because in a world with economic frictions capital structure can generate or destroy value. Imposing a capital structure that firms would not freely choose therefore imposes costs.

Firms affected by the new regs will adjust on many margins. Some will decamp from Europe, for other locales like Singapore. Others who cannot be so footloose will restructure their businesses to mitigate the impact. For instance, they might try to restructure to ring fence the trading activities that are subject to MiFID. Their ability to do so will depend on whether the Commission makes physical forwards subject to the regulation. Again, since these firms did not choose these locations or structures in the absence of the regulation, these changes will involve an increase in cost and a destruction in value, with no corresponding benefit that offsets this cost even  in part.

Privately held firms may face the biggest conundrum. There is a good reason for private ownership: it aligns the incentives of owners and managers because the managers are the owners. This is a more feasible option for commodity firms than large entities in other industries because commodity price risks can be laid off to the broader financial market using derivatives hedges. The downside of private ownership is that it limits access to public capital markets for equity funding. Clever financing policies (e.g., the issuance of very long term debt that provides long term funding without a loss of control) can finesse this problem, but requiring a big boost in equity would likely force firms either to contract their balance sheets and reduce their size (again, creating an economic cost because these firms will be artificially small), or go public, and incur increased agency costs (because of a poorer alignment of incentives).

In brief, application of bank-like capital requirements on commodity traders would be all pain, no gain. The efficiency of commodity intermediation would decline. This will harm producers (who get lower prices) and consumers (who pay higher prices) because middlemen’s margins must rise to cover the higher costs caused by the burdensome regulation of their capital structures. This will not be offset by any reduction in systemic risk.

There’s an early post-WWII SciFi novel titled Day of the Triffids, in which a plague of blindness leads to the rise of an aggressive species of plant. Well, MiFID rhymes with triffid, and Day of the MiFID would be a candidate for a sequel. Why? Because blindness about the realities of commodity trading is allowing an aggressive variety of plant (Brussels bureaucrats-believe me, the metaphor fits!) to wreak havoc on the poor folk who trade, produce, and consume commodities.

Well played, Europe! Well played!

* For those whose intellect cannot conceive of any other reason than personal gain to explain an individual’s opinion, do remember that I arrived at most of the conclusions contained in the white paper when I was retained to analyze the systemic risk of commodity traders by a bank trade association that very much wanted me to conclude the opposite, and who therefore spiked the study. But the truth gets out eventually.

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September 21, 2015

The Wicked Witch of the West Wing Brings on an SWP Acid Flashback Moment

Filed under: Economics,History,Politics — The Professor @ 2:23 pm

I had an acid flashback moment when I read this:

Biotechnology stocks took a sharp dive Monday after Hillary Clinton said she would propose a plan to counteract “price gouging” by drug makers.

Ms. Clinton, who is seeking the Democratic nomination for president, was responding to New York Times article published Sunday that told of a price increase for a drug used to treat a life-threatening parasitic infection. The cost of the drug was recently increase from $13.50 a tablet to $750, the story said.

Why? Because Hillary wreaked havoc on pharmaceutical stock prices 23 years ago, when Bill was running for President. Indeed, this is more than a matter of academic interest to me, because I played a role in the fallout from that. In 1993, I wrote a study, titled “Political Rhetoric and Stock Price Volatility,” that contributed to one of the early Clinton scandals. For you see, while blasting pharma companies, Hillary was also invested in a hedge fund that shorted health care stocks, and I documented using standard event study methodology that her speeches led to economically and statistically significant declines in pharmaceutical company stock prices.

In large part as a result of the study, Hillary was subjected to an official ethics inquiry. Her friend-and arguably more-Vince Foster was working on this and other nascent Hillary scandals when he put a bullet in his brain on the ramparts of Fort Marcy. On a more personal note, the study was the direct cause of the end of my employment at the University of Michigan Business School.

For details about the official fallout of this long-ago and long-forgotten study, see footnote 3 and the associated text in the Senate Whitewater Report. For how this played out for me, see this old SWP post. (As an aside, Sara Ellison and Wally Mullin expanded on my study in an article that was published in the JLE.)

As for Hillary, I think an inquiry into her investment holdings is warranted. Given the sleaze of the Clinton Foundation, and her disdain for the rules that little people follow as illustrated by the Home Brew Server, I would not be in the least surprised if the (once, and hopefully not future) Wicked Witch of the West Wing has been less than punctilious in the separation of her financial and political interests.

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September 9, 2015

The Future of Chinese Futures

Filed under: China,Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 8:19 pm

China has created some amazingly successful futures markets in recent years. By contract volume, the top 5 ag futures are traded in Zhengzhou, Dalian, or Shanghai, as are 4 out of the top 5 metals contracts. Once upon a time, China also had the most heavily traded equity futures contracts. Once upon a time, like two months ago.

Then the crash happened, and China thrashed around looking for scapegoats, and rounded up the usual suspects: Speculators! And it suspected that the CSI 300 Index and CSI 500 Index futures contracts were the speculators’ weapons of mass destruction of choice. So it labeled trades of bigger than 10 (!) contracts “abnormal”–and we know what happens to people in China who engage in unnatural financial practices! It also increased fees four-fold, and bumped up margin requirements.

The end result? Success! Trading volumes declined 99 percent. You read that right. 99 percent. Speculation problem solved! I’m guessing that the fear of prosecution for financial crimes was by far the biggest contributor to that drop.

The stock market (led, as is usually the case, by index futures) was bearing bad news, so the Chinese decided to shoot the messenger. Then back over it a few times with a tank and bury it in cement. Just to make sure.

There is a wider lesson here. Namely, China may talk the reform talk, but doesn’t walk the reform walk. It likes one way bets:  markets when they are rising, not when they are falling. And not just the futures markets have been told to get their minds right. Chinese authorities-and by authorities, I mean security services-have told fund managers not to sell, only buy. A market with Chinese characteristics, apparently: all buyers and no sellers. Kind of zen actually, in the spirit of “what is the sound of one hand clapping?”

This urge to exercise ham-fisted control is exactly the kind of thing that will impede China’s development going forward. It will undermine the ability of capital markets to do their jobs of incentivizing the accumulation of capital and directing it to the highest value uses.

China’s predilection for control has manifested itself in futures markets in other ways. You might recall some months ago that I wrote about China’s threats against Singapore and ICE if the American exchange offered lookalike contracts on ZCE cotton and sugar at its new Singapore affiliate. Yesterday ICE announced the contracts it will launch in Singapore, and cotton and sugar lookalikes were conspicuous by their absence.

No competition for us, thank you. We’re Chinese.

This protectionism may help ensure the success of China’s new futures market initiative: an oil futures contract. Protectionism and pricing in yuan and constraints on the ability of mainland firms to trade overseas make it likely that the contract will succeed. The Chinese are overoptimistic, however, if they believe this contract will supplant WTI and/or Brent. LME and COMEX copper, and ICE cotton and sugar, to give some examples, have thrived even as Chinese markets in these commodities grew. Moreover, myriad restrictions on the ability of foreigners to trade in China and the currency issue will make the Shanghai contract impractical as a hedging and speculative vehicle for non-Chinese firms and funds: the main non-Chinese trading will likely be arbitrage plays between Shanghai, CME/NYMEX and ICE, which will ironically serve to boost to the US exchanges’ volumes.

And the crushing of the CSI300 and CSI500 contracts will impede development of a robust oil futures market. The brutal killing of these contracts will make market participants think twice about entering positions in a new oil futures contract, especially long dated ones (which are an important part of the CME/NYMEX and ICE markets). Who wants to get into a position in a market that may be all but shut down when the market sends the wrong message? This could be the ultimate roach motel: traders can check in, but they can’t check out. Or the Chinese equivalent of Hotel California: traders can check in, but they can never leave. So traders will be reluctant to check in in the first place. Ironically, moreover, this will encourage the in-and-out day trading that the Chinese authorities say that they condemn: you can’t get stuck in a position if you don’t hold a position.

In other words, China has a choice. I can choose to allow markets to operate in fair economic weather or foul, and thereby encourage the growth of robust contracts in oil or equities. Or it can choose to squash markets during economic storms, and impede their development even in good times.

I do not see how, given the absence of the rule of law and the just-demonstrated willingness to intervene ruthlessly, that China can credibly commit to a policy of non-intervention going forward. And because of this, it will stunt the development of its financial markets, and its economic growth. Unfettered power and control have a price.


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September 7, 2015

Putin May Flirt With OPEC, But He’ll Never Put Out

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 6:57 pm

Ambrose Evans-Pritchard reports on the remarks about potential cooperation between Russia and OPEC uttered by that tease, Arkady Dvorkovich:

Riyadh has made it clear that it will not cut output to shore up prices unless non-OPEC producers share of the burden. This essentially means Russia, the world’s biggest producer.

Mr Dvorkovich, the head of Russia’s economic and energy strategy, said his country was in constant talks with OPEC in order to bring about a “more rational policy” but was coy on whether the Kremlin would break the impasse and strike a deal with the Saudis.

“Our consultations do not imply directly that we are going to see any coordinated action. Perhaps ‘yes’, perhaps ‘no’, most likely ‘no’,” he said, speaking at the Ambrosetti forum of world policy-makers on Lake Como. “We are sending signals to each other.”

Russia insists that it cannot switch off output as easily as the Saudis, given the harsh weather in the Siberian fields, a claim dismissed by OPEC as a negotiating ploy.

For his part, our favorite mullet man, Igor Sechin, says that Russia is different than OPEC countries, and cannot play along:

“The Russian oil industry is private, with a high number of foreign shareholders,” Mr Sechin told an audience at the FT Commodities Retreat in Singapore. BP owns 20 per cent of Rosneft, the Russian state-backed oil company, which is majority owned by the Kremlin.

“The Russian government cannot administer the oil industry like an Opec country can,” he said, adding that Russia would also face technical difficulties in shutting production in regions such as Siberia, where extremely cold winters could cause wells to fracture if they were closed.

Although I agree there are real difficulties in shutting down Siberian production, the remarks about Russia’s inability to administer the oil industry is a crock. Suppress the giggle reflex about foreign shareholders, and remember that Russia levies export taxes on crude (and products) that can be used to “administer” the market. If Putin desired to reduce foreign sales of Russian oil in an effort to support price (perhaps in coordination with the Saudis or Opec), he could readily do so by increasing the export tax. Russian exports would decline, the world price would rise, and the Russian domestic crude price would fall. (Russian refining capacity would constrain how much oil can be diverted from exports to domestic use.) Thus, the Russian government undoubtedly has the policy tools to cooperate with OPEC to support the world price.

But truth be told, Russia doesn’t trust OPEC to adhere to production cuts, and OPEC doesn’t trust Russia to adhere to export cuts. OPEC has heard Sechin and Putin whisper sweet nothings in its ear before (in 2009, particularly) and have learned that flirting or no, Putin doesn’t put out.

In other news of unrequited love, there have been numerous stories of late about Russian disappointment about the failure of its dreams of a romance with China. Most notably, Putin returned empty handed from his recent trip to Beijing to witness China’s commemoration of the end of WWII. Most notably, Gazprom failed to secure financing for a gas pipeline into western China, it announced that its deal to ship gas to the east was delayed, and Timchenko (a target of US sanctions) failed to secure Chinese funding for the Yamal project. (Which may be a good thing, as it would be bringing LNG into a glutted market . . . which could explain Chinese reluctance.)

Putin was deluded if he thought that he could pivot to China and get a good deal after the US and Europe imposed sanctions. The Chinese realized that he was turning to them primarily out of weakness, and tough bargainers that they are, it was inevitable that they would exploit his weakness: the alternatives for Putin were a deal on very unfavorable terms, or no deals at all.

Market developments have only intensified Putin’s predicament. The decline in oil prices has increased his financial desperation. Moreover the fact that the decline in oil prices is due primarily to a slowdown in China’s economy means that the Chinese have less need for Russian resources, and less capital to invest: China has to focus on dealing with its own pressing problems, and helping Russia is not a priority. Putin was already deeply exposed to China risk through the resource price channel, and sanctions and his pivot only increased that exposure through an investment channel. Now that risk has crystalized, and Putin is doubly effed.

Just like Glencore, the subject of my previous post, Russia and Opec are at the mercy of China. Russo-Opec cooperation isn’t going to happen. It is devil take the hindmost among oil producers, and the individual incentive for all of them is to produce up to capacity. Price will mainly affect future investments in capacity, not utilization of existing capacity. In the near to medium term, before depletion and lower investment in the US reduce supplies, price will be demand driven, and primarily China demand driven at the margin. Russia and Putin are along for the ride, and can’t do a damn thing about it.

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Regardless of What Happens to Glencore or Noble, The Commodities River Will Keep on Rolling

Filed under: Commodities,Economics,Energy,Financial crisis — The Professor @ 4:16 pm

It is not outside the realm of possibility that my analysis of whether commodity trading firms are systemically risky-“too big to fail”-will be put to the test not once, but twice, in the coming weeks and months.

One firm that has shipped a lot of water lately is the biggest, by far: Glencore. This spawn of Marc Rich has been hit very hard by the sharp decline in copper and coal prices in particular. It’s CDS spreads have widened dramatically, tripling to 450 bp before tightening some in the last few days. Its stock price is down dramatically. S&P has changed its rating to BBB/Negative, meaning that a downgrade to junk is possible.

In response, the company has announced rather radical measures to slash debt in order to maintain its vital investment grade credit rating. It has announced a cut in its dividend and an issuance of new equity via  a rights issue (about a quarter of which  will be purchased by management). It is also shopping assets, notably the recently acquired grain trading assets acquired with the Swiss firm bought Canada’s Viterra. It has responded to the copper price decline by shutting a mine in Africa.

The market’s initial reaction to these moves has been positive: Glencore’s stock rose when it announced these measures.

Glencore’s distress is a direct result of the sharp declines in copper and coal prices, which in turn are the direct result of the slowdown in China.

Although Glencore’s origins were as a trading firm, and it is still considered a trading firm, it is in many respects the exception that proves the rule, and hence is not a harbinger of doom for other traders. As I documented in my first white paper, The Economics of Commodity Trading Firms, Glencore is the most asset heavy of the firms commonly considered traders. Moreover, its assets are concentrated in the upstream, especially in the aftermath of its acquisition of Xsrata. In its current incarnation, it is more of a mining firm with a trading firm attached, than a trading firm.

Glencore always touted that its trading operation could be an internal hedge for its upstream activities: trading profitability is driven by volumes and margins, and these are less sensitive to commodity supply and demand conditions than prices, because the inelasticities of supply and demand mean that price, rather than volume, bears the brunt of demand and supply shocks. The Glencore argument makes sense, but there is only so much that the trading arm can do to offset an upstream bloodbath. Glencore’s exposure to flat price is so large now that in the grim pricing environment of the present it swamps the ability of the trading arm to bail it out.

Will it escape insolvency? I don’t know, precisely because its fate is out of its control, and dependent on flat prices, which neither I nor its management can predict with any certainty. Events, my boy. Events. Because of its upstream exposure, Glencore is on a ride on the China train. (By the way, those who thought that Glencore was a lower risk than other miners because of some superior ability to predict flat price because it is a trader: what were you thinking?)

If it goes insolvent, will it matter? Well, it’s creditors will mind. But beyond that, the arguments I made in my other white paper, Not Too Big to Fail, imply that the knock-on effects will be minimal. Industrial and mining firms can fail, and go through insolvency/bankruptcy without larger systemic effects.

The possible Viterra sale illustrates another point I made in the paper. Namely, that the financial distress of a commodity trader does not mean that the supply of commodity transformation services will decline. The distressed firm’s assets can continue to operate. One way to ensure that they continue to operate efficiently is to sell them to others. The wheat, canola, and barley that go through Viterra’s elevators don’t really care whose name is on the door. Nor, for the most part, do the farmers upstream or the consumers downstream.

What about other commodity traders? The purer traders they are (i.e., the less upstream asset exposure), the better off they are. Indeed, the lower price environment in oil in particular facilitates the contango trade because contangoes tend to widen when prices decline. BP’s trading arm announced lower profits in Q2 precisely because the contango play was not as profitable: I would expect that to turn around in Q3 and Q4 if prices remain low and the contango remains fat. As another example, Vitol made a well-timed purchase of the remainder of a Dutch oil storage company, presumably to allow it to exploit such plays.

The other firm that could test my arguments is the Hong Kong firm Noble. Nobles issues are somewhat different than Glencore’s. Noble’s accounting has come under sharp questioning, by a rather mysterious outfit called Iceberg (which Noble claims is basically the blog of a disgruntled ex-employee).

The issue is Noble’s aggressive booking of profits on long term deals. Something like 90 percent of the book value of its equity is attributable to these accounting items, whereas for other firms the figure is more on the order of 5-10 percent. Iceberg has also questioned Noble’s reported leverage, alleging that it has engaged in various off-balance sheet repo transactions (a la Lehman repo 105) to conceal debt.

The market has taken these charges seriously.  Noble’s stock has taken a pounding. It rebounded some recently, when Mitsubishi announced the acquisition of a 20 percent share of Olam, another Asian commodity firm whose accounting had been challenged, attracting some aggressive short sellers. But even with the rebound, Noble is flirting with dangerous territory and is at serious risk of insolvency or illiquidity if its bankers get sufficiently concerned (which amounts to insolvency for a commodity trader, which is very dependent on access to credit). Noble’s CDS spread reached 700+ bp in mid-August.

In the event of the worst happening, I again would expect that the pain would be limited to the creditors. Other firms, likely Japanese or Chinese trading firms, would pick up the pieces, and perhaps the whole caboodle. The commodities Noble moves would be moved by somebody else. Banks would eat a loss, but that’s part of their business. Other commodity traders’ accounting would get more scrutiny, from their creditors in particular. And that’s not a bad thing.

Commodity firms have come and gone over the years. (Everybody remembers Enron. Anybody remember Cook Industries? Andre Cie?) But the big commodities river keeps on rolling along.

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August 30, 2015

Don’t Get Carried Away By Political Rhetoric on Carried Interest Taxation

Filed under: Economics,Politics — The Professor @ 7:12 pm

The tax treatment of “carried interest” for private equity and hedge fund general partners is something pretty much everyone loves to hate. Politicians particularly. Several major candidates, including Hillary, Sanders, and Trump, have said that they will scrap it.

Their argument is simple. Carried interest is taxed at the lower long run capital gains rate  (20 pct), instead of the rate for earned income (39.6 pct). Obviously unfair!  Private equity and hedge fund managers are greedy bastards who do nothing to earn their money! (Trump says they just push paper around.) They don’t deserve a break! Restore fairness to the tax code!

Tax professionals are largely against the treatment too, though their reasoning is a little more sophisticated. Carried interest is income properly attributable to labor or service provision, and is not a return on capital. It therefore should be taxed as labor income.

A little reflection shows that both arguments are simplistic. I can’t say 20 percent is the right rate, but I am highly confident that 39.6 percent is too high. And that’s because carried interest treatment does affect returns on capital, and this should be taken into consideration when figuring out the proper tax treatment. Capital taxes are a bad idea generally, and the effects of carried interest on returns to capital should be taken into consideration when deciding how heavily to tax it.

First, what is carried interest? Private equity and hedge funds typically have limited partners as investors, and general partners who manage. These entities employ incentive mechanisms. The general partners get a percentage (overwhelmingly 20 percent) of all gains over a benchmark, and get zero incentive comp if they fail to reach the benchmark. This is incentive compensation is carried interest, and is taxed as a long term capital gain.

So what would be the effect of increasing taxation on carried interest? Basic tax incidence analysis applies here. Tax incidence analysis basically shows that the costs of a tax are paid not just on whom it is levied (PE and hedge fund GPs in this instance), but are also paid in part by those who buy from or sell to the taxed entity.

There is a supply and demand for the services of PE and HF managers. Investors are willing to pay for managers because the managers can earn a higher return than the investors could earn by investing themselves. Like the demand for anything, the demand for management services is downward sloping: the lower the cost of managers, the more capital will be invested with them because at a lower cost PE and HF outperform more competing investments.

Since these industries are likely highly competitive, the supply curve of services reflects the marginal costs of managerial services. The supply is upward sloping, mainly because some managers are more efficient than others. To expand the industry requires some managers to expand beyond their efficient scale, and also requires the entry of new, less efficient (i.e., higher cost) managers.

Taxes imposed on managers increases their costs, and shifts up the supply curve of managerial services. As the supply curve moves up and to the left, its intersection with the demand curve moves up and to the left. At the new, post-tax equilibrium, less funds are under management (which is crucial), and the cost paid by investors is higher. Thus, some of the burden of the tax is borne by the investors. The rise in the price of managerial services is typically small rather than increase in the tax, however, meaning that managers’ after tax income declines. Thus, the burden of the tax is shared between investors and managers.

How the burden is split depends on how steep the supply and demand curves are. Only if the supply of managerial services is vertical (“perfectly inelastic”) will all of the burden of the tax fall on the PE and HF bastards. This occurs only if all managers are equally efficient, and all are willing to supply the same amount of services at any price. If the supply of their services is very flat (i.e., a small decline in the price of their services leads to a large decline in the quantity supplied), virtually all the burden of the tax is paid by investors.

Thus, like all taxes, the tax on carried interest drives a wedge between the price paid by consumers (investors in PE and HF, in this instance) and suppliers (PE and HF managers).

The fact that investors pay some of the tax means that the carried interest tax is in part a tax on capital, except in the edge case (perfectly flat supply of PE and HF management). This is true because investor returns are depressed by the higher pre-tax compensation that must be paid to managers. Further, note that except in the edge case, investment in PE and HFs will decline, and thus they have less capital to invest. Although things are complicated by the fact that capital may be diverted to other investments, it is likely that total investment goes down. This means that even if the services managers are providing are deemed “labor” or “services”,  taxing carried interest reduces returns on some capital, and likely leads to a reduction in overall investment.

Since there are strong economic arguments that capital should not be taxed, and certainly not taxed as high as labor income if it is taxed, this in turn implies that taxing carried interest exactly the same as earned income is not likely to be optimal. I don’t know what the tax rate should be, but is plain wrong to analyze carried interest as pure labor income. It impacts returns on capital and this needs to be considered when deciding the right tax rate.

There are some other considerations that bolster this conclusion. In particular, carried interest is like a call option on managerial performance: managers’ compensation increases with performance only once the “strike price” is exceeded. They underperform, they get no incentive comp.

Why choose this form of compensation? To align the incentives of managers and investors. High powered incentives expose managers to a lot of risk. They tend to be more risk averse than investors. In particular, investors shouldn’t care about idiosyncratic, diversifiable risk, but managers with incentive-based fees bear that idiosyncratic risk, and may be less well diversified. They will therefore tend to be more averse to that risk than investors: this creates a conflict of interest between investors and managers.

Option-like compensation mitigates this problem, because the value of options is increasing in risk (volatility). Thus option-like carried interests offsets managerial risk aversion, and tends to align the interests of managers and investors. It induces managers to invest in some higher risk projects that investors prefer because they offer higher average risk-adjusted returns.

Increasing taxes on carried interest reduces the after-tax payoff to the managerial option, but this effect is asymmetric: it only reduces payoffs when managers perform well, but doesn’t affect compensation when they perform badly. They have a weaker incentive to take risk because they get less of the upside, and have the same downside.

Put differently, the tax reduces the alignment of incentives between investors and managers. Managers will tend to make investments that are less risky than investors would like. Thus, increasing the tax on carried interest will tend to impact riskier investments disproportionately, and lead to underinvestment in them. In particular, investments with high idiosyncratic risks (which are likely to include many tech investments, for instance, whose performance depends on the success or failure of a technology, rather than the performance of the overall economy) are disproportionately punished.

(This can also be fit into the tax incidence analysis. With a higher tax rate, it is costlier to provide incentives to managers, and this drives down returns on capital, especially for high idiosyncratic risk investments.)

If the politicians and tax professionals are right about carried interest, raising the tax on it won’t reduce returns on capital and reduce investment, or divert investment away from risky but high average return projects. The foregoing analysis demonstrates that this is not correct. Tax incidence analysis, and a consideration of the effect of carried interest taxation on the incentive for managers to invest in high risk, high return projects that investors favor, show that raising this tax will reduce returns, reduce investment, and divert investment away from high risk projects.

And let’s remember why taxation on capital is harmful: it reduces wages. Less capital means lower productivity. Lower productivity means lower wages. So although the seen effect of higher capital taxation will be on the Gnomes of Greenwich, the unseen costs will be paid by those on whose behalf Hillary, Bernie, and Donald claim to be speaking. Funny how the middle class can get wet when the politicians try to soak the rich.

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August 28, 2015

Walter Russell Meade Saw Trump Coming, 15 Years Ago

Filed under: Economics,Politics — The Professor @ 9:30 pm

More than 15 years ago, Walter Russell Meade anticipated the emergence of Trump:

It is perversion rather than corruption that most troubles Jacksonians: the possibility that the powers of government will be turned from the natural and proper object of supporting the well-being of the majority toward oppressing the majority in the service of an economic or cultural elite—or, worse still, in the interests of powerful foreigners. Instead of trying, however ineptly, to serve the people, have the politicians turned the government against the people? Are they serving large commercial interests with malicious designs on the common good? Are they either by ineptitude or wickedness serving hostile foreign interests—giving all our industrial markets to the Japanese, or allowing communists to steal our secrets and hand them to the Chinese? Are they fecklessly frittering away huge sums of money on worthless foreign aid programs that transfer billions to corrupt foreign dictators?

Jacksonians tolerate a certain amount of government perversion, but when it becomes unbearable, they look to a popular hero to restore government to its proper functions. It was in this capacity that Andrew Jackson was elected to the presidency, and the role has since been reprised by any number of politicians on both the local and the national stages. Recent decades have seen Ronald Reagan master the role, and George Wallace, Ross Perot, Jesse Ventura and Pat Buchanan auditioning for it. The Jacksonian hero dares to say what the people feel and defies the entrenched elites. “I welcome their hatred”, said the aristocratic Franklin Roosevelt, in his role of tribune of the people. The hero may make mistakes, but he will command the unswerving loyalty of Jacksonian America so long as his heart is perceived to be in the right place. [Emphasis added.]

What is bizarre is that the sin of “giving our industrial markets to the Japanese” was somewhat dated by 1999, but Trump pounds on that theme today, when it is well past its sell date. Decades past. Just yesterday, in  Greenville, SC, he said something to the effect that “the Japanese are up here [holding his hand over his head] and we are down here [holding his hand by his knee].” Fact: Japanese per capita GDP is $36K, and US per capital GDP is exactly 50 percent higher, at $54K. But facts don’t matter. The image of Japanese domination (now accompanied by the image of Chinese domination) resonates intensely among Jacksonians.

But moving beyond that particular point, Meade clearly identified the role Trump is playing, and the audience-Jacksonians-to whom he is appealing.

One of the characteristics of Jacksonians that Meade identifies is their hostility to elites.  Angelo Codevilla makes a similar point, saying that Trump is channeling intense anger at the “Ruling Class.”

And truth be told, there is a lot to be hostile to and angry with. Viewed objectively, the term “elite” can only be used ironically in the America of 2015. There has never been such a sorry lot at the upper echelons of politics and culture in our nation’s history, except perhaps for the 1850s. The Jacksonian instinct to break out the pitchforks and torches and get the bastards is understandable.

But Trump is a fatally flawed vessel for this rebellion, in part because of he echoes so well the flawed beliefs of so many Jacksonians, notably the tribalism that gives rise to protectionism and indiscriminate hostility to all immigration. (And I say this as someone with decided Jacksonian impulses on foreign policy, and as someone descended in part from a quintessential Jacksonian family.)

But also in part-in large part-to Trump’s authoritarianism. Virtually every proposal he makes involves some sort of government intervention, such as the imposition of tariffs, a concerted effort to weaken the dollar, or mass deportation. Indeed, it is difficult to find any serious policy differences between Trump and avowed socialist Bernie Sanders.

What’s more, he promises a highly personalized government, in which he will exercise his personal executive authority to impose his policies. (A style pioneered by Andrew Jackson, notably.) He envisions his presidency as the application of the methods of the corporate CEO (who frequently exercises virtually untrammeled authority) to the governance of a nation that dwarfs even the largest company.

Even beyond the defects of his specific policy proposals, this personalization of process is the last thing we need right now. Obama has already taken us far down this road, and we need to retrace our steps, rather than hurtle even further forward on it. We are careening towards presidentialism, which has proved disastrous to both liberty and wealth wherever it has been implemented. (It is not for nothing that Trump sees a kindred spirit in Putin.)

It is ironic that many Tea Party people are ardent Trump fans, despite the fact that he represents the antithesis of the Constitution-worshipping, small-government rhetoric of the Tea Party. If Trump actually wins, these people will wake up with the biggest morning-after regret ever.

That said, I doubt that Trump can win the presidency, or even the nomination. But I temper my doubts because I never thought that he would make it this far. And even if he does not gain the nomination, he may do so much damage to the (already divided and dysfunctional) Republican Party that its electoral prospects may be doomed, even in a year when the presumptive Democratic Party nominee is a walking disaster who is at some risk of trading her orange pantsuits for orange prison garb, and the alternatives are an aging socialist loon and an aging lifelong pol with a well-earned reputation for buffoonery. (This is another illustration of the degraded condition of our purported elites.)

And Trump also brings out in stark relief the Republicans’ fundamental dilemma. They cannot win without the Jacksonians, but it is seriously questionable whether they can win with them, because they repel a large number of the swing voters who will decide the election. Reagan was able to bridge this gap, but the gap was much narrower 35 years ago. Reagan was arguably the only person that could have done it in the 1980s, but even he would almost certainly find it impossible today.

Trump today is polling at 20 percent or so of a party that may-may-account for 50 percent of the electorate. You can’t win with 10 percent, no matter how intense its support, especially if that very intensity alienates 10 percent (or more) of the voters.

This is particularly true if you look at the electoral map. The swing states that the Republicans need to win to regain the White House are the very ones that are most likely to be neuralgic to Trump and his angry band of Jacksonians.

So what will happen? In such discontented times making forecasts is even more difficult than usual, but I cannot identify plausible, positive scenarios. Trump and the Jacksonian faction he appeals to are a destructive force, even though the object of their anger and disdain largely deserves it.  Destructive because they are likely to perpetuate the misrule of the progressives, and destructive even in the (unlikely) event of victory, because Trump’s policies and presidentialism would just represent a different form of misrule.

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August 26, 2015

Donald Trump Can Only Aspire to Match Obama’s Economic Ignorance

Filed under: Climate Change,Economics,Energy,Politics,Regulation — The Professor @ 8:00 pm

Yesterday I said Trump and O’Reilly were in a cage match to determine the world champion of economic ignorance. There is another contender of course, the current occupant of the office to which Trump aspires. Actually, I would say that Obama is the undefeated reigning world champ, and that the O’Reilly-Trump set-to was merely to see who might contend for the title in the future.

Obama’s gobsmacking ignorance-served up with a heaping side of superciliousness-was on full display at the “Clean Energy Summit” in Las Vegas on Monday. Time is finite, and my energy is only intermittently renewable, so I can’t possibly deconstruct these vaporings in detail. So I will limit myself to a few high-level comments:

  1. Obama’s claims that his policies on renewable energy and carbon will make a meaningful impact on climate is a massive fraud that would land you or me in jail. Obama’s own EPA acknowledges that the policy will reduce global mean temperatures by an imperceptible and irrelevant .02 degrees by 2100. Farenheit? Celsius? Who cares? It matters not. It is rounding error on any scale.
  2. Obama’s mantra is all about the jobs that his renewables policies are creating and will create. Jobs are costs, not benefits.
  3. Further, Obama is clueless about the seen vs. unseen. To the extent that these policies raise the cost of electricity, they will have adverse consequences on wealth and income in consuming sectors, and in sectors that could produce electricity more efficiently, but for the subsidized competition from renewables.
  4. And yes, these policies will increase costs. Renewables are intermittent and diffuse and therefore require backup resources to ensure reliability; there is often a long distance between renewable sources and demand, meaning that new investments in icky transmission are required; and there is often a negative correlation between renewable production and electricity demand (e.g., the wind usually stops blowing when it’s really hot). Just look to Germany, with its Energiewende fiasco if you have any doubts. There is a strong correlation between electricity costs and fraction of electricity from renewables, and although this could be due in part to an endogeneity issue (those with more costly electricity sources utilize more renewables), this does not explain the entire effect.
  5. Obama and other boosters of renewables boast about falling costs of solar. Wind is conspicuously absent from this discussion, even though it represents the bulk of renewables generation. Further. Fine! When these inexorable efficiency gains make solar economical as a large-scale source of electricity, it will be able to compete without subsidy. This is no reason to subsidize now. This technical progress in solar argument is a non sequitur of the first magnitude.
  6. Obama and other boosters rave about capacity additions attributable to renewables. Well, due to the intermittence issue, capacity utilization is very low. It takes a lot more than 1MW of renewable capacity to replace 1MW of thermal or nuclear capacity. Indeed, if the wind ain’t blowing, all the windmills in the world can’t replace one conventional plant.
  7. Obama’s ignorance is on full display when he claims that conventional electricity generation was not characterized by “a lot of innovation.” This is just a crock. Compare heat rates of plants 20 years ago to those of today: in California, for instance, thermal efficiency has improved by 17 percent over the last 13 years. Heard of combined cycle, Barry? There has been considerable innovation in electricity generation. Well, not at the light switch plate, which is probably the extent of Barry’s familiarity with the electricity value chain.
  8. Obama mistakes opposing subsidies with being anti-free market. Welcome to bizarro world. And, as is his wont, he did so in an Alinskyite fashion, demonizing his opponents (the always handy Koch Brothers) in a very personal way.

I could go on, but that would be an S&M exhibition, and this is (usually!) a SFW site.

Suffice it to say that in Las Vegas Obama gave a demonstration that proves that when it comes to economic illiteracy, Trump can only aspire to fill Obama’s shows.

And yeah. Take a moment to absorb just what that means.

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