Streetwise Professor

May 25, 2017

OPEC and Inventories: An Exercise in Game Theoretic Futility

Filed under: Commodities,Economics,Energy — The Professor @ 11:37 am

OPEC met today, and agreed to extend its output cuts for another nine months. OPEC’s focus is on “rebalancing the market,” that is, on inducing a decline in world oil stocks to a level well below their current inflated value. This is far easier said than done, and indeed may be impossible because of the inability of OPEC to commit to a path of future output. This is because inventory changes result from changes in the temporal supply and demand balance.

In a competitive market, stocks accumulate when there are unexpected increases in supply or declines in demand, and crucially, these shocks are expected to be highly transitory. Similarly, market participants draw down on stocks when there are unexpected declines in supply or increases in demand that are expected to be highly transitory.

The “transitory” part of the story is very important. It makes sense to store when expected future supply is less than current supply, i.e., when future scarcity is greater than current scarcity. It makes sense to draw down on storage when future scarcity is expected to be low relative to today: why carry inventory to a time of greater abundance? Markets move things from where/when they are abundant to where/when they are scarce. Highly persistent shocks to supply and demand don’t affect the temporal balance, and hence to don’t lead to temporal reallocations. Temporary shocks (or shocks to future supply/demand) also change the temporal balance, and lead to inventory changes.

In my empirical work on the copper market (where inventory data is pretty good), I document that a net supply shock with a half-life of about 1 month drives inventory changes. Much more persistent shocks (e.g., those with a half-life of a year) have virtually no impact on inventory.

Inventories can also decline if expected future supply rises, or expected future demand declines. An increase in expected future supply reduces the future value of oil, and makes it less valuable to hold oil today for future use. Or to put it another way, it is desirable to smooth consumption, so if expected future supply (and hence future consumption) goes up, it makes sense to increase consumption today. This can only be done by drawing down on inventory. (Time travel that would allow bringing the abundant future supply back to the present would do the same thing, but alas, that’s impossible.)

OPEC’s desire to cause a drawdown in inventory would therefore require it to commit to a path of output. Further, this path would involve bigger cuts today than in the future in order to cause a temporal imbalance involving an increase in future supply relative to current supply.

But it is unlikely that this commitment could be credible, precisely because of the reason that OPEC gives for fretting about inventories: that they constrain its pricing power. Assume that inventories do drop substantially. According to its own logic, OPEC would feel less constrained about cutting output even further because non-OPEC supplies (in the form of stocks) have declined. Thus, if inventories indeed fall, OPEC’s logic implies that it would cut output further in the future.

But this path is inconsistent with the path that would be necessary to induce the inventory decline in the first place. Indeed, market participants, looking forward to what OPEC would do in the event that stocks were to decline substantially, would choose to hold on to inventories rather than consume them. Meaning that OPEC would fail in its objective of reducing stocks. In the game between OPEC and other market participants, OPEC’s own rhetoric about inventories and supply/demand balance severely undercuts its ability to cause others to consume inventories rather than continue to hold them.

In sum, OPEC is likely to have little if any ability to influence inventories. To influence inventories, it would have to commit to an output path, but that commitment is not subgame perfect/time consistent.

Instead, inventories will be driven by factors outside of OPEC’s control, namely, unexpected transitory changes in supply and demand. But the effect of even those shocks will depend on how market participants believe OPEC will behave when inventories are low. The supply changes will mainly result from shocks to non-OPEC producers (e.g., US shale producers) and to politically unstable OPEC nations like Libya, Nigeria, and Venezuela. Inventory changes may also result from information about the durability of output cut agreements and cheating: a surprise increase in the estimates of future cheating would tend to cause inventories to decline today. Thus, perversely from OPEC’s perspective, its wish of lower inventories may come true only when it is widely believed that OPEC output discipline will soon collapse.

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May 8, 2017

Whatever Igor Wants, Igor Gets: Primitive Capital Accumulation, a la Sechin

Filed under: Economics,Energy,Politics,Russia — The Professor @ 7:34 pm

Apparently winning the “auction” for Bashneft (after it was widely claimed by Putin, and others, that a sale of the company to Rosneft would be a sham privatization) wasn’t enough for Igor Sechin. Igor is now after MOAR, and is using the “legal” process to get it. Rosneft has filed suit against the former owner of Bashneft, Vladimir Evtushenkov’s holding company Sistema, and is asking for a cool $1.9 billion. News of the suit knocked almost 40 percent off of Sistema’s stock price.

The grounds of the lawsuit are unclear.

In the past Sechin has complained about a sale of a Bashneft asset, oil services company Targin, to Sistema at an allegedly knock-down price. He has also criticized contracts between Targin and Bashneft entered into after the sale as unduly favorable to Sistema.

Both of these allegations are plausible. This is Russia, after all, and related-party transactions and Credit Mobilier-like contracting scams are classic ways of tunneling assets.

Recently Rosneft has had to spend $100 million to address safety problems at Bashneft refineries. Rosneft claims that it has found “irregularities.”

If commercial and legal logic mattered (a big if, I know), the alleged shenanigans involving Targin would not be grounds for a suit, and it would be hard to imagine how Rosneft would have standing. Recall that Bashneft was seized by the state in 2014, and Rosneft bought it from the government. So any uneconomic transactions in 2014 or earlier would not harm Rosneft: it would have known that Targin was not included, and what the contracts were. So Rosneft was not harmed by what happened before the company was nationalized.

Failure to detect “irregularities” at the refineries would suggest a lack of due diligence if these were not discovered prior to buying from the state, or if they were known, they would have been reflected in the price. Again, it is hard to see how Rosneft could have been defrauded. Further, there’s a big difference between a $100 million repair bill and a $1.9 billion legal claim.

But does it matter, really? Any legal claim is almost surely a pretext to expropriate a politically vulnerable oligarch who is, shall we say, Без крыши. And this strategy is in Rosneft’s DNA. After all, the company was built primarily on the assets seized from Yukos, and another big asset–TNK-BP–was obtained only after a campaign of pressure against BP (although the Russian AAR consortium held their own and were paid in cash). Put differently, Rosneft was built by  what Marxists called primitive capital accumulation–force and fraud, sometimes operating under the color of legal authority.

But there is a price to be paid for this. It shows that Russia remains a fraught place for investors with assets that come under the covetous eyes of Sechin, or others like him. This depresses valuations for Russian companies, and is a serious drag on investment. No wonder year in and year out Russia is notable for the small share of investment, which runs about 18 percent of GDP, very low for a country in its stage of development. (The world rate is about 24 percent.)

But whatever Igor wants, Igor gets, evidently. Even though what’s good for Igor isn’t good for Russia.

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May 6, 2017

Son of Glass-Steagall: A Nostrum, Prescribed by Trump

Filed under: Economics,Financial crisis,History,Politics,Regulation — The Professor @ 7:30 pm

Apologies for the posting hiatus. I was cleaning out my mother’s house in preparation for her forthcoming move, a task that vies with the Labors of Hercules. I intended to post, but I was just too damn tired at the end of each day.

I’ll ease back into things by giving a heads up on my latest piece in The Hill, in which I argue that reviving Glass-Steagall’s separation of commercial and investment banking is a solution in search of a problem. One thing that I find telling is that the problem the original was intended to address in the 1930s was totally different than the one that is intended to address today. Further, the circumstances in the 1930s were wildly different from present conditions.

In the 1930s, the separation was intended to prevent banks from fobbing off bad commercial and sovereign loans to unwitting investors through securities underwriting. This problem in fact did not exist: extensive empirical evidence has shown that debt securities underwritten by universal banks (like J.P. Morgan) were of higher quality and performed better ex post than debt underwritten by stand alone investment banks. Further, the  most acute problem of the US banking system was not too big to fail, but too small to succeed. The banking crisis of the 1930s was directly attributable to the fragmented nature of the US banking system, and the proliferation of thousands of small, poorly diversified, thinly capitalized banks. The bigger national banks, and in particular the universal ones, were not the problem in 1932-33. Further, as Friedman-Schwartz showed long ago, a blundering Fed implemented policies that were fatal to such a rickety system.

In contrast, today’s issue is TBTF. But, as I note in The Hill piece, and have written here on occasion, Glass-Steagall separation would not have prevented the financial crisis. The institutions that failed were either standalone investment banks, GSE’s, insurance companies involved in non-traditional insurance activities, or S&Ls. Universal banks that were shaky (Citi, Wachovia) were undermined by traditional lending activities. Wachovia, for instance, was heavily exposed to mortgage lending through its acquisition of a big S&L (Golden West Financial). There was no vector of contagion between the investment banking activities and the stability of any large universal bank.

As I say in The Hill, whenever the same prescription is given for wildly different diseases, it’s almost certainly a nostrum, rather than a cure.

Which puts me at odds with Donald Trump, for he is prescribing this nostrum. Perhaps in an effort to bring more clicks to my oped, the Monday after it appeared Trump endorsed a Glass-Steagall revival. This was vintage Trump. You can see his classic MO. He has a vague idea about a problem–TBTF. Not having thought deeply about it, he seizes upon a policy served up by one of his advisors (in this case, Gary Cohn, ex-Goldman–which would benefit from a GS revival), and throws it out there without much consideration.

The main bright spot in the Trump presidency has been his regulatory rollback, in part because this is one area in which he has some unilateral authority. Although I agree generally with this policy, I am under no illusions that it rests on deep intellectual foundations. His support of Son of Glass-Steagall shows this, and illustrates that no one (including Putin!) should expect an intellectually consistent (or even coherent) policy approach. His is, and will be, an instinctual presidency. Sometimes his instincts will be good. Sometimes they will be bad. Sometimes his instincts will be completely contradictory–and the call for a return to a very old school regulation in the midst of a largely deregulatory presidency shows that quite clearly.

 

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April 21, 2017

The Left Loses Its Mind (Again!) Over Citgo and Trump

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 5:23 pm

Donald Trump is the left’s Theory of Everything. To be more precise, it is the left’s Theory of Everything Bad.

Latest (nut) case in point: Rachel Maddow is blaming Trump for the riots in Venezuela. No-really!

The theory: the Federal Election Commission revealed that Citgo, a US subsidiary of Venezuela’s national oil company/basketcase PDVSA had donated $500,000 to Trump’s inauguration. According to Maddow, this sent Venezuela’s citizenry, which is reeling under an economic catastrophe wrought by Chavez, Maduro, and “Bolivarian Socialism”–a cause that the left from Bernie Sanders to Danny Glover to many others has swooned over for years–into paroxysms of rage at the thought that their national patrimony was paying to honor the evil Trump.

To start with, there have been violent protests in Venezuela for years. The country is facing economic collapse. PDVSA has been looted by the Chavistas for going on 15 years now, and is a complete wreck. $500K is chump change compared to what the leftist darlings have stolen from the company, or destroyed through their grotesque mismanagement–would that the left shown equal concern over THAT. The country is on the verge of hyperinflation. There are food lines. There is no toilet paper–unless you count the currency the Venezuelan central bank is cranking out like nobody’s business. I could go on and on.

So no, Rachel. The Citgo contribution to the inaugural fund–which represents less than .5 percent of the total raised–is not even a piece of dust on the straw on the camels back: the camel’s back was broken long ago, by the vanguard of socialism that Rachel Maddow and her crowd lionized for years. The rage of the Venezuelan people is directed precisely where it should be: at Maduro, the Bolivarian revolution, and the dirt-napping Chavez.

Maddow’s attempt to lay Venezuela’s social explosion at Trump’s feet is very revealing. She and her ilk think that everything is about us–the US that is. Everything. And now in the minds of her and her ilk, everything in the US is all about Trump. So everything everywhere is all about Trump, and supposedly everyone in the world is as obsessed with Trump as they are, and blame him for all that is bad in the world, like they do.

This is clinical solipsism, broadcast live on MSNBC and CNN daily.

And in fact, Rachel should be ecstatic at Citgo’s donation. The company wasn’t spending the money of the Venezuelan people–it was spending Igor Sechin’s money! Rosneft brilliantly–brilliantly I say!–lent PDVSA $5 billion, and negotiated a 50 percent stake in Citgo as partial security. (Rosneft’s brilliance is only surpassed by the Chinese, who lent Venezuela $55 billion. Hahahaha. Good luck collecting on that one Xi! Well played.) Given PDVSA’s parlous condition, it is highly likely that Rosneft will get control of Citgo, meaning that every dollar it spends now is a dollar less in Igor’s pocket.

So the left should be happy! Trump has picked Russia’s pocket!

But no, they are also obsessing about the possibility that Rosneft will get control of Citgo’s US refineries (which represent a whopping ~2.5 percent of US refining capacity) and its gas stations (who cares?). The refineries ain’t going anywhere, so the impact on the US market will be nil. Anything Rosneft would do in operating these refineries that could hurt the US would hurt Rosneft even more. So don’t count on it happening, and if it does, it would be another own goal that weakens Russia.

Again, the left should be experiencing schadenfreude, not panic. Rosneft lent large money to a deadbeat. It’s not going to get paid back so it is seizing assets, and will end up losing money. Playing repo man is hardly the road to riches. It just mitigates the losses from making a bad loan, and it is the bad loan that is the real story here.

But to figure that out would require actual thinking, which is not exactly the strong point of Rachel, et al. Because they have everything figured out. Trump did it! And if Trump is connected, it’s bad!

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April 15, 2017

Is the Order Handling Rule Necessary to Ensure Intense Competition in Securities Markets?

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 2:01 pm

A couple of weeks back Acting SEC Chairman Mike Piwowar announced a new Special Study of the Securities Markets, a reprise of the 1963 Special Study. This is an excellent idea, given that RegNMS (adopted in 2005) has (as was inevitable) spawned many unintended and unexpected consequences. Revision of this regulation in light of experience is almost certainly warranted, and any such revision should be predicated on sound scholarship, lest it be merely a Trojan Horse for vested interests arguing their books.

I wrote about RegNMS in Regulation at the time of its adoption in a piece titled “The Thirty Years War” (an allusion to the fact that the establishment of the National Market System in 1975 had sparked a continuing clash over securities market structure). Overall, I think that piece stands up well, particularly my concluding paragraph:

Therefore, the proposed rules are not the final battle in a Thirty Years War. I fully expect that in 2075, some professor will write an article about the latest clash in an ongoing Hundred Years War over securities market structure regulation.

It is certainly the case that the controversies and conflicts over market structure have continued unabated since 2005, and show no signs of letting up. (Cf. Flash Boys.) Chairman Piwowar’s call for a new Special Study is testament to that.

More specifically, the major prediction of my article has been fully borne out. I predicted that the Order Protection Rule in particular would break the network effect that resulted in the dominance of the NYSE in the securities it listed. Since RegNMS was passed, the highly concentrated listed stock market (where virtually all price discovering transactions in NYSE stocks occurred on the NYSE) has been utterly transformed, with four exchanges now splitting most of the business, with no exchange doing more than a quarter of the volume.

I further predicted that this would result in the disintermediation of traditional intermediaries–like specialists–and the substantial erosion of economic rents. This too has happened. This is best illustrated by the trajectory of Goldman’s investment in specialist firm Spear, Leeds & Kellogg. Goldman paid $5.4 billion for it in 2000 (before RegNMS) and sold it for a pittance–$30 million–in 2014. I didn’t foresee exactly the nature or identity of the new intermediaries–HFT–but I was broadly aware that there would be entry into market making, and that this would reduce trading costs and undermine incumbents with market power. Further, as I’ve written about recently, the new intermediaries don’t appear to be making rents in the new equilibrium.

The years since RegNMS have seen a dramatic decline in trading costs for investors, and it is likely the case that this decline is largely attributable to the increase in competition. Much of the controversy that has raged since 2005 relates to disputes over trading practices that were an inevitable consequence of the breaking of the NYSE near-monopoly–a process pejoratively referred to as “fragmentation.” In particular, multiple markets necessitate arbitrageurs, who effectively enforce the law of one price. The strategies and tactics arbitraguers use often appear unsavory, and strike many as unfair: arbitrageurs get something even though they appear to do nothing substantive. Moreover, arbitrage uses up real resources. That’s costly, and it would be nice if this could be avoided, but that’s unlikely ever to be so. The trade-off between much greater competition (and reduced welfare losses due to the exercise of market power) and the expenditure of real resources to enforce the law of one price seems to be a great bargain.

Much of the criticism of RegNMS relates to the Order Protection Rule, which requires that no order can be executed on market X if a better price is displayed at market Y. The critics (e.g., the Principal Traders Association which ironically represents some of the biggest beneficiaries of RegNMS) argue that this rule (a) has led to a proliferation of order types intended to ensure compliance with the rule, which make the market far more complex, and (b) requires traders to maintain connections with and monitor all trading venues displaying quotes, no matter how small.

These complaints have some merit. The crucial question is whether the equity trading marketplace will be as competitive without the Order Handling Rule as it is with it. This is an open question, and one which should be the focus of the SEC’s inquiry. For if the Order Handling Rule is a necessary condition for robust competition, the costs that the PTA and others identify are likely well worth paying in order to realize the benefits of competition.

My prediction that competition would intensify post-RegNMS was based on my analysis of the effects of the Order Handling Rule, which was in turn based on my work on liquidity network effects done in the late-90s and early-00s. Specifically, in the formal models I derived (e.g., here), the self-reinforcing liquidity effect obtains when investors decide which trading venue to submit an order to on the basis of expected execution cost (i.e., bid-ask spread, price impact). The market with the bigger fraction of trading activity typically offers the lowest execution cost. Therefore, traders submit their orders to the bigger market. This creates a self-reinforcing feedback loop (and a self-fulling prophecy) in which trading activity “tips” to a single exchange. (There are some complexities here, relating to cream skimming of uninformed order flow. See the linked paper for a discussion of that issue.)

Mandating something akin to to the order handling rule forces order flow to the market offering the best price at a particular moment, not the one that offers the best price in expectation. As I phrased it in my Regulation paper, such a rule “socializes order flow”: even if an order is directed to a particular exchange, that exchange does not control that order flow and must direct to any other exchange offering a better price.

I think that both theory and the post-RegNMS experience show that the Order Handling Rule is sufficient to break the liquidity network effect because it socializes order flow. But is it necessary? Maybe not, but it is important to try to find out before jettisoning it.

Here’s a story which suggests that the rule is not necessary in the modern electronic trading environment. One reason why traders may choose to submit orders to where they expect to get the best execution is because of search costs. In a floor-based environment in particular, it is costly to verify which market is offering the best price at any time.  Moreover, since it takes time get quotes from two floor-based markets, by the time that you actually submit your order to the one giving the best quote, the market will have moved and you won’t get the price you thought you were going to get. So economize on search costs and the risks associated with delay by submitting the order to the market that usually offers the best price. Ironically, the inevitable result of this process is that there is only one market left standing.

Search is cheaper and faster–and arguably far cheaper and far faster–in the modern electronic environment. Based on feeds from multiple markets, an electronic trader (and in particular an automated trader) can rapidly compare quotes and send an order to the market offering the best quote, or by viewing depth (something pretty much impossible in the floor days, where much of the liquidity was in the hands of floor brokers) split an order among multiple venues to tap the liquidity in all of them.

In other words, the natural monopoly problem was far more likely in a floor-based environment where pre-trade transparency was so limited that search costs were very high: it was nigh on impossible to know precisely what trading opportunities were or to move fast enough to exploit the one that appeared best at any point in time, so traders submitted their orders to where they expected the opportunities to be the best. In contrast, electronification and automation have created such great pre-trade transparency and the ability to act on it that it is plausibly true that in this environment traders can and will submit their orders to whatever venue is offering the best trading opportunity at a point in time, regardless of whether it usually does so. In this story, technology eliminates the uncertainty and guesswork that created the liquidity network effect.

Maybe. Perhaps even likely. But I can’t be certain. Note that one complaint about the existing market structure is that even though everything has vastly speeded up, some traders are still faster than others. As a result, those who submit a market order in response to seeing a particular displayed price are often dismayed to learn that the market has moved before their order actually reaches the trading venue, and that their order is executed at a worse price than they had anticipated. Freed of the obligations of the Order Handling Rule, these traders may choose to submit their order to where they usually get the best price: if enough do this, the liquidity network effect will reemerge.

Further, the PTA and others have complained that it is costly to monitor and maintain connections with all trading venues as is necessary under the Order Handling Rule. If the Rule is relaxed or eliminated, one would expect that they will disconnect from some venues. If enough do this, the smaller venues will become unviable. After this happens, there will be fewer venues–and some traders may choose to disconnect from the smallest remaining one. This dynamic could result in another feedback loop that results in the survival of a single dominant exchange that exercises market power.

It is therefore not clear to me that elimination of the Order Handling Rule will result in traders having their cake (intense inter-exchange competition) and eating it too (less complexity, lower connection cost). Given the substantial benefits of greater competition that have been realized in the past dozen years, changes to the cornerstone of RegNMS should not be taken lightly. The Special Study, and the SEC, should pay close attention to how competition will evolve if the Order Handling Rule is eliminated. This analysis should take into account the existing technology, but also try to think of how technology will change in the aftermath of an elimination and how this technological change will affect competition.

Most importantly, any analysis must be predicated on an understanding that there are strong centripetal forces in securities trading. Any time traders have an incentive to direct order flow to the venue that is expected to offer the best price, the likely outcome is that only one venue will survive. The incentives of traders in a high speed, largely automated, and electronic market in the absence of an Order Handling Rule need to be considered carefully. It should not be assumed that technology alone will eliminate the incentive to direct orders to the market that is usually best, not the one that is best at any particular instant. This hypothesis should be probed vigorously and skeptically.

Experience in futures markets suggests that liquidity network effects can persist even in high speed, automated, electronic markets: futures contracts in a particular instrument exhibit a strong natural monopoly tendency, and strong tendencies towards tipping. It is arguable that the vertical integration of clearing, and the resulting non-fungibility of otherwise identical contracts traded on different venues, could contribute to this (though I am skeptical about that). But it could also mean that something like the Order Handling Rule (which is not present in futures markets) is necessary to create strong competition between multiple venues even in a highly computerized and automated trading environment.

This is the big issue in any revamping of RegNMS. It should be front and center of any analysis, including in the impending Special Study. The intense competition in the post-RegNMS world is a remarkable achievement, particularly in comparison with the near monopolistic market structure that existed before 2005. It would be a great shame if this were thrown away due to an incomplete analysis of what competition in a modern computerized market would be like in the absence of something like the Order Handing Rule.

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April 14, 2017

SWP Climbs The Hill

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 10:40 am

I have become a regular contributor to The Hill. My inaugural column on the regulation of spoofing is here. The argument in a nutshell is that: (a) spoofing involves large numbers of cancellations, but so do legitimate market making strategies, so there is a risk that aggressive policing of spoofing will wrongly penalize market makers, thereby raising the costs of supplying liquidity; (b) the price impacts of spoofing are very, very small, and transitory; (c) enforcement authorities sometimes fail to pursue manipulations that have far larger price impacts; therefore (d) a focus on spoofing is a misdirection of scarce enforcement resources.

My contributions will focus on finance and regulatory issues. So those looking for my trenchant political commentary will have to keep coming here 😉

Click early! Click often!

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April 4, 2017

The Unintended Consequences of Blockchain Are Not Unpredictable: Respond Now Rather Than Repent Later*

Filed under: Clearing,Commodities,Derivatives,Economics,Regulation — The Professor @ 3:39 pm

In the past week the WSJ and the FT have run articles about a new bank-led initiative to move commodity trading onto a blockchain. In many ways, this makes great sense. By its nature, the process of recording and trading commodity trades and shipments is (a) collectively involve large numbers of spatially dispersed counterparties, (b) have myriad terms, and (c) can give rise to costly disputes. As a result of these factors, the process is currently very labor intensive, fraught with operational risk (e.g., inadvertent errors) and vulnerable to fraud (cf., the Qingdao metals warehouse scandal of 2014). In theory, blockchain has the ability to reduce costs, errors, and fraud. Thus, it is understandable that traders and banks are quite keen on the potential of blockchain to reduce costs and perhaps even revolutionize the trading business.

But before you get too excited, a remark by my friend Christophe Salmon at Trafigura is latent with deep implications that should lead you to take pause and consider the likely consequences of widespread adoption of blockchain:

Christophe Salmon, Trafigura’s chief financial officer, said there would need to be widespread adoption by major oil traders and refiners to make blockchain in commodity trading viable in the long term.

This seemingly commonsense and innocuous remark is actually laden with implications of unintended consequences that should be recognized and considered now, before the blockchain train gets too far down the track.

In essence, Christophe’s remark means that to be viable blockchain has to scale. If it doesn’t scale, it won’t reduce cost. But if it does scale, a blockchain for a particular application is likely to be a natural monopoly, or at most a natural duopoly. (Issues of scope economies are also potentially relevant, but I’ll defer discussion of that for now.)

Indeed, if there are no technical impediments to scaling (which in itself is an open question–note the block size debate in Bitcoin), the “widespread adoption” feature that Christophe identifies as essential means that network effects create scale economies that are likely to result in the dominance of a single platform. Traders will want to record their business on the blockchain that their counterparties use. Since many trade with many, this creates a centripetal force that will tend to draw everyone to a single blockchain.

I can hear you say: “Well, if there is a public blockchain, that happens automatically because everyone has access to it.” But the nature of public blockchain means that it faces extreme obstacles that make it wildly impractical for commercial adoption on the scale being considered not just in commodity markets, but in virtually every aspect of the financial markets. Commercial blockchains will be centrally governed, limited access, private systems rather than a radically decentralized, open access, commons.

The “forking problem” alone is a difficulty. As demonstrated by Bitcoin in 2013 and Ethereum in 2016, public blockchains based on open source are vulnerable to “forking,” whereby uncoordinated changes in the software (inevitable in an open source system that lacks central governance and coordination) result in the simultaneous existence of multiple, parallel blockchains. Such forking would destroy the network economy/scale effects that make the idea of a single database attractive to commercial participants.

Prevention of forking requires central governance to coordinate changes in the code–something that offends the anarcho-libertarian spirits who view blockchain as a totally decentralized mechanism.

Other aspects of the pure version of an open, public blockchain make it inappropriate for most financial and commercial applications. For instance, public blockchain is touted because it does not require trust in the reputation of large entities such as clearing networks or exchanges. But the ability to operate without trust does not come for free.

Trust and reputation are indeed costly: as Becker and Stigler first noted decades ago, and others have formalized since, reputation is a bonding mechanism that requires the trusted entity to incur sunk costs that would be lost if it violates trust. (Alternatively, the trusted entity has to have market power–which is costly–that generates a stream of rents that is lost when trust is violated. That is, to secure trust prices have to be higher and output lower than would be necessary in a zero transactions cost world.)

But public blockchains have not been able to eliminate trust without cost. In Bitcoin, trust is replaced with “proof of work.” Well, work means cost. The blockchain mining industry consumes vast amounts of electricity and computing power in order to prove work. It is highly likely that the cost of creating trusted entities is lower than the cost of proof of work or alternative ways of eliminating the need for trust. Thus, a (natural monopoly) commercial blockchain is likely to have to be a trusted centralized institution, rather than a decentralized anarchist’s wet-dream.

Blockchain is also touted as permitting “smart contracts,” which automatically execute certain actions when certain pre-defined (and coded) contingencies are met. But “smart contracts” is not a synonym for “complete contracts,” i.e., contracts where every possible contingency is anticipated, and each party’s actions under each contingency is specified. Thus, even with smart (but incomplete) contracts, there will inevitably arise unanticipated contingencies.

Parties will have to negotiate what to do under these contingencies. Given that this will usually be a bilateral bargaining situation under asymmetric information, the bargaining will be costly and sometimes negotiations will break down. Moreover, under some contingencies the smart contracts will automatically execute actions that the parties do not expect and would like to change: here, self-execution prevents such contractual revisions, or at least makes them very difficult.

Indeed, it may be the execution of the contractual feature that first makes the parties aware that something has gone horribly wrong. Here another touted feature of pure blockchain–immutability–can become a problem. The revelation of information ex post may lead market participants to desire to change the terms of their contract. Can’t do that if the contracts are immutable.

Paper and ink contracts are inherently incomplete too, and this is why there are centralized mechanisms to address incompleteness. These include courts, but also, historically, bodies like stock or commodity exchanges, or merchants’ associations (in diamonds, for instance) have helped adjudicate disputes and to re-do deals that turn out to be inefficient ex post. The existence of institutions to facilitate the efficient adaption of parties to contractual incompleteness demonstrates that in the real world, man does not live (or transact) by contract alone.

Thus, the benefits of a mechanism for adjudicating and responding to contractual incompleteness create another reason for a centralized authority for blockchain, even–or especially–blockchains with smart contracts.

Further, the blockchain (especially with smart contracts) will be a complex interconnected system, in the technical sense of the term. There will be myriad possible interactions between individual transactions recorded on the system, and these interactions can lead to highly undesirable, and entirely unpredictable, outcomes. A centralized authority can greatly facilitate the response to such crises. (Indeed, years ago I posited this as one of the reasons for integration of exchanges and clearinghouses.)

And the connections are not only within a particular blockchain. There will be connections between blockchains, and between a blockchain and other parts of the financial system. Consider for example smart contracts that in a particular contingency dictate large cash flows (e.g., margin calls) from one group of participants to another. This will lead to a liquidity shock that will affect banks, funding markets, and liquidity supply mechanisms more broadly. Since the shock can be destabilizing and lead to actions that are individually rational but systemically destructive if uncoordinated, central coordination can improve efficiency and reduce the likelihood of a systemic crisis. That’s not possible with a radically decentralized blockchain.

I could go on, but you get the point: there are several compelling reasons for centralized governance of a commercial blockchain like that envisioned for commodity trading. Indeed, many of the features that attract blockchain devotees are bugs–and extremely nasty ones–in commercial applications, especially if adopted at large scale as is being contemplated. As one individual who works on commercializing blockchain told me: “Commercial applications of blockchain will strip out all of the features that the anarchists love about it.”

So step back for a minute. Christophe’s point about “widespread adoption” and an understanding of the network economies inherent in the financial and commercial applications of blockchain means that it is likely to be a natural monopoly in a particular application (e.g., physical oil trading) and likely across applications due to economies of scope (which plausibly exist because major market participants will transact in multiple segments, and because of the ability to use common coding across different applications, to name just two factors). Second, a totally decentralized, open access, public blockchain has numerous disadvantages in large-scale commercial applications: central governance creates value.

Therefore, commercial blockchains will be “permissioned” in the lingo of the business. That is, unlike public blockchain, entry will be limited to privileged members and their customers. Moreover, the privileged members will govern and control the centralized entity. It will be a private club, not a public commons. (And note that even the Bitcoin blockchain is not ungoverned. Everyone is equal, but the big miners–and there are now a relatively small number of big miners–are more equal than others. The Iron Law of Oligarchy applies in blockchain too.)

Now add another factor: the natural monopoly blockchain will likely not be contestible, for reasons very similar to the ones I have written about for years to demonstrate why futures and equity exchanges are typically natural monopolies that earn large rents because they are largely immune from competitive entry. Once a particular blockchain gets critical mass, there will be the lock-in problem from hell: a coordinated movement of a large set of users from the incumbent to a competitor will be necessary for the entrant to achieve the scale necessary to compete. This is difficult, if not impossible to arrange. Three Finger Brown could count the number of times that has happened in futures trading on his bad hand.

Now do you understand why banks are so keen on the blockchain? Yes, they couch it in terms of improving transactional efficiency, and it does that. But it also presents the opportunity to create monopoly financial market infrastructures that are immune from competitive entry. The past 50 years have seen an erosion of bank dominance–“disintermediation”–that has also eroded their rents. Blockchain gives the empire a chance to strike back. A coalition of banks (and note that most blockchain initiatives are driven by a bank-led cooperative, sometimes in partnership with a technology provider or providers) can form a blockchain for a particular application or applications, exploit the centripetal force arising from network effects, and gain a natural monopoly largely immune from competitive entry. Great work if you can get it. And believe me, the banks are trying. Very hard.

Left to develop on its own, therefore, the blockchain ecosystem will evolve to look like the exchange ecosystem of the 19th or early-20th centuries. Monopoly coalitions of intermediaries–“clubs” or “cartels”–offering transactional services, with member governance, and with the members reaping economic rents.

Right now regulators are focused on the technology, and (like many others) seem to be smitten with the potential of the technology to reduce certain costs and risks. They really need to look ahead and consider the market structure implications of that technology. Just as the natural monopoly nature of exchanges eventually led to intense disputes over the distribution of the benefits that they created, which in turn led to regulation (after bitter political battles), the fundamental economics of blockchain are likely to result in similar conflicts.

The law and regulation of blockchain is likely to be complicated and controversial precisely because natural monopoly regulation is inherently complicated and controversial. The yin and yang of financial infrastructure in particular is that the technology likely makes monopoly efficient, but also creates the potential for the exercise of market power (and, I might add, the exercise of political power to support and sustain market power, and to influence the distribution of rents that result from that market power). Better to think about those things now when things are still developing, than when the monopolies are developed, operating, and entrenched–and can influence the political and regulatory process, as monopolies are wont to do.

The digital economy is driven by network effects: think Google, Facebook, Amazon, and even Twitter. In addition to creating new efficiencies, these dominant platforms create serious challenges for competition, as scholars like Ariel Ezrachi and Maurice Stucke have shown:

Peter Thiel, the successful venture capitalist, famously noted that ‘Competition Is for Losers.’ That useful phrase captures the essence of many technology markets. Markets in which the winner of the competitive process is able to cement its position and protect it. Using data-driven network effects, it can undermine new entry attempts. Using deep pockets and the nowcasting radar, the dominant firm can purchase disruptive innovators.

Our new economy enables the winners to capture much more of the welfare. They are able to affect downstream competition as well as upstream providers. Often, they can do so with limited resistance from governmental agencies, as power in the online economy is not always easily captured using traditional competition analysis. Digital personal assistants, as we explore, have the potential to strengthen the winner’s gatekeeper power.

Blockchain will do the exact same thing.

You’ve been warned.

*My understanding of these issues has benefited greatly from many conversations over the past year with Izabella Kaminska, who saw through the hype well before pretty much anyone. Any errors herein are of course mine.

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March 27, 2017

Seeing the OTC Derivatives Markets (and the Financial Markets) Like a State

Filed under: Clearing,Derivatives,Economics,Regulation — The Professor @ 12:07 pm

In the years since the financial crisis, and in particular the period preceding and immediately following the passage of Frankendodd, I can’t tell you how many times I saw diagrams that looked like this:

YellenCCPDiagram_1

YellenCCPDiagram_2

The top diagram is a schematic representation of an OTC derivatives market, with a tangle of bilateral connections between counterparties. The second is a picture of a hub-and-spoke trading network with a CCP serving as the hub. (These particular versions of this comparison are from a 2013 Janet Yellen speech.)

These diagrams came to mind when re-reading James Scott’s Seeing Like a State and his Two Cheers for Anarchism. Scott argues that states have an obsession with making the societies they rule over “legible” in order to make them easier to tax, regulate, and control. States are confounded by evolved complexity and emergent orders: such systems are difficult to comprehend, and what cannot be comprehended cannot be easily ruled. So states attempt to impose schemes to simplify such complex orders. Examples that Scott gives include standardization of language and suppression of dialects; standardization of land tenure, measurements, and property rights; cadastral censuses; population censuses; the imposition of familial names; and urban renewal (e.g., Hausmann’s/Napoleon III’s massive reconstruction of Paris). These things make a populace easier to tax, conscript, and control.

Complex realities of emergent orders are too difficult to map. So states conceive of a mental map that is legible to them, and then impose rules on society to force it to conform with this mental map.

Looking back at the debate over OTC markets generally, and clearing, centralized execution, and trade reporting in particular, it is clear that legislators and regulators (including central banks) found these markets to be illegible. Figures like the first one–which are themselves a greatly simplified representation of OTC reality–were bewildering and disturbing to them. The second figure was much more comprehensible, and much more comforting: not just because they could comprehend it better, but because it gave them the sense that they could impose an order that would be easier to monitor and control. The emergent order was frightening in its wildness: the sense of imposing order and control was deeply comforting.

But as Scott notes, attempts to impose control on emergent orders (which in Scott’s books include both social and natural orders, e.g., forests) themselves carry great risks because although hard to comprehend, these orders evolved the way they did for a reason, and the parts interact in poorly understood–and sometimes completely not understood–ways. Attempts to make reality fit a simple mental map can cause the system to react in unpredicted and unpredictable ways, many of which are perverse.

My criticism of the attempts to “reform” OTC markets was largely predicated on my view that the regulators’ simple mental maps did great violence to complex reality. Even though these “reform” efforts were framed as ways of reducing systemic risk, they were fatally flawed because they were profoundly unsystemic in their understanding of the financial system. My critique focused specifically on the confident assertions based on the diagrams presented above. By focusing only on the OTC derivatives market, and ignoring the myriad connections of this market to other parts of the financial market, regulators could not have possibly comprehended the systemic implications of what they were doing. Indeed, even the portrayal of the OTC market alone was comically simplistic. The fallacy of composition played a role here too: the regulators thought they could reform the system piece-by-piece, without thinking seriously about how these pieces interacted in non-linear ways.

The regulators were guilty of the hubris illustrated beautifully by the parable of Chesterton’s Fence:

In the matter of reforming things, as distinct from deforming them, there is one plain and simple principle; a principle which will probably be called a paradox. There exists in such a case a certain institution or law; let us say, for the sake of simplicity, a fence or gate erected across a road. The more modern type of reformer goes gaily up to it and says, “I don’t see the use of this; let us clear it away.” To which the more intelligent type of reformer will do well to answer: “If you don’t see the use of it, I certainly won’t let you clear it away. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.

In other words, the regulators should have understood the system and why it evolved the way that it did before leaping in to “reform” it. As Chesterton says, such attempts at reformation quite frequently result in deformation.

Somewhat belatedly, there are efforts underway to map the financial system more accurately. The work of Richard Bookstaber and various colleagues under the auspices of the Office of Financial Research to create multilayer maps of the financial system is certainly a vast improvement on the childish stick figure depictions of Janet Yellen, Gary Gensler, Timmy Geithner, Chris Dodd, Barney Frank et al. But even these more sophisticated maps are extreme abstractions, not least because they cannot capture incentives, the distribution of information among myriad market participants, and the motivations and behaviors of these participants. Think of embedding these maps in the most complicated extensive form large-N player game you can imagine, and you might have some inkling of how inadequate any schematic representation of the financial system is likely to be. When you combine this with the fact that in complex systems, even slight changes in initial conditions can result in completely different outcomes, the futility of “seeing like a state” in this context becomes apparent. The map of initial conditions is inevitably crude, making it an unreliable guide to understanding the system’s future behavior.

In my view, Scott goes too far. There is no doubt that some state-driven standardization has dramatically reduced transactions costs and opened up new possibilities for wealth-enhancing exchanges (at some cost, yes, but these costs are almost certainly less than the benefit), but Scott looks askance at virtually all such interventions. Thus, I do not exclude the possibility of true reform. But Scott’s warning about the dangers of forcing complex emergent orders to conform to simplified, “legible”, mental constructs must be taken seriously, and should inform any attempt to intervene in something like the financial system. Alas, this did not happen when legislators and regulators embarked on their crusade to reorganize wholesale the world financial system. It is frightening indeed to contemplate that this crusade was guided by such crude mental maps such as those supposedly illustrating the virtues of moving from an emergent bilateral OTC market to a tamed hub-and-spoke cleared one.

PS. I was very disappointed by this presentation by James Scott. He comes off as a doctrinaire leftist anthropologist (but I repeat myself), which is definitely not the case in his books. Indeed, the juxtaposition of Chesterton and Scott shows how deeply conservative Scott is (in the literal sense of the word).

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March 24, 2017

Creative Destruction and Industry Life Cycles, HFT Edition

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 11:56 am

No worries, folks: I’m not dead! Just a little hiatus while in Geneva for my annual teaching gig at Université de Genève, followed by a side trip for a seminar (to be released as a webinar) at ESSEC. The world didn’t collapse without my close attention, but at times it looked like a close run thing. But then again, I was restricted to watching CNN so my perception may be a little bit warped. Well, not a little bit: I have to say that I knew CNN was bad, but I didn’t know how bad until I watched a bit while on the road. Appalling doesn’t even come close to describing it. Strident, tendentious, unrelentingly biased, snide. I switched over to RT to get more reasonable coverage. Yes. It was that bad.

There are so many allegations regarding surveillance swirling about that only fools would rush in to comment on that now. I’ll be an angel for once in the hope that some actual verifiable facts come out.

So for my return, I’ll just comment on a set of HFT-related stories that came out during my trip. One is Alex Osipovich’s story on HFT traders falling on hard times. Another is that Virtu is bidding for KCG. A third one is that Quantlabs (a Houston outfit) is buying one-time HFT high flyer Teza. And finally, one that pre-dates my trip, but fits the theme: Thomas Peterffy’s Interactive Brokers Group is exiting options market making.

Alex’s story repeats Tabb Group data documenting a roughly 85 percent drop in HFT revenues in US equity trading. The Virtu-KCG proposed tie-up and the Quantlabs-Teza consummated one are indications of consolidation that is typical of maturing industries, and a shift it the business model of these firms. The Quantlabs-Teza story is particularly interesting. It suggests that it is no longer possible (or at least remunerative) to get a competitive edge via speed alone. Instead, the focus is shifting to extracting information from the vast flow of data generated in modern markets. Speed will matter here–he who analyzes faster, all else equal, will have an edge. But the margin for innovation will shift from hardware to data analytics software (presumably paired with specialized hardware optimized to use it).

None of these developments is surprising. They are part of the natural life cycle of a new industry. Indeed, I discussed this over two years ago:

In fact, HFT has followed the trajectory of any technological innovation in a highly competitive environment. At its inception, it was a dramatically innovative way of performing longstanding functions undertaken by intermediaries in financial markets: market making and arbitrage. It did so much more efficiently than incumbents did, and so rapidly it displaced the old-style intermediaries. During this transitional period, the first-movers earned supernormal profits because of cost and speed advantages over the old school intermediaries. HFT market share expanded dramatically, and the profits attracted expansion in the capital and capacity of the first-movers, and the entry of new firms. And as day follows night, this entry of new HFT capacity and the intensification of competition dissipated these profits. This is basic economics in action.

. . . .

Whether it is by the entry of a new destructively creative technology, or the inexorable forces of entry and expansion in a technologically static setting, one expects profits earned by firms in one wave of creative destruction to decline.  That’s what we’re seeing in HFT.  It was definitely a disruptive technology that reaped substantial profits at the time of its introduction, but those profits are eroding.

That shouldn’t be a surprise.  But it no doubt is to many of those who have made apocalyptic predictions about the machines taking over the earth.  Or the markets, anyways.

Or, as Herb Stein famously said as a caution against extrapolating from current trends, “If something cannot go on forever, it will stop.” Those making dire predictions about HFT were largely extrapolating from the events of 2008-2010, and ignored the natural economic forces that constrain growth and dissipate profits. HFT is now a normal, competitive business earning normal, competitive profits.  And hopefully this reality will eventually sink in, and the hysteria surrounding HFT will fade away just as its profits did.

The rise and fall of Peterffy/Interactive illustrates Schumpeterian creative destruction in action. Interactive was part of a wave of innovation that displaced the floor. Now it can’t compete against HFT. And as the other articles show, HFT is in the maturation stage during which profits are competed away (ironically, a phenomenon that was central to Marx’s analysis, and which Schumpeter’s theory was specifically intended to address).

This reminds me of a set of conversations I had with a very prominent trader. In the 1990s he said he was glad to see that the markets were becoming computerized because he was “tired of being fucked by the floor.” About 10 years later, he lamented to me how he was being “fucked by HFT.” Now HFT is an industry earning “normal” profits (in the economics lexicon) due to intensifying competition and technological maturation: the fuckers are fucking each other now, I guess.

One interesting public policy issue in the Peterffy story is the role played by internalization of order flow in undermining the economics of Interactive: there is also an internalization angle to the Virtu-KCG story, because one reason for Virtu to buy KCG is to obtain the latter’s juicy retail order flow. I’ve been writing about this (and related) subjects for going on 20 years, and it’s complicated.

Internalization (and other trading in non-lit/exchange venues) reduces liquidity on exchanges, which raises trading costs there and reduces the informativeness of prices. Those factors are usually cited as criticism of off-exchange execution, but there are other considerations. Retail order flow (likely uninformed) gets executed more cheaply, as it should because it it less costly (due to the fact that it poses less of an adverse selection risk). (Who benefits from this cheaper execution is a matter of controversy.) Furthermore, as I pointed out in a 2002 Journal of Law, Economics and Organization paper, off-exchange venues provide competition for exchanges that often have market power (though this is less likely to be the case in post-RegNMS which made inter-exchange competition much more intense). Finally, some (and arguably a lot of) informed trading is rent seeking: by reducing the ability of informed traders to extract rents from uninformed traders, internalization (and dark markets) reduce the incentives to invest excessively in information collection (an incentive Hirshleifer the Elder noted in the 1970s).

Securities and derivatives market structure is fascinating, and it presents many interesting analytical challenges. But these markets, and the firms that operate in them, are not immune to the basic forces of innovation, imitation, and entry that economists have understood for a long time (but which too many have forgotten, alas). We are seeing those forces at work in real time, and the fates of firms like Interactive and Teza, and the HFT sector overall, are living illustrations.

 

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March 10, 2017

US Shale Puts the Saudis and OPEC in Zugzwang

Filed under: Commodities,Derivatives,Economics,Energy,Politics — The Professor @ 2:55 pm

This was CERA Week in Houston, and the Saudis and OPEC provided the comedic entertainment for the assembled oil industry luminaries.

It is quite evident that the speed and intensity of the U-turn in US oil production has unsettled the Saudis, and they don’t know quite what to do about it. So they were left with making empty threats.

My favorite was when Saudi Energy Minister Khalid al-Falih said there would be no “free rides” for US shale producers (and non-OPEC producers generally). Further, he said OPEC “will not bear the burden of free riders,” and “[w]e can’t do what we did in the ’80s and ’90s by swinging millions of barrels in response to market condition.”

Um, what is OPEC going to do about US free riders? Bomb the Permian? If it cuts output, and prices rise as a result, US E&P activity will pick up, and damn quick. The resulting replacement of a good deal of the OPEC output cut will limit the price impact thereof. The best place to be is outside a cartel that cuts output: you can get the benefit of the higher prices, and produce to the max. That’s what is happening in the US right now. OPEC has no credible way of showing off, or threatening to show off, free riders.

As for not doing what they did in the ’80s, well that’s exactly OPEC’s problem. It’s not the ’80s anymore. Now if it tries to “swing millions of barrels” to raise price, there is a fairly elastic and rapidly responding source of supply that can replace a large fraction of those barrels, thereby limiting the price impact of the OPEC swingers, baby.

Falih’s advisers were also trying to scare the US producers. Or something:

“One of the advisors said that OPEC would not take the hit for the rise in U.S. shale production,” a U.S. executive who was at the meeting told Reuters. “He said we and other shale producers should not automatically assume OPEC will extend the cuts.”

Presumably they are threatening a return to their predatory pricing strategy (euphemistically referred to as “defending market share”) that worked out so well for them the last time. Or perhaps it is just a concession that US supply is so elastic that it makes the demand for OPEC oil so elastic that output cuts are a losing proposition and will not endure. Either way, it means that OPEC is coming to the realization that continuing output cuts are unlikely to work. Meaning they won’t happen.

OPEC also floated cooperation with US producers on output. Mr. al-Falih, meet Senator Sherman! And if the antitrust laws didn’t make US participation in an agreement a non-starter, it would be almost impossible to cartelize the US industry given the largely free entry into E&P and the fungibility of technology, human capital, land, services, and labor. Maybe OPEC should hold talks with the Texas Railroad Commission instead.

Finally, in another laugh riot, OPEC canoodled with hedge funds. Apparently under the delusion that financial players play a material role in setting the price of physical barrels, rather than the price of risk. Disabling speculation could materially help OPEC only by raising the cost of hedging, which would tend to raise the costs of E&P firms, especially the more financially stretched ones. (Along these lines, I would argue that the big increase in net long speculative positions in recent months is not due to speculators pushing themselves into the market, but instead they have been pulled into the market by increased hedging activity that has occurred due to the increase in drilling activity in the US.)

Oil prices were down hard this week, from a $53 handle to a (at the time of this writing) $49.50 price. The first down-leg was due to the surprise spike in US inventories, but the continued weakness could well reflect the OPEC and Saudi messaging at CERA Week. The pathetic performance signaled deep strategic weakness, and suggests that the Saudis et al realize they are in zugzwang: regardless of what they do with regards to output, they are going to regret doing it.

My heart bleeds. Bleeds, I tells ya!

 

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