Streetwise Professor

December 7, 2016

Ivan Glasenberg’s Shock and Awe: But There Has to Be More Than Meets the Eye

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 8:25 pm

Today saw a major surprise. I mean a major surprise. The Russian government announced that a consortium consisting of Glencore and the Qatar Investment Authority had purchased a 19.5 percent stake in Rosneft for €10.5 billion. (Glencore said the price was €10.2 billion.)

The major surprise was that outside investors were involved at all at this time. For weeks the story had been that Rosneft itself would buy back the shares from the Rosneftgaz holding company, and then sell them to a private investor at a later date. This looked like a sham privatization, which fit in with the idea that Igor Sechin was less than enamored with the idea of selling equity to outsiders.

Also a surprise was Glencore’s participation. Qatar’s name had been floated as a possible buyer, but not Glencore’s. And no wonder. The firm is just recovering from a near death experience, has been feverishly de-leveraging, and only a few days ago announced it would pay $1 billion in dividends next year. So it hardly looked like a firm that would have the cash to pay out of pocket, and was not a candidate to borrow a lot.

But it appears there is some financial engineering going on here. A Glencore-QIA joint venture will buy the Rosneft shares, and the two investors will put up a mere €300 million each in equity. The remainder will be financed (according to Putin) by one of “the largest European banks.” Furthermore, the debt is supposedly non-recourse to Glencore or QIA. This means that the loan is essentially secured by the Rosneft shares.

This would allow Glencore to keep the debt off its balance sheet, and skirt sanctions by not having an equity stake in Rosneft.

If those numbers are right, the deal will be leveraged 17.5-to-1. That reminds me of a real estate boom SPV–except that the underlying asset here is even riskier than subprime. Given the riskiness of the underlying asset (Rosneft shares) that gearing seems unsustainable to me. What bank would take that risk?: the bank owns all the downside, and the JV partners get all the upside.

You can bet that any bank wouldn’t let you buy Rosneft shares on that geared a margin loan–and a non-recourse one no less. So I am guessing that there is some other part of the deal that passes the equity price risk back to Glencore and QIA. For instance, a total return swap between the JV and its owners. Or a put (which would make it unnecessary for the JV to make payments to the investors in the event Rosneft stock rises in value, as would be the case in a TRS.) If that, or something like it, is going on here, this is a cute way to keep investment off Glencore’s balance sheet, and also may be a way to work around sanctions, because derivatives on Rosneft debt (e.g., CDS) and equity are not subject to the sanctions. I cannot believe that any bank would lend so heavily based only on the security of Rosneft stock. So there must be a part of the deal that hasn’t been disclosed yet. (This may also involve an arrangement between Qatar and Glencore that limits the latter’s exposure.) There is more here than meets the eye, at least from the initial reporting.

Speaking of sanctions, the fact that a European bank (who?–reportedly Intesa Sanpaolo) is stepping up suggests that they believe the structure is sanctions-proof. This may also be a Trump effect: banks may have less concern about aggressive sanctions interpretation and enforcement in a Trump administration.

If it is Intesa Sanpaolo–that’s also rather interesting. Italian banks aren’t exactly in great shape these days, and are particularly shaky in the aftermath of the rejection of the referendum on Sunday. It is one of Italy’s healthier banks, but like saying someone is one of the healthier patients in the oncology ward. (Its equity is about 7 percent of assets.) Normally a loan of this size would be syndicated to spread the risk. If it isn’t, the loan represents more than 20 percent of Intesa’s equity and almost a quarter of its market cap. That’s insane.

All the more reasons to think that the bank has to find a way to lay off the price risk in the deal. (All the ways I can think of would expose it to the credit risk of Glencore and QIA. The latter isn’t an issue . . . the former could be. All the more reason to consider the possibility of QIA providing some credit support in the deal even if it is formally non-recourse.)

Another interesting aspect to the deal. Trafigura has been an important bulwark for Rosneft in the last two plus years. It dramatically stepped up its pre-pay deals with Rosneft, thereby providing vital (though very short-term sanctions compliant) funding when the Russian company was cut off from the capital markets. Moreover, Trafigura’s participation was a linchpin in Rosneft’s acquisition of Indian refiner Essar. As a result of these deals, Trafigura had nudged out Glencore as Rosneft’s biggest Russian partner. Now Glencore owns a major equity stake, and as part of the deal gets a 220,000 barrel-per-day off-take agreement with Rosneft. This gives Glencore 11.5 million tons/year of oil. Trafigura has been doing about 20 million tons of crude and 20 million tons of product from Rosneft. (Glencore also has off-take volume stemming from a 2013 pre-pay deal.)

Perhaps Trafigura did not have an appetite or capacity for doing much more volume with Rosneft, but it must be disconcerting to see Glencore take such a large equity stake. That undoubtedly has implications for Rosneft’s future dealings.

This transaction says a lot about Ivan Glasenberg. Given the experience of the last two years, one could have understood if he had been risk averse. This shows that his legendary appetite for risk remains. (And the more of the equity risk that is passed back to Glencore through financial engineering, the bigger that appetite will be shown to be.) This was shock and awe.

This deal is a boon for Russia and Putin, who can really use the money, and outside money especially. I wonder if Sechin is all that pleased, though. As noted earlier, he has been dragging his feet on privatization. Earlier this year a Rosneft analysis said the company would only be able to raise $1-$2 billion: obviously this was intended to convince Putin that a privatization would be a giveaway that he should take a pass on. But I’m sticking with my earlier guess that going through with the privatization was the quid pro quo for Putin allowing Rosneft to buy Bashneft. And again, Vlad really needs the money.

One last thing to put this all in perspective. Yes, €10 billion seems like a lot, but that values Rosneft at around $55 billion. The company’s reserves are about 34.5 billion barrels of oil equivalent (BOE). Its output is around 1.75 billion BOE per annum. For comparison, ExxonMobil is worth ~$350 billion. Its reserves are a third smaller than Rosneft’s: 24.8b BOE. Its output of 1.43 billion BOEPA is about 80 percent of Rosneft’s. So on a dollars per unit of reserves or output basis, XOM is about 8-9 times as valuable as Rosneft. That speaks volumes about Rosneft’s inefficiency, and the political risks that go along with the normal commercial risks inherent in an oil company. Keep that in mind when evaluating Putinism.

 

Print Friendly

December 3, 2016

The Trumpharrumphers’ Latest Freakout

Filed under: China,Economics,History,Military,Politics — The Professor @ 2:30 pm

In the nearly 4 weeks since Trump’s election, we’ve seen a daily freakout on this issue or that. Every day, we hear about another statement or appointment or Tweet that is apparently going to result in the impending arrival of the end times. For those thinking about career moves, becoming a Pfizer manufacturer’s rep in a blue state is a sure winner, because Xanax sales are certain to skyrocket.

Yesterday’s Freak Out by the Trumpharrumphers–which is spilling over into today–is that their bête noire took a phone call from the president of Taiwan. How this call came about is somewhat obscure. CNN reported that a former Cheney advisor now working the Trump transition, Stephen Yates, arranged it. Yates denies it.

That’s really neither here nor there. The issue is whether this is some grave blunder on Trump’s part. The immediate reaction by many is that this was thoughtless and rash, but I wouldn’t be so sure. It could very well be calculated to send a message to China that Trump does not accept the status quo that has developed over the past decades. China has challenged this status quo, particularly through its construction of artificial islands in the South China Sea. This could be Trump’s way of pushing back. Sending a message to the revisionist power that revisions can be a two way street.

It is a low cost way of sending that message. Unlike some alternatives, it is not latent with potential for an immediate confrontation. China would have to make an aggressive countermove. Consider an alternative way of sending a signal: sending US ships or aircraft to challenge Chinese claims in the South China Sea. That presents the potential of immediate conflict, due either to the decision of the leadership in Beijing, or a hotheaded commander on the spot. Recall that soon after Bush II took over that the Chinese forced down a US EP-3 aircraft off Hainan.

Not to say that Trump will not order freedom of navigation missions after becoming Commander in Chief. Just pointing out that taking the phone call certainly gets China’s attention, and gets it to think about what the new administration’s posture will be, without putting US and Chinese military forces in close contact in a way that could result in a disastrous incident.

One thing that is very striking about the hysterical reaction to The Call is that many of those responding most hysterically that it raises the risk of World War III have also favored a much more confrontational approach with Russia, especially in Syria. Gee, you’d think that declaring a no fly zone over Syria would create a far greater risk of an armed confrontation between nuclear superpowers than taking a phone call from the Taiwanese president.

This asymmetric approach to Russia and China makes no sense. Yes, Putin has a zero sum view of the world; wants to revise the post-Cold War settlement; nurses historical grievances; and believes that the United States is hell-bent on denying Russia its proper place in the world (or worse yet, overthrowing its government). But the Chinese have a zero sum view of the world; want to revise the balance of power in Asia; nurse historical grievances; and believe that the United States is hell-bent on denying China its proper place in the world. Russia hacks. China hacks. Indeed, if anything, Chinese hacks have been far more threatening to US national security than the alleged Russian hacks that have generated the greatest outrage, namely the DNC and Podesta email lacks. For instance, the Chinese hack of the Office of Personnel Management database likely caused grievous harm to US security: the DNC and Podesta hacks only embarrassed, well, political hacks. (Which probably explains the intensity of the outrage.) Insofar as Russian propaganda is concerned, if RT (which does not even register on the Nielsen ratings) and fringe internet sites gravely threaten US democracy, we have bigger problems to worry about: we will have met the enemy, and he is us.

The key issue is capability. With the exception of nuclear weapons, Russian capabilities are declining and limited, whereas Chinese capabilities are increasingly robust. The Soviets were big on “the correlation of forces.” The correlation of forces is strongly against the Russians at present. They have limited ability to project power beyond their immediate borders, and then only (in a persistent way) against ramshackle places like the Donbas and Abkhazia. The Russian Navy is a shambles: its current deployment off Syria would make Potemkin blush. The Navy faces the same problem that it has faced since the time of Peter I: it is split between inhospitable ports located at vast distances from one another. The submarine force has made something of a comeback, but its surface units are old and decrepit, and fielded in insufficient numbers. The potential for expansion is sharply constrained by the near collapse of Russian shipbuilding: even frigate construction is hamstrung because of the loss of Ukrainian gas turbine engines.

Russia is also in an acute demographic situation: during his recent speech, Putin crowed that fertility had increased from 1.70 live births/woman to 1.78–still well below replacement. This problem manifests itself in the form of increasing difficulties of manning the Russian military. It still relies on conscription for about 1/2 of its troops, and those serve for an absurd 12 months. After 8 years of reform efforts, 50 percent of the personnel are now kontraktniki, but the Defense Ministry’s refusal to release information on the number of contract soldiers who leave each year (while touting the number of new volunteers) suggests that there is considerable turnover in these forces as well. There is still no long-term cadre of non-commissioned officers, and the force structure is still very top heavy.

Moreover, this military rests on a very shaky economic foundation. In particular, Russian military manufacturing is a shadow of what it once was, and the fiscal capacity of the state is sharply limited by a moribund economy. This makes a dramatic expansion in Russian military capability impossibly expensive: even the modest rearmament that has occurred in the past several years has forced the government to make many hard tradeoffs.

In contrast, Chinese military power is increasing dramatically. This is perhaps most evident at sea, where the Chinese navy has increased in size, sophistication, and operational expertise. Submarines are still a weak spot, but increasing numbers of more capable ships, combined with a strong geographic position (a long coastline with many good ports, now augmented by the man-made islands in the South China Sea) and dramatically improved air forces, long range surface-to-surface missiles, and an improving air defense system make the Chinese a formidable force in the Asian littoral. They certainly pose an anti-access/area denial threat that makes the US military deeply uneasy.

In contrast to Russia, China is actually in the position of having a surfeit of military manpower, and is looking to cut force numbers while increasing the skill and training of the smaller number of troops that will be in the ranks after the reforms are completed.

Policy should emphasize capability over intentions. Intentions are hard to divine, especially where the Russians and Chinese are involved: further, the United States’ record in analyzing intentions has been abysmal (another argument for gutting the CIA and starting over). Moreover, intentions change. It must also be recognized that capabilities shape intentions: a nation with greater power will entertain actions that a weaker power would never consider.

Taking all this into consideration, I would rate Russia as a pain in the ass, but a pain that can be managed, and far less of a challenge to US interests than China. Putin has played a very weak hand very well. Indeed, as I have written several times, we have actually fed his vanity and encouraged his truculence by overreacting to some of his ventures (Syria most notably). But the fact remains that his is a weak hand, whereas China’s power is greater, and increasing.

I am not advocating a Cold War: East Asia Edition. But when evaluating and responding to capabilities of potential adversaries, China should receive far greater attention than Russia. Certainly there is no reason to risk a confrontation over Syria, and pique over embarrassing disclosures of corrupt chicanery that the perpetrators should damn well be embarrassed about is no reason for a confrontation either. A longer term focus on China, and managing its ambitions, are far more important. That is a relationship that truly needs a revision–a Reset, if you will. And methinks that Trump’s taking the phone call from the Taiwanese president was carefully arranged to tell the Chinese that a Reset was coming. A little chin music to send a message, if you will.

A more provocative thought to close. Realpolitik would suggest trying to find ways to split China and Russia, rather than engage in policies like those which currently are driving them together. A reverse Nixon, if you will. I am by no means clear on how that would look, or how to get there. But it seems a far more promising approach than perpetuating and escalating a confrontation with a declining power.

PS. This is fitting in many ways:

Print Friendly

December 2, 2016

Lucy Putin?

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 12:53 pm

I was somewhat surprised that OPEC came to an agreement. I will be more surprised if they live up to it: that would be not just going against history, but against basic economics. The incentives to cheat are omnipresent (as the Saudi’s ex-Minister of Petroleum of Petroleum Naimi acknowledged in the aftermath of the announcement). Further, what is the enforcement mechanism? Retaliatory output increases/price cuts (i.e., price wars)? Moreover, given that many OPEC nations are facing acute budgetary strains, the present looms and the future looks very, very far away: consequently, getting some additional revenue today at the risk of losing some revenue a year or two from now when a price war breaks out looks pretty attractive.

The breathless TigerBeat-style reporting of the meeting states that Russia’s last-minute intervention rescued the deal. A few things to keep in mind. Russian oil output has surged in the last few months, meaning that its promise to cut 300,000 bbl/day basically puts its output back to where it was in March. This is in fact pretty much true of the OPEC members too: the deal very much as the feel of simply taking two steps back to reverse the two steps forward that major producers took in the past 9 months (and the two steps forward were no doubt driven in large part to improve bargaining positions in anticipation of the November OPEC meeting).

Moreover, the timing of the Russian commitment is rather hazy. Energy Minister Alexander Novak said Russia would cut “gradually.” That can mean almost anything, meaning that the Russians can say “the cuts are coming! Trust us! We said it would be ‘gradual!'” and that there will be no hard evidence to contradict them.

The most amusing part of this to me is that many are interpreting Putin’s personal involvement as proof that the Russians will indeed cut. “If Putin tells Russian oil companies to cut, they’ll ask ‘how deeply’?”

Seriously?

Call me cynical (yeah, I know), but I find this scenario far more plausible: Putin sweet-talked the Saudis and Iranians to overcome their differences to cut output in order to raise prices, all the while planning to sell as much as possible at the (now 10 percent) higher prices. Breezy promises cost nothing, and even if eventually OPEC members wise up to being duped, in the meantime Russia will be able to sell to capacity at these higher prices. Yes, the OPEC members will be less likely to believe him next time, but Putin’s time horizon is also very short, for a variety of reasons. He’s not getting any younger. And more immediately, the Russian recession is dragging into its third year, and budgetary pressures are mounting (especially since he is committed to maintaining a high level of military spending). The Russian Wealth Fund (one of its two sovereign wealth funds) has been declining inexorably: the rainy day fund is almost empty, and the skies still haven’t cleared. And the presidential election looms in 2018. For Putin, the future is now. The future consequences of making and breaking a promise are not of great importance in such circumstances. But more money in the door today is very, very important.

Russia isn’t like other OPEC producers, which have national oil companies that respond to government orders. Although government-controlled Rosneft is the biggest producer in Russia, there are others, and even Rosneft and Gazpromneft have more autonomy than, say, Saudi Aramco. Yes, Putin could, er, persuade them, but a far more effective (and credible) tool would be to adjust taxes (especially export taxes on both crude and fuels) to give Russia’s producers an incentive to cut output (and especially exports, which is what OPEC members really care about). A tax boost would be a very public signal–and reversing it would be too, making it harder to cheat/renege. (Harder, but not impossible. The government could give stealth tax cuts or rebates. This is Russia, after all.) But I have not seen the possibility of a tax rise even be discussed. That makes me all the more skeptical of Putin’s sincerity.

So my belief is that Putin is stepping into the role that Sechin played in 2009, that is, he is being Lucy beckoning Charlie Brown/OPEC with the football. And Charlie Brown is attempting a mighty boot. We know how that works out.

Even if Putin lives up to his pinky-swear to cut output, Russia has cut a much better deal than the Saudis. The promised Russian cut is about 60 percent of the Saudi cut, yet both get the same (roughly 10 percent) higher price, meaning that (roughly speaking) Russian revenues will rise 40 percent more than than Saudi revenues do–assuming that both adhere to the cuts. The disparity will be greater, to the extent that Russia cheats more than the Saudis.

Time will tell, but what I am predicting is that (a) Russia will not cut anything near 300kbbl/d, and (b) cheating by OPEC members will snowball, meaning that next November’s OPEC meeting will likely be another rancorous effort dedicated to repairing a badly tattered deal, rather than a celebration of the anniversary of a successful and enduring bargain.

Print Friendly

November 29, 2016

A Policy Inspired More by the Marx Brothers Than Marx

Filed under: China,Climate Change,Commodities,Economics,Politics,Regulation — The Professor @ 9:51 pm

As goes China, so go the commodity markets. The problem is that where China goes is largely driven by a bastardized form of central planning which in turn is driven by China’s baroque political economy. In past years, China’s rapid growth conferred on the government a reputation for wisdom and foresight that was largely undeserved, but now more people are waking up to the reality that Chinese policy engenders tremendous waste, and that the country would actually be richer–and have better prospects for the future–if its government tempered its dirigiste tendencies.

Case in point: Morgan Stanley’s Chief China Economist uses the ham-fisted intervention into the coal industry to illustrate the broader waste in the Chinese system:

These reforms entail the necessary reduction of excess capacity, particularly in state-owned enterprises (SOEs) and industries where overproduction issues are often the most acute.

While economists agree that a reduction of excess capacity, particularly in heavy industry, is key to the nation’s efforts to get on a more sustainable growth trajectory, China’s supply side reforms bare little resemblance to the “trickle down” Reaganomics of the 1980s, which seized upon tax cuts and deregulation as a way to foster stronger growth.

In Morgan Stanley’s year-ahead economic outlook for the world’s second-largest economy, Chief China Economist Robin Xing uses the coal industry to detail two key ways in which supply-side reforms with Chinese characteristics have been ill-designed.

“The state-planned capacity cuts and the slow progress in market-oriented SOEs reform have come at the cost of economic efficiency,” laments the economist.

In a bid to shutter overproduction and address environmental concerns, Beijing moved to restrict the number of working days in the sector to 276 from 330 in February.

But in enacting these cuts, policymakers employed a one-size-fits-all approach.

“The production limit was implemented to all companies in the sector, which means good companies that are more profitable and less vulnerable to excess capacity are affected just as much as the bad ones with obsolete capacity and weak profitability,” writes Xing.

This is largely true, but begs the question of why China adopted this approach. The most likely explanation is that the real motive behind the cuts has little to do with “environmental concerns”, though those are a convenient excuse. Instead, forcing the most inefficient producers out of business–or allowing them to go out of business–would cause problems in the banking and (crucially) the shadow banking sectors because these firms are heavily leveraged. Allowing them to continue to produce, and propping up prices by forcing even relatively efficient firms to cut output, allows them to service their debts, thereby sparing the banks that have lent to them, and the various shadow banking products that hold their debt (often as a way of taking it off bank balance sheets).

If the goal was to reduce pollution, it would have been far more efficient to impose a tax on coal-related pollutants. But this tax would have fallen most heavily on the least efficient producers, and would caused many of them to fail and shut down. The fact that China has not pursued that policy is compelling evidence that pollution–as atrocious as it is–was not the primary driver behind the policy. Instead, it was a backdoor bailout of inefficient producers, and crucially, those who have lent to them.

Morgan Stanley further notes the inefficiency of the capital markets which favor state owned enterprises:

As such, this misallocation of production serves to amplify the already prevalent misallocation of credit stemming from state-owned firms’ favorable access to capital. That arguably undermines market forces that would otherwise help facilitate China’s economic rebalancing.

But this too is driven by politics: SOEs have favorable access to capital because they have favorable access to politicians.

The price shock resulting from the output cuts hit consuming firms in China hard, which has led to a lurching effort to mitigate the policy:

This month, Beijing was forced to reverse course to allow firms to meet the pick-up in demand — another case of state dictate, rather than price signals, driving economic activities.

“In this context, we think the more state-planned production control and capacity cuts cause distortions to the market and are unlikely to be sustainable,” concludes Xing.

“Beijing was forced to reverse course” because utilities consuming thermal coal and steel producers consuming coking coal pressured the government to relent.

The end result is a policy process that owes more to the Marx Brothers than to Marx. A cockamamie scheme to address one pressing problem causes problems elsewhere.

Methinks that Mr. Xing is rather too sanguine about the ability or willingness of the Chinese government to sustain such highly distorting policies. They have done so for years, and are showing no inclination to change their ways. Efficiency is sacrificed to achieve distributive and political objectives, and the bigger and more complex the Chinese economy the more difficult it is for the authorities to predict and control the effects of their policy objectives. But this just induces the government to resort to more authoritarian means, and attempt to exercise even more centralized power. This is costly, but these are costs the authorities are willing and able to bear. Inefficiency is the price of power, but it is a price that the authorities are willing to pay.

Print Friendly

November 15, 2016

Igor Sechin Takes His Revenge

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 12:07 pm

The Bashneft sale to Rosneft (which I wrote several posts about) is a done deal, but apparently there was some unfinished business. Namely, the business of  revenge.

On Monday Economic Development Minister Alexei Ulyukayev was detained for corruption. He allegedly took a $2 million bribe to “allow” the sale. Indeed, Bloomberg claims he was caught in the act:

Ulyukayev, 60, was detained on Monday “in the act” of receiving the cash, said Russia’s Investigative Committee. He was later charged with demanding the money from Rosneft PJSC to allow its purchase last month of the government’s 50 percent stake in regional oil producer Bashneft PJSC, the agency said in a statement. The economy minister denies any wrongdoing, his lawyer Timofei Gridnev told Business FM radio. Investigators moved that he be held under house arrest before he arrived for arraignment Tuesday at Moscow’s Basmanny Court.

Ah, Basmanny justice. Gotta love it.

This all seems quite bizarre. The Bashneft acquisition was clearly a source of intense conflict with the Russian government, with the government ministries–including Ulyukayev–initially expressing opposition. Then there was temporizing, with Putin seeming to come down on both sides of the issue. Then it was decided in Rosneft’s–that is, Igor Sechin’s–favor.

Presumably, Putin was the ultimate decider here. If so, Ulyukayev was in no position to “allow” anything. Maybe he had a chance to make his case, either directly to Putin, or indirectly via Medvedev. But once he lost, he would have been delusional to think he had any leverage over whether the deal would proceed.

Further, the timing is beyond strange. The deal was decided in September, and finalized on October 12, more than a month ago. So, did Ulyukayev give net 30 terms on the bribe? Net 60? Was it half now, half later? Is bribery really done on credit in Russia?

I would also venture that attempting to shake down Sechin and Rosneft is tantamount to suicide. Did Ulyukayev attempt such a risky thing? Did Sechin play along and then facilitate a sting by the Investigative Committee? Or was this a set-up job from the start?

One thing that is almost certainly true is that this is Sechin taking his revenge, and sending a message to others: look at what happens to those who cross me.

The Energy Ministry, under Novak, also opposed the deal initially. I wonder if he is sleeping well.

There are some comic elements to the story. Several stories breathlessly report a law enforcement leak saying that Ulyukayev’s phone had been tapped “for months.” Um, pretty sure it was tapped like forever.

Ulyukayev has a reputation as a “liberal” in Russia, and assorted Western dimwits expressed Shock! Shock! at his arrest. Prominent among these were Anders Aslund and my fellow professor and buddy Michael McFaul. I say dimwits for several reasons. First, is it news to them that the “liberals” in the Russian government are marginalized, and exist at the sufferance of people like Sechin who are in Putin’s inner circle? Second, are they so credulous as to believe that these liberals are untainted by corruption? Puh-lease. Ulyukayev appeared in the Panama Papers. Further, the “liberals” and “reformers” mainly go back to the Yeltsin period, and remember that  Yeltsin elevated Putin in exchange for foregoing any investigation or prosecution of the rife corruption of the Yeltsin administration. Ulyukayev was associated with Gaidar, who was also tied to corruption (although the publicly revealed instances were small beer by Russian standards).

There are no clean hands in Russia. This very fact is what usually keeps people in line, for they know the adage “for my friends, everything: for my enemies, the law!” Everybody is vulnerable to prosecution, because everybody is corrupt: actual prosecution is used sparingly, however, to punish those who have committed a political transgression.

Ulyukayev clearly committed such a transgression, and hence he finds himself in the dock.

There is no reason to be shocked by this. It merely confirms that people like Sechin are the real power. But this is apparently a revelation to alleged Russia experts.

Bashneft is the Hope Diamond of oil companies: it seems to bring bad luck to anyone who touches it. Ural Rakhimov, the son of the boss of Bashkortostan (where the company is located), who profited from the corruptly done privatization of the company in 2002, but who apparently fled Russia when the privatization and subsequent sale came under government scrutiny. Vladimir P. Yevtushenkov, who bought Bashneft from Rakhimov, but then wound up under house arrest for 92 days for allegations related to the privatization: he walked only after the government seized Bashneft shares from Yevtushenkov’s holding company before performing the re-privatization Kabuki that ended with the company being bought by Rosneft. And now Ulyukayev.

Will the skein of bad luck end with Rosneft and Sechin? That’s a good bet, but not a lock. Who knows what changes in power are in store, especially as Putin ages, or if there is some economic or political shock?

Print Friendly

November 13, 2016

Let Them Use Canvas! A Vignette on the Dangers of Majoritarianism & the Benefits of the Electoral College

Filed under: Economics,History,Politics — The Professor @ 12:55 pm

In the aftermath of the stunning election result, we are witnessing much wailing and gnashing of teeth and rending of garments. One common whinge is that the result is illegitimate because Hillary apparently won (barely) the national popular vote, but was trounced in the Electoral College vote. I will pass over some of the issues this raises (e.g., that campaign strategies would have been different had the election been a national referendum/plebiscite) to focus on the benefits of the Electoral College.

The Electoral College is a departure from majoritarianism, one of many that the Founders deliberately incorporated into the Constitution. Meaning that the real debate is not over this particular deviation from national majoritarianism, but whether there should be any such deviations at all.

Put me down as a deviant, because I strongly believe that pure majoritarianism is a disaster. The tyranny of the majority is a real concern. To get all geeky about it, the core is empty in pure majoritarian games: no stable coalitions can form, and the outcome is chaos and shifting alliances of Peters conspiring to rob Pauls. The dangers of this are particularly great when there are few checks on the power of the state to transfer property and power from one group to another. There is also much greater potential for conflict and a greater incentive to spend resources to win the popular vote because small changes in the popular vote lead to discontinuously large changes in the distribution of power–including the power to expropriate. The stakes are much bigger, especially in closely divided polities.

If you want to see an example of what happens when there are fewer checks on the majority, look at California. It is no accident that California is Whinge Central post 11/8/16. The state voted strongly for Clinton: I may exaggerate only slightly that the net-wits called California for Clinton within 30 seconds of the polls closing.

But as Victor Davis Hanson has movingly shown, there are two Californias. (Joel Kotkin has written in a similar vein.) The coastal region, with Silicone Valley and Silicon Valley. Urban, expensive, and wealthy–with large pockets of plutocratic wealth. It draws its wealth disproportionately from high rent industries–entertainment and software tech. But there is another California, the interior. It is far poorer, and far grittier. It is heavily agricultural, and agrarian. It wrests what wealth it has from the earth, with sweat and toil. The only rents are to the land.

This is reflected in the electoral map, which is a microcosm of the US. There is a blue California on the coasts, and a red California in the interior. Even some places with large numbers of Mexican immigrants (e.g., Kern County) went for Trump. But the coast was solid Clinton.

In terms of population as well as wealth, Coastal California dominates. This means that in terms of state legislation and government, the interior of California is largely disenfranchised, and the governing elites have little reason to take the interests of the interior into account. This problem is exacerbated by the heavy use of referendums in California. Referenda are a strongly majoritarian institution, which do have a purpose, namely, placing a check on minorities that can use government to advance their interests. But this comes at a cost of allowing majorities to run roughshod over minorities.

There were several referenda on the ballot in California on Tuesday. Most were advanced by the coastal majority and involved issues that can and should be decided on a local basis, but which a highly ideological majority wanted to force on everyone. One example is the gun control measures that passed. But the example that is most telling to me is the referendum which banned the use of plastic grocery bags.

This is an issue that is virtue signaling par excellence. Around the world (e.g., France) liberals have made the banning of plastic bags a major environmental issue, despite the fact that the environmental benefits of the ban are far more asserted than proven. In California in particular, most major coastal metropolises have banned plastic bags. Bully for them. But that was not enough for the coastal denizens: they had to force their preferences on the entire state.

As Tim Newman wrote several months ago in several excellent posts, the plastic bag ban imposes substantial inconvenience on many normal people, hits lower income people the hardest, and is basically yet another effort by the better thans to instruct the benighted proles:

And that was my point about the Soviet Union: the privileged imposing artificial material restrictions on society which hit those at the bottom hardest, all the while saying it is for their own good.

In summary, I’m not necessarily saying the ban on carrier bags is a bad thing.  I just take objection to people making the assumption that plastic use is in itself bad, alternatives better, and the ban good as if it these were self-evident truths; and the lifestyle preferences of the wealthy middle-classes being imposed on everyone else with nothing but condescending dismissal of the costs and inconvenience to those not so fortunate.

Exactly right.

In California, the coastal majority succeeded in imposing its will on a less wealthy minority. It did so with plastic bags (and bullets) by referendum: it does so on myriad other matters via the state legislature which it dominates. These elites are throwing a post-Trump temper tantrum–which has gone so far as for many to advocate California’s secession–precisely because the Electoral College has thwarted their ability to do the same in the US as a whole.

If you look at what California does to the political minority in the interior, you will see that the tyranny of the majority is a real thing. The majority doesn’t have to pay any heed to the rubes in the Central Valley–let them use canvas! The genius of the Electoral College is that it forces the popular majority to temper its ambitions and moderate its program in order to attract at least some support from–or at least, diminish the opposition from–other constituencies. The urban must make some accommodations to the rural and suburban. The coastal must make some concessions to flyover country.

This serves to reduce conflict between constituencies, and mitigates centrifugal and fissile forces in a large and extremely diverse nation. These are very good things. If you think that politics in the US is contentious and divisive now, you have no idea what it would be like without the Electoral College.

One of the left’s arguments against the Electoral College is that it was adopted in large part as an accommodation to the slave states. There is an element to truth in that, although it should be noted that small non-slave states (e.g., Connecticut) also supported it because they feared being ground under the heel of large states like New York and Virginia. But the role of slavery actually illustrates the politically and socially beneficial role of the institution.

Absent departures from majoritarianism like the Electoral College, it is unlikely that highly disparate regions like the North and the South could have come together to form a nation in the first place, or would have long avoided secession and armed conflict if they had. The Civil War occurred precisely when demographic and economic changes threatened to permit the majority North from imposing its will on the minority South. Anti-majoritarian institutions (not just the Electoral College, but the Senate) permitted a nation to be formed in the first place, and prevented secession and military conflict for over 70 years.

In the instance of slavery, the anti-majoritarian provisions of the Constitution protected an evil institution for decades.* But that fact does not mean that anti-majoritarian features are inherently bad. To the contrary. Pure majoritarianism can be oppressive, and that increases the potential for political division and conflict. The Electoral College requires a party to moderate its appetites and broaden its appeal. It does not eliminate conflict, but it does temper it. And it does so precisely because it constrains the ability of arrogant majorities to impose their will on diverse minorities. The Electoral College gives greater voice to minorities: without voice, the minorities are more likely to resort to exit or combat.

Which is exactly why the left in the US is currently freaking out about the Electoral College. Their hysteria is the best advertisement for this institution that I could possibly imagine.

* As a practical matter, a purely majoritarian Constitution, or a Constitution with fewer anti-majoritarian features, would not have shortened the life of slavery, and likely would have extended it. One possible result would have been that there was no United States, and the Southern states would have been free to perpetuate their institutions without interference. The Northern states would have had little or no incentive to interfere. (One strong economic motive for the North to fight secession was that the tariff system redistributed income from the South to the North, and secession undermined that. That provided an economic incentive for Massachusetts and New York to cohabit with South Carolina and Alabama, and to oppose their moving out.)

If through some miracle a nation embracing North and South had formed under a more majoritarian Constitution, it is highly likely that a more purely majoritarian system would have resulted in secession at a far earlier date, when the economic (especially industrial) and population balance was much closer, and the North probably would have been powerless to prevail over the South militarily. The Civil War came in a non-purely majoritarian system only when the economic imbalance between the sections became so pronounced that military advantage rested with the North, and even given that preponderance, it was barely able to prevail, and then only after epic bloodshed.

Thus, adopting the William Lloyd Garrison position that the Constitution was a bargain with the devil and the North would be morally purified by a separation with the South might have salved his conscience and those of other (primarily evangelical) abolitionists, it would not have freed one person from bondage, and may indeed have cursed many more to suffer from it for much longer.

Print Friendly

November 9, 2016

Blessed Are Ye Who Are Long Gamma

Filed under: Economics,Energy,Politics,Regulation — The Professor @ 9:03 am

Hillary Clinton made history last night. Just not quite the way she had expected. Rather than “shatter the glass ceiling” (gag), she was crushed as the roof caved in on a complacent, corrupt, and clueless establishment of which she was the exemplar. Donald Trump was the personification of the forces that defeated her and the “elite”, but pretty much only that: either by canny calculation or dumb luck he rode a deep current of popular discontent to achieve a stunning victory that saw at least five, and likely six, strongly Democratic states flip from D to R. The Democrats prevailed only in the leftist strongholds of the P-Coast, the Northeast, The Illinois Salient, and Governmentlandia (Virginia and Maryland). The rest of the country went red. Trump was the effect, not the cause. The vessel that floated on the tide, not the tide itself.

Blessed are ye who are long gamma. Those who have the flexibility and optionality to respond to uncertain developments are the winners here, for there will be uncertainty aplenty. The future with Hillary would have been drearily predictable: the future with Trump will be a wild ride.

Consider few representative areas.

The Supreme Court: Hillary would have chosen rigid leftist ideologues intent on remaking the country–not just its government and economy, but its social fabric. Trump? I have no clue, and either does anyone else. My guess that his court picks generally will be highly idiosyncratic with no unifying philosophical orientation–because Trump lacks one as well.

Government appointments: Hillary would tap from the Empire’s vast array of apparatchiks, most of whom would be statist to the core. The middle and lower level appointments would have teemed with the kinds of political cockroaches revealed in the light of the Podesta emails. As an outsider, Trump has no similar pool of bureaucrats-in-waiting. The transition process will likely be chaotic, and he will have to rely on a Republican establishment that he distrusts (and which distrusts him) to advance candidates. Again, the outcome is wildly unpredictable, and will probably result in a hodgepodge of appointments with no unifying ideology or philosophy, who will often work at cross purposes.

There will be new blood, which is a good thing: people from outside the ranks of the courtiers in DC and the coastal metropolises are desperately needed. These people will inevitably be high variance. But that is an inevitable part of the process of change.

Economic policy: Hillary would have continued the onslaught of regulations that has been producing an Amerisclerosis that rivals Eurosclerosis. Agencies like the EPA would have continued to propose and implement burdensome, growth-sapping regulations. She would have pushed the kinds of taxes on capital that are also inimical to growth (although her ability to get those through Congress would have been a very open question). Trump? He is an economic ignoramus, but it is likely that Congress will temper some of his wackier ideas. Further, he is open to reducing many of the regulatory monstrosities like those that the EPA has imposed, and to removing barriers to energy production and transportation. His tax ideas are unpredictable, but again they are not relentlessly hostile to investment and capital. And a big thing: there is an opportunity to fix Obamacare. Hillary would have fixed it by moving to single payer. There is an opportunity to move away from government control, not doubling down on it.

Regulatory policy and taxes will require cooperation with Congress. The relations between Trump and the Republican leadership are fraught, at best. Idiots like Max Boot are delusional if they think that a Republican House and Senate will give Trump carte blanche. But Trump views himself as a negotiator, and will no doubt engage in negotiations with Congress with zest. The outcome of those negotiations? Impossible to predict. Likely something best described by the old joke: “What is a giraffe? A horse designed by committee [or negotiation].” Again, tremendous uncertainty.

With respect to economic policy, personnel will matter here. Again, Hillary’s appointments to agencies like EPA, SEC, FERC, FTC, FCC, and CFTC would have been tediously predictable statists intent on extending government control over the economy. Trump’s appointments are much more likely to be a very mixed bag, leading to less predictable outcomes. I do think it is likely, however, that there will be many fewer regulatory control freaks. Thus, I expect that at the CFTC, for instance, a Trump commission will jettison economic inanities like Reg AT and position limits.

Foreign policy: Hillary has a strong interventionist, not to say warmongering, streak, and would have almost certainly been more aggressive in Syria than Obama has been, with very sobering consequences (including a substantially increased risk of confrontation with Russia). Trump’s predilections seem much less interventionist, but events, dear boy, events, can lead presidents to do things that they would prefer not to. And given Trump’s mercurial nature, how he will respond to events is wildly unpredictable.

He will have to deal with other major issues, notably China. He will approach these like a negotiator–including, I expect, large doses of bluff and bluster–and the outcomes of these negotiations will be even harder to predict than those of his negotiations with Congress. (One issue that could have both domestic and foreign policy effects is that I conjecture it is likely that the Sequester will die under Trump, whereas it would have continued with a divided government.)

It is clear, therefore, that Trump will disrupt the system, both domestically and internationally, whereas Hillary would have perpetuated it. And I am not unduly concerned about extreme disruptions, because the inherent complexity of the American system of government, the tension between Trump and Congress, and quite frankly, Trump’s limited attention span will temper his more extreme impulses.

Further, shaking up the system is a good thing, for the system is dysfunctional and corrupt. Hillary would have continued our relentless slouch to cryptosocialism and would have cemented the rule of a contemptible and remote establishment: the possibility of an upside is greater with Trump, even if by accident. Hillary would have delivered us sclerosis on purpose.

I would also suggest that a Hillary victory would have increased the likelihood of a bigger cataclysm in the future. She and her acolytes would have disdained and dismissed the forces that in the event propelled Trump to victory. She would have doubled down on the policies that have contributed to our present discontent. As a result, that discontent would have only increased, thereby increasing in turn the likelihood of an even bigger political spasm in the future.

To put things differently: with Trump, we will be on a roller coaster. With Hillary, we would have been on the luge.

I think Trump will be a transitional figure. Transitioning to what, I have no idea. But given the deeply dysfunctional nature of the status quo, transition holds out hope. Shaking up a decrepit and corrupt system creates the possibility for change. Creative Destruction is a possibility with Trump. With Hillary, no.

All this said, the Empire will strike back. It will wage a relentless war from its redoubts in the media, and to a lesser degree, the courts. Look at what the Remain crowd is doing in the UK in its attempt to undo its loss at the polls. That will happen here too: there will be a Thermidor, or at least an attempted one. And that battle will produce uncertainty.

And not all of the Empire’s minions are Democrats: the Republican establishment will fight Trump from within the citadel. This political warfare adds the prospect of even more uncertainty. Again, a reason to be long gamma.

I cannot say I predicted this, because I didn’t. I do think it is fair to say that I limned the outlines of what has transpired. This came in two parts. First, I noted that as with Brexit, this possibility was far more likely than elite opinion believed. A complacent elite sat smugly atop the volcano, blithely ignorant of the pressure of deep popular disdain pushing up the earth under their feet, disdain powered by the financial crisis, bloody and inconclusive wars, and an anemic economy. Talking only to one another, the elite received no feedback about what voters were thinking and feeling.  Existing in an echo chamber made them vulnerable to shock and surprise. Moreover, their contempt for those not in their class also led them to think that such feedback was irrelevant, because these little people didn’t matter. They knew better.

But the little people, largely without voice in the forums in which the elite communicate and interact, nursed their injuries, bided their time, and took their revenge.

Second, Hillary is a horrible person, and a horrible candidate–or should I say deplorable? Look at the vote totals vs. Obama in 2012. To say she underperformed is an extreme understatement. She underperformed because she had nothing new to offer, and indeed, the old conventional liberal stuff she was offering was long past its sell-by date. Add to that her horrible personal packaging (the corruption, the endless scandal, the inveterate lying) and she was crushed by an inarticulate political novice carrying more baggage than the cargo hold of an Airbus A380.

I did not have the courage of my convictions to predict that these two factors would result in a Trump victory. I thought Jacksonian America was too small to prevail. I too was in the thrall of conventional wisdom to some degree.

If you asked me to describe my mood, I would echo the title of a Semisonic song: Feeling strangely fine. Part of that feeling, I must admit somewhat guiltily, is due to schadenfreude: the hysteria of those whom I despise is quite enjoyable to witness. But part of it is that I think I am long gamma, and that the US is long gamma too. The old system and the old establishment have crushed American dynamism. Shaking up that system has more upside than downside, and whatever you think about Trump, you have to know he will shake things up.

I’ll close by quoting about the most un-Trump-like president I can think of: Eisenhower. “If you can’t solve a problem, enlarge it.” In other words, disrupt. Get out of the box. Don’t continue down the same endless path: try something new. The United States has been facing many insoluble problems, political, economic, strategic. The establishment had no clue at how to solve these problems, and their attempts to try the same things expecting different results put us on a slow road to ruin. Or maybe not so slow. A disruption was needed. An overthrow of the elite was imperative. Those things will in some respects enlarge our problems, by creating turmoil. But out of that enlargement there is the prospect of solutions–and yes, the prospect of catastrophe.

I don’t think that Trump himself will be the architect of those solutions. His role will be to tear down–he’s already done that to a considerable degree. Others will have to build up. Who that is, I don’t know. What construction will emerge, I don’t know. But there is far more upside now than there would have been with President Hillary Clinton. And that is reason to feel fine, strangely so or not

Print Friendly

November 8, 2016

WTI Gains on Brent: You Read It Here First!

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 8:22 pm

Streetwiseprofessor, August 2011:

WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

. . . .

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.

Bloomberg, November 2016:

In the battle for supremacy between the world’s two largest oil exchanges, one of them is enjoying a turbo charge from the U.S. government.

Traders bought and sold an average of almost 1.1 billion barrels of West Texas Intermediate crude futures each day in 2016, a surge of 35 percent from a year earlier. The scale of the gain was partly because of the U.S. government lifting decades-old export limits last year, pushing barrels all over the world, according to CME Group Inc., whose Nymex exchange handles the contracts. By comparison, ICE Futures Europe’s Brent contract climbed by 13 percent.

WTI and Brent have been the oil industry’s two main futures contracts for decades. In the past, the American grade’s global popularity was restrained by the fact that exports were heavily restricted. Now, record U.S. shipments are heading overseas, meaning WTI’s appeal as a hedging instrument is rising, particularly in Asia, where CME has expanded its footprint.

“You have turbo-charged WTI as a truly waterborne global benchmark,” Derek Sammann global head of commodities and options products at CME Group, said in a phone interview regarding the lifting of the ban. “You’re seeing the global market reach out and use WTI — whether that’s traders in Europe, Asia and the U.S.”

This should surprise no one–but the conventional wisdom had largely written off WTI in 2011. Given that economic price signals were providing a strong incentive to invest in infrastructure to ease the bottleneck between the Midcon and the sea, it was inevitable that WTI would become reconnected with the waterborne market.

Once the physical bottleneck was eased, the only remaining bottleneck was the export ban. But whereas the export ban was costless prior to the shale boom (because it banned something that wasn’t happening anyways), it became very costly when US supply (especially of light, sweet crude) ballooned. As Peltzman, Becker and others pointed out long ago, politicians do take deadweight costs into account. In a situation like the US oil market, which pitted two large and concentrated interests (upstream producers and refiners) against one another, reducing deadweight costs probably made the difference (as the distributive politics were basically a push).  Thus, the export ban went the way of the dodo, and the tie between WTI and the seaborne market became all that much tighter.

This all means that it’s not quite right to say that CME’s WTI contract has been “turbocharged by the federal government.” Shale it what has turbocharged everything. The US government just accommodated policy to a new economic reality. It was along for the ride, as are CME and ICE.

ICE’s response was kind of amusing:

“ICE Brent Crude remains the leading global benchmark for oil,” the exchange said in an e-mailed response to questions. “With up to two-thirds of the world’s oil priced off the Brent complex, the Brent crude futures contract is a key hedging mechanism for oil market participants.”

Whatever it takes to get them through the day, I guess. Reading that brought to mind statements that LIFFE made about the loss of market share to Eurex in early-1998.

The fact is that there is hysteresis in the choice of the pricing benchmark. As exiting contracts mature and new contracts are entered, market participants will have an opportunity to revisit their choice of pricing benchmark. With the high volume and liquidity of WTI, and the increasingly tight connection between WTI and world oil flows, more participants will shift to WTI pricing.

Further, as I noted in the 2011 post (and several that preceded it) Brent’s structural problems are far more severe. Brent production is declining, and this decline will likely accelerate in a persistent low oil price environment: not only has shale boosted North American supply, it has contributed to the decline in North Sea supply. Brent’s pricing mechanism is already extremely baroque, and will only become more so as Platts scrambles to find more imaginative ways to tie the contract to new supply sources. It is not hard to imagine that in the medium term Brent will be Brent in name only.

Since WTI will likely rest on a strong and perhaps increasing supply base, Brent’s physical underpinning will become progressively shakier, and more Rube Goldberg-like. These different physical market trajectories will benefit WTI derivatives relative to Brent, and will also induce a shift towards using WTI as a benchmark in physical trades. Meaning that ICE is whistling past the graveyard. Or maybe they are just taking Satchel Paige’s advice: “Don’t look back. Something might be gaining on you.” And in ICE Brent’s case, that’s definitely true, and the gap is closing quickly.

 

 

Print Friendly

October 31, 2016

A Brexit Horror Story That Demonstrates the Dangers of Clearing Mandates

Filed under: Clearing,Derivatives,Economics,Regulation — The Professor @ 12:43 pm

When I give my class on the systemic risks of clearing, I usually joke that I should give the lecture by a campfire, with a flashlight held under my chin. It is therefore appropriate that on this Halloween Risk published Peter Madigan’s take on the effects of Brexiton derivatives clearing: it is a horror story.

Since the clearing mandate was a gleam in Barney Frank’s eye (yes, a scary mental image–so it fits in the theme of the post!) I have warned that the most frightening thing about clearing and clearing mandates is that they transform credit risk into liquidity risk, and that liquidity risk is more systemically threatening than credit risk. This view was born of experience, slightly before Halloween in 1987, when I witnessed the near death experience that the CME clearinghouse, BOTCC, and OCC faced on Black Monday and the following Tuesday. The huge variation margin calls put a tremendous strain on liquidity, and operational issues (notably the shutdown of the FedWire) and the reluctance of banks to extend credit to FCMs and customers needing to meet margin calls came perilously close to causing the CCPs to fail.

The exchange CCPs were pipsqueaks by comparison to what we have today. The clearing mandates have supersized the clearing system, and commensurately increased the amount of liquidity needed to meet margin calls. The experience in the aftermath of the surprise Brexit vote illustrates just how dangerous this is.

As a result of Brexit, US Treasuries rallied by 32bp. The accompanying move in swap yields resulted in huge intra-day margin calls by multiple CCPs (LCH, CME, and Eurex). Madigan estimates that these calls totaled $25-$40 billion, and that some individual banks were asked to pony up multiple billions to meet margin calls from multiple CCPs. And to illustrate another thing I’ve been on about for years, they had to come up with the money in 60 minutes: failure to do so would have resulted in default. This provides a harrowing example of how tightly coupled the system is.

Some other crucial details. Much of the additional margin was to top up initial margin, meaning that the cash was sucked into the CCPs and kept there, rather than paid out to the net gainers, where it could have been recirculated. (Not that recirculating it would have been a panacea. Timing differences between flows of VM into and out of CCPs creates a need for liquidity. Moreover, recirculation by extension of credit is often problematic during periods of market stress, as that’s exactly when those who have liquidity are most likely to hoard it.)

Second, each CCP acted independently and called margin to protect its own interests. With multiple CCPs, there is a non-cooperative game between them. Each has an incentive to demand margin to protect itself, and to demand it before other CCPs do. The equilibrium in this game is inefficient because there is an externality between CCPs, and between CCPs and those who must meet the calls. This is ironic, because one of the alleged justifications for clearing mandates was the externalities present in the OTC derivatives markets. This is another example of how problems have been transformed, rather than truly banished.

This also illustrates another danger that I’ve pointed out for some time: building the levies high around CCPs just forces the floodwaters somewhere else.

Although there were some fraught moments for the banks who needed to stump up the cash on June 24, there were no defaults. But consider this. As I point out in the Risk article, Brexit was a known event and a known risk, and the banks had planned for it. Events like the October ’87 Crash or the September ’98 LTCM crisis are bolts from the blue. How will the system endure a surprise shock–especially one that could well be far larger than the Brexit move?

Horror stories are sometimes harmless ways to communicate real risks. Perhaps the Brexit event will be educational. Churchill once said that “Nothing in life is so exhilarating as to be shot at without result.” The market dodged a bullet on June 24. Will market participants, and crucially regulators, take heed of the lessons of Brexit and take measures to ensure that the next time it isn’t a head shot?

I have my doubts. The clearing mandate is a reality, and is almost certain to remain one. The fundamental transformation of clearing (from credit risk to liquidity risk) is an inherent part of the mechanism. It’s effects can be at most ameliorated, and perhaps the Brexit tremor will provide some guidance on how to do that. But I doubt that whatever is done will make the system able to survive The Big One.

Print Friendly

October 26, 2016

China Has Been Glencore’s Best Friend, But What China Giveth, China Can Taketh Away

Filed under: China,Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 3:55 pm

Back when Glencore was in extremis last year, I noted that although the company could do some things on its own (e.g., sell assets, cut dividends, reduce debt) to address its problems, its fate was largely out of its hands. Further, its fate was contingent on what happened to commodity prices–coal and copper in particular–and those prices would depend first and foremost on China, and hence on Chinese policy and politics.

Those prognostications have proven largely correct. The company executed a good turnaround plan, but it has received a huge assist from China. China’s heavy-handed intervention to cut thermal and coking coal output has led to a dramatic spike in coal prices. Whereas the steady decline in those prices had weighed heavily on Glencore’s fortunes in 2014 and 2015, the rapid rise in those prices in 2016 has largely retrieved those fortunes. Thermal coal prices are up almost 100 percent since mid-year, and coking coal has risen 240 percent from its lows.

As a result, Glencore was just able to secure almost $100/ton for a thermal coal contract with a major Japanese buyer–up 50 percent from last year’s contract. It is anticipated that this is a harbinger for other major sales contracts.

The company will not capture the entire rally in prices, because it had hedged about 50 percent of its output for 2016. But that means 50 percent wasn’t hedged, and the price rise on those unhedged tons will provide a substantial profit for the company. (This dependence of the company on flat prices indicates that it is not so much a trader anymore, as an upstream producer married to a big trading operation.) (Given that hedges are presumably marked-to-market and collateralized, and hence require Glencore to make cash payments on its derivatives at the time prices rise, I wonder if the rally has created any cash flow issues due to mismatches in cash flows between physical coal sales and derivatives held as hedges.)

So Chinese policy has been Glencore’s best friend so far in 2016. But don’t get too excited. Now the Chinese are concerned that they might have overdone things. The government has just called an emergency meeting with 20 major coal producers to figure out how to raise output in order to lower prices:

China’s state planner has called another last-minute meeting to discuss with more than 20 coal mines more steps to boost supplies to electric utilities and tame a rally in thermal coal prices, according to two sources and local press.

The National Development and Reform Commission (NDRC) has convened a meeting with 22 coal miners for Tuesday to discuss ways to guarantee supply during the winter while sticking to the government’s long-term goal of removing excess inefficient capacity, according to a document inviting companies to the meeting seen by Reuters.

What China giveth, China might taketh away.

All this policy to-and-fro has, of course is leading to speculation about Chinese government policy. This contributes to considerable price volatility, a classic example of policy-induced volatility, which is far more common that policies that reduce volatility.

Presumably this uncertainty will induce Glencore to try to lock in more customers (which is a form of hedging). It might also increase its paper hedging, because a policy U-turn in China (about which your guess and Glencore’s guess are as good as mine) is always a possibility, and could send prices plunging again.

So when I said last year that Glencore was hostage to coal prices, and hence to Chinese government policy–well, here’s the proof. It’s worked in the company’s favor so far, but given the competing interests (electricity generators, steel firms, banks, etc.) affected by commodity prices, a major policy adjustment is a real possibility. Glencore–and other major commodity producers, especially in coal and ferrous metals–remain hostages to Chinese policy and hence Chinese politics.

Print Friendly

Next Page »

Powered by WordPress