Streetwise Professor

July 4, 2017

Donald Trump, LNG Impressario: Demolishing the Putin Puppet Narrative

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 9:50 am

If Trump has a signature policy issue, it is promoting US energy to achieve what he calls “energy dominance.” The leading edge of this initiative is the promotion of LNG. Immediately prior to his appearance at the G20 Summit (where ironically he will be tediously hectored on trade by the increasing insufferable Angela Merkel), he will speak Thursday at the “Three Seas Summit” in Poland, where he will tout American LNG exports as both an economic and security fillip to Europe, and in particular eastern Europe.

“I think the United States can show itself as a benevolent country by exporting energy and by helping countries that don’t have adequate supplies become more self-sufficient and less dependent and less threatened,” he said.

This strikes at the foundation of Putin’s economic and geopolitical strategy. Export revenues from gas and oil keep his country afloat and his cronies flush. He uses gas in particular as a knout to bludgeon recalcitrant eastern Europeans (Ukraine in particular) and as a lever to exercise influence in western Europe, Germany in particular.

Gazprom routinely sniffs that LNG is more costly than Russian gas, and that LNG will not appreciable erode its market share. That’s true, but illustrates perfectly the limitations of market share as a measure of economic impact. The increased availability of LNG, particularly from the US, increases substantially the elasticity of supply into Europe. This, in turn, substantially increases the elasticity of demand. As the low cost producer (pipeline gas being cheaper), Russia/Gazprom will continue to be the source of the bulk of the methane molecules burned in Europe, but this increased elasticity of demand will reduce Gazprom’s pricing power and hence its revenues.

Furthermore, the effect on short-run elasticities will be particularly acute. Pre-LNG, there were few sources of additional supply available in a period of days or weeks that could substitute for Russian gas cutoff during some geopolitical power play. With LNG, the threat of shutting off the gas has lost much of its sting: especially as LNG evolves towards a traded market, supplies can swing quickly to offset any regional supply disruption, including one engineered by Putin for political purposes. So LNG arguably reduces Putin’s political leverage even more than it reduces his economic leverage. This is particularly true given complementary European policy changes that permit the flow of gas to regions not serviced by LNG directly.

Trump is getting some pushback from domestic interests in the US (notably the chemical industry) because greater exports would support prices and deprive these industries of the cheap fuel and feedstock that has powered their growth (something totally unpredictable a decade ago, when the demise of the US petrochemical industry was a real possibility). But (a) Trump seems totally committed to his pro-export course, and (b) complementary efforts to reduce restrictions on supply will mitigate the price impact. So I expect the opposition of the likes of the Industrial Energy Consumers of America to be little more than a speed bump in his race to promoting energy exports.

This all reveals Trump for the mercantilist he is: imports bad, exports good. This is economically illiterate and incoherent, but it’s Trump trade policy in a nutshell. Economic coherence aside, however, Donald Trump, LNG Impressario totally demolishes the Putin puppet narrative. Not that you’d notice–the hysteria continues unabated, because reality doesn’t matter to the soi disant reality-based community.

Here we have Trump devoting the bulk of his non-Twitter-directed energies (and he is high energy!) to promoting an economic policy that hits Putin at his most vulnerable spot, economically and geopolitically. Whatever his Russia-related rhetoric, pace Orwell, he is objectively anti-Putin.

Not that this causes neo-McCarthyites even to experience cognitive dissonance, let alone to engage in a serious re-evaluation. To them, Trump is literally a Kremlin operative in Putin’s thrall. And nothing–not even Trump venturing to the heart of the area Putin and his ilk believe to be in Russia’s sphere of influence and loudly (very loudly) proclaiming that he is offering American gas to free Europe from its energy thralldom–will divert them from their non-stop narrative.

As an aside, I do Joseph McCarthy a grave disservice by comparing today’s mainstream media, the Democratic Party, Neocons, and large swathes of the Republican establishment to him. There was actually a far more substantial factual basis for his paranoia than there is for that of the anti-Trump brigades.

There is an irony here, though. I have often sneered at Putin (and when he was president, Medvedev), for acting like a glorified Secretary of Commerce, going around being the pitchman for Russian economic interests, in energy in particular. Stylistically, Trump is doing somewhat the same. But substantively, in Making American Energy (LNG particularly) Great, Trump is giving Putin a good swift kick in the stones.

Not that the promoters of the New Red Scare are paying the slightest heed. Which demonstrates that theirs is a completely partisan and grotesquely intellectually dishonest campaign.

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July 1, 2017

All Flaws Great and Small, Frankendodd Edition

On Wednesday I had the privilege to deliver the keynote at the FOW Trading Chicago event. My theme was the fundamental flaws in Frankendodd–you’re shocked, I’m sure.

What I attempted to do was to categorize the errors. I identified four basic types.

Unintended consequences contrary to the objectives of DFA. This could also be called “counter-intended consequences”–not just unintended, but the precise opposite of the stated intent. The biggest example is, well, related to bigness. If you wanted to summarize a primary objective of DFA, it would be “to reduce the too big to fail problem.” Well, the very nature of DFA means that in some ways it exacerbates TBTF. Most notably, the resulting regulatory burdens actually favor scale, because they impose largely fixed costs. I didn’t mention this in my talk, but a related effect is that increasing regulation leads to greater influence activities by the regulated, and for a variety of reasons this tends to favor the big over the medium and small.

Perhaps the most telling example of the perverse effects of DFA is that it has dramatically increased concentration among FCMs. This exacerbates a variety of sources of systemic risk, including concentration risk at CCPs; difficulties in managing defaulted positions and porting the positions of the customers of troubled FCMs; and greater interconnections across CCPs. Concentration also fundamentally undermines the ability of CCPs to mutualize default risk. It can also create wrong-way risks as the big FCMs are in some cases also sources of liquidity support to CCPs.

I could go on.

Creation of new risks due to misdiagnoses of old risks. The most telling example here is the clearing and collateral mandates, which were predicated on the view that too much credit was extended via OTC derivatives transactions. Collateral and netting were expected to reduce this credit risk.

This is a category error. For one thing, it embodies a fallacy of composition: reducing credit in one piece of an interconnected financial system that possesses numerous ways to create credit exposures does not necessarily reduce credit risk in the system as a whole. For another, even to the extent that reducing credit extended via derivatives transactions reduces overall credit exposures in the financial system, it does so by creating another risk–liquidity risk. This risk is in my view more pernicious for many reasons. One reason is that it is inherently wrong-way in nature: the mandates increase demands for liquidity precisely during those periods in which liquidity supply typically contracts. Another is that it increases the tightness of coupling in the financial system. Tight coupling increases the risk of catastrophic failure, and makes the system more vulnerable to a variety of different disruptions (e.g., operational risks such as the temporary failure of a part of the payments system).

As the Clearing Cassandra I warned about this early and often, to little avail–and indeed, often to derision and scorn. Belatedly regulators are coming to an understanding of the importance of this issue. Fed governor Jerome Powell recently emphasized this issue in a speech, and recommended CCPs engage in liquidity stress testing. In a scathing report, the CFTC Inspector General criticized the agency’s cost-benefit analysis of its margin rules for non-cleared swaps, based largely on its failure to consider liquidity effects. (The IG report generously cited my work several times.

But these are at best palliatives. The fundamental problem is inherent in the super-sizing of clearing and margining, and that problem is here to stay.

Imposition of “solutions” to non-existent problems. The best examples of this are the SEF mandate and position limits. The mode of execution of OTC swaps was not a source of systemic risk, and was not problematic even for reasons unrelated to systemic risk. Mandating a change to the freely-chosen modes of transaction execution has imposed compliance costs, and has also resulted in a fragmented swaps market: those who can escape the mandate (e.g., European banks trading € swaps) have done so, leading to bifurcation of the market for € swaps, which (a) reduces competition (another counter-intended consequence), and (b) reduces liquidity (also counter-intended).

The non-existence of a problem that position limits could solve is best illustrated by the pathetically flimsy justification for the rule set out in the CFTC’s proposal: the main example the CFTC mentioned is the Hunt silver episode. As I said during my talk, this is ancient history: when do we get to the Trojan War? If anything, the Hunts are the exception that proves the rule. The CFTC also pointed to Amaranth, but (a) failed to show that Amaranth’s activities caused “unreasonable and unwarranted price fluctuations,” and (b) did not demonstrate that (unlike the Hunt case) that Amaranth’s financial distress posed any threat to the broader market or any systemic risk.

It is sickly amusing that the CFTC touts that based on historical data, the proposed limits would constrain few, if any market participants. In other words, an entire industry must bear the burden of complying with a rule that the CFTC itself says would seldom be binding. Makes total sense, and surely passes a rigorous cost-benefit test! Constraining positions is unlikely to affect materially the likelihood of “unreasonable and unwarranted price fluctuations”. Regardless, positions are not likely to be constrained. Meaning that the probability that the regulation reduces such price fluctuations is close to zero, if not exactly equal to zero. Yet there would be an onerous, and ongoing cost to compliance. Not to mention that when the regulation would in fact bind, it would potentially constrain efficient risk transfer.

The “comma and footnote” problem. Such a long and dense piece of legislation, and the long and detailed regulations that it has spawned, inevitably contain problems that can lead to protracted disputes, and/or unpleasant surprises. The comma I refer to is in the position limit language of the DFA itself: as noted in the court decision that stymied the original CFTC position limit rule, the placement of the comma affects whether the language in the statute requires the CFTC to impose limits, or merely gives it the discretionary authority to do so in the even that it makes an explicit finding that the limits are required to reduce unwarranted and unreasonable price fluctuations. The footnotes I am thinking of were in the SEF rule: footnote 88 dramatically increased the scope of the rule, while footnote 513 circumscribed it.

And new issues of this sort crop up regularly, almost 7 years after the passage of Dodd-Frank. Recently Risk highlighted the fact that in its proposal for capital requirements on swap dealers, the CFTC (inadvertently?) potentially made it far more costly for companies like BP and Shell to become swap dealers. Specifically, whereas the Fed defines a financial company as one in which more than 85 percent of its activities are financial in nature, the CFTC proposes that a company can take advantage of more favorable capital requirements if its financial activities are less than 15 percent of its overall activities. Meaning, for example, a company with 80 percent financial activity would not count as a financial company under Fed rules, but would under the proposed CFTC rule. This basically makes it impossible for predominately commodity companies like BP and Shell to take advantage of preferential capital treatment specifically included for them and their ilk in DFA. To the extent that these firms decide to incur costs (higher capital costs, or the cost of reorganizing their businesses to escape the rule’s bite) and become swap dealers nonetheless, that cost will not generate any benefit. To the extent that they decide that it is not worth the cost, the swaps market will be more concentrated and less competitive (more counter-intended effects).

The position limits proposed regs provide a further example of this devil-in-the-details problem. The idea of a hedging carveout is eminently sensible, but the specifics of the CFTC’s hedging exemptions were unduly restrictive.

I could probably add more categories to the list. Different taxonomies are possible. But I think the foregoing is a useful way of thinking about the fundamental flaws in Frankendodd.

I’ll close with something that could make you feel better–or worse! For all the flaws in Frankendodd, MiFID II and EMIR make it look like a model of legislative and regulatory wisdom. The Europeans have managed to make errors in all of these categories–only more of them, and more egregious ones. For instance, as bad as the the US position limit proposal is, it pales in comparison to the position limit regulations that the Europeans are poised to inflict on their firms and their markets.

 

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June 24, 2017

Why Are Progressives Fawning Over Proto-Classical Liberal Ibn Khaldun?

Filed under: Economics,Politics — The Professor @ 9:56 pm

This article about the 14th century Arab/Muslim scholar and proto-economist Ibn Khaldun has attracted great deal of attention from the leftist progressive set, including leftist progressive economists like Paul Krugman. In part, that’s because the author (Dániel Oláh) bashes those that Krugman et al love to hate, neoclassical (now often style “neoliberal”) economists. The piece’s subtitle is “neoclassical economists created a false narrative of the history of economics,” and it concludes with this rather bizarre screed:

But why do we need a new narrative, rediscovering our past? The answer is simple: to avoid such superficial beliefs that Adam Smith (or Ibn Khaldun) is the father of economics, the development of economics started in the New Age to culminate in neoclassical thought, Khaldun already invented the Laffer-curve, the financial market effectively regulates itself or a big government is always bad for the economy – among others. Economists have to exercise self-reflection: the crisis of 2008 proved that gaps in the mainstream transform easily into policy mistakes.

With a new, more plural approach to history of thought the Alzheimer’s disease of mainstream economics can be cured which is badly needed in the 21th century.

There’s another reason for the leftist love, of course: it is very fashionable to embrace the Muslim Other, because they are now the most potent foe of the leftist progressives’ real enemy: more traditionalist Westerners and traditional Western thought. (The refusal of self-described feminists to confront Muslim misogyny, and indeed, their desire to silence those who do attempt to confront it is the most flagrant example of this odd alliance between progressives and a socio-religious group that is as objectively at odds with progressive ideals as one can possibly imagine.)

Substantively, it does appear based on my limited exposure to him that Ibn Khaldun was indeed well ahead of his time, and that his insights were quite penetrating. Further, it seems bizarre to make him into some progressive poster boy, given that much of what he says indeed could be characterized as classical liberal thinking. If he was Adam Smith before Adam Smith–and the case can be made–then why do the enemies of Adam Smith claim him for their own, other than that they have found a way to conscript him in their war against their real enemies, the intellectual descendants of Adam Smith?

And it is the issue of descendants which holds the real meaning here: Ibn Khaldun apparently had few, if any, whereas Smith’s were legion.* That raises issues of true importance: why would the intellectual line of a flourishing civilization die out and fade into obscurity, whereas the product of a hardscrabble society like 18th century Scotland (which was largely wild and untamed not long before) be the progenitor of a great intellectual tradition?

And it is not only scholarship. A friend once sent me pictures she took of pages of her kids’ social studies textbook that lavishly praised how economically and socially advanced the Muslim world was in the Middle Ages, when Europe was mired in poverty and strife. Scotland during the time of Ibn Khaldun was dreary, violent, pastoral, and poor. Yet by the time of Adam Smith, Scotland (and other places in the British Isles and Continental Europe like the Netherlands) were advancing rapidly economically and socially, while once flourishing Arab Muslim lands were undergoing a secular decline that in many respects continues to this day.

Those who sing the praises of the Glory Days of the Muslim world–like the very PC authors of the aforementioned social studies text–beg these very important questions. What caused these reversals of fortune? It’s also rather strange: rather than somehow validating the current value of The Other, this heaping of praise on long past glories actually casts an unflattering light on present despair, revealing that there is something deeply dysfunctional in that society that led to their absolute and relative decline. How could a civilization that was so far ahead (according to the textbook telling, and likely the truth), fall so far behind?

Of course, one response to that question advanced by the left is that like other non-Western societies, the Arab world was victimized, exploited, and degraded by the colonialist West. But that again just poses the same question in a slightly different form: how could relative economic, social, and military capacities change so dramatically to permit the once marginal Occident that quaked in fear before “Mohammedans” and “Musselmans” to master the once dominant Muslim Orient?

These are large questions for which there are no easy answers. But ironically, part of the answer may be that the ideas and institutions now known as classical liberal that were present in Ibn Khaldun’s work did not take root in the Arab and then Ottoman worlds, whereas they did in Adam Smith’s UK, the Netherlands, the United States, and elsewhere (and somewhat later) in northern Europe. That Ibn Khaldun’s prescient insights did not reflect the realities of his society, whereas Adam Smith’s did.

 

Oláh’s article notes that Ronald Reagan praised Ibn Khaldun. Indeed, it appears that there is a greater intellectual affinity between Reagan and Khaldun than between Krugman and the Andalusian, which just makes plain the PC-driven superficiality of the progressives’ recent praise for him.

* Oláh notes that it is unknown whether Smith knew of Ibn Khaldun’s work. I consider it unlikely. The phenomenon of multiple independent discoveries of important ideas is well known. The sociologist Robert K. Merton posited the theory of multiple independent discovery. Ironically, his son, Robert C. Merton, illustrates that: Merton fils was a co-discoverer with Black & Scholes of preference free options pricing. [Stephen] Stigler’s Law of Eponymy states that no law is named for its original discovery: ironically, Stigler said that his law should have been named after Merton, and hence provides an illustration of his law. Stigler’s father George wrote an article about multiple discoveries in economics, titled “Merton on Multiples, Denied and Affirmed.” George Stigler was editor of the JPE when it published the Black-Scholes article. So there are multiple family connections in the intellectual history of the theory of multiple discoveries.

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June 17, 2017

We Can Now Bound From Above the Price of German Principles

Filed under: Commodities,Economics,Energy,History,Military,Politics,Russia — The Professor @ 12:30 pm

If you really concentrate, I’m sure you can stretch your memory to recall those long past days when Angela Merkel was hailed as the new Leader of the Free World, most notably because of her stalwart stance on Russia, in contrast to Trump, who was deemed a squish on Russia at best, and a collaborationist at worst. But that was so . . . May. Now in mid-June, the Germans and much of the rest of Europe and their fellow travelers here in the US are totally losing it over the 98-2 vote in the US Senate (the two dissenters being ideological bookends Rand Paul and Bernie Sanders) to strengthen the sanctions regime on Russia, and notably, to limit Trump’s ability to relax sanctions unilaterally.

So: In May, soft on Russia bad, hard on Russia good. In June, hard on Russia bad. In May, Trump had too much power. In June, limiting Trump’s power is inexcusable.

What changed? Actually nothing changed. This is volte face reflects an enduring constant: German commercial interests. The Senate sanctions bill would impose potential penalties on those assisting in the construction of Russian pipelines, most notably NordStream 2. NordStream 2 is a joint project between Gazprom and a handful of major European, and particularly German, corporate behemoths.

German explanations of the motivation behind the Senate’s action betray extreme psychological projection. Echoing Gazprom (an action which if you were to do it in the US would immediately bring down upon on your head screams of “RUSSIAN TROLL”), several European policymakers have claimed that this action was intended to advance the interests of US LNG exporters.

Um, no. Not even close. The objections of the US to NordStream date back to the Obama administration, which was hardly a major promoter of the US natural gas industry. Further, the main drivers in the Senate were people like McCain, for whom economic considerations are tertiary, at best: McCain et al have had it in for Russia generally and NordStream particularly for geopolitical reasons, and their opposition dates back years. Moreover, the bill reflects the current anti-Russia hysteria in the US, which in turn reflects a strange mix of political factors, not least of which is the clinical insanity of the Democratic Party post-November, 2016.

Indeed, US opposition to Russian gas pipelines into Europe dates back to the Reagan administration. The US tried to stop the pipelines through Ukraine that Putin is now trying to outflank with NordStream, because it thought the pipelines provided an economic benefit to the USSR and made Europe hostage to Russian economic pressure. This was in fact a source of one of the few disagreements between Thatcher (who supported the pipelines) and Reagan.

How much did the US hate the USSR-Europe gas pipelines, you ask? Enough to blow them up. Blow them up real good: “The result was the most monumental non-nuclear explosion and fire ever seen from space.”

Those who claim economic motivations say a lot more about themselves than they do about the US Senate: adopting a policy to advance German/European economic interests is exactly what they would do, and they are projecting this motivation on the US.  Indeed, the Germans’ hysterical reaction demonstrates just how important economic considerations are to them, and how marginal are geopolitical considerations vis-a-vis Russia.

If you think the Russians are as big a threat as the Germans and other gas-poor nations say, they should be deeply grateful for the emergence of US LNG which reduces their dependence on the evil Russkies. But the Germans say: we don’t want your methadone, we’d rather continue to buy smack from this really nasty dealer.

The hypocrisy and projection don’t stop there. Of course German economic policy is strongly oriented towards boosting its exports, often at the cost of beggaring its supposed European brothers and sisters (especially the swarthy ones down south). What’s good for zee goose, kameraden. .  .

Further, recall (if you can remember back that far) that one reason for the German/European freakout over Trump in May was his refusal to acknowledge solidarity with our allies by mouthing the words “Article 5.” All for one! One for all!

Right?

Well, eastern Europeans–the Poles in particular–think that NordStream basically sells them out to the Russians in order to benefit Germany. The Germans have totally blown off this criticism, and have subjected the Poles and Baltic States to considerable criticism and pressure for their opposition to NordStream. So much for European solidarity. It’s all for one, all right: that one being Germany. That one for all . . . not so much.

It gets better! Merkel and other Euros are fond of saying “more Europe.” Well, that’s exactly what the dispute and the sanctions are about, isn’t it? The economics of NordStream 2 are dubious, but it presents a nearly existential threat to Ukraine. The entire reason for the conflict in Donbas and the seizure of Crimea (conflicts that Merkel is allegedly attempting to mediate) were Ukraine’s attempt to move closer to Europe.

That is: (1) Ukraine takes “more Europe” seriously, and enters into an agreement with the EU that would open up trade with an eye on Ukraine joining the union in the future, (2) Putin takes exception to this, and initiates a series of actions that culminate with the ouster of Yanukovych followed by the seizure of Crimea, and a hot war in Donbas, (3) the US Senate attempts to penalize Russian actions by sanctions, and (4) the Europeans scream bloody murder at US intrusion into their policy domain.

In other words, when forced to put their money (and their gas) where their mouths are, the Europeans jettison “more Europe”. And then turn around and slag the US for taking them at their word.

Hey, they can do what they want. And the US can do what it wants. Just spare me the sanctimonious bullshit about standing up to Russia, European solidarity, more Europe, and on and on. It’s all about the Euros, baby–€–and German € in particular. Every “principle” that supposedly earned Merkel the designation as Leader of the Free World went out the window in a nanosecond, once some big German companies were going to have to pay a price for those principles.

We can now bound from above the price of German principles. The upper bound is in the billions of Euros. I am sure that the true price is far lower than that.

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June 8, 2017

Rosneft Follies, Redux

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 1:16 pm

Sarah Mcfarlane dropped a long piece in the WSJ claiming that the already sketchy Rosneft-QIA-Glencore deal was even sketchier than it appeared at the time, hard as that is to believe. Specifically, according to Sarah (and Summer Said), Putin and the emir of Qatar, Sheikh Tamim bin Hamad Al Thani, agreed in that Russia would repurchase the stake at a future date:

Moscow agreed with Qatar that Russia would buy back at least a portion of the stake from the rich Persian Gulf emirate, the people said. The Qatar Investment Authority and Glencore, the Swiss-based commodities giant, formed a partnership to buy the 19.5% stake in Russia’s energy jewel at a time when Mr. Putin’s government needed cash.

The people with knowledge of the deal say the buyback arrangement was negotiated with involvement from Mr. Putin and the emir of Qatar, Sheikh Tamim bin Hamad Al Thani. Russia and Qatar saw it as an opportunity to build a bridge between countries that had taken up opposite sides in the Syrian civil war, the people said. One of the people said the buyback would happen in the next 10 years.

Color me skeptical. For one thing, Glencore is a principal in the deal, and it would have to sign off too: the story does not assert, claim, suggest, or imply that Glencore did so. Both Glencore and QIA vigorously deny the story, for whatever that’s worth, as do the Russians. (As an aside, a source in Russia tells me that Ivan Glasenberg refused to discuss anything about the deal recently. Why the UK authorities and the LSE are so willing to accept the extremely deficient disclosure by a major UK issuer relating to a major transaction is beyond me. Maybe they are trying to convince Saudi Aramco that if it lists in London, it can do pretty much anything anywhere, no questions asked! BP’s silence is also curious.)

For another thing, Putin saying “I’ll buy it back later” without a mechanism to determine price is meaningless. I smile when I think about the number of times going back to at least 2006 the Russians announced that they had almost completed a gas deal with China: all that remained to determine was the price! And this went on year, after year, after year.  In other words, no agreement on pricing means no real agreement.

This is pretty funny:

Qatar wanted its Rosneft stake to be temporary, the people said. The emirate believes it will profit from selling the shares back to Russia at a later date, the people said, betting that oil prices will rise and push up Rosneft’s share price. Qatar saw the political benefits of giving Russia access to quick cash as a sort of loan to address a budget deficit that had widened due to lower oil prices, the people said.

In the 7 months (to the day) since the deal was announced, this has turned out to be a bad bet: Rosneft’s stock is down about 12 percent in Euros. (It’s down about 18 percent in rubles.)

This raises some other crucial issues. The €2.8 billion that QIA and Glencore put down represents about 26 percent of the value of the deal. Meaning that about one-half of the equity cushion is gone. Thus, the indemnities and guarantees that the Russian banks provided Glencore (there is no clarity on whether they similarly indemnified the QIA portion of the loan, but its non-recourse nature suggests they did) are getting pretty close to being in the money. Given the recent bloodbath in the oil market there is a decent probability that the loan will be underwater in the near to medium term.

Intesa’s statement suggests that QIA is indemnified/guaranteed too:

An Intesa spokesman said the loan to the Qatar/Glencore partnership “is covered by a robust package of guarantees.” Intesa is trying to spread the risk of its loan by syndicating it to other banks, but a person familiar with the matter said the bank hasn’t yet found willing banks.

The syndication part makes me laugh. Um, you’re kinda supposed to arrange the syndication at the front end, either before the deal or shortly (I mean days) afterwards. Seven months later, when you have zero negotiating leverage because you already are wearing the entire loan? With about half the equity cushion gone? With the loans being backed by Russian banks that are (a) not in the most robust health, and (b) under a cloud due to Russian sins real, and recently, feverishly imagined? Yeah, that will be an easy sell! I’m sure other banks are just lining up for a piece of that!

In bocca al lupo, signori!

The story suggests that Putin pressured Sechin to stitch together this Frankenstein’s monster to address pressing budget issues. I have no doubt that this was done under duress, but less because of budget than because of prestige and reputation. Putin had said that a stake in the company would be privatized in 2016, and to a non-Russian buyer. So Putin put his reputation on the line, and Sechin had to come through.

But virtually all the downside risk resides in Russia (something I pointed out early). So although the deal (a) generated some cash inflow that did address some budget issues, and (b) provided some reputational benefits (for a few weeks, anyway), it did nothing to mitigate the Russian government’s exposure to Rosneft’s downside, but did give away the upside. In essence, Putin and Sechin got their PR play by giving away a put on Rosneft. That’s what enticed QIA and Glencore.

In other news from the bizarre world of Russian–and Rosneft specifically–transactions, the Rosneft/Sechin-Sistema litigation rolls on. Indeed, Sechin increased his demands by more than 50 percent, from $1.9b to $3b. My same Russian source says all of Russia is mystified by this, but he did provide a valuable tidbit.

What had mystified me was how Rosneft could go after Sistema when it bought Bashneft from the state. Well, apparently Igor was in such a hurry to complete the deal that Rosneft didn’t begin the audit/due diligence until after the deal was completed! 

Why was Igor in a hurry? My guess is that Putin had opposed Rosneft’s purchase in August, and changed his mind in September, and Sechin wanted to move before Putin changed his mind again.

Perhaps Igor was thinking that if the audit uncovered irregularities, he could get a Russian court to give him a mulligan and claw back the money. In which case, the current litigation might have been part of the plan (at least as a contingency) all along.

I’m still puzzled, though, because some of the things Sechin goes on about (e.g., the sale of Bashneft’s oilfield services business to a Sistema entity, and the subsequent contract between Bashneft and that entity for said services) was known about before. So maybe Igor is just throwing everything into the litigation claim, even when it doesn’t make any sense. After all, this isn’t being heard in a London court or arbitration in a European country: although this is an intra-Russian dispute, Sechin definitely has home field advantage.

Keep this all in mind whenever anyone (and now it seems that means pretty much everyone) tries to scare you about the Russian bogeyman. The follies of one of Russia’s premier companies, a so-called national champion, illustrate just what a ramshackle, and at times clownish, contraption the Russian state is. Putin does a great Wizard of Oz imitation, but when Toto pulls back the curtain as has happened with the Rosneft/Glencore/QIA deal, you’ll see that there’s a little man blowing a lot of smoke.

 

 

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June 2, 2017

Trump Rejects the Climate Gateway Drug: Global Progressives Go All Spanish Inquisition

Filed under: China,Climate Change,Economics,Energy,Politics — The Professor @ 7:00 am

The wailing, gnashing of teeth, and rending of garments that has followed Trump’s widely expected decision to withdraw the US from the Paris Climate Accord is truly amazing to witness. It is virtue signaling taken to a new extreme. Indeed, since so many people want to signal simultaneously, each apparently feels obliged to outdo the other in hysterics in order to attract the attention their precious egos crave. Hence the apocalyptic paroxysms of rage that started the moment Trump spoke.

Truth be told, even if one believes the predictions of standard climate models, and even if one believes there will be compliance with the commitments of the Accord (which is slightly less likely than my becoming Pope), it would have a trivial impact on global temperatures: on the order of .2 degrees. The impact of the US withdrawal alone, given its declining CO2 emissions relatively (especially compared to China and India) and even absolutely (something the pious Europeans have not been able to manage despite their moribund economy and costly—and insane–commitment to renewables), means that Trump’s action by itself will have an immeasurable effect on climate in any time frame.

So despite all of the screeching that Trump has doomed—doomed I say!—life on earth, in reality the accord is not a practical agreement, but a ritual. And like all rituals, its primary purpose is to provide an opportunity to display obeisance to a creed, theology, doctrine, or dogma.

Which explains the overwrought reaction: those rejecting creeds, theologies, doctrines, and dogmas are heretics, and heretics must be attacked, ostracized, ridiculed, and in the dreams of some, burned. Trump is accused of heresy on three counts — heresy by thought, heresy by word, heresy by deed, and heresy by action — four counts! Yet he does not confess, and indeed revels in his heresy, only infuriating his inquisitors all the more.

There is much dispute over the concrete effects of Paris qua Paris. Some claim it is merely symbolic. Others claim that it will lead to real policy changes. Whatever the practical effects, there is no doubt about the ambitions of those pushing Paris, and Trump rejected them all. He rejected the delegation of authority over the United States to an unelected and unaccountable (self-perceived but actually utterly failed) elite. He rejected the exploitation of climate concerns to implement a vast scheme of international wealth redistribution.

And perhaps most importantly, he called out, confronted, and rejected the role of Paris as a gateway drug to even more intrusive supranational elite control and power:

The risks grow as historically these agreements only tend to become more and more ambitious over time.  In other words, the Paris framework is a starting point — as bad as it is — not an end point.  And exiting the agreement protects the United States from future intrusions on the United States’ sovereignty and massive future legal liability.  Believe me, we have massive legal liability if we stay in.

Absolutely. Climate concerns (hysteria, really) have become an engine for rent seeking and power grabbing on a global scale never seen before, and it needs to be throttled in the crib. For it is evident from years of experience how the leftist-statist-dirigiste march through the institutions works. Stake out a modest set of policies to achieve a lofty goal. When the policies fall short, impose more draconian ones. When those policies in turn fail, unleash more bureaucratic dragoons to intrude on every aspect of institutional life. And in this case, the institution at stake is the world. Better to stop it now, then to watch it metastasize later.

The reaction has been predictable. Corporate rent seekers—Goldman Sachs’ Lloyd Blackfein, GE’s Jeffrey Immelt, and our favorite among them Elon Musk—have expressed their rage and dismay. Political power seekers, the Euros most notable among them, are beside themselves.

The Euros are particularly amusing. After Trump spurned them, they are now looking to China’s Xie for climate policy leadership, just as they did on “free trade” at Davos. Daddy didn’t give them what they wanted, so they are throwing themselves into the arms of the leader of a biker gang. That will show that meanie, harrumph!

That won’t end well, and don’t bother come crying to us when it doesn’t! China is a mercantilist environmental disaster that will pump out increasing quantities of CO2 for the foreseeable future. China is in this for China, and will exploit climate policy to advance its economic interests while paying lip service to green pieties. Only the willfully self-deluded refuse to see otherwise.

The economic costs of any actual implementation of Paris promises would have dwarfed any benefits accruing to its effects on climate. Force-feeding of renewables will increase energy costs, thereby impairing growth—which will have a disproportionate effect on the poor. Taxes to fund global wealth transfers will have similar effects: and if you think that money transferred to poor countries is going to go to the poor, rather than sticky-fingered elites, you are truly a fool.

So Donald Trump has said we’ll never have Paris. And that’s a damn good thing. Arguably the best thing he’s done—and the shrieking of global progressives is about the best proof of that I can think of.

 

 

 

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May 30, 2017

Clearing Fragmentation Follies: We’re From the European Commission, and We’re Here to Help You

Filed under: Clearing,Derivatives,Economics,Financial Crisis II,Politics,Regulation — The Professor @ 6:33 am

Earlier this month came news that the European Commission was preparing legislation that would require clearing of Euro derivatives to take place in the Eurozone, rather than in the UK, which presently dominates. This has been an obsession with the Euros since before Brexit: Brexit has only intensified the efforts, and provided a convenient rationalization for doing so.

The stated rationale is that the EU (and the ECB) need regulatory control over clearing of Euro-denominated derivatives because a problem at the CCP that clears them could have destabilizing effects on the Eurozone, and could necessitate the ECB providing liquidity support to the CCP in the event of trouble. If they are going to support it in extremis, they are going to need to have oversight, they claim.

Several things to note here. First, it is possible to have a regulatory line of sight without having jurisdiction. Note that the USD clearing business at LCH is substantially larger than the € clearing business there, yet the Fed, the Treasury, and Congress are fine with that, and are not insisting that all USD clearing be done stateside. They realize that there are other considerations (which I discuss more below): to simplify, they realize that London has become a dominant clearing center for good economic reasons, and that the economies of scale and scope clearing mean that concentration of clearing produces some efficiencies. Further, they realize that it is possible to have sufficient information to ensure that the foreign-domiciled CCP is acting prudently and not taking undue risks.

Canada is another example. A few years ago I wrote a white paper (under the aegis of the Canadian Market Infrastructure Committee) that argued that it would be efficient for Canada to permit clearing of C$ derivatives in London, rather than to require the establishment and use of a Canadian CCP. The Bank of Canada and the Canadian government agreed, and did not mandate the creation of a maple leaf CCP.

Second, if the Europeans think that by moving € clearing away from LCH that they will be immune from any problems there, they are sadly mistaken. The clearing firms that dominate in LCH will also be dominant in any Europe-domiciled € CCP, and a problem at LCH will be shared with the Euro CCP, either because the problem arises because of a problem at a firm that is a clearing member of both, or because an issue at LCH not originally arising from a CM problem will adversely affect all its CMs, and hence be communicated to other CCPs.  Consider, for example, the self-preserving way that LCH acted in the immediate aftermath of Brexit: this put liquidity demands on all its clearing members. With fragmented clearing, these strains would have been communicated to a Eurozone CCP.

When risks are independent, diversification and redundancy tend to reduce risk of catastrophic failure: when risks are not independent, they can either fail to reduce the risk substantially, or actually increase it. For instance, if the failure of CCP 1 likely causes the failure of CCP 2, having two CCPs actually increases the probability of a catastrophe (given a probability of CCP failure). CCP risks are not independent, but highly dependent. This means that fragmentation could well increase the problem of a clearing crisis, and is unlikely to reduce it.

This raises another issue: dealing with a crisis will be more complicated, the more fragmented is clearing. Two self-preserving CCPs have an incentive to take actions that may well hurt the other. Relatedly, managing the positions of a defaulted CM will be more complicated because this requires coordination across self-interested CCPs. Due to the breaking of netting sets, liquidity strains during a crisis are likely to be greater in a crisis with multiple CCPs (and here is where the self-preservation instincts of the two CCPs are likely to present the biggest problems).

Thus, (a) it is quite likely that fragmentation of clearing does not reduce, and may increase, the probability of a systemic shock involving CCPs, and (b) conditional on some systemic event, fragmented CCPs will respond less effectively than a single one.

The foregoing relates to how CCP fragmentation will affect markets during a systemic event. Fragmentation also affects the day-to-day economics of clearing. The breaking of netting sets resulting from the splitting off of € will increase collateral requirements. Perverse regulations, such as Basel III’s insistence on treating customer collateral as a CM asset against which capital must be held per the leverage requirement, will cause the collateral increase to increase substantially of providing clearing services.

Fragmentation will also result in costly duplication of activities, both across CCPs, and across CMs. For instance, it will entail duplicative oversight of CMs that clear both at LCH and the Eurozone CCP, and CMs that are members of both will have to staff separate interfaces with each. There will also be duplicative investments in IT (and the greater the number of IT potential points of failure, the greater the likelihood of at least one failure, which is almost certain to have deleterious consequences for CMs, and the other CCP). Fragmentation will also interfere with information flows, and make it likely that each CCP has less information than an integrated CCP would have.

This article raises another real concern: a Eurozone clearer is more likely to be subject to political pressure than the LCH. It notes that the Continentals were upset about the LCH raising haircuts on Eurozone sovereigns during the PIIGS crisis. In some future crisis (and there is likely to be one) the political pressure to avoid such moves will be intense, even in the face of a real deterioration of the creditworthiness of one or more EU states. Further upon a point made above, political pressures in the EU and the UK could exacerbate the self-preserving actions that could lead to a failure to achieve efficient cooperation in a crisis, and indeed, could lead to a catastrophic coordination failure.

In sum, it’s hard to find an upside to the forced repatriation of € clearing from LCH to some Eurozone entity. Both in wartime (i.e., a crisis) and in peacetime, there are strong economies of scale and scope in clearing. A forced breakup will sacrifice these economies. Indeed, since breaking up CCPs is unlikely to reduce the probability of a clearing-related crisis, but will make the crisis worse when it does occur, it is particularly perverse to dress this up as a way of protecting the stability of the financial system.

I also consider it sickly ironic that the Euros say, well, if we are expected to provide a liquidity backstop to a big financial entity, we need to have regulatory control. Um, just who was supplying all that dollar liquidity via swap lines to desperate European banks during the 2008-2009 crisis? Without the Fed, European banks would have failed to obtain the dollar funding they needed to survive. By the logic of the EC in demanding control of € clearing, the Fed should require that the US have regulatory authority over all banks borrowing and lending USD.

Can you imagine the squealing in Brussels and every European capital in response to any such demand?

Speaking of European capitals, there is another irony. One thing that may derail the EC’s clearing grab is a disagreement over who should have primary regulatory responsibility over a Eurozone CCP. The ECB and ESMA think the job should be theirs: Germany, France, and Italy say nope, this should be the job of national central banks  (e.g., the Bundesbank) or national financial regulators (e.g., Bafin).

So, hilariously, what may prevent (or at least delay) the fragmentation of clearing is a lack of political unity in the EU.  This is as good an illustration as any of the fundamental tensions within the EU. Everybody wants a superstate. As long as they are in control.

Ronald Reagan famously said that the nine scariest words in the English language are: “I’m from the government and I’m here to help.” I can top that: “I’m from the EC, and I’m here to help.” When it comes to demanding control of clearing, the EC’s “help” will be about as welcome as a hole in the head.

 

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May 28, 2017

Calling Out the Free Riding Euroweenies

Filed under: Economics,History,Military,Russia — The Professor @ 4:26 pm

Trump’s continued insistence that Europe pony up to pay for its own defense–by living up to its commitment to spend 2 pct of GDP on the military–sent the Euros into a tizzy during the recent Nato and G-7 meetings. Ironically, given that the UK is leaving Europe, the FT has been particularly obnoxious in its defense of the decided lack of Euro defense spending. Two opeds from last week are perfect cases in point.

In this one, Ivo Daalder, former US permanent representative to Nato, and diehard foreign policy establishmentarian, opines that defense expenditures are not the measure of a defense alliance. Instead, “[t]he heart of the alliance lies in the commitment of each member to defend the others.”

That this is retarded is self-evident. What, pray tell, is the commitment to defend worth if those making the “commitment” do not have the means to live up to it?

It is worth exactly nothing. If, for instance, the Russians invaded the Baltics or Poland: what could the Europeans do? They could no doubt issue stirring statements expressing solidarity with their eastern brethren. But as for actually doing something–fat chance.

Belgium has committed to defend other Nato members. Belgium has zero main battle tanks. The Netherlands has committed to defend other Nato members. The Netherlands has 18 MBTs. Germany has committed to defend other Nato members. Germany–an economic colossus–has a grand total of 250 MBTs.

Furthermore, not only do these nations have little actual combat power, they have virtually no strategic mobility. God only knows how the 18 Dutch MBTs would actually make it to Nato’s eastern marches.

When the Europeans intervened in Libya, they depended almost exclusively on the US for reconnaissance, intelligence, and aerial refueling.

In brief, non-US Nato countries have little combat power, and no ability to sustain what little power they have outside of their own countries.

Meaning that the hallowed commitment is worth exactly squat.

The second oped, by a Princeton poli sci prof, claims that Europe pays its fair share because measuring contributions to security by looking at military expenditure alone “rests on an outdated notion of global power.”

Pray tell, Professor Moravcsik, how is that “civilian power” is working out in Syria, Iraq, Libya, Ukraine, etc.? Besides, I thought that the reason that Putin was such a grave threat is precisely that he clings to “outdated notions of global power”, for which the Europeans have no answer.

Moravcsik and others who make the same argument also present a false choice: “civilian power” and military power are not mutually exclusive. In fact they are highly complementary. As the Al Capone line goes, you can get much farther with a kind word and a gun than you can with a kind word alone. That’s especially true when those you are dealing with do not embrace the same post-modern conceits as you.

This last point is of particular importance. “Civilian power” may work in a world where there are only sheep: it is not a feasible strategy when there are wolves, too. Moreover, playing the sheep strategy makes it quite advantageous for others to adopt the wolf strategy. If you declare force to be an “outmoded measure of global power,” and disarm yourself accordingly, as sure as night follows day, a nation or nations will find such “outmoded” notions work quite fine, thank you. Indeed, by disarming you make it quite affordable for economic basket cases that could not compete otherwise (e.g., Russia) to obtain a relative advantage in conventional military power–and a relative advantage is all that they need.  By disdaining “outmoded measures of global power” you make it eminently affordable for less edified nations to achieve an advantage.

Today Angela Merkel said that Europe can no longer rely on the US. That’s projection, Angie baby: the US has not been able to rely on Germany for decades. Well, we can rely on them for pretentious preening, carping, and ankle biting. But for actual contributions to mutual defense, not so much.

Trump is right to continue to pound of the Euros about this. If it hurts their tender little feelings, oh well. Free riders need to be called out.

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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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