Streetwise Professor

April 20, 2015

Cargill: Still Private After All These Years to Solve Agency Problems, or Because of Them?

Filed under: Commodities,Derivatives,Economics,History — The Professor @ 8:29 pm

The commodity trading sector is remarkable for the prevalence of private ownership, even among the largest firms. My recent white paper discusses this issue in some detail. In a nutshell, publicly-held equity is a risk sharing mechanism. The ability of commodity traders to share some of their largest risks-notably, commodity flat price risks-through the derivatives markets reduces the need to rely on public equity. Moreover, private ownership can mitigate agency problems between equity owners and managers: the equity owners are often the managers. As a consequence, private ownership is more viable in the commodity trading sector.

The biggest cost of this ownership structure is that it constrains the ability to fund large investments in fixed assets. Thus, private ownership can impede a firm’s ability to pursue asset heavy strategies. As I note in this white paper, and my earlier one, commodity firms have used various means to loosen this constraint, including perpetual debt, and spinoffs of equity from asset-heavy subsidiaries.

Another cost is that owners tend to be poorly diversified. But to the extent that the benefits of high powered incentives exceed this cost, private ownership remains viable.

Cargill is the oldest, and one of the largest, of the major privately held commodity traders. (Whether it is biggest depends on whether you want to consider Koch a commodity trader.) It is now commemorating its 150th anniversary: its history began as the American Civil War ended. Greg Meyer and Neil Hume have a nice piece in the FT that discusses some of Cargill’s challenges. Foremost among these is funding its ambitious plans in Indonesia and Brazil.

The article also details the tensions between Cargill management, and the members of the Cargill and McMillan families who still own 90 percent of the firm.

The last family member to serve as chief executive retired in 1995, and now only one family member works full time there. This raises questions about how long the company will remain private, despite management’s stated determination to keep it that way. The families are already chafing due to their inability to diversify. Further, at Cargill private ownership no longer serves to align the incentives of owners and managers, in contrast to firms like Trafigura, Vitol, and Gunvor: even though Cargill is private, the owners aren’t the managers. Thus, the negatives of private ownership are becoming more prominent, and the benefits are diminishing. There is separation of ownership and control, with its associated incentive problems, but there is no compensating benefit of diversification.

Indeed, it is arguable that the company remains private because of agency problems. Current management, which does not own a large fraction of the firm, is not incentivized to de-privatize: there would be no big payday for them from going public, because they own little equity, and they would give up the perquisites attendant to controlling a vast corporation. Moreover, as long as the families can be kept happy, management doesn’t have to worry about capital market discipline or nosy analysts. Thus, management may be well entrenched in the current private structure, and the number of family owners (about 100) could make it difficult to form a coalition that would force the company to go public, or to craft a package that would make it worth management’s while to pursue that option.

In sum, Cargill is a marvelous company, and has been amazingly successful over the years. Its longevity as a private company is remarkable. But there are grounds to wonder whether that structure is still efficient, or whether it persists because it benefits management.

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April 18, 2015

A Greek Gas Farce

Filed under: Commodities,Energy,Financial Crisis II,History,Politics,Russia — The Professor @ 11:44 am

Der Spiegel reported that Greek officials claim that the country is on the verge of signing a deal with Russia that would give the Greeks €5 billion upfront, to be repaid from transit fees on a yet-to-be-built Turkish Stream pipeline: the Russians deny any deal. The quoted (but anonymous) Greek official said that this would “turn the tide” for Greece.


Some thoughts off the top.

First, Greece owes €320 billion, including payments of €30 billion in 2015 alone. It is “scraping the bottom of the barrel” by borrowing from various state entities (e.g., the public transport system) to meet April payroll. It has a budget deficit of €23 billion. Deposits at Greek banks fell by about €20 billion last week. This creates a liability for the Bank of Greece to Target2 (i.e., to the members of the ECB). A measly €5 billion will buy it a few weeks time, at best.

Second, it’s not as if creditors (e.g., the EU and the IMF and Target2 members) are going to give Greece discretion over how to spend this money. And they have many levers to pull. So it would set the stage for more arguments between the creditors and the debtor.

Third, the Russians are likely to write terms that secure the debt and give it priority over other creditors (at least with respect to any future transit fees). (Just remember how tightly the Russians crafted the Yanuk Bonds.) The Euros will flip out over any such terms. This would set up an epic The Good, The Bad, and the Ugly three-way standoff.

Fourth, this initiative would be directly contrary to European energy policy, which is finally attempting to reduce dependence on Russia and limit vulnerability to Russian gasmail and the use of energy as a wedge to create divisions within the EU.

Fifth, what are the odds that the pipeline will get built? The Europeans are against it. It requires the Greeks and the Turks to play well together, and we know how that usually works out. It requires additional investment in infrastructure in Turkey, which is problematic. Further, the Russian track record on these sorts of projects leaves much to be desired.

So what happens if the pipeline isn’t built, or is delayed significantly. No doubt the Russians will anticipate this contingency in the debt agreement, and write things in such a way that they have security or priority, which will just spark another battle with Greece’s European creditors.

In sum, such a deal would hardly be a solution to Greece’s problems. Indeed, it only escalates conflicts between Greece and the EU.

Which may be Putin’s purpose, exactly. Exacerbating Greek-EU conflict over a matter involving Russia directly at a time when Greece could scupper the extension of sanctions against Russia suits Putin perfectly. The fact that the pipeline is as much pipe dream as realistic project doesn’t matter a whit. This is all about stirring trouble. And that’s Putin’s speciality.

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April 5, 2015

Not So Krafty?

Filed under: Commodities,Derivatives,Economics,Regulation — The Professor @ 10:23 am

The CFTC has filed a complaint against Kraft and Mondelez Global, accusing the companies of manipulating the December, 2011 CBT Wheat Futures Contract. A few comments, based on what is laid out in the complaint (and therefore not on a full evaluation of all relevant facts and data):

  1. A trader executes a market power manipulation (i.e., a corner or a squeeze) by taking excessive, and uneconomic, deliveries on a futures contract. This causes the calendar spread to increase, and the basis at locations where delivery does not (or cannot) occur to fall. The complaint alleges that Kraft took large deliveries. The relevant calendar spread (December-March) rose sharply, and according to Kraft emails cited in the complaint, the basis at Toledo declined. Thus, the facts in the CFTC complaint support a plausible allegation that Kraft and Mondelez executed a market power manipulation/corner/squeeze.
  2. A cornerer takes uneconomic deliveries. That is, the deliveries taken are not the cheapest source of the physical commodity for the cornerer. The complaint does not provide sufficient detail to determine with precision whether this was the case here (but discovery will!), but it does include circumstantial evidence. Specifically, Kraft took delivery on the Mississippi, whereas it needed physical wheat at its mill in Toledo. Further, Kraft did not use most of the wheat it bought via delivery. Instead, it sold it, which is consistent with “burying the corpse.” In addition, given cash bids in Toledo and the futures price at which the defendants took delivery, it is highly likely that it was cheaper for Kraft to buy wheat delivered to its mill in Toledo than it was to take delivery (at an opportunity cost equal to the futures price) and pay load out and freight costs to move the wheat from the Mississippi to Toledo. Again, though, the complaint doesn’t provide direct evidence of this.
  3. A cornerer liquidates a large fraction of its futures position: whereas it loses money on the deliveries it takes, it makes money by liquidating futures at a super competitive price. Kraft liquidated more than half its futures position. This provides further evidence that it did not establish its futures position as a means of securing the cheapest source of cash wheat, and is consistent with the execution of a corner/squeeze.
  4. A processor hedging anticipated cash purchases doesn’t buy calendar spreads. The complaint quotes an email stating that Kraft did.
  5. One clunker in the complaint is the allegation that Kraft’s actions “proximately caused cash wheat prices in Toledo to decline.” Market power manipulation when Toledo is not the cheapest to deliver location (as was evidently the case here, as deliveries did not occur in Toledo) would be expected to reduce the Toledo basis (i.e., the difference between the Toledo cash price and the December futures price), and there is some evidence in the complaint that this occurred. But this is different from causing the flat price of wheat to decline, which is what the CFTC alleges. Any coherent theory of market power manipulation implies that a corner or squeeze would increase, or at least not reduce, the cash price at locations where delivery does not occur, but that the rise in the cash price at these locations is smaller than the rise in the futures price (and in the cash price at the delivery location). This results in a compression of the basis, but a rise (or non-decline) in flat prices.
  6. In sum, the complaint presents a plausible case that Kraft-Mondelez executed a market power manipulation.
  7. But the CFTC doesn’t come out and allege a corner, squeeze, or market power manipulation: these words are totally absent. Instead, the agency relies on its shiny new anti-manipulation authority conferred by Frankendodd under section 6(c)(1) of the Commodity Exchange Act, and CFTC Rule 180.1 that it adopted to implement this authority. This is essentially a Xerox of the SEC’s Rule 10b-5, and proscribes the employment of any “deceptive or manipulative device.” That is, this is basically an anti-fraud rule that has nothing to do with market power and therefore it is ill-adapted to reaching the exercise of market power.
  8. The CFTC no doubt is doing this because under 6(c)(1) and Rule 180.1 the CFTC has a lower burden of proof than under its pre-Frankendodd anti-manipulation authority. Specifically, it does not have to show that Kraft-Mondelez had specific intent to manipulate the market, as was the case prior to Dodd-Frank. Instead, “recklessness” suffices. Further, it does not have to demonstrate that the price of wheat was artificial. In my view, the straightforward application of economics permits determination of both specific intent and price artificiality, but earlier decisions like Indiana Farm and in re Cox make it difficult to for the CFTC to do so. Or at least that’s what CFTC believes.
  9. Although I understand the CFTC’s choice, it has jumped from the frying pan into the fire. Why? Well, to mix metaphors, there is a square peg-round hole problem. As I’ve been shouting about for years, fraud-based manipulations and market power manipulations are very different, and using a statute that targets fraudulent (“deceptive”) actions to prosecute a market power manipulation is likely to end in tears because the legal concept does not fit the allegedly manipulative conduct. The DOJ learned this to its dismay in the Radley case (which grew out of the BP propane corner in 2004). Even though BP executed a garden variety corner, the DOJ alleged that the company engaged in a massive fraud. Judge Miller found this entirely unpersuasive, and shot down the DOJ in flames. The CFTC risks the exact same outcome. Tellingly, it asserts in a conclusory fashion that Kraft-Mondelez employed a “deceptive or manipulative contrivance” but doesn’t say: (a) what that device was, (b) how Kraft’s taking of a large number of deliveries deceived anyone, (c) who was deceived, and (d) how the deception affected prices.

It will be interesting to see what happens going forward. The CFTC is obviously using this as a test case of its new authority. Perhaps it thinks it is being crafty (or would that be Krafty?) but I fear that by using a law and rule targeted against fraudulent conduct to prosecute a market power manipulation, the agency will just be finding a new way to screw up manipulation law, thereby undermining, rather than strengthening, deterrence of market power manipulation.

So will the Beastie Boys be singing about the CFTC? We’ll see, but I’m not hopeful.


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April 4, 2015

The IECA Libels Me: I Am Oddly Flattered

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 10:22 am

The Industrial Energy Consumers of America has submitted a comment letter on the CFTC’s position limit rule making. The letter contains this libel:

If one looks at the agenda from the February 26, 2015 meeting (see below), other than CFTC presenters, every presenter has views that are not consistent with CFTC action to set speculative position limits. Professor Pirrong has a long history of client paid studies in this area and will need to identify who paid for the underlying data and study for his results to be credible on this subject.

If “this area” is the subject of speculation and position limits, this statement is categorically false. I have not done one “client paid study” on these issues. Period.

In fact, most of my writing on speculation has either been in my academic work (as in my 2011 book), or here on the blog. I have been arguing this issue on my own time.

Actually, I did do one client paid study on these issues about 11 or 12 years ago. For the IECA, in fact, which was just certain that the NYMEX’s expanded accountability limits for natural gas had caused volatility to increase. They hired me to study this issue. I did, using methods that I had employed in peer reviewed research, and found that IECA’s firm beliefs were flatly contradicted by the data: data that IECA paid for, analyzed using methods that were disclosed to it. IECA decided not to release the study. Surprise, surprise. So IECA knows from direct experience that my opinions are not for sale.

So just who here is hiding something? Hint: it ain’t me.

I could provide other examples. The GFMA study on commodity traders is a well known case: it was written up in the Financial Times. Another example that is not as well known was my work on a project for the Board of Trade in 1991-1992, in which I studied the delivery mechanism for corn and soybeans. (The resulting report was published as Grain Futures Markets: An Economic Appraisal.) I concluded that the delivery mechanism was subject to manipulation, and recommended the addition of delivery points at economic par differentials to Chicago. This was not the desired answer. On the day I presented my results to the committee of the CBT that commissioned the study, the chief economist of the exchange pressured me to change my recommendations. I refused. The meeting that followed became heated. So heated, in fact, that the head of the committee and I almost literally came to blows when I refused to back down: committee members from Cargill and ADM actually took the guy bodily from the room until he calmed down.

So the track record is abundantly clear: I call them like I see them, even if it isn’t what the client wants to hear.

In fact, it is IECA’s ad hominem that lacks credibility. My white papers for Trafigura are not related to the issue of speculation at all. To the contrary, they are related to the issue of physical commodity trading. I did a study for CME in 2009 on the performance of the WTI futures contract. Nothing related to speculation. Data sources disclosed, and the methodologies are clearly set out. Again, if IECA has specific critiques of any of these analyses, bring it on. Anytime. Anywhere. And they can leave their libelous insinuations behind.

Perhaps IECA head Paul Cicio is still sore over how I smacked him around at a House Ag committee hearing in July 2008. Cicio said it was obvious that speculation had inflated energy prices. He used the metaphor of a swimming pool: if a bunch of speculators jump in, it has to raise the water level. I retorted that this shows the exact opposite, because all the speculators get out of the pool before contracts go spot. Long speculators are sellers of futures as delivery approaches, meaning they are out of the pool (the physical market) as delivery approaches, and hence can’t be inflating spot prices.

If Cicio is still sore, all I have to say is: Get over it.

To reiterate: IECA’s statement in a document submitted to a government regulatory agency is categorically false, and libelous.

And oddly flattering. You don’t go out of your way to libel the irrelevant. The fact that this organization feels compelled to slur me by name and attack my credibility (even though the attack is false) means that they must believe that I pose a threat to them. I sure as hell hope so.

Word to the wise. Don’t bring a wet noodle to a gunfight. (I cleaned that up.) You’re going to lose.


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March 23, 2015

The Systemic Risk, or Not, of Commodity Trading Firms

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics,Russia — The Professor @ 2:03 pm

My latest white paper, “Not too big to fail: Systemic Risk, Regulation, and the Economics of Commodity Trading Firms” was released today. A video of me discussing it can be found here (as can my earlier white papers on commodity traders and LNG trading).

The conclusion in a nutshell: commodity trading firms do not pose systemic risks, and therefore it is inappropriate to subject them to bank-like prudential regulations, including capital requirements. Commodity trading firms are not systemically risky because (a) they aren’t really that big, (b) they are not that highly leveraged, (c) their leverage is not fragile, (d) the financial distress of a big trader is unlikely to result in contagious runs on others, or fire sale problems, and (e) their financial performance is not highly pro cyclical. Another way to see it is that banks are fragile because they engage in maturity and liquidity transformations, whereas commodity trading firms don’t: they engage in different transformations altogether.

Commodity traders are in line to be subject to Capital Requirement Directive IV starting in 2017. If the rules turn out to be binding, they will cause firms to de-lever by shrinking, or issue more equity (which may force them to forego private ownership, which aligns the interests of owners and managers). These will be costs, not offset by any systemic benefit. All pain, no gain.

It is my understanding that banks obviously think differently, and are calling for “consistent” regulations across banks, commodity traders, and other intermediaries. Since these firms differ on many dimensions, imposing the same regulations on all makes little sense. Put differently, apropos Emerson, a foolish consistency is the hobgoblin of little minds. Or bankers who want to handicap competitors.

The white paper has received some good coverage, including the Financial Times, Reuters, and Bloomberg. I will be writing more about it when I return to the states later in the week.

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March 17, 2015

The Biggest Loser, Iran Deal Edition: That Would Be Russia

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 11:52 am

I am following around Iranian negotiator Javad Zarif, arriving this morning in Geneva, and then going to Brussels next week. Don’t worry, I won’t go biking. Certainly not in the absurd getup that Zarif’s interlocutor-or should I say Sancho Panza-John Kerry did here on the shores of Lac Leman. The man is obviously immune to mockery.

I am resigned that Sancho-I mean John-and Javad (remember, they are on a first name basis!) will reach some sort of deal that will clear Iran’s path to becoming a nuclear power in the near-to-medium term, with all of the malign consequences that entails. Which leads me to contemplate some of those consequences.

One of which relates to the price of oil (and natural gas), the malignity of which depends on whether you are long or short oil (and gas). Of course, one of the countries that is very long oil (and gas) is Russia, and from its perspective the consequences of a deal will be very malign. Which makes one wonder if Putin (or whoever is really in charge these days!) will attempt to do something to derail it. (Or are they too distracted by the folly in Ukraine? Or by dog fights under the carpet?)

The crucial issue is how rapidly, and by how much, Iranian output will ramp up if a deal is reached. There is both a political dimension to this, and an operational one.

The political issue is how rapidly a deal will result in the dismantling of the myriad sanctions that impede Iran’s ability to sell oil:

“Don’t expect to open the tap on oil,” one Gulf-based Western diplomat told Reuters. It is much easier to lift financial sanctions because so many components of Iran’s oil trade have been targeted, the diplomat said.

. . . .

But for Iran to sell significantly more crude and repatriate hard currency earnings, many U.S. and European restrictions on its shipping, insurance, ports, banking, and oil trade would have to be lifted or waived.

Yet because they represent the bulk of world powers’ leverage over Iran, initial relief would probably be modest, said Zachary Goldman, a former policy advisor at the U.S. Treasury Department’s Office of Terrorism and Financial Intelligence, where he helped develop Iransanctions policy.

Goldman predicted the first step would be to allow Tehran to use more of its foreign currency reserves abroad, now limited to specific bilateral trade.

“It’s discrete, and it doesn’t involve dismantling the architecture of sanctions that has been built up painstakingly over the last five years,” said Goldman, who now heads the Center on Law and Security at New York University.

Even with a nuclear deal, oil sanctions would probably effectively stay in place until early 2016, said Bob McNally, a former White House adviser under George W. Bush and now president of the Rapidan Group energy consultancy.

The operational issue is how rapidly Iran can reactivate its idled fields, and how much damage they have suffered while they have been off-line. The Iranians claim that 1mm barrels per day can come online within months. The IEA concurs:

Turning lots of production back on suddenly can be complicated—and time consuming—even if wells and reservoirs are maintained studiously. It could be even harder in complex Iranian fields that have been pumping for decades.

Still, some analysts have concluded that a good deal of that lost output could return more quickly than often anticipated. The International Energy Agency, for example, has said that it expects a relatively rapid burst of exports if sanctions are lifted.

“They’ve deployed considerable ingenuity in getting around sanctions and keeping fields in tiptop shape. We think Iran could pretty much come back to the market on a dime,” Antoine Halff, head of the IEA’s oil industry and markets division, recently told an audience at the Center for Strategic Studies in Washington.

Perhaps up to 2mm bpd of additional output could come back later. Then there is the issue of how a relaxation or elimination of sanctions would affect output in the long run as (a) western investment flows into the Iranian oil sector, and (b) other producers, and notably OPEC, respond to Iran’s return to the market.

In the short run, the 1mm bpd number  (corresponding to about 1.1 percent of world output) looks reasonable, and given a demand elasticity of approximately 10, that would result in a 10 percent decline in oil prices. Additional flows in the medium term would produce additional declines.

Even if Iran’s return to the market is expected to take some time, due to the aforementioned complications of undoing sanctions, much of the price effect would be immediate. The mechanism is that an anticipated rise in future output reduces the demand to store oil today: the anticipated increase in future output reduces future scarcity relative to current scarcity, reducing the benefit of carrying inventories. There will be de-stocking, which will put downward pressure on spot prices. Moreover, since an increase in expected future output reduces future scarcity relative to current scarcity, future prices will fall more than the spot price, meaning that contango will decline.

Some of the price decline effect may have already occurred due to anticipation of the clinching of a deal: the May Brent price has declined about $10/bbl in the last month. However, the movement in the May-December spread is not consistent with the recent price decline being driven by the market’s estimation that the odds  that Iranian output will increase in the future have risen. The May-December spread has fallen from -$4.47 (contango) to -$6.36. This is consistent with a near-term supply-demand imbalance rather than an anticipated change in the future balance in favor of greater supply. So too is the increase in inventories seen in recent weeks.

Predicting the magnitude of the price response to the announcement of a deal-or the breakdown of negotiations-is difficult because that requires knowing how much has already been priced in. My lack of a yacht that would make a Russian oligarch jealous indicates quite clearly that I lack such penetrating insight. However, the directional effect is pretty clear-down (for a deal, up for a breakdown).

Which is very bad news for the Russian government and economy, which are groaning under the effects of the oil price decline that has already occurred. Indeed, Iran’s return to the market would weigh on prices for years, reducing the odds that Russia could count on a 2009-like rebound to retrieve its fortunes.

Add to this the fact that a lifting of sanctions would open Iran’s vast gas reserves (second only to Russia’s) to be supplied to Europe and Asia, dramatically reducing the profitability of Russian gas sales in the future, and Iran’s return to the energy markets is a near term and long term threat to Russia.

Which makes Putin’s apparent indifference to a deal passing strange. The Russians freak out over developments (e.g., the prospect for an antitrust investigation of Gazprom, or pipsqueak pipeline projects like Nabucco) that pose a much smaller threat than the reemergence of Iran as a major energy producer. But they have not done anything overt to scupper a deal, nor have they unleashed their usual screeching rhetoric.

What gives? Acceptance of the inevitable? A belief that in the long run the deal will actually increase the likelihood of chaos in the Middle East that will redound to Russia’s benefit? Strategic myopia (i.e., an obsession with reassembling Sovokistan, starting with Donbas) that makes the leadership blind to broader strategic considerations? Distraction by internal disputes? Or does Putin (or whoever is calling the shots!) have something up his (their) sleeve(s)?

My aforementioned pining for a super yacht that would make Abramovich turn green again betrays my inability to penetrate such mysteries. But it is quite a puzzle, for at least insofar as the immediate economic consequences are concerned, Russia would be the Biggest Loser from a deal that clears Iran’s return to the oil market.

H/T to @libertylynx for the idea for this post.


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March 10, 2015

Resource Rents, Russian Aggression, and the Nature of Putinism

Filed under: Commodities,Economics,Energy,History,Military,Russia — The Professor @ 9:00 pm

This nice piece from the WaPo points out the link between oil prices and Russian aggressiveness:

From this perspective, Russia is not so much an insecure superpower as it is a typical petrostate with a short-term horizon that gets aggressive and ambitious once it accumulates substantive oil revenues. Back in the early 2000s when the price of oil was $25 a barrel, Putin was a friend of the United States and didn’t mind NATO enlargement in 2004. According to Hendrix’s research, this is exactly how petrostates behave when the oil prices are low: In fact, at oil prices below $33 a barrel, oil exporters become much more peaceful than even non-petrostates. Back in 2002 when the Urals price was around $20, in his Address to the Federal Assembly Putin enumerated multiple steps to European integration and active collaboration aimed at creating a single economic space with the European Union among Russia’s top priorities. In 2014 – with the price of oil price around $110 – Putin invaded Ukraine to punish it for the attempts to create that same single economic space with the E.U.

I made these basic points eight years ago, in a post titled “Cocaine Blues.”

The graph depicts Gaddy’s estimates of the energy rents accruing to the Soviet–and Russian–economy. Each of the two spikes in the graph corresponds to a period of Soviet/Russian adventurism. The first shot of oil/cocaine during the 1970s oil shock fueled Soviet aggressiveness around the world. The second oil/cocaine shot–the post-2003 runup in oil prices–is powering Putin’s recent revanchism.

There were some follow up posts on the same theme.

This post from Window on Eurasia quotes a Russian social scientist who disputes the importance of oil prices in explaining Russian behavior in the Putin era. Instead, Vladislav Inozemtsev identifies the lack of formal institutions as the characteristic feature of Putinism.

But these things are not mutually exclusive. Indeed, another SWP theme from about this same time period (2007-2008) is that Russia is a natural state in which Putin uses control over resource rents to maintain a political equilibrium. Resource rents permit personalized rule and impede the development of formal, impersonal institutions.

In other words, in Russia, resource rents, and especially oil/energy rents matter, both for its political structure and evolution, and its behavior as an international actor.

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Chinese Chutzpah: Using IP to Ice Cotton Competition

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 7:32 pm

China is notorious for flouting intellectual property rights. From stolen technology (including notably military gear) to designer knock-offs, China pirates everything and everyone. It is therefore a rather jaw-dropping act of chutzpah for to Chinese Zhengzhou Commodities Exchange to send a nasty cease-and-desist letter to the Singapore subsidiary of ICE demanding that ICE not copy ZCE’s cotton and sugar contracts:

Intercontinental Exchange has been forced to delay the launch of its new Singapore platform after a Chinese exchange threatened legal action to stop the US group launching two commodity futures that are copies of contracts offered in China.

The move by the Zhengzhou Commodity Exchange is likely to send shockwaves through the global futures industry because it signals that China will not tolerate foreign exchanges copying its futures contracts, and comes despite the practice of offering “lookalike” contracts being accepted around the world for years.

The ICE contracts are not copies, exactly. Similar to its “NYMEX lookalike” contracts, which cash settle against the expiring NYMEX future, the ICE Singapore commodity contracts are to be cash settled based on the settlement price of the expiring ZCE future. The ZCE future is delivery-settled. Meaning that the delivery mechanism ensures convergence between physical and futures prices, and the lookalike contract can ensure convergence by cash-settling against the delivery-settled contract.

The issues here are common to all intellectual property controversies. Strong intellectual property rights impede competition. Against that, free riding off the creativity or investment of others can impede innovation.

There isn’t a one-size-fits-all answer to this trade-off. In the case of exchange traded contracts, I tend to lean towards weak intellectual property rights.  The network effects of liquidity tend to weaken competition, and to give incumbents a strong advantage over entrants. There is already a substantial stream of rents to being first that gives strong (and maybe overly-strong) incentives to innovate, making strong intellectual property rights superfluous, and indeed damaging because they place another burden on already weak competition.

The US courts arrived at a similar conclusion, ruling that NYMEX did not have property rights over its settlement prices that it could use to preclude ICE from using them to cash settle its contracts. This is one factor that has encouraged a relatively robust competition in energy derivatives, which is the exception rather than the rule.

In sum, I hope ICE is able to prevail in its battle with ZCE. In part on economic grounds, and in part on the grounds that it burns me to see IP pirates protect their turf by asserting IP, especially over something for which IP is unwarranted.

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March 1, 2015

The Clayton Rule on Speed

Filed under: Commodities,Derivatives,Economics,Exchanges,HFT,Politics,Regulation — The Professor @ 1:12 pm

I have written often of the Clayton Rule of Manipulation, named after a cotton broker who, in testimony before Congress, uttered these wise words:

“The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

High Frequency Trading has created the possibility of the promiscuous application of the Clayton Rule, because there is a lot of things about HFT that do not suit a lot of gentlemen at this moment, and a lot of ladies for that matter. The CFTC’s Frankendodd-based Disruptive Practices Rule, plus the fraud based manipulation Rule 180.1 (also a product of Dodd-Frank) provide the agency’s enforcement staff with the tools to pursue a pretty much anything that does not suit them at any particular moment.

At present, the thing that least suits government enforcers-including not just CFTC but the Department of Justice as well-is spoofing. As I discussed late last year, the DOJ has filed criminal charges in a spoofing case.

Here’s my description of spoofing:

What is spoofing? It’s the futures market equivalent of Lucy and the football. A trader submits buy (sell) orders above (below) the inside market in the hope that this convinces other market participants that there is strong demand (supply) for (of) the futures contract. If others are so fooled, they will raise their bids (lower their offers). Right before they do this, the spoofer pulls his orders just like Lucy pulls the football away from Charlie Brown, and then hits (lifts) the higher (lower) bids (offers). If the pre-spoof prices are “right”, the post-spoof bids (offers) are too high (too low), which means the spoofer sells high and buys low.

Order cancellation is a crucial component of the spoofing strategy, and this has created widespread suspicion about the legitimacy of order cancellation generally. Whatever you think about spoofing, if such futures market rule enforcers (exchanges, the CFTC, or the dreaded DOJ) begin to believe that traders who cancel orders at a high rate are doing something nefarious, and begin applying the Clayton Rule to such traders, the potential for mischief-and far worse-is great.

Many legitimate strategies involve high rates of order cancellation. In particular, market making strategies, including market making strategies pursued by HFT firms, typically involve high cancellation rates, especially in markets with small ticks, narrow spreads, and high volatility. Market makers can quote tighter spreads if they can adjust their quotes rapidly in response to new information. High volatility essentially means a high rate of information flow, and a need to adjust quotes frequently. Moreover, HFT traders can condition their quotes in a given market based on information (e.g., trades or quote changes) in other markets. Thus, to be able to quote tight markets in these conditions, market makers need to be able to adjust quotes frequently, and this in turn requires frequent order cancellations.

Order cancellation is also a means of protecting market making HFTs from being picked off by traders with better information. HFTs attempt to identify when order flow becomes “toxic” (i.e., is characterized by a large proportion of better-informed traders) and rationally cancel orders when this occurs. This reduces the cost of making markets.

This creates a considerable tension if order cancellation rates are used as a metric to detect potential manipulative conduct. Tweaking strategies to reduce cancellation rates to reduce the probability of getting caught in an enforcement dragnet increases the frequency that a trader is picked off and thereby raises trading costs: the rational response is to quote less aggressively, which reduces market liquidity. But not doing so raises the risk of a torturous investigation, or worse.

What’s more, the complexity of HFT strategies will make ex post forensic analyses of traders’ activities fraught with potential error. There is likely to be a high rate of false positives-the identification of legitimate strategies as manipulative. This is particularly true for firms that trade intensively in multiple markets. With some frequency, such firms will quote one side of the market, cancel, and then take liquidity from the other side of the market (the pattern that is symptomatic of spoofing). They will do that because that can be the rational response to some patterns of information arrival. But try explaining that to a suspicious regulator.

The problem here inheres in large part in the inductive nature of legal reasoning, which generalizes from specific cases and relies heavily on analogy. With such reasoning there is always a danger that a necessary condition (“all spoofing strategies involve high rates of order cancellation”) morphs into a sufficient condition (“high rates of order cancellation indicate manipulation”). This danger is particularly acute in complex environments in which subtle differences in strategies that are difficult for laymen to grasp (and may even be difficult for the strategist or experts to explain) can lead to very different conclusions about their legitimacy.

The potential for a regulatory dragnet directed against spoofing catching legitimate strategies by mistake is probably the greatest near-term concern that traders should have, because such a dragnet is underway. But the widespread misunderstanding and suspicion of HFT more generally means that over the medium to long term, the scope of the Clayton Rule may expand dramatically.

This is particularly worrisome given that suspected offenders are at risk to criminal charges. This dramatic escalation in the stakes raises compliance costs because every inquiry, even from an exchange, demands a fully-lawyered response. Moreover, it will make firms avoid some perfectly rational strategies that reduce the costs of making markets, thereby reducing liquidity and inflating trading costs for everyone.

The vagueness of the statute and the regulations that derive from it pose a huge risk to HFT firms. The only saving grace is that this vagueness may result in the law being declared unconstitutional and preventing it from being used in criminal prosecutions.

Although he wrote in a non-official capacity, an article by CFTC attorney Gregory Scopino illustrates how expansive regulators may become in their criminalization of HFT strategies. In a Connecticut Law Review article, Scopino questions the legality of “high-speed ‘pinging’ and ‘front running’ in futures markets.” It’s frightening to watch him stretch the concepts of fraud and “deceptive contrivance or device” to cover a variety of defensible practices which he seems not to understand.

In particular, he is very exercised by “pinging”, that is, the submission of small orders in an attempt to detect large orders. As remarkable as it might sound, his understanding of this seems to be even more limited than Michael Lewis’s: see Peter Kovac’s demolition of Lewis in his Not so Fast.

When there is hidden liquidity (due to non-displayed orders or iceberg orders), it makes perfect sense for traders to attempt to learn about market depth. This can be valuable information for liquidity providers, who get to know about competitive conditions in the market and can gauge better the potential profitability of supply ing liquidity. It can also be valuable to informed strategic traders, whose optimal trading strategy depends on market depth (as Pete Kyle showed more than 30 years ago): see a nice paper by Clark-Joseph on such “exploratory trading”, which sadly has been misrepresented by many (including Lewis and Scopino) to mean that HFT firms front run, a conclusion that Clark-Joseph explicitly denies. To call either of these strategies front running, or deem them deceptive or fraudulent is disturbing, to say the least.

Scopino and other critics of HFT also criticize the alleged practice of order anticipation, whereby a trader infers the existence of a large order being executed in pieces as soon as the first pieces trade. I say alleged, because as Kovac points out, the noisiness of order flow sharply limits the ability to detect a large latent order on the basis of a few trades.

What’s more, as I wrote in some posts on HFT just about a year ago, and in a piece in the Journal of Applied Corporate Finance, it’s by no means clear that order anticipation is inefficient, due to the equivocal nature of informed trading. Informed trading reduces liquidity, making it particularly perverse that Scopino wants to treat order anticipation as a form of insider trading (i.e., trading on non-public information). Talk about getting things totally backwards: this would criminalize a type of trading that actually impedes liquidity-reducing informed trading. Maybe there’s a planet on which that makes sense, but its sky ain’t blue.

Fortunately, these are now just gleams in an ambitious attorney’s eye. But from such gleams often come regulatory progeny. Indeed, since there is a strong and vocal constituency to impede HFT, the political economy of regulation tends to favor such an outcome. Regulators gonna regulate, especially when importuned by interested parties. Look no further than the net neutrality debacle.

In sum, the Clayton Rule has been around for the good part of a century, but I fear we ain’t seen nothing yet. HFT doesn’t suit a lot of people, often because of ignorance or self-interest, and as Mr. Clayton observed so long ago, it’s a short step from that to an accusation of manipulation. Regulators armed with broad, vague, and elastic authority (and things don’t get much broader, vaguer, or more elastic than “deceptive contrivance or device”) pose a great danger of running amok and impairing market performance in the name of improving it.

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February 15, 2015

As An Oil Analyst, Mullet Man Igor Sechin Makes a Better KGB Agent

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 11:10 am

Igor Sechin, he of the ape drape, has taken to the pages of the Financial Times to diagnose the causes of the recent collapse in oil prices. I am sure you will be  shocked to learn that it is those damned speculators:

In today’s distorted oil markets, prices do not reflect reality. They are driven instead by financial speculation, which outweighs the real-life factors of supply and demand. Financial markets tend to produce economic bubbles, and those bubbles tend to burst. Remember the dotcom bust and the subprime mortgage crisis? Furthermore, they are prone to manipulation. We have not forgotten the rigging of the Libor interest rate benchmark and the gold price.

. . . .

Financial bubbles, market manipulations, excessive regulation, regional disparities — so grotesque are these distortions that you might question whether there is any such thing as an oil “market” at all. There is the semblance of a market: buyers and sellers and prices. But they are performing a charade.

What is to be done? First, financial players should no longer be allowed to have such a big influence on the price of oil. In the US, Senators Carl Levin and John McCain have called for steps to prevent price manipulation, though whether they will be implemented, and when, remains an open question.

In any case, the authorities should go further, ensuring that at least 10 or 15 per cent of oil trades involve actually delivering some physical oil. At present almost all “oil trades” are conducted by financial traders, who exchange nothing but electronic tokens or pieces of paper.

No, condemnations of speculation are not the last refuge of scoundrels attempting to assign blame for sharp movements in commodity prices: they are the first and only refuge. Prices going up? Speculators! Prices going down? Speculators! Poor, poor little companies like doughty Rosneft and even international cartels like OPEC are mere straws at the tossed before the speculative gales.

Sechin’s broadside is refreshingly untainted by anything resembling actual evidence. The closest he comes is to invoke long run considerations, relating to the costs of drilling new wells. But supply and demand are both very inelastic in the short run, meaning that even modest demand or supply shocks can have large price impacts that cause prices to deviate substantially from long run equilibrium values driven by long run average costs.

It is also hard to discern a credible mechanism whereby diffuse and numerous financial speculators could cause prices to be artificially low for a considerable period of time. (It is straightforward to construct models of how a local market can be manipulated downwards, but these are implausible for a global market. Moreover as I showed years ago, markets that are vulnerable to upward manipulation by longs are relatively invulnerable to downward manipulation by shorts.)

And the empirical implications of any such artificiality are sharply inconsistent with what we observe now. Artificially low prices would induce excessive consumption, which would in turn result in a drawdown in inventories. This is the exact opposite of what we see now. Inventories are growing rapidly in the US in particular (where we have the best data). There are projections that Cushing storage capacity will be filled by May. Internationally, traders are leasing supertankers to store oil. These are classic effects of demand declines or supply increases or both that are expected to be transient.

Insofar as requiring some percentage of oil contracts (by which I presume he means futures and swaps) be satisfied by delivery, the mere threat of delivery ties futures prices to physical market fundamentals at contract expiration. What’s more, the fact that paper traders are largely out of the market when contracts go spot means that they cannot directly affect the supply or demand for the physical commodity.

Sechin’s FT piece is based on a presentation he gave at International Petroleum Week. Rosneft thoughtfully, though rather stupidly given the content, posted Sechin’s remarks and slides on its website. It makes for some rather amusing reading. Apparently shale oil companies are like dotcoms, and shale oil was a bubble. According to Igor, US shale producers are overvalued. His evidence? A comparison of EOG and Hess to Lukoil. The market cap of the EOG is substantially higher than Lukoil’s, despite its lower reserves and production, and lack of refining operations. Therefore: Bubble! Overvaluation!

Gee, I wonder if the fact that Lukoil is a Russian company, and that Russian company valuations are substantially below those of international competitors, regardless of the industry, has anything to do with it? In fact, it has everything to do with it. Sechin’s comparison of a US company with a Russian one points out vividly the baleful consequences of Russia’s lawless business climate. It’s not that EOG and other shale producers are bubbles: it’s that Lukoil (and other Russian companies) are black holes.  (It was the very fact that Russia’s lack of property rights, the rule of law, and other institutional supports of a market economy that got me interested in looking at the country in detail in the first place almost a decade ago.)

I was also amused by Sechin’s ringing call for greater transparency in the energy industry. This coming from the CEO of one of the most opaque companies in the most opaque countries in the world.

Reading anything by Sechin purporting to be an objective analysis of markets or market conditions is always good for a chuckle. His FT oped and IPW remarks are no exception. As a market analyst, he makes a better KGB operative. Enjoy!

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