Streetwise Professor

January 18, 2015

Putin, Inc.: How Russia’s Current Crisis Will Condemn It to Enduring Stagnation

Filed under: Commodities,Economics,Politics,Russia — The Professor @ 1:59 pm

Russia’s economic position remains parlous. The ruble has continued to weaken, and although the price of oil rallied somewhat late last week, it still remains far below levels necessary to permit growth. The World Bank is predicting a 2.9 percent decline in GDP in 2015. 9.2 percent is more likely.

So what is Putin/Russia going to do? The options are limited. Given the weak economic conditions, and the lack of access of the banking and corporate sectors to international funding, there appears to be only one option. As a lawyer friend sagely put it, the government will essentially have to move massive amounts of liabilities from big banks and large state enterprises onto the government balance sheet. Formally, it will be done through the banks. The banks will extend credit to the corporate sector (including most notably big state firms) and the government will capitalize or guarantee/backstop the banks.

This is certainly the view of Sberbank’s Chairman, German Gref (one of the last liberals-as Russians go-in the power structure):

The head of Russia’s largest bank, German Gref, offered a bleak picture of the fate awaiting the country’s banking sector in 2015 during the set piece Gaidar economic forum in Moscow this week.

“It’s obvious that the banking crisis will be massive,” the Sberbank chief told reporters.

“The state will capitalize the banks and increase its stake in them, and the banks will buy industrial enterprises and become financial-industrial groups,” Gref said Wednesday. “All our economy will be state-run.”

The result will be a simulacrum of the Soviet economy.

Two things are worth noting. The first is that this gives the lie to those who are sanguine about the prospects of a sovereign default in Russia. These optimists downplay the impending downgrades by the rating agencies, and the  fact that Russian CDS are trading well into the junk range by pointing out that Russia’s government debt is relatively small compared to GDP. But one always needs to pay attention to the contingent liabilities, and in the current circumstances these contingent liabilities include a large fraction of the liabilities of the banking and corporate sectors. That’s why Russian 5 year CDS are trading at implied default probabilities of around 10 percent despite modest levels of government indebtedness.

The second notable fact is that once things move onto the government balance sheet, it’s hard to move them off. Companies get quite comfortable with government support and the avoidance of capital market discipline: soft budget constraints-or no budget constraints at all-have their attractions. It’s easier for managers in the elite to influence the members of the elite in government than it is to persuade investors, especially foreign ones. The managers can muster 1000 excuses: think of all the justifications Sechin pushed to stave off privatization of a large stake in Rosneft. Even more excuses will be forthcoming in the midst or even the aftermath of a crisis. What’s more, appeals to patriotism-chauvinism and paranoia, really-will be quite effective. And perhaps most importantly, Putin and his clique will relish exercising even greater control over big firms than they do now. For reasons of power and personal profit.

This means that the prospects for any real structural change in Russia will be even more doubtful than they ever were, and they were never very good, especially in the mature stages of Putinism. Thus, the consequences of the immediate crisis will be severe, but the consequences of the likely response to the crisis will be enduring and quite negative. An even more statist economy even more thoroughly dominated by Putin and his cronies is doomed to stagnation.

We have already seen that to some degree in the aftermath of the last crisis: Russia’s post-2009 growth has been a fraction of its pre-crisis growth. I expect that post-2015, long run growth will ratchet down yet again, as the dead hand of the state and the dying hand of Putin weigh heavily upon the economy.

The geopolitical consequences of this are hard to discern, because there are conflicting forces at work. An economically moribund Russia will have less capacity for adventurism. But a resentful Russia that will blame the crisis and its dreary aftermath on its enemies abroad, and a Putin who will be looking to stoke these resentments for domestic political gain, will be more likely to provoke conflict.

Some years ago Andrei Shleifer said that Russia was becoming a normal,  middle income country. I always thought that was doubtful, especially once Putinism really took hold. I think it is utterly fantastical now. A combination of economic and political factors accentuated by a crisis brought on by sanctions and especially low oil prices will defer indefinitely Russia’s convergence to western-style normalcy.

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January 15, 2015

Alexei Miller Blows More Gas

Filed under: Commodities,Economics,Politics,Regulation — The Professor @ 8:07 pm

As is its wont when desperate, Russia is throwing around threats. And Gazprom and its CEO Alexei Miller are the usual heavies in this role, like mouth-breathers that mafiosi send around to talk to you about how you have such a nice family and it would be a shame if something happened to it.

Yesterday, Miller told Europe it better support Gazprom’s initiative to circumvent Ukraine by shipping gas through Turkey by building a connector between Turkey and Greece, or else:

“Our European partners have been informed of this and now their task is to create the necessary gas transport infrastructure from the Greek and Turkish border,” said Miller, according to a Gazprom statement. [Can the Russians please give this “partners” thing a rest? With partners like them, who needs Ebola?]

“They have a couple of years at most to do this. It’s a very, very tight deadline. In order to meet the deadline, the work on building new trunk gas pipelines in European Union countries must start immediately today,” Miller warned.

Or else what, Alexei?:

“Otherwise, these volumes of gas could end up in other markets.”

Hahahahahaha.

Like where? And don’t tell me China. Heard that one. Over and over and over again.

Look, if you make threats, you need to make them credible. Miller is basically saying that if gas can’t move to Europe via Turkey, Gazprom won’t ship it via Ukraine. If it comes to that, and if Europe is the most valuable destination for Russian gas, Gazprom will sell it there, and ship it via Ukrainian pipes. It can’t afford not to.

This is  a bluff that even the Euroweenies will have no problem calling. This is particularly true if market conditions are like at present, where LNG prices have cratered in Asia, and gas imports are now viable. When the big Australian and US projects come on line later this year, there is a real possibility of an LNG glut which would undercut Russian leverage, not just in Europe, but in China too. (And you know that the Chinese will squeeze Putin’s kiwis like a hungry python.)

What’s more, the whole Turkish route looks like a stitch up job done at the last moment when Bulgaria toed the European line and rejected South Stream. There are so many problems.

First, even ignoring the Turkey-Greece link (and yeah, they always play so well together), it is by no means clear that Turkey has the domestic infrastructure to get the gas from the Black Sea shore to the Aegean. From an Oxford Institute for Energy Studies report (h/t Number One Daughter):

The BOTS [the Turkish national gas company] transport system’s throughput capacity is not sufficiently developed to accept and ship all the contracted gas volume from the eastern suppliers due to the limited installed capacity of the existing compressor stations. BOTAS is able to take some 90% of the gas from the Trans-Balkan Gas Pipeline (the Western Line) and the Blue Stream pipeline from Russia, but has struggled to cope with volumes contracted from Azerbaijan and Iran. Therefore, the company has had to pay billions of dollars for ‘untaken’ gas.

That’s given current flows: it will obviously take a substantial investment in Turkey to handle large additional flows via the new pipeline.

Second, just who is going to pay for this? It ain’t like Gazprom is rollin’ in the dough. To the contrary, like all Russian corporations, Gazprom is in desperate straits. It’s not sanctioned now, but that could change with one wrong move in Ukraine. Moreover, its hard currency revenue picture is dire. Gazprom shipments to Europe were down more than 9 percent last year, no gas is yet flowing to China, and the best part is still to come: Gazprom prices-at its own insistence!-are tied to lagged oil prices. So it is looking at a potential revenue decline from European sales in the 60 percent ballpark.

Schadenfreude doesn’t even come close to describing my feelings at contemplating Gazprom getting what it asked for-nay, insisted on: an oil price link. It made this link a matter of principle, and marshaled one inane argument after another to justify it.

How’s that working out for y’all? Be careful what you ask for!

Third, there’s the little matter of price. Isn’t there always? Immediately after the ballyhooed announcement of the Turkish project, it became known that the Russians and Turks were far apart on price. Look at the history of Vapor Pipe (analogous to vaporware) deals announced with China going back to 2006: they didn’t materialize because of an inability to come to agreement on price. (Even the deal signed when Putin was under the gun has not fully resolved price issues.) This “deal” has every prospect of having the same issues, especially since the Turks realize Russia’s weak bargaining hand here.

Hell, the Russians and Turks can’t even agree on the gas price for this year. They are going to magically lock in a long term price/pricing formula? As if.

So this Turkey route looks like . . . a turkey. Miller is blowing gas. Yet again. I’d be astounded if 1 percent of what that guy says in public turns out to be true.

One last thing. There was a report in the Daily Mail yesterday claiming that shipments of Russian gas via Ukraine to 6 southern European countries had been cut off. This was duly repeated breathlessly by the usual Kremlin echo chambers like Zero Hedge and Infowars. But I have yet to see confirmation in any other source, and I pinged an industry contact who can’t find confirmation either.

It sounds like this is another way of delivering a threat, directed at the most vulnerable parts of the EU, including a country (Greece) that is in political turmoil and which could cause no end of headaches to the Euros-and the Euro. This happens at a time when the wets in Europe are making noises about easing off on sanctions. So I’m getting the impression that this is a story planted in the Daily Mail with the same purpose that Don Corleone places a horse’s head in someone’s bed.

Update. Do I feel like an idiot. Apparently ZH linked to a Daily Mail story from 6 years ago and made it sound like it was from yesterday. When you click through the link, the current date appears at the top of the story. That’s beyond bizarre even for ZH. Shame on me. [The story is that someone emailed asking if I’d seen that ZH story. I hadn’t, but clicked through the link. Like I say, shame on me.]

 

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January 13, 2015

It’s Deja Vu All Over Again, or the Putin Hamster Wheel, Crisis Edition

Filed under: Commodities,Economics,Energy,Financial crisis,Politics,Russia — The Professor @ 8:12 pm

I was glancing over some posts from the 2008-2009 crisis period, and was struck at the similarities between what happened in Russia then and what is happening now. The imploding ruble. Capital flight. Discussions of whether capital controls were necessary to stem the rout. The heavily stressed banking system. The government’s desperate attempts to support the the banking system and big firms. The attempts of Rosneft and Gazprom to use the crisis as an excuse to feed at the government trough. Putin’s crazed and frequently paranoid ramblings, and a broader national paranoia.

Russia scraped by last time, in part because oil prices rebounded starting in mid-2009, and because the world economy (notably China) also fought its way out of the crisis. The stimulus-driven Chinese rebound was especially important, because it supported commodity prices, which was vital for a commodity producer like Russia.

Will it scrape by this time? Well, there is a lot of ruin in a country, as Adam Smith informed us, so it’s always risky to predict a collapse. And Russia has rebounded from even worse situations (think 1998).

That said, things aren’t nearly so favorable for Russia this time around. First, there is the self-inflicted wound: the invasion of Ukraine and the sanctions that followed. This is harming the banking and extractive sectors in particular. The fundamentals are bad enough for these sectors: sanctions exacerbate the problems. Second, Russia can’t look to a return to rapid Chinese demand growth to save it this time. China’s slowdown (which is have broad based effects, including on Tesla which has seen Chinese sales on which it was counting decline substantially) is at the root of the current commodity downturn, and since it is likely that this growth slowdown will persist Russia can’t look for succor from that quarter. Third, as bad as Russia’s institutional environment and governance were in 2009, they are even worse now. The ossification of Putinism (and Putin himself!) and his deep fear of overthrow are leading to regress, rather than progress in the development of the rule of law, secure property rights, and civil society, and the reduction of corruption, cronyism and rent seeking. The horrible institutions and governance will be a drag on growth. Fourth, the fiscal situation is weaker. Reserves are relatively smaller now, and Putin’s electoral promises to raise social payments and his commitment to increase dramatically armaments expenditures represent a significant departure from the fiscal probity of the Kudrin years.

Russia emerged tenuously from the last crisis, and never regained the pre-crisis rate of growth. Its post-2009 growth performance was lackluster, given the fundamental environment and Russia’s stage of development. In my view, the conditions for a recovery are even less favorable this time. Some-and arguably the lion’s share-of the reasons for that are self-inflicted, or more accurately, inflicted by one Vladimir Vladimirovich Putin, whom the Russian populace has chosen to inflict on itself. Consequently, though Russia will hit bottom and rebound, I think it is likely that this rebound will be even weaker than the last one. The national equivalent of a dead cat bounce.

Not that the current situation is not without its moments of levity. Today, for instance, oligarch Mikhail Prokhorov announced he is putting the Brooklyn Nets up for sale. Prokhorov’s wealth has been running in reverse for the past several years, and in the current circumstances, the Nets are arguably his most salable asset. His Russian holdings, not so much.

In a way this is sad, because although Prokhorov is a jerk like most NBA owners, he is also somewhat amusing. In contrast, other owners are just jerks.

But back to the main show. When looking at Russia today, Yogi Berra comes to mind. It’s deja vu all over again. Only worse.

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Call Me Buffy

Filed under: Commodities,Economics,Energy — The Professor @ 7:31 pm

When it comes to the Saudi predatory pricing meme, I feel like Buffy the Vampire Slayer. No matter how many times I drive a stake through its heart, in the next episode it reappears in a different guise.

Here’s yet another example. 

I stipulate that the current low price environment is imposing substantial financial losses on shale producers. I further stipulate that they are currently slashing capex, which will lead to production growth declines at the least, and perhaps production declines  (depending on the race between reduced number of new wells and the increase in well productivity), while prices remain low. I stipulate further still that these effects would be reduced, if the Saudis had cut output to support prices.

Yet it does not follow that the Saudis are not cutting output because they are attempting to drive out shale producers. Because they can’t do so for long. The capital that is leaving the industry now can come back in when demand rebounds. This will limit the price upside, thereby depriving the Saudis of any payoff to recoup the losses they are incurring now.

Instead, the Saudis, just like everybody else in the industry, are coping with the consequences of a decline in demand the best way they can. Given Saudi market share, the elasticity of demand for oil, and crucially, the elasticity of supply of shale oil (which is relatively high, due to the relative flexibility of the technology and the availability of a large amount of prospects), the demand for Saudi oil is relatively elastic. This makes output cuts money losing: the cuts don’t increase price enough to offset the lower number of barrels sold. So keep producing, and pray for a demand turnaround.

Tune in soon for the next installment of Buffy the Saudi Conspiracy Theory Slayer. Alas, I think it will be a long running series, and there’s not a lot of variation in the plot lines, because the economics don’t really change.

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January 11, 2015

Twitter Lunacy on Keystone Makes The Bigtime: The Senate Floor. Which Is No Coincidence.

Filed under: Climate Change,Commodities,Economics,Energy,Politics — The Professor @ 1:22 pm

A few weeks ago I ridiculed one of the arguments raised against Keystone XL: Namely, that oil transported on the pipeline will be exported. I pointed out that this is idiocy. The very purpose of the pipeline is to transport it to the very complex refineries at the Gulf of Mexico. These refineries are clearly able to outbid anyone for oil sands crude transported on Keystone XL, and they will. Moreover, export through the Gulf to Asia, is far more costly than export to Asia via Canada’s west coast.

The main targets of my ridicule in that post were various Internet and Twitter economic geniuses. Hardly an august group. But their voices have been heard! For now the Democrats in Congress are making this argument the centerpiece of their opposition to pro-Keystone legislation:

As Republicans revive the Keystone debate in Congress, opponents are trying to shift the focus to where the Canadian pipeline’s oil will end up once it reaches Texas: China or U.S. gas tanks?

Massachusetts Democrat Edward Markey stood on the floor of the Senate this week next to a giant sign reading “Keystone Export Pipeline” as he argued against a bill to approve the project.

Ed Markey. I should have known.

You can just see TransCanada CEO Russ Girling’s frustration at having to deal with such economic inanity:

Russ Girling, head of pipeline builder TransCanada Corp. (TRP) issued a lengthy statement saying it doesn’t make any sense to export the oil once it reaches the U.S. coast of the Gulf of Mexico, home to the world’s biggest concentration of refineries.

But TransCanada has concluded that this argument, inane as it is, is politically effective:

Girling said the company’s internal polling shows the export issue raises the most concern for Americans. In an interview last month with Bloomberg News, Girling acknowledged that critics found a “nerve that resonates” in that argument.

So much for the influence of economic reasoning on political debate.

I mentioned the Twidiots earlier. There’s something interesting here, and clearly illustrates a pattern. Specifically, that there are no coincidences, comrade. Especially in social media. Or to put it differently, there are too many coincidences for them to be coincidences.

The Twitter storm of the Keystone export meme coincided closely in time with Obama making the same point, and led into the Democratic leadership making this argument the center of their anti-Keystone campaign. In combination with other such “coincidences” strongly suggests manipulation of social media to support political strategies, and in particular administration political strategies. The Twitter storm that broke out in support of the (equally inane) administration free community college initiative over the last few days is another example.

Meaning that pushing back on Twitter stupidity may not be a waste of time. For such stupidity is often merely the handmaiden of some asinine political agenda.

 

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January 6, 2015

Whither Chinese Commodity Demand? Your Guess Is As Good As Mine

Filed under: China,Commodities,Economics,Energy,Politics — The Professor @ 8:40 pm

Commodities are down broadly: Oil gets the headlines, but most major commodities-especially industrial commodities-are down, with iron ore leading the pack. The main driver is Chinese demand: perhaps it’s more accurate to say that the main brake is slackening Chinese demand. Forecasting the course of future Chinese demand is challenging, because there is a huge political component to it.

China has long followed a commodity-intensive, investment-focused (including construction and infrastructure), credit-fueled economic model. It has long been recognized that this model is unsustainable because it is fraught with imbalances. There have been signs that China has recognized this, and in particular the new Xi government is attempting to to navigate this transition, signaling a desire to transform to a consumption-based model with growth rates in the 6-7 percent range rather than 10 percent (though analysts like Michael Pettis say that growth rates in the 3-4 percent range are more realistic.)

One sign of that is the central government’s recent attempts to rein in local governments that borrowed heavily through “local government funding vehicles” (“LGFVs”) to support local infrastructure, housing construction, and industry. Clamping down on LGFVs would be one way of steering China’s economy away from the investment-intensive model:

China’s local government bond issuers face judgment day as authorities in the world’s second-largest economy decide which debt they will or won’t support.

Borrowing costs soared by a record amount last month before today’s deadline for classifying liabilities, on speculation some local government financing vehicles will lose government support after the finance ministry starts reviewing regional authorities’ debt reports. Yield premiums on one-year AA notes, the most common ranking for such issuers, jumped a record 98 basis points in December.

Premier Li Keqiang has stepped up curbs on local borrowings just as LGFVs prepare to repay 558.7 billion yuan ($89.8 billion) of bonds this year amid economic growth that’s set for the slowest pace in more than two decades. The yield on the 2018 notes of Xinjiang Shihezi Development Zone Economic Construction Co., a financing arm in a northwestern city with 620,000 people, climbed a record 63 basis points in December.

But there are mixed signals. Today China announced a $1 trillion stimulus:

China is accelerating 300 infrastructure projects valued at 7 trillion yuan ($1.1 trillion) this year as policy makers seek to shore up growth that’s in danger of slipping below 7 percent.

Premier Li Keqiang’s government approved the projects as part of a broader 400-venture, 10 trillion yuan plan to run from late 2014 through 2016, said people familiar with the matter who asked not to be identified as the decision wasn’t public.

. . . .

The projects will be funded by the central and local governments, state-owned firms, loans and the private sector, said the people. The investment will be in seven industries including oil and gas pipelines, health, clean energy, transportation and mining, according to the people. They said the NDRC is also studying projects in other industries in case the government needs to provide more support for growth.

The NDRC’s spokesman, Li Pumin, said last month China would encourage investment in those areas.

So which is it? A transition to a less-investment intensive model, implemented in large part by reducing the use of credit by local governments? Or continuing the old model, to the tune of $1 trillion over the next couple of years?

Commodity traders want to know. But given the opacity of the Chinese decision making process, it’s impossible to know. The signals are very, very mixed. No doubt there is a raging debate going on within the leadership now, and between the center and the periphery, and decisions are zigging and zagging along with that debate.

I see three alternatives, two of which are commodity bearish. First, there is a transition to a more consumption-based model: this would lead to a decline in commodity demand. Second, there is a crash or hard landing as the credit boom implodes due to the underperformance of past investments: definitely bearish for commodities. Third, the Chinese keep pumping the credit, thereby keeping commodity demand alive. The third alternative only delays the inevitable choice between Options One and Two.

In brief, for the foreseeable future, the most important factor in commodity markets will be what goes on in Chinese policymaking circles. And insofar as that goes, your guess is as good as mine.

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December 31, 2014

The Oil Price Decline: No Conspiracy Theories Need Apply

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 11:50 pm

2014 is in the books, and fittingly the last day of the year  saw a fall in the price of oil. The nearly 50 percent decline in oil prices from the end of June to today was the biggest commodities story of the year. This decline has spawned numerous conspiracy theories, which like most conspiracy theories, are pure bunk.

Most of the stories focus on Saudi Arabia and shale oil. In some versions, the Saudis decided to crash the price of oil to drive out competition from US shale production. I analyzed, and dismissed, this story some weeks back. In other versions, the Saudis decided to crash the price of oil in order to strike a blow at its arch enemy Iran, or in some variants, at Iran and Russia (either in cahoots with the US, or to punish Russia for its support of Assad).

Well, to crash prices it is necessary to increase output. The Saudis, however, did not increase output over the past 6 months: it has remained relatively static. This couldn’t be more different from what happened during the 1985-1986 price collapse, to which the most recent decline is often compared. In the early-80s, the Saudis cut output from about 10 million barrels per day (mmbpd) to as low as 3.5 mmbpd in order to maintain prices in the face of rampant cheating on output quotas by other OPEC members. Realizing that it was being the chump, the Saudis increased output about 44 percent. Nothing like that has happened in the past six months.

The other purported cause of the price decline is the increase in US output. This increase is indeed remarkable, but its timing and magnitude doesn’t explain the price decline. US output has been rising inexorably for a couple of years, and the rate of increase has exceeded forecasts, but not by nearly enough to explain the post-June price decline. Since June, US output has risen by about 100kbpd per month. Cumulatively, that’s about 600kbpd, or a less than .7 of world output. Even using an elasticity on the high side of 10*, this could account for about a 7 percent decline in the price. What’s more, some of the US increase has been needed to offset the on again, off again production in Libya and declines in production in Mexico.

Meaning that the focus on the supply side has been totally misplaced. This in turn implies that all of the hyperventilating about S&S-Shale and the Saudis-is wrongheaded.

Instead, the most likely explanation for the price decline is a decline in demand. The fall in price parallels quite closely declines in world GDP forecasts. Chinese manufacturing in particular has slowed. This has been reflected in other commodity prices which are driven by Chinese industrial demand, most notably iron ore, which has fallen almost 50 percent over the last year, and copper, which has fallen by about 15 percent since June. And somehow I don’t think the Australians or Chileans are attempting to punish their economic rivals or geopolitical enemies. They are just along for the ride on the demand train.

The biggest price daily oil price decline occurred the day after Thanksgiving, when OPEC announced it would not cut output. Prices have also declined on days when the Saudis or other Gulf states reiterated their intention to maintain output. But maintaining and increasing output are two different things. The Saudis didn’t announce that they were opening the taps, like they did in 1986. They are just saying they won’t shut them. And as I argued in an earlier post, given their market share and the elasticity of demand for oil, that’s a rational thing to do without having to resort to predatory explanations.

Again, although most analysis focused on supply, the post-Thanksgiving price decline was really attributable to demand too. Market participants were predicting that OPEC would cut output to support prices in the face of falling demand, and this expectation helped to prop up prices. When the expectation was contradicted, prices fell.

I was only surprised that people were surprised that OPEC didn’t cut output. I didn’t see that happening, and I was right: The Saudis only cut output very modestly (by about 3 percent) during the price collapse in the aftermath of Lehman. Where I was wrong was not understanding that it appears that it was almost universally believed that OPEC was almost certain to make a large cut: I was right about the Saudis, but wrong about what everybody thought about the Saudis. This is why I am blogging, rather than sipping Mai Tais on a yacht that would make Abramovich green with envy.

So, it’s not exactly a case of move along, there’s nothing to see here: the price decline is certainly worth watching. It’s just that what you are seeing is not the result of some grand scheme engineered by the Saudis or anybody else. If there is any scheming going on, it is China’s attempt to move to a more sustainable growth model that is less dependent on stimulus-driven investment in industry and infrastructure.

It is certainly the case that the decline in commodity prices generally, and the oil price in particular, could have -and is indeed already having-seismic economic and geopolitical consequences. It is definitely the case that Russia and Iran are going to suffer mightily as a result of the price decline. This may in turn force them to dial back their geopolitical ambitions, although particularly in the case of Russia it could lead to the opposite response by a desperate leadership. But just because these outcomes might be desirable to the US or the Saudis doesn’t mean that the price decline was deliberately engineered to produce them. They are just consequences of broad economic developments that were intended by no one. For the Saudis, the unintended geopolitical consequences at best palliate some serious economic pain.

Given that (unlike in 2008-2009) the demand decline isn’t due to weakness in the US economy, on the whole the US will benefit from the lower oil price, though some regions (like here in Texas and in North Dakota) will obviously suffer. Drilling activity in the US will decline, but this shouldn’t warm Saudi hearts, because if demand rebounds and drives up prices, drilling will rebound too. The oil and the technology aren’t going anywhere: they are on tap for when the price is right.

Recent academic research shows that most of the price variations in oil over the past decades have been demand driven, rather than supply driven. This most recent decline is just another example of that.

Conniving oil ticks and outlandish Texas oilmen make colorful copy , but usually the world is much more prosaic. Oil supply is very inelastic in the short run, so when demand declines even modestly, prices can plunge. This is counterintuitive to most: how can small changes in demand have such huge effects on prices? This leads to speculations about conspiracy, especially when the price changes can shake nations like Russia to their cores. But such speculations are idle. The normal operations of commodity markets routinely produce such price movements. Which is precisely why subjecting grandiose ambitions for geopolitical power to the vicissitudes of commodity prices is the strategy of fools.

And yeah. I’m looking at you, VVP.

Putin may not be having a happy New Year, but I close this post by wishing all my readers all the best for 2015. Enjoy the schadenfreud!

*This elasticity of 10 is related to the sensitivity of oil consumption to prices. Speculative storage makes oil demand more elastic. Indeed, in response to the price decline, visible speculative storage (primarily at Cushing) has increased, and the market has moved into a contango, which is associated with greater storage.

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December 29, 2014

Three Card Monte, In New York and Moscow

Filed under: Commodities,Economics,Politics,Russia — The Professor @ 8:31 pm

One of the most vivid memories of my early trips to New York was the three card monte games on virtually every corner. The guys would slide their bent cards on the top of cardboard boxes. The most amusing memory is that when a cop would approach one of the card sharps. The hustler running that table would whistle, and you could see others on nearby corners fold up their boxes in a flash and scurry off onto a side street.

Well, they’re back. And like everything else, their games are more expensive. Now you get the privilege of losing $100 when you play: back in the day, it was merely $20.

Speaking of three card monte, it appears that currency traders have figured out the three card monte game that Elvira Nabiullina of the Central Bank of Russia has been playing. The ruble resumed its plunge, declining more than 9 percent today.

As I noted last week, it looks for all the world that the CBR is trying to fool the suckers and hide the black lady with a lot of sleight of hand. Rather than spend reserves officially to prop up the ruble, the CBR is lending dollars to the big banks (VTB and Sberbank) which is lending them to Russian exporters, and the government is ordering the corporates to sell dollars and buy rubles, thereby supporting the currency. See! Reserves stay the same! The country’s finances are healthy!

But if you watch closely, and follow the money and the risk, and you’ll see that the CBR has effectively spent the reserves, or at least put them at significant risk of loss, by replacing dollar liabilities of the US government with dollar liabilities of soon-to-be-junk corporates whose ability to earn dollars to repay the loans has plunged along with the prices of commodities, especially oil.  If that happens, the CBR will have to eat the losses on the collateral posted by the banks (i.e., the loans the banks make to the Russian corporates).

This con game worked for, oh, a good week or so. Today’s big ruble move suggests that market participants are seeing through the scam. So lookout below, and don’t stand under a falling ruble, lest you end up like Wile E. Coyote looking up at the anvil that’s about to drive him into the pavement.

Come to think if it, it amuses me to imagine Putin in the role of Wile E., watching all of his machinations and dreams of conquest come crashing down upon him.

Me-meep.

PS. In the early-80s, the three card monte wager was a little more than 1/2 of the price of a barrel of oil. Today, the price of a barrel of oil is a little more than 1/2 of a three card monte wager. Food for thought.

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December 22, 2014

CFIUS to Rosneft: You Can Do What You Like, Just Don’t Do It Here*

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 7:29 pm

Bowing to the inevitable, Rosneft and Morgan Stanley scuppered their agreement to sell MOST’s energy trading operations to the Russian company. The official explanation was that the deal failed to get approvals from US regulators.

Go figure.

Glad that the Committee on Foreign Investment in the United States,which consists of Treasury, Justice, Homeland Security, Defence, State, Commerce, the US Trade Representative and the Office of Science and Technology Policy, saw off Igor and Co. Putting the FU in CFIUS.

That said, even if the regulatory approvals had been forthcoming, I don’t see how the deal would have worked. As I wrote in September, I didn’t see how a company without access to long term dollar credit (due to sanctions) could operate economically such a credit-intensive business as oil trading. Hell, today Rosneft’s other big announcement was that it paid off some loans it took on when it acquired TNK-BP. When a company announces a loan repayment like it’s some sort of triumph, you know that they aren’t in any position to buy and run a trading business.

Put differently, if CFIUS hadn’t have gotten Rosneft, the sanctions would have.

This might actually be a blessing to Morgan Stanley. The current high volatility, contango, low price environment is actually quite favorable for trading. Low prices reduce working capital needs. Contango makes for profitable storage opportunity. Volatility creates trading opportunities. MOST might actually get more now than Rosneft had agreed to pay.

*Title inspired by Springsteen’s Blinded by the Light.

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December 11, 2014

The Height of Absurdity: The Operation of the Government Hinges on Blanche Lincoln’s Brainchild

Filed under: Commodities,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 9:20 pm

There’s a whole lotta stupid in Frankendodd. A whole lot. The SEF Mandate is at the top of the list, but the “Swaps Pushout” isn’t far behind.

The Pushout was the brainchild of ex-Arkansas Senator Blanche Lincoln. (NB: I understand the risks of using “brain” in the same sentence as “Blanche Lincoln”.) Blanche, she of the historic 21 point annihilation in the 2010 midterms.

In brief, the Pushout required federally insured banks to move-“push out”-some swaps dealing activities to separate subsidiaries that do not have access to federal deposit insurance. This does not apply to all swaps, mind you. Not even to the bulk of them (interest rate swaps, many CDS). But just to commodity derivatives (other than gold), equity derivatives, and un-cleared CDS.

I took particular interest in this because-again-it slammed commodity derivatives. It was one of several provisions (position limits being another prominent example) that explicitly targeted commodities. Apparently the belief is that commodity derivatives are uniquely risky and subject to abuse, which is just untrue.

Consider a dealer making a market in a commodity index swap. That swap is easily hedged in the futures markets. Ditto with a NYMEX lookalike gas or oil swap. Yes, maybe an unhedged commodity swap is riskier than your typical unhedged IRS, but so what? That’s not the way dealers typically trade (they typically run matched books, or nearly matched books), and capital requirements and other regulations mean that riskier positions incur additional costs that mitigate the incentive to take on excessive risks.

So commodity derivatives (or equity derivatives) don’t create exceptional risks that justify exceptional treatment. What’s more, creating stand-alone affiliates to handle this business entails additional costs. More people. Duplication of infrastructure. Additional capital. There are also scope economies (deriving in particular from capital efficiencies that arise from greater netting opportunities that arise from holding multiple, relatively uncorrelated, positions in a single book). Sacrificing those scope economies will lead to fewer commodity swaps dealers, which in turn makes hedging costlier and the market for these swaps less competitive.

In other words, like many parts of Frankendodd, the Pushout was all pain, no gain. And the pain, mind you, will be suffered not so much by the dealer banks, but by the firms in the real economy that use commodity derivatives to hedge their price risks.

That said, it never seemed to be that big a deal, given the relatively small scale of commodity derivatives and equity derivatives in comparison to IRS and other trades that banks were allowed to keep on the books of insured entities. Small beer compared to the rest of the havoc wreaked by the rampaging Frankendodd Monster.

But this obscure provision could be the one that brings on yet another government shutdown. The most hardcore lefties in the Senate (e.g., Elizabeth Warren) and the House (e.g., Maxine Waters) have drawn a line in the sand over the part of the “Cromnibus Bill” that would repeal the Pushout. If passed, “Cromnibus” would fund the government (except DHS) for the next year, thereby avoiding another shutdown.

But claiming that eliminating the Pushout would be an unconscionable capitulation to Wall Street, the lefties are going to the barricades, and threatening to bring DC to a grinding halt rather than let the Pushout bite the dust. This is not about substance, but symbolism. It is also about a defeated party carrying out a rearguard action on ground where its most rabid partisans can rally.

You cannot make up this stuff. Blanche Lincoln’s populist hobby horse, a desperate effort by a doomed politician, could be the pretext for yet another unproductive partisan confrontation that has virtually nothing to do with the more serious issues associated with funding the government for the next year. (If the Pushout hadn’t passed, would Lincoln have lost by 25 points or 15, rather than 21?) (I note that Gary Gensler worked very closely with Lincoln on Frankendodd: “During drafting sessions, Gensler sometimes sat at the table reserved for staff, advising its Democratic chairwoman, Blanche Lincoln of Arkansas.”)

Cromnibus raises very serious issues. The Swaps Pushout isn’t one of them. But rather than joining the debate on the real issues, or conceding their thumping at the polls, demagogic progs are screaming Swaps Pushout or Fight.

What a travesty.

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