Streetwise Professor

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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November 19, 2014

Science!©, KXL Edition

Filed under: Climate Change,Commodities,Economics,Energy,Politics — The Professor @ 4:04 pm

When he said that oil shipped from Canada to the Gulf Coast would be “sent everywhere”, Obama was regurgitating a mantra of the enviro left and mainstream media outlets (but I repeat myself). Remarkably, his own government disagrees.

The State Department’s very detailed analysis of KXL addressed this specific issue in the market analysis chapter of the Environment Impact Statement. The relevant section, on  page 1.4-140 specifically notes that it had received comments throughout the review process claiming that KXL-shipped oil would be exported, and that it felt obliged to respond to these claims. It did so, and delivered a smackdown:

However, such an option appears unlikely to be economically justified for any significant durable trade given transport costs and market conditions.

. . . .

In short, while it is possible that some cargos of heavy WSCB crude could be exported, it is unlikely for a range of economic factors that any such trade flows would be significant or durable in the long run

The supporting analysis basically repeats and supports the arguments I made in my Keystone posts. This analysis is based on an exhaustive review of available data and a firm grasp of refining and transportation economics. Unlike Obama’s, in other words. The analysis states that two alternative models, including one from the EIA (another part of the government) predict no appreciable exports of Canadian heavy crude piped to the US via Keystone, and that this conclusion is robust to various assumptions about available transportation options.

To summarize, President Science!© did not perform, or rely on, any systematic economic analysis when he delivered his verdict on the economics of KXL. He just parroted claims from NRDC, Earth First! and the like that had been thoroughly debunked by a careful analysis of US government economists.

Why does anyone pay the slightest attention to anything he says? He speaks authoritatively about things of which he knows nothing. He is not just ignorant, he is willfully ignorant. His own government did the work that definitely demonstrates the falsity of his arrogantly-delivered claims. Yet he and his acolytes presume to lecture the hoi polloi about Science!©

As an aside, a bill to authorize KXL went down in the Senate yesterday, delivering a likely final blow to the dead parrot candidacy of Louisiana’s Mary Landrieu. Her soon to be erstwhile colleagues preferred to kick her to the curb, rather than force Obama to veto KXL. Now, anyways, because the Republicans will almost surely pass the bill in January, after Mary has moved back to Louisiana, that is if she can bear to leave her DC mansion.

The best part of the day was that a group of Rosebud Sioux (you read about them here first!) interrupted the session with protest chants while Elizabeth Warren was presiding. Senator Warren was not amused. Perhaps if they’d chanted in Cherokee she would have been more sympathetic.

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November 15, 2014

Perhaps Fittingly, a Post on the Land of the Looney Brings Out the Lunatics

Filed under: Climate Change,Commodities,Economics,Energy,Politics — The Professor @ 7:59 pm

Tweeting my post about Obama’s Keystone mendacity unleashed a vortex of leftist idiocy that was stunning even by Twitter standards. Between a visceral and unthinking hatred of Keystone, and the need to rally to the defense of their cult leader (who also has a visceral and unthinking hatred of Keystone), the lunatics felt compelled to swarm from the hive.

One idée fixe was that Obama was right, and the oil is just going to travel down Keystone (spilling huge quantities all the way!), be put on tankers, and sail on its merry way to furriners abroad, especially the Chinese. The fact that the terminus to KXL is located at the heart of the largest concentration of refineries in the US, and refineries tailored to refine heavy crude to boot, could not shake them from their conviction. Apparently refiners in Texas are just going to stand by the Houston Ship Channel and wave as tanker after tanker of oil that they could be refining passes them by on its way to distant markets with much less efficient refineries. It’s rather amusing that some people believe (I won’t say think) that 830kbd is somehow supposed to sneak past the world’s largest concentration of sophisticated refineries tailor-made to process it, and end up in China.

Nor could they be budged by the fact that large quantities of Canadian crude, including oil sands, are already being shipped (via rail, barge, and rail then pipeline) to PADD 3 refineries and refined here. (Canadian oil sands already represent the largest single source of crude imported to, and refined in, the US.) Nor could geography sway them: if you want to ship oil from northwestern Canada to China, going via the Gulf would be a pretty stupid way to do it. Far better to pipe it to Canada’s Pacific coast: indeed, Canada has suggested that’s what it will do if KXL is blocked, which indicates that even that is the 2d best alternative, the best being to refine it in the US. If heavy oil is to go to China, it’s cheaper to substitute Canadian oil for Venezuelan, and have the Bolivarians ship it to the Maoists. (One Einstein said that the expansion of the Panama Canal proves that the oil is destined for China. Er, no. Even after expansion, the Canal can handle only  ships with about 1/2 to 1/3 of the capacity of a VLCC that is the most efficient way to ship crude long distances.)

A few grudgingly conceded that it would be refined in the US, but that wouldn’t benefit Americans, because then the refined products would be snapped up by the voracious Chinese. That there is EIA data showing that 80 percent of US refinery output is consumed domestically, and that less than 4 percent of US refinery exports (and hence less than 1 percent of refinery output) goes to China (and most of that from PADD 5 on the West Coast) made not a dent. And irony is apparently lost on some people: Canada is the 2d largest importer of US refined products. Meaning that a gallon of Keystone crude is far more likely to wind up in a Canuck gas tank than a Chinese one.

One genius Tweeted a Guardian article saying that most of Keystone oil would be exported. Obama is right! QED! Except that the article clearly meant that it would be exported from Canada. Or would that be Cana-duh?

Nor did the fact that transport of oil by rail  is much more dangerous, and poses far greater environmental hazards have the slightest impact on those who are allegedly so sensitive to the fraught state of the planet.

Then it got really nuts. It became all about the Indians. Apparently the ogichidaag* of the Rosebud Lakota Sioux tribe have stated that the House’s approval of Keystone was an act of war:

“The House has now signed our death warrants and the death warrants of our children and grandchildren. The Rosebud Sioux Tribe will not allow this pipeline through our lands,” said President Scott of the Rosebud Sioux Tribe. “We are outraged at the lack of intergovernmental cooperation. We are a sovereign nation and we are not being treated as such. We will close our reservation borders to Keystone XL. Authorizing Keystone XL is an act of war against our people.”

In February of this year, the Rosebud Sioux Tribe and other members of the Great Sioux Nation adopted Tribal resolutions opposing the Keystone XL project.

“The Lakota people have always been stewards of this land,” added President Scott. “We feel it is imperative that we provide safe and responsible alternative energy resources not only to Tribal members but to non-Tribal members as well. We need to stop focusing and investing in risky fossil fuel projects like TransCanada’s Keystone XL pipeline. We need to start remembering that the earth is our mother and stop polluting her and start taking steps to preserve the land, water, and our grandchildren’s future.”

Yes. The Indians hate oil as a despoiler of land. They are all about sustainability and alternative energy. They would never have anything to do with the stuff. Never mind the 30mm bbl of oil produced on reservations, an amount that has spiked up in recent years, primarily because of the fact that the Three Affiliated Tribes on the Fort Berthold Reservation have been major beneficiaries of the Bakken boom.

Keystone’s alleged oppression of Indians brought forth a torrent of race-based idiocy, culminating in this gem.

And I thought Custer died for my sins.

It is also bizarre that Keystone turns prog Citizens of the World into ranting America Firster nationalists. Keystone just helps the Canadians! The Chinese! Apparently, the Chinese get the oil, the Canadians get the money, and ‘Mericans get the pollution. When @libertylynx pointed out that some good ol’ made in the USA Bakken oil would be shipped on Keystone (a true fact, as there will be a Bakken MarketLink on-ramp that will pump US oil into KXL), someone responded, YOU LIE!!! (yes, complete with caps and exclamation marks). Some people just can’t handle the truth.

And yes, of course I was accused of being a Fox News watching (not), Tea Party (not), Koch Brothers shill (not). And a racist by implication.

I was almost tempted to see if I could make things truly nuts by figuring out some way to bring gold bugs into the conversation. I decided against it, figuring that it would risk creating a singularity of stupidity that could destroy the universe. (I will tempt fate, probably tomorrow, by writing a post on recent Russian gold purchases, which will  bring out the gold bugs and the Russian trolls.)

I have very low expectations on the level of debate on Twitter. Subterranean expectations, in fact. But even given that, I was stunned at the level of insanity, stupidity, ignorance, and venom that the topic of Keystone unleashed. I guess it represents a convergence of prog bugbears (oil, capitalism, “climate change”, criticism of Obama), compounded by the trauma of a rout at the polls.

This may seem like a small thing, but I regretfully conclude that it is a harbinger of something bigger. Obama will spend the next two years dog whistling and throwing red meat to his rabid progressive pack as a part of his post-election, lame duck (or would that be lame loon?) guerrilla campaign. Since he can no longer play Moses, he will become Sampson. Keystone is just one of the columns that he will use to pull down the temple around our ears.

It is going to be ugly, ugly, ugly. And Elizabeth Warren is waiting in the wings.

*This is weird, since this is apparently an Ojibwe (Chippewa for you old timers) word for warrior, and not a Lakota word. The Ojibwe are/were a helluva long way from the Great Plains generally, and Nebraska or the Dakotas specifically. Indeed, it gets better! The Ojibwe and the Lakotas were inveterate enemies. (I am always amused at the romanticization of Indians by prog peaceniks: just who the hell were those warriors and braves fighting before the arrival of Europeans? Other tribes, of course.) The Ojibwe got firearms before the Lakota, and drove the Sioux into the Dakotas.

 

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November 14, 2014

Lies, Damn Lies, and Obamaisms

Filed under: Climate Change,Commodities,Economics,Energy,Politics — The Professor @ 6:44 pm

The Gruber Gone Wild video collection (with a release a day!) demonstrates graphically that Obamacare is a 900+ ply tissue of lies. And Obama himself was the lead retailer of those lies.

Today gives another example of Obama’s mendacity. He came out against Keystone, again, but this time on the grounds that it just helps Canada, and doesn’t benefit the US one whit:

“Understand what this project is: It is providing the ability of Canada to pump their oil, send it through our land, down to the Gulf, where it will be sold everywhere else. It doesn’t have an impact on U.S. gas prices,” Mr. Obama said, evidently frustrated with questions about the Canadian-backed project while he was standing alongside Myanmarese opposition leader Aung San Suu Kyi.

(Using a human rights champion-whom he is going to toss aside-as a prop is a great touch.)

Like a good leftist, Obama apparently aspires to become Lillian Hellman, for every word in that statement is a lie, including “and” and “the”.

Where would Canadian heavy crude pumped through Keystone go? The US Gulf.

Now think hard, people. What is located on the Gulf Coast? Think, think, think.

Got it yet? Of course you do: Refineries! You know, those things that turn crude gunk into stuff we can actually use. I know that even idiot leftists know that there are refineries in Texas, because each of the 4 times a Bush ran for president, they told us ad nauseum about the pollution in Houston/Texas from the eeeeeevvvvillll refineries.

US refineries are optimized to handle heavy crude like that produced from oil sands in Canada. At present, we get most of that from Venezuela and Mexico. Canadian crude would displace most, and perhaps all, of that. (Maybe that’s what frosts Obama: boring, pasty white, Anglo Saxon Canadians benefit, and Bolivarians/Chavistas lose out!) Meaning that US refineries would benefit from cheaper crude which would, inevitably, reduce gasoline prices in the US. (It will also alleviate some of the excess supply of condensate and  light crudes produced in the US-particularly the Bakken-as these can be used as diluents. And I know Obama has totally mastered all of the intricacies of pipeline transportation.)

Indeed, Gulf refineries are already processing Canadian heavy crude. More than 100kbd is reaching the Gulf, via rail or barge, and via rail to Cushing and then pipeline to the Gulf. Keystone would just make those flows cheaper-and safer.

So the “it goes everywhere else” line is a total crock. It comes here, is refined, and fuels our cars, and airliners and homes, and is sold overseas so that we can buy other things foreigners produce that we like to consume.

The only question is: What is worse? That Obama actually believes this crock, or he doesn’t but is willing to say anything to defend an indefensible position?

Obama poses as a great environmentalist. Pray tell, how does relying on riskier forms of transport (tankers from Venezuela and Mexico, barges down the US inland waterways, and rail) rather than pipelines help the environment?

And I am sure it is a total coincidence that Obama booster Warren Buffett, he of the BNSF and Union Tank Car Company, is  a major beneficiary of the  stonewalling of Keystone.

The mendacity is not all that’s appalling about this statement. One of Obama’s worst habits has been giving allies the back of his hand, while he sucks up to sworn enemies. Canada is a close ally, and has been for decades. Indeed, even now Canada is actually contributing military force to Obama’s otherwise farcical anti-ISIS coalition.

Fat lot of good that it does them. Who needs friends like Canada when you have Iran? Can Canada help Obama build a legacy? No! So what good are they? (Please ignore the fact that the legacy will really be a nuclear arms race in the other Gulf: the Arab/Persian one.)

The sad thing is that we are in for two years of this mendacity. It will be all Alinsky, all the time. Non-stop demagoguery in the service of progressive causes. He lost, but we’ll pay.

So we will have to update Twain. No longer should you say “lies, damn lies, and statistics.” The version that will describe the next two years is: “lies, damn lies, and Obamaisms.”

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Russians May Want to Consider Starting to Panic

Filed under: Commodities,Economics,Politics,Russia — The Professor @ 1:00 pm

At the outset of the Financial Crisis in September, 2008, Putin touted that Russia would be an “island of stability.” We know how that worked out. Russia experienced the most severe decline of any G-20 economy in large part due to a steep fall in the price of oil.

Today Putin said that Russia was preparing for a “catastrophic” fall in the oil price, but no worries!, everything is under control:

President Vladimir Putin said Russia’s economy, battered by sanctions and a collapsing currency, faces a potential “catastrophic” slump in oil prices.

Such a scenario is “entirely possible, and we admit it,” Putin told the state-run Tass news service before attending this weekend’s Group of 20 summit in Brisbane, Australia, according to a transcript e-mailed by the Kremlin today. Russia’s reserves, at more than $400 billion, would allow the country to weather such a turn of events, he said.

. . . .

With $421 billion in international reserves, Russia has a “big enough” buffer to meet all social commitments and maintain budgetary and economy stability, Putin said. The value of the stockpile last week extended its slide to the longest since 2008 as the monetary authority attempted to smooth the ruble’s decline.

“A country like ours finds the situation easier to cope with,” Putin said. “Why? Because we are producers of oil and gas and we handle our gold and currency reserves and government reserves sparingly.”

Read that again: “A country like ours finds the situation easier to cope with. Why? Because we are producers of oil and gas.” The prices of which are highly sensitive to global economic conditions. And how does being a producer of oil and gas make a catastrophic decline in the price of oil “easier to cope with”? Really. I’d like to know.

As for being a producer of oil and gas, this is true. And that’s the problem: Russia is not a producer of much else. A nicely illustrative factoid: Apple’s market cap exceeds that of the entire Russian stock market (which is dominated by natural resource firms, of course).

Putin mentions meeting social commitments. What about military spending? What about the cost of foreign adventures? Which do you think is going to get whacked first if oil prices decline further, or even stay at current levels?

Given Putin’s track record as a prognosticator of economic crisis, and Russia’s economic resilience, and his interesting theoretical perspectives, his calming words should make Russians think about panicking. Like now.

 

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November 10, 2014

The Saudis: Crazy Like a (Desert) Fox?

Filed under: Commodities,Economics,Energy,Politics — The Professor @ 11:53 am

The recent decline in oil prices, and the failure of Saudi Arabia to cut output has led to many to conclude that the Saudis are trying to drive down prices in order to drive out shale production. I am extremely skeptical, because this would be crazy. It would only make sense if the Saudis are trying to convince shale producers that they are in fact crazy.

The alleged Saudi strategy is a variety of predatory pricing, and such strategies have major problems. Most notably, in the case of shale, driving down prices today would not eliminate any oil that’s in the ground. It would not eliminate drillers’ knowledge about the oil and how to get it out. Perhaps low prices will induce shale producers to delay drilling, and idle some rigs. But as soon as the Saudis cut output in order to cause prices to rise, the shale producers can restart their drilling programs, and under the theory that shale production is keeping prices lower than the Saudis like, this restart will keep prices rising to the level that the Saudis are targeting.

If the Saudis keep prices low for a considerable period of time, some resources (notably labor) may exit the US shale sector, and it may take some time to ramp up production again. But even so, the period of time during which the Saudis can suppress US shale production is limited. The oil ain’t going anywhere, and US producers will bring it out of the ground when the price is right. The Saudis can’t do anything about the fact that the right price for US shale producers is lower than the price they would like.

In brief, predatory pricing requires the predator (KSA in this instance) to suffer losses during the period when it is waging a price war: price wars are costly. But since the price war does not destroy competitive capacity, but just idles it (if that), there is only a very limited period-and perhaps no period at all-during which the predator can sell at higher prices to recoup these costs. This is why predation is usually a losing strategy.

This isn’t a new story, either the predatory pricing argument or the economic retort. Standard Oil was widely believed (based on the tendentious writings of Ida Tarbell, in particular) to have engaged in predation. But John McGee showed more than 50 years ago that this was a fairy tale that did not correspond with the facts.

The analysis above is based on the assumption that everyone is rational and everyone knows everyone is rational. In the 80s, game theorists altered these assumptions and showed that when there is a positive probability that a large firm (e.g., KSA) is irrational and likes to engage in price wars for the fun of it, predation can become a rational strategy by a non-crazy firm. A rational firm can get a reputation for being crazy by preying on competitors. Not wanting to fight crazy, competitors exit or don’t enter.

This theory, like a lot of game theory is quite elegant. And like a lot of game theory, it doesn’t appear to describe anything in that actually happens in reality. Price predators have been very rarely observed in the wild, and arguably they are like the monsters at the edge of pre-Columbian maps.

I am therefore very skeptical that the Saudis are crazy, or acting crazy. This is particularly true given that there is a rational explanation. Given the Saudi market share, and the elasticity of demand for oil, the demand for Saudi oil is elastic. Given that marginal cost is likely very inelastic, it may not reduce output much at all even in the face of a demand decline. Indeed, US shale supply has likely increased the elasticity of the Saudi net demand curve.

I’d also note that there have been stories recently about how some countries, including India and Indonesia, are using the current low prices as an opportunity to cut subsidies. Subsidies have made demand more inelastic (because subsidized consumers get the price signal): reducing or eliminating these subsidies will make demand more elastic.

Greater net demand elasticity, due to greater elasticity of US supply, reduced subsidies, or both, reduces the Saudi incentive to cut output.

Recall that during the financial crisis, even though prices fell about 70 percent from peak to trough, world oil output fell only about 3 percent from its high in July, 2008 to its low in March, 2009. Saudi output fell somewhat more, about 12 percent, but given that the current demand decline is far smaller than observed at the depths of the crisis, and that (as just noted) fundamental conditions have changed so as to reduce Saudi incentive to cut output, the lack of output cuts in the current weak market doesn’t require an explanation based on predatory pricing strategies.

In sum, it is highly likely that the Saudis are not crazy, and aren’t acting crazy, but are instead responding rationally to existing market conditions. Predatory pricing stories should always be viewed with suspicion, because they are seldom ever true. That’s almost certainly the case here too.

 

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November 5, 2014

Will Commodity Traders Replace Banks as Swap Dealers? I Think Not

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 9:09 pm

As many (but not all) banks reduce their paper and physical commodity market activities, it is often suggested that commodity trading firms like Glencore, Vitol, Trafigura and Mercuria will step into the breach, and become swap dealers offering customized risk management structures to clients (and loans to customers to boot). Mercuria CEO Marco Dunand says his company is exploring that:

Last month Swiss trading house Mercuria completed the purchase of U.S. bank JPMorgan’s physical commodities unit. It now wants to expand its provision of hedging services to external customers.

“There’s the desire for the company to enter a bit more into the space of customer service – trying to see whether we can offer some solutions to clients, primarily in Europe,” Dunand told the annual Reuters Commodities Summit.

Others, including Trafigura’s Pierre Lorinet, expressed skepticism.

When asked about this over the past several months, I have been firmly in the skeptic camp. It all comes down to balance sheet.

Yes, commodity traders utilize paper markets extensively, but as hedgers to reduce risks. This allows them to deploy their capital, and leverage it, so that they can carry out their core transformation activities: logistics, storage, processing, and blending. They are really buy-side firms, with relatively thin capital bases.

Derivatives market making, particularly in long tenor deals, or structured ones, is a very capital intensive activity. Indeed, one of the reasons that some banks are cutting back  is that particularly in the existing regulatory environment, the capital commitments for this business make it difficult to operate profitably. If Barclays can’t make money, how can Mercuria?

I can see joint efforts between banks and commodity traders in offering such products, in the same way that banks and traders collaborate to provide commodity prepays. But in those deals, the risk participation of the traders is usually 10 percent or less. Maybe something similar will evolve with commodity derivatives, where the trader faces the customer but most of the risk-and the capital to bear it-resides on bank balance sheets. Perhaps clever bankers will be able to find ways to engage in capital arbitrage in these kinds of deals, but I doubt it.

There is another big impediment: Frankendodd and its European equivalents. Under Dodd-Frank, becoming a swaps market maker brings with it a variety of burdens, including reporting requirements, and most notably capital and collateral requirements. Capital requirements are an anathema to trading firms, precisely because they are typically very capital light. They are also not keen in tying up working capital in margins. One of the factors that drove “futurization” in energy derivatives is that due to the swapaphobia of Congress, swaps were subject to more onerous treatment than swaps: to avoid becoming swap dealers energy market participants eagerly stopped using swaps and switched to economically equivalent futures instead.

The trading arms of two oil majors-BP and Shell-have become swap dealers and will offer risk management products to customers: they were so big, that it was likely infeasible to escape the swap dealer designation. Cargill has become a swap dealer as well, and will make markets. But these are large, asset-heavy firms with the balance sheets to carry these sorts of activities. Although I could see Glencore making a similar choice, I can’t see the rest of the big traders doing the same.

Banks and commodity trading firms are fundamentally different. They are both intermediaries that engage in various transformations, but the transformations that banks and traders perform are quite different. Banks are in the business of bearing credit risk and intermediating market price risks (e.g., by hedging in listed markets exposures they assume through OTC transactions). Traders are in the business of transforming physical commodities. Traders are natural customers of banks, not competitors in credit and risk intermediation. These different functions mean that banks and traders have different capital structures. This further means that it commodity traders cannot readily step into functions that banks exit or cut back.

So methinks banks will remain banks, and traders will remain traders.

 

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Finally: Letting Slip the Accountants of War. Target: Timchenko-and Gunvor.

Filed under: Commodities,Energy,Politics,Russia — The Professor @ 8:13 pm

At the time of the Russian invasion of Georgia in 2008, I advocated that the US government “cry havoc! and let slip the accountants of war.” I specifically identified Gunvor as one of the targets.

Well, more than six years and another invasion later, that’s exactly what’s happening. Federal prosecutors from the Eastern District of New York-the go to guys and gals for big time financial cases-are going after ex(?)-Gunvor owner Gennady Timchenko for potentially corrupt transactions between Gunvor and Rosneft:

U.S. prosecutors have launched a money-laundering investigation of a member of Vladimir Putin ’s inner circle, several people familiar with the efforts said, in a politically sensitive escalation of pressure on the Russian president’s cadre of billionaire supporters.

The U.S. Attorney’s Office for the Eastern District of New York, aided by the Justice Department, is investigating whether Gennady Timchenko transferred funds linked to allegedly corrupt deals in Russia through the U.S. financial system, the people said.

The prosecutors are probing transactions in which the Geneva-based commodities firm Mr. Timchenko founded, Gunvor Group, purchased oil from Russia’s OAO Rosneft and later sold it to third parties, one of the people familiar with the matter said. Investigators have in recent months requested information about the prices Gunvor charged, the person said.

A State Department cable released by Wikileaks suggests at least part of which prosecutors are looking at:

Cables from the U.S. Department of State in 2008, later released by WikiLeaks, relayed allegations that Gunvor is the mandatory trader for certain oil exports, and that the firm adds $1 to each barrel. “In a competitive market, by contrast, an oil trader might add anywhere from five to 20 cents ‘maximum’ to the price,” they said. One cable relayed allegations that Gunvor “is just a front for ’massive corruption.’ ”

Buying Russian oil at prices discounted from world prices and then selling it at world prices has been a ticket to riches in Russia since before the collapse of the USSR, and a proven way of getting money out of the country.

And it gets better! The prosecutors are specifically investigating whether any illicit funds went into Putin’s personal pocket, after a few trips through the laundry.

If indicted, Timchenko would likely be put on an Interpol Red Notice list, which would result in his arrest in most jurisdictions in the world. Even though he has been Red Noticed yet, the US’s FUD campaign has already put a major crimp in Gennady’s get along:

Mr. Timchenko told Russian news agency Itar-Tass in August that he’s afraid to travel to much of Europe.

“Alas, there are reasons to be seriously afraid of provocations from the U.S. special services,” he said in the interview. “Believe me, this isn’t speculation, but concrete information, whose details I cannot share with you yet for obvious reasons. But we are working on this issue.”

So I guess it’s not too big a deal that sanctions have grounded Timchenko’s Gulfstream G650. Not like he’s going anywhere.

The most amusing part of the article was the response of Putin’s Jay Carney, Dmitry Peskov:

Mr. Putin’s spokesman, Dmitry Peskov, said: “We’re not aware of any investigation, and we’re not following such things.”

Not following. Riiiggghhht.

Although the article suggests that Timchenko personally is the target of the probe, Gunvor is inextricably entangled in such an investigation. So speaking of probe, Gunvor can expect months if not years of the financial and legal equivalent of a proctological exam. Thus, the company’s recent frantic efforts to de-Russify may come to naught. The existential crisis that the firm apparently escaped in March and April is likely to re-appear, with a vengeance. Since this investigation strikes at the company directly, and since it involves actions and events that have occurred (or not), there is no ready expedient like severing ties with Timchenko that can defuse this threat. Its fate now largely hinges on what investigators turn up. And believe me, they will leave no stone unturned.

It will be interesting to see what the company’s bond will do tomorrow. Its yield spiked when Timchenko was sanctioned. I’d expect the same tomorrow. It will also be quite interesting to see what the banks do. The company put on a full court press with the banks (and on Capitol Hill too) to keep the loans flowing last time, and succeeded. But this investigation represents a threat that is orders of magnitude greater. Thoughts of BNP are no doubt going through many banker brains right now. The company’s fate therefore truly hangs in the balance.

Ironically, I’m in Atlanta for an Atlanta Fed conference to present a paper about the systemic risks posed (or not) by commodity trading firms. Are they too big to fail? Would the financial distress of a big commodity trading firm pose threats to the broader financial system? I think not, but I believe there are pretty good odds that I will soon be able to add a new case study to the paper.

 

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November 4, 2014

This Cuts No ICE With Me

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 9:24 pm

I admire  Jeffrey Sprecher. ICE has been an amazing success story, and a lot of that has to do with his rather unique combination of vision and ability to execute.

But he is not above talking his book, and he delivered some self-serving, and in fact anti-competition, remarks in ICE’s earnings call held earlier today:

The head of Intercontinental Exchange, the world’s second-largest exchange group by market value, launched an unusually explicit criticism of its bigger competitor’s business strategy as he touted growth in his flagship oil contract.

Commercial customers such as refineries and airlines propelled this growth “as we see our competitors adopting incentives that attract the type of algorithm . . . trading that typically drives commercial users away,” Mr Sprecher said.

Mr Sprecher said “payment for order flow schemes” such as CME’s expanded the market by “attracting traders that really don’t want to hold the risk of your products but just want . . . to get paid to be there.”

If Mr. Sprecher actually believes that, he should be glad that CME (to speak of competitors plural is rather amusing) is implementing a program that per his telling drives away the paying customers, the commercial users.  That’s doubly true since those commercial users would presumably go to ICE. How is CME supposed to make money giving away trading incentives to traders whose presence those who repel those who pay full fare? If that’s what CME is doing, Mr. Sprecher should remember the old adage about not intervening when your enemy is intent on committing a blunder.

Sprecher was touting the fact that ICE’s Brent contract had now surpassed the older CME WTI contract in open interest. Well, this is good for ICE, certainly, but Sprecher and his exchange really have had very little to do with it: this is further proof that it’s usually better to be lucky, than good. Brent’s relative rise is the result of structural factors, most notably the prolonged logistical bottleneck that isolated WTI from waterborne crudes: that bottleneck is largely gone, replaced instead by a regulatory bottleneck, the US export ban.

ICE should not gloat for too long, though, because it is quite likely that the export ban will go, one way or another. What’s more, the resource base supporting the Brent contract is dwindling, and rapidly, whereas the Midcontinent of the US is experiencing a crisis of abundance, if it is experiencing a crisis at all. Logistical bottlenecks created by such crises tend to be transitory, and even regulatory bottlenecks can be overcome. In a few years, WTI will be deeply connected with the waterborne market, albeit in a non-traditional direction. And Brent will be at the mercy of inexorably declining production, and the ability of Platts and an often fractious community of producers and traders to figure out a contractual fix. (Adding Urals to the Brent basket? Really?) So Brent is riding high now, but over the medium to long term, CME will be one breaking out the shades, because WTI will have the brighter future.

As for incentives offered by upstart markets to unseat incumbents, as CME is attempting to do to ICE in Brent, this is a classic competitive tactic, and almost necessary in futures markets. The network effect of order flow means that (as I say in Gregory Meyer’s FT piece) bigger incumbent contracts have a big competitive advantage. The only way that  a competing contract can possibly build order flow and liquidity is to offer incentives, both to market makers (including HFT and algo traders!) who supply liquidity and to the hedgers and speculators that consume liquidity. (I wrote about this last year. Amusingly, I had forgotten about that post until Greg reminded me of it:-P)

Even that is a dicey proposition. Many have tried, and most have failed. But sometimes the upstart the succeeds, and at other times has forced the incumbent to meet the incentives to keep market share, and that can be expensive for the incumbent. That’s probably what Sprecher really doesn’t like. It’s not that incentives don’t work (as the criticism quoted above suggests): it’s that they just might. And if CME’s incentives work it could be an costly proposition for ICE to respond in kind.

In other words, Sprecher is really criticizing a reasonable competitive tactic, because like any dominant incumbent, he doesn’t like competition. That’s his job, but that kind of criticism cuts no ice with me. Or ICE, either, as much as I admire its achievement.

 

 

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October 28, 2014

Convergence to Agreement With Matt Levine

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

Matt Levine graciously led his daily linkwrap with a response to my post on his copper column:

It’s not that hard to manipulate copper.

Craig Pirrong, who knows a lot more about commodities markets than I do [aw, shucks], objects to my take on copper. My view is sort of efficient-markets-y: If one person buys up all the copper in the LME warehouses and then tries to raise the price, the much much greater supply of copper that’s not in those warehouses will flow into the warehouses and limit his ability to do that. And I still think that’s broadly true, but broadly true may not be the point. Pirrong quite rightly points out that there’s lots of friction along the way, and the frictions may matter more than the limits in actual fact.

. . . .

So there are limits to cornering, but they may not be binding on an actual economic actor: You can’t push prices up very much, or forvery long, but you may be able to push them up high enough and for long enough to make yourself a lot of money.

I agree fully there are limits to cornering. The supply curve isn’t completely inelastic. People can divert supplies (at some cost) into deliverable position. The cornerer presents the shorts with the choice: pay me to get out of your positions, or incur the cost of making delivery. Since those delivery costs are finite, the amount the cornerer can extract is limited too.

I agree as well that corners typically elevate prices temporarily: after all, the manipulator needs to liquidate his positions in order to cash out, and as soon as that happens price relationships snap back. But that temporary period can last for some time. Weeks, sometimes more.

What’s more, when the temporary price distortions happen matters a lot. Some squeezes occur at the very end of a contract. This is what happened in Indiana Farm Bureau in 1973. A more recent example is the expiry of the October, 2008 crude oil contract, in which prices spiked hugely in the last few minutes of trading.

The economic harm of these last minute squeezes isn’t that large. There are few players in the market, most hedgers have rolled or offset, and the time frame of the price distortion is too short to cause inefficient movements of the commodity.

But other corners are more protracted, and occur at precisely the wrong time.

Specifically, some corners start to distort prices well before expiration, and precisely when hedgers are looking to roll or offset. Short, out-of-position hedgers looking to roll or offset try to buy either spreads or outrights. The large long planning to corner the market doesn’t liquidate. So the hedgers bid up the expiring contract. Long still doesn’t budge. So the shorts bid it up some more. Eventually, the large long relents and sells when prices and spreads get substantially out of line, and the hedgers exit their positions but at a painfully artificial price. I have documented price distortions in some episodes of 10 percent or more. That’s a big deal, especially when one considers the very thin margins on which commodity trading is done. Combine that price distortion with the fact that a large number of shorts pay that distorted price to get out of their positions, and the dollar damages can be large. Depending on the size of the contract, and the magnitude of the distortion, nine or ten figures large.  (I analyze the liquidation/roll process theoretically in a paper titled “Squeeze Play” that appeared in the Journal of Alternative Investments a few years ago.)

But this is all paper trading, right, so real reapers of wheat and miners of copper aren’t damaged, right? Well, for the bigger, more protracted squeezes that’s not right.

Most hedgers are “out-of-position” they are using a futures contract to hedge something that isn’t deliverable. For example, shippers of Brazilian beans or holders of soybean inventories in Iowa use CBT soybean futures as a hedge. They are therefore long the basis. Corners distort the basis: the futures price rises to reflect the frictions and bottlenecks and technical features of the delivery mechanism, but the prices of the vastly larger quantities of the physical traded and held elsewhere may rise little, if at all. So the out-of-position hedgers don’t gain on their inventories, but they pay an inflated price to exit their futures.

This is why corners are a bad thing. They undermine  the most vital function of futures markets: hedging/risk transfer. Hedgers pay the biggest price for corners precisely because the delivery market is only a small sliver of the world market for a commodity, and because the network effects of liquidity cause all hedging activity to tip to a single market (with a very few exceptions). Thus, the very inside baseball details of the delivery process in a specific, localized market have global consequences. That’s why temporary and not very big and localized are not much comfort when it comes to the price distortions associated with market power manipulations.

 

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