Streetwise Professor

October 24, 2014

Someone Didn’t Get the Memo, and I Wouldn’t Want to be That Guy*

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 9:23 am

Due to the five year gap in 30 year bond issuance, in mid-September the CME revised the deliverable basket for the June 2015 T-bond contract. It deleted the 6.25 of May, 2015 because its delivery value would have been so far below the values of the other bonds in the deliverable set. This would have made the contract more susceptible to a squeeze because only that bond would effectively be available for delivery due to the way the contract works.

The CME issued a memo on the subject.

Somebody obviously didn’t get it:

It looks like a Treasury futures trader failed to do his or her homework.

The price of 30-year Treasury futures expiring in June traded for less than 145 for about two hours yesterday before shooting up to more than 150. The 7.3 percent surge in their price yesterday, on the first day these particular contracts were traded, was unprecedented for 30-year Treasury futures, according to data compiled by Bloomberg. Volume amounted to 1,639 contracts with a notional value of $164 million.

What sets these futures apart from others is they’re the first ones where the U.S. government’s decision to stop issuing 30-year bonds from 2001 to 2006 must be accounted for when valuing the derivatives. The size and speed of yesterday’s jump indicates the initial traders of the contracts hadn’t factored in the unusual rules governing these particular products, said Craig Pirrong, a finance professor at the University of Houston.

“That is humongous,” said Pirrong, referring to the 7.3 percent jump. “We’re talking about a move you might see over weeks or a month occur in a day.” Pirrong said he suspected it was an algorithmic trader using an outdated model. “I would not want to be that guy,” the professor said.

Here’s a quick and dirty explanation. Multiple bonds are eligible for delivery. Since they have different coupons and maturities, their prices can differ substantially. For instance, the 3.5 percent of Feb 39 sells for about $110, and the 6.25 of 2030 sells for about $146. If both bonds were deliverable at par, no one would ever deliver the 6.25 of 2030, and it would not contribute in any real way to deliverable supply. Therefore, the CME effectively handicaps the delivery race by assigning conversion factors to each bond. The conversion factor is essentially the bond’s price on the delivery date assuming it yields 6 percent to maturity. If all bonds yield 6 percent, their delivery values would be equal, and the deliverable supply would be the total amount of deliverable bonds outstanding. This would make it almost impossible to squeeze the market.

Since bonds differ in duration, and actual yields differ from 6 percent, the conversion factors narrow but do not eliminate disparities in the delivery values of bonds. One bond will be cheapest-to-deliver. Roughly speaking, the CTD bond will be the one with the lowest ratio of price to conversion factor.

That’s where the problem comes in. For the June contract, if the 6.25 of 2030 was eligible to deliver, its converted price would be around $142. Due to the issuance/maturity gap, the converted prices of all the other bonds is substantially higher, ranging between $154 and $159.

This is due a duration effect. When yields are below 6 percent, and they are now way below, at less than 3 percent, low duration bonds become CTD: the prices of low duration bonds rise less (in percentage terms) for a given decline in yields than the prices of high duration bonds, so they become relatively cheaper. The 6.25 of 2030 has a substantially lower duration than the other bonds in the deliverable basket because of its lower maturity (more than 5 years) and higher coupon. So it would have been cheapest to deliver by a huge margin had CME allowed it to remain in the basket. This would have shrunk the deliverable supply to the amount outstanding of that bond, making a squeeze more likely, and more profitable. (And squeezes in Treasuries do occur. They were rife in the mid-to-late-80s, and there was a squeeze of the Ten Year in June of 2005. The 2005 squeeze, which was pretty gross, occurred when there was less than a $1 difference in delivery values between the CTD and the next-cheapest. The squeezer distorted prices by about 15/32s.)

The futures contract prices the CTD bond. So if someone-or someone’s algo-believed that the 6.25 of 2030 was in the deliverable basket, they would have calculated the no-arb price as being around $142. But that bond isn’t in the basket, so the no-arb value of the contract is above $150. Apparently the guy* who didn’t get the memo merrily offered the June future at $142 in the mistaken belief that was near fair value.


After selling quite a few contracts, the memo non-reader wised up, and the price jumped up to over $150, which reflected the real deliverable basket, not the imaginary one.

This price move was “humongous” given that implied vol is around 6 percent. That’s an annualized number, meaning that the move on a single day was more than a one-sigma annual move. I was being very cautious by saying this magnitude move would be expected to occur over weeks or months. But that’s what happens when the reporter catches me in the gym rather than at my computer.

This wasn’t a fat-finger error. This was a fat-head error. It cost somebody a good deal of money, and made some others very happy.

So word up, traders (and programmers): always read the memos from your friendly local exchange.

*Or gal, as Mary Childs pointed out on Twitter.

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October 19, 2014

It *Was* Too Quiet Out There

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis — The Professor @ 5:28 pm

Four weeks ago I gave the keynote talk at Energy Risk Asia in Singapore. My talk was a look back at commodity market developments in the past year, followed by a look forward.

The theme of the look back was “A Perfect Calm.” I noted that volatility levels across all markets, not just commodities, were at very low levels. Equity vols, as measured by the VIX, had been in the 10 percent range in August and had only ticked up to around 12 percent by late-September. Commodity volatilities were even more remarkable. Historically, the low level of commodity volatilities (the 5th percentile) have been around the median of equity vols and well above currency and bond vols. During the first half of the year, however, commodity vols were below the 5th percentile of equity vols, and below the 95th percentile of currency and bond vols. Pretty amazing.

I argued that this reflected a happy combination of supply and demand factors. In energy and ags in particular, abundant supplies put a drag on volatility. But volatility from the demand side was low too. The low VIX levels are a good proxy for macro uncertainty, or the lack thereof. Put both of those together, and you get a perfect calm.

But perfect calms are the exception, rather than the rule. The last slide in my talk looked forward, and cribbed a movie cliche: It was titled “It’s Quiet Out There. Too Quiet.” I noted that periods of very low volatility frequently bear the seeds of their destruction. When risk measures are low, firms and traders lever up and increase position sizes. A bit of economic turbulence increases volatilities, which leads to breaches in risk limits, which forces deleveraging and reductions in positions. This tends to lead to reduced liquidity, exaggerated price moves, yet higher volatility, leading to more deleveraging and repositioning, and on it goes. That is, there can be a positive feedback loop. Transitions from low to high volatility can be very abrupt.

It looks like that’s what has happened in the weeks since my return. Equity markets are down substantially. Commodities, notably energy, have slumped: Brent is down to around $88. Volatilities have spiked. The VIX reached over 31 percent last week, and the crude oil VIX went from about 15 percent at the end of August to over 37 percent last week.

The spark appears to have been mounting evidence of a slowdown in Europe and China. Ebola might have been a contributing factor in the last week or two, but in my view the economic weakness is the main driver.

I admit to being like the title character in My Cousin Vinnie. He had difficulty sleeping in the Alabama country quiet, but slept like a lamb in a raucous county jail. Times like these are more interesting, anyways.

So it turns out it was too quiet out there.

And remember. Today is the 27th anniversary of the ’87 Crash (one of the formative experiences of my professional life). Octobers are often . . . interesting (the most dangerous word in the English language). So the markets bear watching closely. If you aren’t interested in them, they may well be interested in you.

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October 14, 2014

The IEA Has Identification Issues: Econ 101 Fail

Filed under: Commodities,Economics,Energy — The Professor @ 1:39 pm

The IEA’s most recent report includes this gem of an analysis:

Recent price declines have sparked speculation about their potentially supportive impact on demand. The price elasticity of oil demand tends to be asymmetric in nature: oil demand falls on high prices more easily than it expands on lower prices. Looking at the last five incidences of crude oil price declines of 15% or more over a four‐month period (as occurred, at the time of going to press, June‐through‐ October), only in one case (in 2006) was a noticeable uptick in demand seen.

The immediate impact tends to be weakening demand reducing oil prices, as opposed to lower prices triggering additional deliveries, which is very much lagged. The dramatic price decline of late 2008/early 2009, for example, was not followed by a noticeable uptick in global oil demand growth until 2H09, many months after prices had started to rebound. Oil price changes will naturally affect demand differently depending on whether they are themselves supply‐ or demand‐driven. The price drop in 2008 was overwhelmingly demand led, whereas recent declines appear to have been largely in response to rising supply. Nevertheless, recent price movements are not expected to significantly lift demand in the short term, especially since crude price drops are not fully carried through to retail product prices.

That sound you just heard was me doing a I-coulda-had-a-V8 head slap.

Um, the IEA is making the most basic error possible: mistaking a fall in quantity demanded (consumed) for a fall in demand. A decline in demand (i.e., a movement in the demand curve) leads to a decline in price and quantity. This is exactly what happened in the episodes the IEA discusses: the 2008-2009 episode is the most severe example. Demand fell precipitously due to the financial crisis and subsequent Great Recession. This cratered prices, and also led to a decline in consumption.

Prices and consumption move inversely when there is a move along the demand curve. This occurs due to a supply shock.

This is Econ 101 textbook stuff, people. It has an name: identification. You can identify a demand curve only by holding it fixed and moving the supply curve. If the demand curve is moving around, you can’t identify a demand curve from price and quantity movements.

Hell, the IEA even recognizes this problem: look at the second paragraph. But if they recognize the problem in the second paragraph, why did they write the first paragraph? And this asymmetry in elasticity stuff? What, did the IEA have an acid flashback of a 60s textbook’s analysis of Sweezy’s Kinked Demand Curve?

I would seriously question whether the current price drop is totally supply driven as well. Chinese demand appears to have dropped steeply, and the European economy is slowing notably: Germany in particular has hit a rough patch.

So the IEA fails Econ 101, but we’re supposed to take seriously its analysis of more complex issues?

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October 13, 2014

Russia in a Nutshell: Three Stories That Convey Important Truths About an Aggressive, Mendacious, and Economically Weak Empire

Filed under: Commodities,Economics,Energy,Military,Politics,Russia — The Professor @ 2:43 pm

A quick rundown on some Russia stories. Three stories that encapsulate important truths about an unhappy country that seems intent on forcing others to share in its unhappiness.

First, there was a lot of attention paid to Putin’s announcement that 17,000 soldiers would be withdrawn from Rostov, on the Ukrainian border, to return to their bases. The reactions are a combination of poor memory, ignorance, and wishful thinking. Poor memory because something similar happened in the spring, which didn’t preclude an invasion in the summer. Ignorance, because if you are aware of Russia’s conscription cycle, you are aware that the fall 2013 conscript class is due to be mustered out, and units must return to their bases to discharge last year’s class and induct and train this year’s. That’s what happened in the spring. This ignorance is inexcusable now, as it was written about in the spring, notably by Pavel Felgenhauer: I wrote about it here as well. Wishful thinking, because everyone is grasping at the hope that Putin will back down from the Ukraine battle. As if.

There is no news here. This is an artifact of Russia’s conscription system. Period. Watch for new training exercises in a few months, and the deployment of units to the Ukrainian border again, once the new conscripts are integrated into their units.

Second, Russia will sign several intergovernmental agreements with China when Premier Li visits next month. One of them is an agreement to export gas from Russia to China.

I know what you’re thinking: “Wait, didn’t they sign that deal to huge fanfare back in May?” Apparently not:

Russia has prepared intergovernmental agreements to sign during Chinese Premier Li Keqiang’s visit to Moscow next week including one on a $400 billion natural gas deal agreed in May, Russia’s deputy foreign minister said.

Russian gas exporter Gazprom and China National Petroleum Corp (CNPC) have agreed that Russia will supply China with 38 billion cubic metres of gas starting from 2019.

Yet on Friday Gazprom said an intergovernmental agreement between Russia and China required for the plan to come into force had not yet been signed.

Russian Deputy Foreign Minister Igor Morgulov told Chinese state news agency Xinhua that governmental agreements including one on gas were ready for signing during Li’s coming visit.

“They include an intergovernmental agreement on natural gas supplies via an “‘eastern’ route,” he said. [Emphasis added.]

Proving yet again that announcements from the Russians about any deal should be treated with extreme skepticism. They are the masters of vaporcontracts.

The Russians are touting various deals with the Chinese as proof of their invulnerability to western sanctions and pressure. The feebleminded believe this. In fact, Russian desperation is palpable: the fact that they hyped the gas non-deal is a perfect example of this. If you don’t think that the Chinese are aware that they have the whip hand here, and are flogging the Russians for all it is worth, please contact me. I’ve securitized some bridges, and I’m sure they’d be perfect for your portfolios!

Third, the Russians are in full paranoid mode over the decline in oil prices. Brent is down to $88/bbl, which puts Urals at about $86. Speaking of 86, they are having flashbacks to 1986, when the Saudis flooded the world with oil. This began the fatal crash of the Soviet economy (described well in Gaidar’s book, Empire).

The vice-president of Russia’s state-owned oil behemoth Rosneft has accused Saudi Arabia of manipulating the oil price for political reasons. Mikhail Leontyev was quoted in Russian media as saying:

Prices can be manipulative. First of all, Saudi Arabia has begun making big discounts on oil. This is political manipulation, and Saudi Arabia is being manipulated, which could end badly.

Er, this is way different from 1986. At most, the Saudis have increased output only slightly (about 100kbbl/day): in ’86, they more than doubled output. The Saudis are just acknowledging market reality. Demand is weak,  supplies from the US are growing, and Libya is coming back into the market. Put those  things together, and prices are inevitably going to fall. The Saudis can see the writing on the wall, and their market share is sufficiently small that unilateral reductions in their output are not economically rational. Funny, now that I mention it: Saudi market share is about the same as Russian market share. The Russians produce up to capacity, because that is profit maximizing. Yet they expect the Saudis to cut back output? Of course they do! The Saudis should sacrifice their own interests to bail out the Russians! Of course they should!

Leontyev seems to be vying with the Gazprom guy Komlev to see who can make the most idiotic statements about world energy markets. Something that commentor Ivan passed on suggests that as idiotic as Komlev was, Leontyev has him hands down. The Rosneft spokesman also blamed low oil prices on ISIS selling oil at a “triple discount.” Hilarious! World oil prices are determined in the world market. ISIS has to sell at a huge discount because it is politically radioactive, and because it cannot access world markets directly. Those to whom it sells pocket the discount to adjust for the risk of dealing with a political leper (a radioactive leper!-I’m not mixing metaphors), and sell at the world price. The world price is determined by world output, not the price of the first sale. If anything, ISIS is propping up prices by reducing output in Syria (not a big deal) and threatening output in Iraq (a bigger deal).

Together, these three stories convey important truths  about Russia. And truth is ugly indeed. An aggressive, economically tottering empire dependent on commodity rents, and constitutionally unable to tell the truth or deal with reality.

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October 7, 2014

The Crude Export Ban: Moot For Now, But That’s Not Necessarily a Good Thing

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 7:55 pm

Markets are wondrous things.

Consider the crude oil market. Remember the debate about the US crude export ban? Well, in a few months, that has turned out to be a moot issue. Due to the collapse of demand in Europe, and the freeing up of Nigerian supplies formerly exported to the US, price relationships have changed dramatically. Whereas Louisiana Light Sweet had recently traded at a big discount to Brent, it is now at a sufficiently high premium that it is economical to import Brent to the US, especially to the East Coast. Jones Act tankers expected to take crude from the Gulf to the East Coast are swinging at anchor because it is now economical to feed the EC refineries with Brent.

What’s more, the US crude glut fattened domestic refining margins. So how did US refiners respond? By increasing capacity, and reducing maintenance schedules by 30 percent. This has increased the demand for domestic crude, which has in turn helped close, and at times reverse, the US price discount. This investment in capacity and adjustment of maintenance schedules is arguably inefficient: it’s better to direct some of the crude to underutilized European refineries than to expand refining capacity in the US. But the point is that this inefficiency is attributable to inefficient laws: the laws on oil export have stood still, but the markets have moved on to mitigate the damage.

Meaning at present, price differentials are such that it would not be profitable to export crude even if it were permitted.

This may be true now, but of course it is not destined to be true forever. Therefore, it is still desirable to eliminate the ban, if only to eliminate the incentives to use scarce resources to take advantage of the price distortions that the ban can sometimes cause.  The ban might be a moot issue for now, but that’s not necessarily a good thing.

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Manipulation Prosecutions: Going for the Capillaries, Ignoring the Jugular

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

The USDOJ has filed criminal charges against a trader named Michael Coscia for “spoofing” CME and ICE futures markets. Frankendodd made spoofing a crime.

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.

Is this inefficient? Yeah, I guess. Is it a big deal? Color me skeptical, especially since the activity is self-correcting. The strategy works if those at the inside market, who these days are likely to be HFT firms, consider the away from the market spoofing orders to be informative. But they aren’t. The HFT firms at the inside market who respond to the spoof will lose money. They will soon figure this out, and won’t respond to the spoofs any more: they will deem away-from-the-market orders as uninformative. Problem solved.

But the CFTC (and now DOJ, apparently) are obsessed with this, and other games for ticks. They pursue these activities with Javert-like mania.

What makes this maddening to me is that while obsessing over ticks gained by spoofs or other HFT strategies, regulators have totally overlooked corners that have distorted prices by many, many ticks.

I know of two market operations in the last ten years plausibly involving major corners that have arguably imposed mid-nine figure losses on futures market participants, and in one of the case, possibly ten-figure losses. Yes, we are talking hundreds of millions and perhaps more than a billion. To put things in context, Coscia is alleged to have made a whopping $1.6 million. That is, two or three orders of magnitude less than the losses involved in these corners.

And what have CFTC and DOJ done in these cases? Exactly bupkus. Zip. Nada. Squat.

Why is that? Part of the explanation is that previous CFTC decisions in the 1980s were economically incoherent, and have posed substantial obstacles to winning a verdict: I wrote about this almost 20 years ago, in a Washington & Lee Law Review article. But I doubt that is the entire story, especially since one of the cases is post-Frankendodd, and hence the one of the legal obstacles that the CFTC complains about (relating to proving intent) has been eliminated.

The other part of the story is too big to jail. Both of the entities involved are very major players in their respective markets. Very major. One has been very much in the news lately.

In other words, the CFTC is likely intimidated by-and arguably captured by-those it is intended to police because they are very major players.

The only recent exception I can think of-and by recent, I mean within the last 10 years-is the DOJ’s prosecution of BP for manipulating the propane market. But BP was already in the DOJ’s sights because of the Texas City explosion. Somebody dropped the dime on BP for propane, and DOJ used that to turn up the heat on BP. BP eventually agreed to a deferred prosecution agreement, in which it paid a $100 million fine to the government, and paid $53 million into a restitution fund to compensate any private litigants.

The Commodity Exchange Act specifically proscribes corners. Corners occur. But the CFTC never goes after corners, even if they cost market participants hundreds of millions of dollars. Probably because corners that cost market participants nine or ten figures can only be carried out by firms that can hire very expensive lawyers and who have multiple congressmen and senators on speed dial.

Instead, the regulators go after much smaller fry so they can crow about how tough they are on wrongdoers. They go after shoplifters, and let axe murderers walk free. Going for the capillaries, ignoring the jugular.

All this said, I am not a fan of criminalizing manipulation. Monetary fines-or damages in private litigation-commensurate to the harm imposed will have the appropriate deterrent effect.

The timidity of regulators in going after manipulators is precisely why a private right of action in manipulation cases is extremely important. (Full disclosure: I have served as an expert in such cases.)

One last comment about criminal charges in manipulation cases. The DOJ prosecuted the individual traders in the propane corner. Judge Miller in the Houston Division of the  Southern District of Texas threw out the cases, on the grounds that the Commodity Exchange Act’s anti-manipulation provisions are unconstitutionally vague. Now this is only a district court decision, and the anti-spoofing case will be brought under new provisions of the CEA adopted as the result of Dodd-Frank. Nonetheless, I think it is highly likely that Coscia will raise the same defense (as well as some others). It will be interesting to see how this plays out.

But regardless of how it plays out, regulators’ obsession with HFT games stands in stark contrast with their conspicuous silence on major corner cases. Given that corners can cause major dislocations in markets, and completely undermine the purposes of futures markets-risk transfer and price discovery-this imbalance speaks very ill of the priorities-and the gumption (I cleaned that up)-of those charged with policing US futures markets.

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October 6, 2014

Laughing Gaz(prom)

Filed under: Commodities,Derivatives,Economics,Energy,Russia — The Professor @ 6:21 pm

Silly me, I thought the “gaz” in Gazprom was methane. But reading this article in Platts, I’m thinking it’s nitrous oxide.  I had to read it several times before I could catch a glimpse of what Sergei Komlev, head of Gazprom Export’s contract structuring and price formation department, was getting at. I now see the basic problem is that he thinks the price of gas in Europe is too low. And the culprit? Speculators! Paper traders! “Virtual gas”!

Come on Sergei, you can’t get originality points for that one. Round up the usual suspects and all that.

Anyways, FWIW, here are Sergei’s deep, N20 inspired thoughts on the subject:

“Paradoxically, gas price erosion is taking place at a time when physical supplies are tight,” Komlev said, adding that some European market analysts had acknowledged that hubs were overflowing with largely “paper” gas.

This became possible with the development of the spot gas market as hubs developed a new class of customer such as banks and commodity traders, Komlev said.

But “as no one is in a position to predict the weather, traded volumes of ‘paper’ gas significantly surpassed real world demand for gas because of the abnormally warm winter in 2014,” he said.

This artificial oversupply had put significant pressure on the market, resulting in a collapse in spot prices, he said.

“As a result, our European customers are facing negative margins as they have to supply gas to end-consumers at lower prices than they pay for physical deliveries under long-term contracts,” he said.

“When some time ago our clients sold our contract volumes on a forward curve for many months ahead they targeted this new class of customers first,” he said.

I’m doubled over in convulsions here, and I haven’t even taken a hit. Is there such a thing as second hand N20?

Let me translate what really happened. Speculators went long. Weather was unusually warm. Prices fell, and speculators took a bath. Simple story. As for “tight physical supplies”, later on Sergei lets on that gas demand in Europe fell 20 percent in the 1st half of 2014.

Sorry, but “paper gas” doesn’t heat a single home or turn a single turbine. It doesn’t oversupply. It doesn’t overdemand. It just transfers price risk. As contracts go prompt, the price of paper gas converges to the price of physical gas, which is driven by supply and demand fundamentals-most notably the weather. What frosts (or is it burns?) Sergei is that the price converged to a low price which is out of line with the oil-linked prices in Gazprom contracts. This has imposed pain on Gazprom’s customers, who are clamoring to renegotiate their contracts, which Sergei and Gazprom no likey.

Like the proverbial blind hog and the acorn, Sergei did root up a bit of the truth:

Long-term contracts were shaped at a time when spot gas markets in Europe were not developed, and the gas price — linked to oil prices — “was practically independent of supply/demand dynamics,” Komlev said.

I repeat: The oil linked price was/is “practically independent of supply/demand dynamics.”

Exactly! That’s the problem! That’s why a move to hub-based pricing, where gas prices can reflect gas values, is so necessary: it ensures that contract prices reflect supply/demand dynamics. Prices that don’t reflect values lead to distortions in output and consumption and investment, and to conflicts between buyers and sellers that inflate transactions costs.

Komlev went on to say that since price in the contracts was not flexible, and was out of line with gas values, it was necessary to permit quantity flexibility in Gazprom contracts. If the company is dragged kicking and screaming into the 21st century, and must index its contractual gas prices to-wait for it-gas prices, it will eliminate the quantity optionality.

Throw the customers into that b’rer patch, Sergei. Truth be told, fixed quantity forward supply contracts are quite the thing in the US, and have been since the dysfunctional price controls on gas were discarded in the 1980s. Companies can buy and sell base load volumes using fixed quantity long term contracts (perhaps at indexed prices); respond to near term fundamental conditions with short-term (e.g., month ahead) forward contracts entered into during something analogous to “bid week” and respond to intra-month/daily supply and demand swings with spot transactions. They can also get various customized contracts that are seasonally shaped, or have some optionality that permits efficient responses to supply and demand shocks (though the CFTC’s proposed Seven Prong-Prong, not Pirrong-test for determining whether supply contracts with quantity optionality are swaps subject to Frankendodd could wreak havoc with that).

A liberated gas market offers a variety of contract terms, including contracts that embed various sorts of quantity optionality. But the point is that heterogeneous suppliers and demanders can utilize a variety of contracts tailored to meet their idiosyncratic needs, as opposed to Gazprom contracts, which remind me of nothing so much as an ill-fitting Soviet suit.

I do have to thank Sergei. I haven’t had such a good laugh in a long time, with or without chemical assistance. But I doubt he-and Gazprom-will be laughing for long. The disconnect between oil and gas prices has become too large and too persistent for their beloved oil linkage to survive much longer.

Speaking of oil-linked prices, this is an issue in LNG markets too. I recently authored a white paper on the subject. I’ll provide a link and write a post on that subject in the next few days.

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September 28, 2014

Discounting Sechin, and Making Perfidious Exxon Suck It Up

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 7:13 am

Igor Sechin has made a breathless announcement of a discovery of oil in the Kara Sea:

Exxon Mobil Corp. and Russia’s OAO Rosneft have found major amounts of oil and natural gas at their first well in the Arctic, Rosneft said Saturday, offering a glimpse of the potential buried beneath the ice-studded waters north of Siberia.

. . . .

“This is an outstanding result of the first exploratory drilling on a completely new offshore field,” Igor Sechin, Rosneft’s chief executive, said in a statement. Rosneft praised other western partners including Schlumberger Ltd., Halliburton Co. and Weatherford International PLC.

Sechin said the field would become the Arctic equivalent of Saudi Arabia, in terms of reserves.

To which I say: not so fast. First, this is the first well and the full analysis of the results has barely begun, let alone been completed. Second, the area is huge, and a single well cannot provide more than a rough estimate of the productivity of the entire field. Third, ExxonMobil was far more circumspect:

“We have encountered hydrocarbons but it is premature to speculate on any potential outcome regarding the University-1 exploration well,” Alan Jeffers, an Exxon spokesman, said Saturday

Fifth, even if the size of the reserves is similar to those in Saudi, the cost of getting at them, and the technological and logistical challenges of exploiting them, are far greater: even with such assistance, Arctic drilling is a fraught enterprise (just as Shell). Development and production will require the assistance of the “western partners” that Sechin praised, and that assistance is on hold for who knows how long as a result of sanctions. No doubt Perfidious Exxon will be pulling out all the stops to get the sanctions lifted, but betting on that is even more dicey than Arctic oil exploration, at the present political juncture.

But most importantly, one must heavily discount Sechin’s happy talk due to these very same political circumstances. He needs to put on a bold front to counter negative news about the company and its prospects in the aftermath of sanctions. Further, to the extent that he can convince the west that a bonanza awaits only if sanctions are eased he can increase the odds of a lifting of the sanctions. He thus has an even greater incentive to exaggerate than would normally be the case, and note that he is not operating under the same legal restrictions on making forward looking statements as a US CEO would (which could explain Exxon’s reticence, despite the fact it also would like to advance arguments that would undermine the sanctions regime).  Exaggerations therefore are basically costless, and could have a big positive payoff to the extent they are believed. All the more reason not to believe him.

Exxon’s complicity here is disturbing. Understandable, but disturbing. It is dealing with the devil, and although the deal benefits shareholders, these benefits pale with the costs resulting from bolstering a revisionist, revanchist, and expansionist gangster state, and the capos who benefit directly from it. This is a case where state action is warranted on public goods grounds.

Indeed, the more Rex Tillerson squeals, the stronger my conviction that the sanctions are a good idea. Exxon will reap only a fraction of the benefits of cooperation with Rosneft: the larger fraction will accrue to Rosneft and the Russian state, and thereby fuel its predations, and those in the power structure that are the residual claimants. In this case, what’s good for Exxon is good for Putinistan, which given the malign consequences of the latter is precisely why the former should have to suck it up.

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September 26, 2014

Gazprom: Price Discriminating, Monopolist Thugs. What’s Not to Love?

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 8:48 am

Russia is mounting a full-spectrum offensive to grind Ukraine into the dust. Military, paramilitary, diplomatic, political, and economic.

The centerpiece of the economic campaign is, of course, gas. Today Russia’s energy minister threatened a gas cutoff to any country that resold gas to Ukraine, in violation of Gazprom’s sales contracts. Hungary immediately knuckled under.

Energy Minister Alexander Novak asserted that the re-export to Ukraine of gas Europe buys from Russia was illegal and could see some of its nations go without fuel shipments from state energy giant Gazprom for the first time since 2009.

“We hope that our European partners will stick to the agreements. That is the only way to ensure there are no interruptions in gas deliveries to European consumers,” Novak told Friday’s edition of Germany’s Handelsblatt business daily.

Novak’s comments were published only hours after Ukraine’s state energy firm Naftogaz reported an interruption of gas supplies it receives through Hungary.

Naftogaz noted that the apparent cut “came only a few days after a visit to Hungary by representatives from (Russian state gas firm) Gazprom”.

Hungarian Prime Minister Viktor Orban conceded that his country could not risk losing access to Russian gas — responsible for about 60 percent of the country’s supplies — over Ukraine.

“Hungary can not get into a situation in which, due to the Russian-Ukrainian conflict, it cannot access its required supply of energy,” Orban said on state radio.

For its part, the EU disputes Russia’s interpretation of contracts:

The European Union rapped Hungary over the supply interruption.

“There is nothing preventing EU companies to dispose freely of gas they have purchased from Gazprom, and this includes selling this gas to customers both within the EU as well as to third countries such as Ukraine,” Commission spokeswoman Helene Banner said in Brussels.

Any such contractual terms would be, literally, agreements in restraint of trade. They restrain trade between first buyers of Russian gas and others.

Sometimes  restraints enhance efficiency. That is definitely not the case here. The restrictions have one purpose, and one purpose only. To facilitate price discrimination (and hence the exercise of market power) by Gazprom and Russia. This map provides a fascinating visual demonstration of how Gazprom discriminates by price. Adjacent countries can pay dramatically different prices. More distant countries pay lower prices than ones nearer to Russia.

Much of the discrimination is purely economic. Countries with access to few alternative suppliers or few alternative energy sources pay higher prices. But much of the discrimination is political. Note that Belarus and Armenia, reliable Russian clients, pay very low prices, but Ukraine and Lithuania, which bracket Belarus, pay very high ones.

Destination clauses are necessary to maintain these big price differentials. Hence eliminating them would reduce Gazprom’s market power and profitability (though the welfare effects of 3d degree price discrimination are ambiguous) and also reduce Russia’s political leverage. With the ability to resell, those buying at a favored price could resell to those whom Gazprom wants to charge a high price. Gazprom would have to charge pretty much the same price to everyone (though since diversions are not costless it would retain some ability to discriminate, but not nearly as much, especially in the longer run as new infrastructure could be created).

Which makes it all the more bizarre that Europe, and Germany in particular, hyperventilate over far more dubious and abstract theories of market abuse by Google and Microsoft, but meekly let Gazprom run roughshod with textbook monopolist tactics. The lack of a unified energy policy, and unified energy purchasing (Europe could act as a monopsonist) allows Gazprom to play its usual divide and conquer games, of which price discrimination is one obvious result. Expediting the antitrust action against Gazprom would be another way of combating Gazprom’s malign influence.

In the current dispute the stakes are both economic and political/geopolitical. Despite the high stakes, Europe will doubtless limit its response to theoretical objections like those delivered by Helene Banner.

One (bitterly) amusing sidelight to this is despite its market power (the result of Russian law which gives it a monopoly over gas exports and of European acquiescence) Gazprom is still a horrible performer by all conventional metrics. It’s price-earnings ratio is about 3. Contrast that to Shell, Chevron, and Exxon, which have ratios of 10, 11, and 12, respectively. Performance metrics, such as value added per employee or earnings as related to reserves, are horrible.

This is a testament in large part to appalling corporate governance and the insecurity of profits and property in Russia. Speaking of which, there were several developments in the Yevtushenkov/Sistema/Bashneft story today. Yevtushenkov’s house arrest was confirmed and extended, and the Russian government seized Sistema’s Bashneft shares.

I’m never going to run out of material. Never.

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Sanctions Bite. Just Ask Igor Sechin . . . and Morgan Stanley

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 1:05 am

Some months ago, Morgan Stanley agreed to sell its oil trading business to Rosneft. Now the deal is at risk of unraveling, due to the effect of sanctions on the Russian company:

Rosneft has enough cash to buy the Morgan Stanley unit, which sources said carries a price tag of between $300 million to $400 million. But to operate day-to-day, the business requires billions of dollars of bank lines of credit, funding that is difficult to secure given the sanctions.

Reuters could not learn the precise size of these credit lines, but trading houses that compete with Morgan Stanley such as Vitol, [VITOLV.UL] Mercuria and Trafigura [TRAFGF.UL] each have $30 billion to $40 billion worth of credit lines with dozens of banks.

“This deal just cannot go through. It is not an issue of finding $300 million to buy the business. Rosneft has the money. But it won’t be able to operate it,” one Russian-based source with direct knowledge of the matter said.

Trading is an extremely working capital intensive business. Depending on its size, a supertanker can carry oil worth $50 million-$300 million, and this has to be financed during the period of the voyage. A decent-sized trading operation can have several tankers on the water, plus additional oil in storage, all of which needs to be financed. A major trading operation needs access to billions in funding on a continuous basis.

Typically, traders finance this with bank credit, with the bigger ones using open lines with banks (which offer considerable flexibility). (I discuss commodity trade financing in my white paper, The Economics of Commodity Trading Firms-bonus video!) You cannot compete efficiently in this business without access to such credit/credit lines. Loss of access to credit is a death sentence to a trading firm, and one that can’t get access in the first place will never be born. That’s where Rosneft finds itself now.

This is another blow to Sechin’s (and Putin’s) aspirations to make Rosneft into a peer super major like BP or Shell or Total that have  robust trading operations. The firm’s longer term ambitions have been seriously dented by the withdrawal of western firms from deepwater and unconventional onshore drilling projects in response to sanctions.

This is also a pain for Morgan Stanley, which is under government pressure to exit the physical trading business: it’s not clear that there’s anyone with enough appetite to pay what Rosneft agreed to. But its pain is nothing compared to Rosneft’s, which will remain dependent on traders to market its oil for the foreseeable future.

Breaks me all up.

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