Streetwise Professor

November 8, 2016

WTI Gains on Brent: You Read It Here First!

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 8:22 pm

Streetwiseprofessor, August 2011:

WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

. . . .

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.

Bloomberg, November 2016:

In the battle for supremacy between the world’s two largest oil exchanges, one of them is enjoying a turbo charge from the U.S. government.

Traders bought and sold an average of almost 1.1 billion barrels of West Texas Intermediate crude futures each day in 2016, a surge of 35 percent from a year earlier. The scale of the gain was partly because of the U.S. government lifting decades-old export limits last year, pushing barrels all over the world, according to CME Group Inc., whose Nymex exchange handles the contracts. By comparison, ICE Futures Europe’s Brent contract climbed by 13 percent.

WTI and Brent have been the oil industry’s two main futures contracts for decades. In the past, the American grade’s global popularity was restrained by the fact that exports were heavily restricted. Now, record U.S. shipments are heading overseas, meaning WTI’s appeal as a hedging instrument is rising, particularly in Asia, where CME has expanded its footprint.

“You have turbo-charged WTI as a truly waterborne global benchmark,” Derek Sammann global head of commodities and options products at CME Group, said in a phone interview regarding the lifting of the ban. “You’re seeing the global market reach out and use WTI — whether that’s traders in Europe, Asia and the U.S.”

This should surprise no one–but the conventional wisdom had largely written off WTI in 2011. Given that economic price signals were providing a strong incentive to invest in infrastructure to ease the bottleneck between the Midcon and the sea, it was inevitable that WTI would become reconnected with the waterborne market.

Once the physical bottleneck was eased, the only remaining bottleneck was the export ban. But whereas the export ban was costless prior to the shale boom (because it banned something that wasn’t happening anyways), it became very costly when US supply (especially of light, sweet crude) ballooned. As Peltzman, Becker and others pointed out long ago, politicians do take deadweight costs into account. In a situation like the US oil market, which pitted two large and concentrated interests (upstream producers and refiners) against one another, reducing deadweight costs probably made the difference (as the distributive politics were basically a push).  Thus, the export ban went the way of the dodo, and the tie between WTI and the seaborne market became all that much tighter.

This all means that it’s not quite right to say that CME’s WTI contract has been “turbocharged by the federal government.” Shale it what has turbocharged everything. The US government just accommodated policy to a new economic reality. It was along for the ride, as are CME and ICE.

ICE’s response was kind of amusing:

“ICE Brent Crude remains the leading global benchmark for oil,” the exchange said in an e-mailed response to questions. “With up to two-thirds of the world’s oil priced off the Brent complex, the Brent crude futures contract is a key hedging mechanism for oil market participants.”

Whatever it takes to get them through the day, I guess. Reading that brought to mind statements that LIFFE made about the loss of market share to Eurex in early-1998.

The fact is that there is hysteresis in the choice of the pricing benchmark. As exiting contracts mature and new contracts are entered, market participants will have an opportunity to revisit their choice of pricing benchmark. With the high volume and liquidity of WTI, and the increasingly tight connection between WTI and world oil flows, more participants will shift to WTI pricing.

Further, as I noted in the 2011 post (and several that preceded it) Brent’s structural problems are far more severe. Brent production is declining, and this decline will likely accelerate in a persistent low oil price environment: not only has shale boosted North American supply, it has contributed to the decline in North Sea supply. Brent’s pricing mechanism is already extremely baroque, and will only become more so as Platts scrambles to find more imaginative ways to tie the contract to new supply sources. It is not hard to imagine that in the medium term Brent will be Brent in name only.

Since WTI will likely rest on a strong and perhaps increasing supply base, Brent’s physical underpinning will become progressively shakier, and more Rube Goldberg-like. These different physical market trajectories will benefit WTI derivatives relative to Brent, and will also induce a shift towards using WTI as a benchmark in physical trades. Meaning that ICE is whistling past the graveyard. Or maybe they are just taking Satchel Paige’s advice: “Don’t look back. Something might be gaining on you.” And in ICE Brent’s case, that’s definitely true, and the gap is closing quickly.

 

 

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October 30, 2016

Hillary’s the One!

Filed under: Politics — The Professor @ 7:01 pm

No. I have not lost my mind and decided to come out in support of Hillary. The reference in the post title is to Richard Nixon’s 1968 campaign slogan, and Hillary epitomizes all of the worst of Nixon’s traits.

Nixon infamously said “if the president does it, it’s not illegal.” Hillary’s version of this is actually more ambitious: by deed, if not word, her credo is: “If Hillary does it, it’s not illegal.” The email saga is just the latest in a series of events going back almost 40 years (to her work on a Watergate committee, ironically) in which Hillary has acted as if the rules do not apply to her. Any rules. Any laws.

The Podesta emails reveal that even many of those around her were shocked and chagrined at her audacity to flouting the law and democratic and republican mores by operating a private server. But there was no adult who was willing to challenge her. Instead, everyone–and this arguably includes Obama, who corresponded (under an alias!) with her on her private email–enabled and excused her lawlessness.

One of Hillary’s rationalizations for her behavior is that everyone is out to get her–her paranoia is another Nixonesque trait. This most recent episode will only deepen that paranoia.

Which means that if Hillary is actually elected next Tuesday, the nation is in for a continuing series of these scandals. As president, her sense of entitlement and superiority to the law and paranoia will only only increase. In her mind, if Hillary does it, it’s not illegal, especially because she does it because otherwise her enemies (who are everywhere!) will destroy her.

Put differently, the woman is constitutionally unfit for any position of public trust, let alone the most powerful office in the land. Because of her constitutional unfitness, she is a walking (well, sometimes) Constitutional crisis.

The truly dispiriting thing about all this is that it is not news. The standard Clinton excuse for everything is “this is old news.” Well, Hillary’s defective character is very, very old news: the country has been on notice since at least 1993, and those paying attention knew about it well before that. Nonetheless, she was elected to the Senate from New York twice; appointed to the most senior cabinet position; nominated to run for president by the oldest political party in America; and is on the cusp of being elected president.

Hillary’s character failings are her responsibility alone. Tens of millions of people are responsible for the fact that she remains a carbuncle on the body politic. The most culpable are the alleged elite in this country, who plague us from their dens in DC, Manhattan, the Hamptons, Boston, and California. They are the main accessories in the degradation of the rule of law that is the result of the relentless rise of this woman who believes herself above the law.

One last thing. My comparison of Hillary to Nixon is terribly unfair to the latter. Hillary has none of the intelligence and strategic insight of Nixon. Hillary has ridden the coattails of her husband, whereas Nixon was as close to a self-made man as there has been in American politics in the 20th century. Most importantly, for all of his ethical and legal lapses, from time to time Nixon betrayed having a conscience: Hillary has exhibited no such weakness. (I think Obama knows this too. When the email scandal broke anew and Obama advised Hillary to “follow her conscience,” I think he was engaged in trolling on an epic scale.)

But this is the woman who, barring a staggering development in the most recent episode of the email saga, is likely to be the next president. God bless America. We’ll need it.

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October 29, 2016

James Comey: From Hero to Demon

Filed under: Politics — The Professor @ 9:02 pm

In July, FBI Director James Comey was a hero on the left. He made a contorted presentation of the law and the facts relating Hillary Clinton’s email in order to justify not recommending charging her with any crime. Yes, he said some very critical things about Hillary, but the end result was that she appeared to be out of legal jeopardy.

For her part, Hillary misrepresented what Comey had said, and claimed that he had found nothing discreditable about her conduct. That wasn’t true, but it didn’t really matter. What mattered was that this particular obstacle to her election appeared to have been cleared.

As a result, Comey was lionized on the left, and the Democrats attacked Republicans who criticized him. Donna Brazile, for instance, tweeted  link to a Washington Post article that claimed that Republican criticism of Comey was an attack on the rule of law.

But that was then! Now the left is in paroxysms of rage because yesterday–on a Friday afternoon, natch–Comey sent a letter to Congress claiming that new information found in the–get this–Anthony Weiner investigation had led him to re-open the Hillary investigation. Comey’s letter was equivocal and hedged, but the fact that 11 days before the election the email issue had risen from the dead (just in time for Halloween!) has unleashed leftist furies.

Hillary was informed of this new development while on her plane. She did not leave it for 25 minutes while it sat on the ground in Iowa. Maybe she was doing her best Keith Moon impersonation. You know she’s capable of it.

Yesterday and today the left has been out in full force, demonizing Comey for being a partisan hack attempting to throw the election to Trump. Yesterday I Tweeted in jest “Does the FBI work for the Russians?” because they have become the explanation for all of Hillary’s travails of late. (Joe McCarthy, call your office!) But some people apparently take this seriously. Like Howard Dean, who tweeted “Ironically, James Comey put himself on the same side as Putin.”

The absurdity just keeps on metastasizing.

And just how does this work, exactly? If Comey is a partisan hack intent on torpedoing Clinton and electing Trump, why would he twist himself into knots to exonerate her (well, at least put an end to any thought of charging her) in July? He could have well and truly put her in political peril then. Further, the accommodations he made to Clinton and her close staff were truly extraordinary, and would not have been extended to you or me or pretty much anybody other than Hillary. That’s hardly the kind of thing some partisan Javert would have done. This late in the day modified limited hangout is certainly not a welcome development to Hillary, but is not nearly as threatening as a recommendation to charge would have been in July.

So it is wildly implausible that Comey is attempting to swing the election. Washington being Washington, the most likely explanation for what Comey is doing is CYA. It’s what they do best on the banks of the Potomac.

There was no doubt tremendous discontent in the ranks at the way he handled the Hillary investigation. The (probably unexpected) discovery of information on Anthony Weiner’s and Huma Abedin’s devices would have come out eventually, and if Comey had sat on it until after the election there would have been a political explosion that would have cost him dearly. He also had to calculate that there was a high likelihood that some agent outraged at how the investigation had been handled would leak the new development, which would be the worst of both worlds for him: the information would be out, and it would look like he had tried to suppress it.

So I am guessing that Comey felt himself to be in the position of the weasel in a snare, and chewed off his leg to escape. Yeah, it’s not something he wanted to do, but given the alternatives, it was probably the best course of action available to him.

Just moments ago I read that the FBI did not have permission from Justice to actually read what they had discovered. Given its harrumphing today about how Comey violated department policy by taking actions that could affect an election, no doubt DoJ will not give such permission. And no doubt, Comey knew that they wouldn’t. He could therefore issue his CYA letter in the knowledge that its practical and legal ramifications would be very limited. Justice would stop the investigation dead in its tracks, meaning that no compromising information would be released before the election.

I therefore sadly conclude that this will mean little in the end. The most likely outcome is that Huma Abedin will be sacrificed to save the queen. But the queen will live. And James Comey will limp off into obscurity.

 

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October 27, 2016

Michael Morrel, One of Hillary’s Camp Followers Slouching Towards Washington

Filed under: History,Military,Politics — The Professor @ 8:19 pm

Back in the 1970s there was an entire genre in popular fiction, film, and television in which the CIA was the arch-villain, engaged in vast conspiracies to subvert free government at home or abroad. The stock personal villain in these works was invariably a tightly wrapped, bloodless, controlling, manipulative and often psychopathic CIA official.

At the time, I was not a big fan of these dramas. They were formulaic and seemed overwrought. But I am reconsidering that after the recent rise to public prominence of one Michael Morrel, the ex-deputy director of the CIA. Morrel is straight out of 1970s central casting–tightly wrapped, bloodless, controlling, manipulative and arguably psychopathic.

Morrel is hell-bent on getting the US involved neck-deep into the wars in Syria and Yemen, including doing things that would run the risk of a war with Russia. In August, he advocated killing Russians and Iranians in Syria, “to make them pay a price”:

“The Iranians were making us pay a price. We need to make the Iranians pay a price in Syria. We need to make the Russians pay a price.”

He went on to explain making them “pay the price” would mean killing Russians and Iranians, and said he wants to make Syrian president Bashar al-Assad uncomfortable.

“I want to go after those things that Assad sees as his personal power base. I want to scare Assad.”

This is all but an open call for the US to engage in assassinations of Russians, Iranians, and Syrians in Syria. Perhaps Mr. Morrel missed the part about this being illegal since the 1970s.

Today he advocated intervening on the Saudi side in the war with the Houthis in Yemen, including boarding Iranian vessels. So apparently Mr. Morrel is totally on board with the US being Saudi mercenaries.

This is what America has come to. From fighting against Hessian hirelings to achieve independence, to advocating serving as hirelings for terror funding oil ticks engaged in a pointless war that does not involve American interests in the slightest–and which also risks bringing the US into a broader regional conflict that could easily escalate.

Morrel has also been out front of the attack on Trump’s national security credentials, including making the allegation (based on his ipse dixit alone, of course) that Putin recruited Trump as an “unwitting agent” of Russia.

Just like the stock 70s CIA villain, Morrel obviously burns with ambition. He clearly wants to be Hillary’s CIA director and is willing to say anything to achieve that ambition. Of course, she already owes him, for Morrel was deeply involved in altering the Benghazi talking points in order to support her false version of events.

The thought of someone like Morrel as head of CIA is deeply disturbing. The thought that he likely reflects Hillary Clinton’s foreign policy instincts is doubly so. For getting involved deeply in Syria to overthrow Assad (and confronting the Russians to do so) and in Yemen to advance the Saudi proxy war against Iran are decidedly not in American interests, and would likely result in the waste of great amounts of American blood and treasure, for no strategic purpose whatsoever.

I have long said that you don’t have to worry just about the candidate that is elected to the presidency: you have to pay close attention to her or his camp followers who upon her/his election would be ensconced throughout the vast government bureaucracy, where they can do untold damage with little prospect of being held to account. Michael Morrel epitomizes these dangers. He is a soulless, power-obsessed little man who cavalierly muses about embroiling America in pointless wars, and risking superpower confrontation to do so. He is one of Hillary’s most prominent camp followers. Think of what other ones are currently slouching their way towards Jerusalem on the Potomac in her train.

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October 26, 2016

China Has Been Glencore’s Best Friend, But What China Giveth, China Can Taketh Away

Filed under: China,Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 3:55 pm

Back when Glencore was in extremis last year, I noted that although the company could do some things on its own (e.g., sell assets, cut dividends, reduce debt) to address its problems, its fate was largely out of its hands. Further, its fate was contingent on what happened to commodity prices–coal and copper in particular–and those prices would depend first and foremost on China, and hence on Chinese policy and politics.

Those prognostications have proven largely correct. The company executed a good turnaround plan, but it has received a huge assist from China. China’s heavy-handed intervention to cut thermal and coking coal output has led to a dramatic spike in coal prices. Whereas the steady decline in those prices had weighed heavily on Glencore’s fortunes in 2014 and 2015, the rapid rise in those prices in 2016 has largely retrieved those fortunes. Thermal coal prices are up almost 100 percent since mid-year, and coking coal has risen 240 percent from its lows.

As a result, Glencore was just able to secure almost $100/ton for a thermal coal contract with a major Japanese buyer–up 50 percent from last year’s contract. It is anticipated that this is a harbinger for other major sales contracts.

The company will not capture the entire rally in prices, because it had hedged about 50 percent of its output for 2016. But that means 50 percent wasn’t hedged, and the price rise on those unhedged tons will provide a substantial profit for the company. (This dependence of the company on flat prices indicates that it is not so much a trader anymore, as an upstream producer married to a big trading operation.) (Given that hedges are presumably marked-to-market and collateralized, and hence require Glencore to make cash payments on its derivatives at the time prices rise, I wonder if the rally has created any cash flow issues due to mismatches in cash flows between physical coal sales and derivatives held as hedges.)

So Chinese policy has been Glencore’s best friend so far in 2016. But don’t get too excited. Now the Chinese are concerned that they might have overdone things. The government has just called an emergency meeting with 20 major coal producers to figure out how to raise output in order to lower prices:

China’s state planner has called another last-minute meeting to discuss with more than 20 coal mines more steps to boost supplies to electric utilities and tame a rally in thermal coal prices, according to two sources and local press.

The National Development and Reform Commission (NDRC) has convened a meeting with 22 coal miners for Tuesday to discuss ways to guarantee supply during the winter while sticking to the government’s long-term goal of removing excess inefficient capacity, according to a document inviting companies to the meeting seen by Reuters.

What China giveth, China might taketh away.

All this policy to-and-fro has, of course is leading to speculation about Chinese government policy. This contributes to considerable price volatility, a classic example of policy-induced volatility, which is far more common that policies that reduce volatility.

Presumably this uncertainty will induce Glencore to try to lock in more customers (which is a form of hedging). It might also increase its paper hedging, because a policy U-turn in China (about which your guess and Glencore’s guess are as good as mine) is always a possibility, and could send prices plunging again.

So when I said last year that Glencore was hostage to coal prices, and hence to Chinese government policy–well, here’s the proof. It’s worked in the company’s favor so far, but given the competing interests (electricity generators, steel firms, banks, etc.) affected by commodity prices, a major policy adjustment is a real possibility. Glencore–and other major commodity producers, especially in coal and ferrous metals–remain hostages to Chinese policy and hence Chinese politics.

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October 11, 2016

Why Waste US Special Operators in Battles That Make Game of Thrones Look Simple and Civilized?

Filed under: Military,Politics — The Professor @ 9:43 pm

A week ago, a US Special Forces soldier was killed by an IED in Afghanistan. In its disgusting fashion, the administration denied that this truly fine soldier had perished in combat, but said he was in a “combat situation.” This post-modern word weaseling for political purposes is an insult to those who are putting their lives on the line.

I have long been deeply disturbed by the overuse of special operations troops, for no apparent strategic purpose. To Obama, they are the human equivalent of drones, a way of employing military power in the shadows.

Things are likely to get worse. Special operators are on the ground in northern Syria. (Do they wear boots? Or do they levitate? Obama promised no boots on the ground, after all.) For their troubles, they are routinely insulted by Turkish-backed Salafist rebels, who call them Christian pigs and Crusaders.

But it will likely get even worse. After months of glacial preparation, an attack on Mosul appears if not imminent, on the verge of being imminent. Why do I say worse? Not just because the battle for Mosul is likely to be something akin to Fallujah I and Fallujah II, but because even if ISIS is defeated the aftermath is likely to be extremely messy, and the conditions will likely create fertile conditions for the emergence of another radical Sunni group.

Things were already complicated, with the Kurds and the Shia-dominated Iraqi government sharing the goal of ejecting ISIS, but having incompatible purposes once that happens. But things are getting even more convoluted and conflicted, with Turkey’s Erdogan asserting that his nation will participate in the campaign. Erdogan doesn’t want to see the Kurds in control. He also wants to gain power in northern Iraq, which is oil rich. He also has sectarian motives.

So glad that Obama thought that Erdo was one of his five best friends among world leaders. With friends such as these . . . . Another example of Obama’s incredibly flawed judgment.

Erdogan’s agenda is an anathema to the government of Iraq, so there is now a war of words going on between Erdogan and the Iraqi prime minister Haider al-Adabi.

All this means that post-“victory” Mosul will be a seething cockpit of competing forces, each one worse than the other (with the Kurds being the best of the lot, but thoroughly hated by all the rest). Kurds fighting Turks fighting Iraqi government forces and Shia militias. The Iranians will get involved, likely through their intelligence forces working hand-in-glove with the militias. Local Sunnis will be abused by the Iraqis and will fight back. The situation will make Game of Thrones look simple, ordered, and civilized.

The US will be everyone’s enemy, but every one of these factions will attempt to manipulate the US to do its bidding. And who will be at the center of this mess? US special operations forces. Who will have to keep their heads on a swivel. They will inevitably be targeted by everyone, and will not be able to do anything more than furiously spin the hamster wheel from hell. It will be Afghanistan, only worse. They will exhibit exceptional heroism and unmatched operational skill, and kill a lot of horrible people, but the ultimate result will be indecisive.

What could be our objective? What outcomes are even possible, and what would it cost in lives and treasure to achieve them? I find it hard to conceive of any outcome that would be worth the cost.

And US special operations troops would bear the brunt of those costs. They are too special, in many senses of the word, to fritter away in incipient fiascos like Mosul promises to be.

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October 6, 2016

We Are Not Saudi Arabia’s Mercenaries

Filed under: Military,Politics — The Professor @ 6:57 pm

The Middle East has become the Mother of All FUBARs. Yet there are many in the United States, on both sides of the partisan divide, advocating deeper American involvement.

The focus is on Syria. Yes, the war there is horrific. Yes, the Syrians and Russians have dramatically ratcheted up the intensity of their brutal air campaign in Aleppo, even during an alleged cease fire. But what could the US accomplish by getting more deeply involved? Perpetuating a stalemate?

Or let’s say that somehow magically the US is able to support the toppling of Assad without sparking a war with Russia. What would be the outcome? It would be the victory of Sunni jihadis who would inevitably wreak a vengeance on Alawis, Shias, and Christians that would rival if not exceed anything Assad has done. Further, Sunni jihadis are America’s enemies, and have killed far more Americans than the Assads ever did, even when they were neck deep in supporting terrorism. Indeed, the worst that Assad has done to the US in the past decades is support the rat line that supplied Al Qaeda in Iraq (ISIS’ predecessor). After an Assad defeat, Syria would become a base for anti-American jihadis.

Which helps us how, exactly?

Many of those advocating deeper American involvement in Syria point to the fact that Putin is winning there. So what? To think that a Putin victory axiomatically spells an American defeat are engaged in precisely the type of zero sum thinking that leads Putin to exaggerate Syria’s importance. The more we fret about his “winning” in Syria, the more we feed his ambitions there and elsewhere in the region, and convince him that he’s on the right track.

Speaking of Russia, John Kerry has expressed outrage that Russia deceived him, and ramped up its military operations in Aleppo immediately after he thought they had agreed to a cease fire. Have we ever had such a credulous oaf in such a high position? Kerry needs to acquaint himself with The Farmer and the Viper (or the Frog and the Scorpion). The entire idea of a deal between Russia and the US is farcical, as long as the US insists that Assad must go. Russia is all in for Assad, and will not go for any deal that threatens him. The US claims it will not go for any deal that strengthens him. These positions are utterly incompatible.

Truth be told, it is the Saudis and the Qataris and others in the GCC who have a strong interest in Syria. They view it as a front in their Muslim Civil War with Shia Iran and express grave fear of a Shia Crescent running from Iran through Iraq to the Mediterranean. They exert tremendous influence in DC. Those who fall for their line, and parrot their line, are not acting in American interests.

The Saudis’ attempts to influence US policy are not limited to Syria. They are bogged down in a war in Yemen that is also a front in their conflict with Iran, and are importuning the United States to support them in that conflict as well.

The US has even less of an interest in Yemen than it does in Syria.

In fact, the US has very little interest in the Muslim Civil War, other than that neither side win. Militarily, neither the Iranians or the GCC have the ability to conquer the other, so we have zero reason to get in the middle. If they want to fritter away treasure and lives in peripheral conflicts, so be it.

We are not Saudi Arabia’s mercenaries. Let them fight their own battles.

It is highly unlikely we could achieve a good military outcome in either Syria or Yemen.  The latter has a lot in common with Afghanistan, the former with Iraq and Libya, and look how swimmingly THOSE are going. And even if we could create some simulacrum of peace, at what would be a heavy price in lives and money, how would the US gain? I am not seeing it.

These are sideshows. We should be more focused on peer competitors like China and Russia. After 15 years of grinding conflict and budgetary stringency, the US urgently needs to recapitalize its military. In these circumstances, risking a confrontation with Russia to fight Saudi Arabia’s battles is beyond insane. To hell with them and the camel they rode in on.

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Igor for the Win!, or Privatization With Russian Characteristics

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 5:19 pm

Today Russia announced that Rosneft has been approved to purchase Bashneft. This despite the Economics Ministry’s earlier attempts to prevent state-owned Rosneft from participating in a “privatization” of a company that had been de-privatized (through expropriation), and Putin’s statement that this was not the best option.

But there’s more! The company was handed to Rosneft on a platter. Rosneft didn’t have to win an auction. There was no competitive tender process. It was just Christmas in October for Igor.

This speaks volumes about how Russia is run. (I won’t say “governed” or “managed.”) In a natural state way, a favored insider was rewarded despite the fact that all economic considerations push the other way. For one thing, privatization has been touted as a way of alleviating Russia’s severe budgetary problems. This will not do that. The decision occurred at a time when all indications are that the economic stringency will endure. There is no prospect for a serious rebound in oil prices, and there is also little prospect of an easing in sanctions. Indeed, Putin’s obduracy in Ukraine and his escalation in Syria may result in the imposition of additional sanctions. Putin’s spending priorities are increasing the economic strain. He plans to increase defense spending by $10 billion, and reduce social spending by less than that. Furthermore, Rosneft is a wretchedly run company that will generate far less value from Bashneft than would another owner, including a private Russian firm like Lukoil.

In brief, a cash-strapped Putin passed up an opportunity to generate some revenue and handed over Bashneft to a company that destroys value rather than enhances it. Such are the ways of a natural state that functions by allocating rents to courtiers. Privatization, with Russian characteristics.

In sum, in the Bashneft deal, Igor wins. And Russia loses.

The only thing that could potentially redeem this is if there was a quid pro quo, namely, that Sechin would relent to the sale of big stake in Rosneft to outside investors. Nothing of the sort was announced today, and perhaps they are waiting for some time to pass so as not to suggest that there was a deal. But I doubt it. I am guessing that Igor will win that argument too.

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War Communism Meets Central Clearing

Filed under: Clearing,Derivatives,Economics,Politics,Regulation — The Professor @ 1:58 pm

I believe that I am on firm ground saying that I was one of the first to warn of the systemic risks created by the mandating of central clearing on a vast scale, and that CCPs could become the next Too Big to Fail entities. At ISDA events in 2011, moreover, I stated publicly that it was disturbing that the move to mandates was occurring before plans to recover or resolve insolvent clearinghouses were in place. At one of these events, in London, then-CEO of LCH Michael Davie said that it was important to ensure to have plans in place to deal with CCPs in wartime (meaning during crises) as well as in peace.

Well, we are five years on, and well after mandates have been in effect, those resolution and recovery authorities are moving glacially towards implementation. Several outlets report that the European Commission is finalizing legislation on CCP recovery. As Phil Stafford at the FT writes:

The burden of losses could fall on the clearing house or its parent company, its member banks; the banks’ customers, such as pension funds, or the taxpayer.

Brussels is proposing that clearing house members, such as banks, be required to participate in a cash call if the clearing house has exhausted its so-called “waterfall” of default procedures.

The participants would take a share in the clearing house in return, according to drafts seen by the Financial Times.

Authorities would also have the power to reduce the value of payments to the clearing house members, the draft says. In the event of a systemic crisis, regulators could use government money as long as doing so complies with EU rules on state aid.

Powers available to regulators would include tearing up derivatives contracts and applying a “haircut” to the margin or collateral that has been pledged by the clearing house’s end users.

Asset managers have long feared that haircutting margin would be tantamount to expropriating assets that belong to customers.

The draft is circulating in samizdat form, and I have seen a copy. It is rather breathtaking in its assertions of authority. Apropos Michael Davie’s remarks on operating CCPs during wartime, my first thought upon reading Chapters IV and V was “War Communism Comes to Derivatives.” One statement buried in the Executive Summary Sheet, phrased in bland bureaucratic language, is rather stunning in its import: “A recovery and resolution framework for CCPs is likely to involve a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders.”

In a nutshell, the proposal says that the resolution authority can do pretty much it damn well pleases, including nullifying normal protections of bankruptcy/insolvency law, transferring assets to whomever it chooses, terminating contracts (not just of those who default, but any contract cleared by a CCP in resolution), bailing in any CCP creditor up to 100 percent, suspending the right to terminate contracts, and haircutting variation margin. The authority also has the power to force CCP members to make additional default fund contributions up to the amount of their original contribution, over and above any additional contribution specified in the CCP member agreement. In brief, the resolution authority has pretty much unlimited discretion to rob Peter to pay Paul, subject to only a few procedural safeguards.

About the only thing that the law doesn’t authorize is initial margin haircutting. Given the audacity of other powers that it confers, this is sort of surprising. It’s also not evident to me that variation margin haircutting is a better alternative. One often overlooked aspect of VM haircuts is that they hit hedgers hardest. Those who are using derivatives to manage risk look to variation margin payments to offset losses on other exposures that they are hedging. VM haircutting deprives them of some of these gains precisely when they are likely to need them most. Put differently, VM haircutting imposes losses on those that are least likely to be able to bear them when it is most costly to bear them. Hedgers are risk averse. One reason they are risk aversion is that losses on their underlying exposures could force them into financial distress. Blowing up their hedges could do just that.

Perhaps one could argue that CCPs are so systemically important and the implications of their insolvency are so ominous that extraordinary measures are necessary–in its Executive Summary, and in the proposal itself, the EC does just that. But this just calls into question the prudence of creating and supersizing entities with such latent destructive potential.

There is also a fundamental tension here. The potential that the resolution authority will impose large costs on members of CCPs, and even their customers, raises the burden of being a member, or trading cleared products. This is a disincentive to membership, and with the economics of supply clearing services already looking rather grim, may lead to further exits from the business. Similarly, bail-ins of creditors and the potential seizure of ownership interests without due process will make it more difficult for CCPs to obtain funding. Thus, mandating expansion of clearing makes necessary exceptional resolution measures that lead to reduced supply of clearing services, and reduced supply of the credit, liquidity, and capital that they need to function.

It must also be recognized that with discretionary power come inefficient selective intervention and influence costs. The resolution body will have extraordinary power to transfer vast sums from some agents to others. This makes it inevitable that the body will be subjected to intense rent seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens. Rent seeking is costly. Furthermore, it will inevitably inject a degree of arbitrariness into the outcome of resolution. This arbitrariness creates additional uncertainty and risk, precisely at a time when these are already at heightened, and likely extreme, levels. Furthermore, it is likely to create dangerous feedback loops. The prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that pushes it over the edge.

To put it simply, if the option to resort to War Communism is necessary to deal with the fallout from a CCP failure in a post-mandate world, maybe you shouldn’t start the war in the first place.

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October 4, 2016

Going Deutsche: Beware Politicians Adjudicating Political Bargains Gone Bad

A few years ago, when doing research on the systemic risk (or not) of commodity trading firms, I thought it would be illuminating to compare these firms to major banks, to demonstrate that (a) commodity traders were really not that big, when compared to systemically important financial institutions, and (b) their balance sheets, though leveraged, were not as geared as banks and unlike banks did not involve the maturity and liquidity transformations that make banks subject to destabilizing runs. One thing that jumped out at me was just what a monstrosity Deutsche Bank was, in terms of size and leverage and Byzantine complexity. Its

My review (conducted in 2012 and again in 2013) looked back several years.  For instance, in 2013, the bank’s leverage ratio was around 37 to 1, and its total assets were over $2 trillion.

Since then, Deutsche has reduced its leverage somewhat, but it is still huge, highly leveraged (especially in comparison to its American peers), and deeply interconnected with all other major financial institutions, and a plethora of industrial and service firms.

This makes its current travails a source of concern. The stock price has fallen to record low levels, and its CDS spreads have spiked to post-crisis highs. The CDS curve is also flattening, which is particularly ominous. Last week, Bloomberg reported signs of a mini-run, not by depositors, but by hedge funds and others who were moving collateral and cleared derivatives positions to other FCMs. (I’ve seen no indication that people are looking to novate OTC deals in order to replace Deutsche as a counterparty, which would be a real harbinger of problems.)

Ironically, the current crisis was sparked by chronic indigestion from the last crisis, namely the legal and regulatory issues related to US subprime. The US Department of Justice presented a settlement demand of $14 billion dollars, which if paid, would put the bank at risk of breaching its regulatory capital requirements: the bank has only reserved $5 billion. Deutsche’s stock price and CDS have lurched up and down over the past few days, driven mainly by news regarding how these legal issues would be resolved.

The $14 billion US demand is only one of Deutsche’s sources of legal agita, most of which are also the result of pre-crisis and crisis issues, such as the IBOR cases and charges that it facilitated accounting chicanery at Italian banks.

Deutsche’s problems are political poison in Germany, for Merkel in particular. She is in a difficult situation. Bailouts are no more popular in Europe than in the US, but if anyone is too big to fail, it is Deutsche. Serious problems there could portend another financial crisis, and one in which the epicenter would be Germany. Merkel and virtually all other politicians in Germany have adamantly stated there would be no bailouts: politically, they have to. But such unconditional statements are not credible–that’s the essence of the TBTF problem. If Deutsche teeters, Germany–no doubt aided by the ECB and the Fed–will be forced to act. This would have seismic political effects, particularly in Europe, and especially particularly in southern Europe, which believes that it has been condemned to economic penury to protect German economic interests, not least of which is Deutsche Bank.

No doubt the German government, the Bundesbank, and the ECB are crafting bailouts that don’t look like bailouts–at least if you don’t look too closely. One idea I saw floated was to sell off Deutsche assets to other entities, with the asset values guaranteed. Since direct government guarantees would be too transparent (and perhaps contrary to EU law), no doubt the guarantees will be costumed in some way as well.

The whole mess points out the inherently political nature of banking, and how the political bargain (in the phrase of Calomaris and Haber in Fragile by Design) has changed. As they show quite persuasively (as have others, such as Ragu Rajan), the pre-crisis political bargain was that banks would facilitate income redistribution policy by provide credit to low income individuals. This seeded the crisis (though like any complex event, there were myriad other contributing causal factors), the political aftershocks of which are being felt to this day. Banking became a pariah industry, as the very large legal settlements extracted by governments indicate.

The difficulty, of course, is that banks are still big and systemically important, and as the Deutsche Bank situation demonstrates, punishing for past misdeeds that contributed to the last crisis could, if taken too far, create a new one. This is particularly true in the Brave New World of post-crisis monetary policy, with its zero or negative interest rates, which makes it very difficult for banks to earn a profit by doing business the old fashioned way (borrow at 3, lend at 6, hit the links by 3) as politicians claim that they desire.

It is definitely desirable to have mechanisms to hold financial malfeasors accountable, but the Deutsche episode illustrates several difficulties. The first is that even the biggest entities can be judgment proof, and imposing judgments on them can have disastrous economic externalities. Another is that there is a considerable degree of arbitrariness in the process, and the results of the process. There is little due process here, and the risks and costs of litigation mean that the outcome of attempts to hold bankers accountable is the result of a negotiation between the state and large financial institutions that is carried out in a highly politicized environment in which emotions and narratives are likely to trump facts. There is room for serious doubt about the quality of justice that results from this process. Waving multi-billion dollar scalps may be emotionally and politically satisfying, but arbitrariness in the process and the result means that the law and regulation will not have an appropriate deterrence effect. If it is understood that fines are the result of a political lottery, the link between conduct and penalty is tenuous, at best, meaning that the penalties will be a very poor way of deterring bad conduct.

Further, it must always be remembered that what happened in the 2000s (and what happened prior to every prior banking crisis) was the result of a political bargain. Holding bankers to account for abusing the terms of the bargain is fine, but unless politicians and regulators are held to account, there will be future political bargains that will result in future crises. To have a co-conspirator in the deals that culminated in the financial crisis–the US government–hold itself out as the judge and jury in these matters will not make things better. It is likely to make things worse, because it only increases the politicization of finance. Since that politicization is is at the root of financial crises, that is a disturbing development indeed.

So yes, bankers should be at the bar. But they should not be alone. And they should be joined there by the very institutions who presume to bring them to justice.

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