Streetwise Professor

January 27, 2015

A Good SWIFT Kick

Filed under: Economics,Politics,Russia — The Professor @ 7:39 pm

They say a foolish consistency is the hobgoblin of little minds, so it must be that Russians have truly expansive minds indeed. On the one hand, by May they will have established a payments system that will eliminate dependence on the international payments system called SWIFT. The Russians have also been boasting about how deals with China and Iran to conduct business using their own currencies rather than the dollar will immunize them from American financial measures. Do your worst, stupid Americans!

On the other hand, excluding Russia from SWIFT would be a declaration of war. According to VTB CEO Andrei Kostin, the day after this occurred, ambassadors would be leaving capitals.

Today Medvedev (yes, he’s alive! and awake too!) reiterated the threat:

Western countries’ threats to restrict Russia’s operations through the SWIFT international bank transaction system will prompt Russia’s counter-response without limits, Prime Minister Dmitry Medvedev said on Tuesday.

“We’ll watch developments and if such decisions are made, I want to note that our economic reaction and generally any other reaction will be without limits,” he said.

Without limits! And that goes for non-economic reactions too! So I guess that Putin plans to do a reverse Reagan, and in the event of a SWIFT cutoff take to the airways and intone “My fellow Russians, I’m pleased to tell you today that I’ve signed legislation that will outlaw the US forever. Bombing begins in 5 minutes.”

Of the two inconsistent sets of statements, the ones where the Russians freak out about being shut out of SWIFT are much more likely to be true. It would be a devastating blow to the Russian economy, and even if a parallel system is in place, unless foreign entities agree to use it, it could not supplant SWIFT for international transactions (including getting cash out of the country!) And even if foreign entities were considering ROTS (Russian Overseas Transactions System, as I’ve decided to call it), they could easily be persuaded not to by the US imposing penalties on those who did. Due to the FUD effect, even the potential for such penalties would have a deterrent effect.

Word to the wise: autarky ain’t all it’s cracked up to be.

Realistically, though, I don’t think either the US or the Europeans have the fortitude to take this step. Russian hysterical threats of “unlimited” responses are no doubt intended to feed Western reluctance. Normally I’d say the Russian threats aren’t credible, but Putin is just crazy enough that there’s room for doubt, especially given that a SWIFT kick would be an existential threat to the Russian economy.

The Greek election, which has put a pro-Putin coalition in power, makes European action even less likely. Once the EU’s Greek gangrene was only financial: now it has infected foreign policy as well, as just today the new PM rejected an EU statement blaming Russia for the Mariupol attack, and threatening additional sanctions. The Euros should have amputated long ago, and are likely to rue their failure to do so.

It is unlikely, therefore, that a SWIFT cutoff will be used, precisely because it would be so devastating. But if Putin goes all in in Ukraine, who knows?

One last humorous aside. Zero Hedge highlighted the Medvedev threat and Russia’s move to reduce its exposure to the dollar system. ZH claimed that this is another in a series of blows against the dollar: de-dollarization is one of its favorite hobby horses to ride.

So riddle me this, Tyler: if there is such panicked flight from the dollar, led by such countries as Russia, China, and Iran, why is it up almost 20 percent (as measured by the DXY) since May? That would be the most bizarre flight from a currency in recorded history. (h/t Ty-not Tyler-for pointing me to the ZH post, and the contradiction.)

 

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Quiet, Please. Paranoids at Work.

Filed under: Economics,Exchanges,Military,Russia — The Professor @ 1:34 pm

The indictment in the Russian espionage* case is available online, and having had a chance to read the portion related to HFT, it’s now clear to me what the Russians were up to. Contrary to certain idiots desperate for attention who are breathlessly claiming that this was part of a plot to bring down Wall Street and the American financial system, this was all about Russian paranoia about the vulnerability of their own financial system to the devilishly clever HFT.

Here’s the relevant part of the indictment:

Screen Shot 2015-01-27 at 1.16.05 PM

ETFs on Russian stocks, including Market Vectors Russian Index ($RSX) are traded in the US, and HFT firms are major participants in ETF trading. What Badenov-sorry, I mean Buryakov-and his co-conspirators are worried about is that “trading robots”-why not trading drones?-could be used to trade Russian ETFs in a way that destabilized the Russian market. They are also curious about who trades ETFs on Russian stocks. Further, they want to gauge the NYSE’s interest in limiting these robots, presumably to learn whether the robots actually posed a threat to Russia.

In other words, this is Russian paranoia talking. More defensive than offensive. Still rather amusing.

Note that the Vnesheconombank employee, Buryakov, is the “expert” here, and the SVR agent operating under diplomatic cover, Igor Sporyshev, is the go between with the “news organization.”

As I noted yesterday, Russian cyber and hacking capabilities are formidable, and they don’t need a couple of disgruntled guys to garner secrets about the vulnerability of Wall Street. Instead, Bulyakov was just channeling fears about the vulnerability of the Russian financial markets.

That was in May, 2013. Just think of how paranoid they are today.

* Tellingly, these guys weren’t charged with committing espionage. Bulyakov was charged with failing to register as a foreign agent. Enough to put him in jail, and an excuse to fire this shot at Putin, but a charge that is likely easier to prove and which doesn’t require the government reveal too much about sources and methods.

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January 26, 2015

If the Russians Want to Know About HFT, They Don’t Need Spies

Filed under: Economics,Exchanges,Military,Politics,Russia — The Professor @ 8:08 pm

Attorney General Holder today announced espionage charges against three Russians, one of whom was arrested today in New York. Two were Russian diplomatic officials, and the third-the one arrested-was an employ of a Russian bank, reported to be Vneshekonombank. The FBI had the men under surveillance since 2012.

So just what were these agents after? Information about potential future sanctions targets for one thing. But they were also after information on high frequency trading of exchange traded funds, or in acronymspeak, HFT of ETFs:

According to the complaint, Sporyshev told Buryakov to tell an unnamed Russian state-owned news organization to ask about how the New York Stock Exchange used exchange-traded funds and potential limits on the use of high-frequency automated trading systems.

Why, pray tell, would this be of such great interest to the Russians? Economic sabotage? Or a money making opportunity?

And why the need for such cloak-and-dagger? There are Russians working in pretty much every HFT shop on and off Wall Street: remember Sergey Aleynikov in Flash Boys? Can’t they find one susceptible to blackmail, bribery, or appeals to patriotism?

Further, what really could be learned by having an “unnamed Russian state-owned news organization” (can you say “RT”? I knew you could) ask someone (presumably the NYSE itself) about “limits on the use of” HFT that couldn’t be obtained by reading public disclosures?

The best of all: it’s not as if the Russians couldn’t find out-and haven’t found out-pretty much anything about NYSE (or NASDAQ or any other exchange) operations without leaving home. They have been fingered for hacking many financial firms, including NASDAQ. (CME has also been hacked, although Russians have not been specifically implicated.) That would be a much more informative, and much less risky, way of divining HFT secrets.

And it’s not as if Russians in Russia aren’t aware of the details of HFT. The Moscow Exchange is actively trying to attract HFT firms (h/t @libertylynx), and has introduced capabilities such as co-location in order to do so. (But perhaps the Moscow Exchange rep is speaking in code. No doubt Fort Meade and Langley have their best men working on this.) Just Google “HFT Moscow Exchange” and you’ll find numerous links describing HFT activities there.

And if they want to learn about ETFs, why not just buy some books? Or do a little surfing? And there are Russian stock ETFs. (Note my clever insertion of the Market Vectors Russia ETF tag.)

You know that HFT and ETFs are hardly Russian espionage priorities. US intelligence and intelligence capabilities, defense technology, and even other types of economic espionage are of far greater interest. The triviality of the targets of this cell, compared to other things of much greater sensitivity, just reveals how pervasive Russian intelligence operations in the US likely are. So why go after this rather hapless group? And why now?

Viewed in context, it’s pretty clear. We rolled up what is likely the least important and sensitive operation the FBI is monitoring at this time and had the Attorney General announce it as a bit of Kabuki theater to communicate our displeasure with the Russians. We have had this group under surveillance since 2012, and could have netted them anytime. That time was now because of the escalating tensions with Russia. It is a signal that we can do things that would hurt the Russians much worse.

Will Putin listen? Doubtful. So what will we do next? That will be interesting to see.

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January 25, 2015

Mewling Oligarchs Move Putin Not At All: The Security Forces Are a Different Matter

Filed under: Military,Politics,Russia — The Professor @ 8:36 pm

Bloomberg breathlessly reports that oligarchs are irked at Putin because he adamantly refuses to countenance backing down in Ukraine.

And Putin really doesn’t care. Mewling oligarchs move him not in the least. Or if they have an effect on him, it is to create disgust and disdain. Putin cares about retaining power, and the oligarchs don’t threaten that.  He can destroy them, in a trice, and they know that: the recent example of Evtushenkov is surely fresh in their minds.

The Bloomberg piece states that Putin’s circle has shrunk to a few:

The ruble’s plunge has heightened opposition to Putin’s backing of the rebellion in Ukraine among his wealthiest allies, prompting the president to shrink his inner circle from dozens of confidants to a small group of security officials united by their support for the separatists, two longtime associates said.

. . . .

The core group around Putin is led by Security Council Secretary Nikolai Patrushev, Federal Security Service head Alexander Bortnikov, Foreign Intelligence Service chief Mikhail Fradkov and Defense Minister Sergei Shoigu, according to Markov.

This selection is probably overdetermined. As a Chekist, Putin’s views are likely broadly similar to those in the security services and the military. But perhaps more importantly, these people can actually pose a threat to Putin. A challenge is most likely to arise from their ranks, and unlike oligarchs, these people have force at their disposal.

Meaning that Putin is likely acting along the lines of the old adage: “Hold your friends close, and your enemies closer.” Putin doesn’t need the oligarchs as friends. Patrushev et al may not be enemies, as such, at least not yet, but they are a threat. And so keeping them close, and satisfied, is wise as a survival strategy.

This has broader implications. Putin likely has every intention of continuing his attempts to bring Ukraine to heel. But if he thinks about backing off in the face of pressure, or because of rising casualties and costs of continuing the campaign, he realizes that he risks running afoul of the hard men around him. Which implies that internal political forces will continue to impel Putin to continuing confrontation.

This further implies that outraged denunciations by Kerry or the Euros or even Obama will have little effect on Putin. Something sterner is required, for behind Putin stand some very stern men.

 

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January 24, 2015

The World in Flames: Another Low, Dishonest Decade

Filed under: History,Military,Politics,Russia — The Professor @ 3:36 pm

Recent days have seen a dramatic escalation of military operations in eastern Ukraine. The New York Times headline is on point: “War Is Exploding Anew in Ukraine.” The Russians* launched an assault on the battered hulk of the Donetsk airport, which had held out for 242 days. The airport fell, with the garrison of “cyborgs” being killed or captured. A counterattack by Ukrainian regulars was abortive. Recent days have seen rocket attacks in Donetsk and Luhansk,with civilians dying. Today a Grad attack in Mariupol killed over 30.  A Ukrainian salient centered on Debaltseve (between Donetsk and Luhansk) is evidently under attack. The “leadership” of the rebels in Donetsk announced-and then unannounced-that an assault on Mariupol was underway.

As I wrote in November, an attack along the coast to open up a route to Crimea would be an obvious move. As for those (including some former military) who claim that major offensive operations would be postponed to the spring, I say: Huh? Winter warfare is a Russian specialty, and even a passing familiarity with the history of campaigns in Russia (Napoleon’s, WWI, and WWII) shows that it is spring (and fall) mud that is a far greater impediment to military operations than cold and snow. The notorious “raputitsa” that follows the snow melt (or fall rains) causes movement to grind to a halt until the fields and roads dry.

This offensive could be underway now, but given the lack of reliable reporting it is impossible to know.

What is Putin’s objective here? Securing Crimea, which is now isolated and vulnerable and difficult to supply, is clearly paramount. Beyond that, I doubt he really wants to take ownership of a Sovok sh*thole like the Donbas. His main objective is to force Kiev to sacrifice its sovereignty, and become a reliable satrapy of Russia. A combination of economic and military pressure falling short of an all out invasion is likely sufficient for that purpose. This is especially true inasmuch as the feckless West is quite clearly unwilling to risk anything to protect Ukraine. Keeping the meat grinder turning in Donbas advances this objective.

As for the indiscriminate attacks on cities, I have no good explanation. Perhaps it is just the thuggishness of the anti-Kiev forces. Perhaps it is part of Putin’s testing of the West. If killing of civilians elicits no more than a shrug of indifference, Putin can be assured that further escalation will come at little cost.

So much for Obama’s State of the Union boast:

Second, we are demonstrating the power of American strength and diplomacy. We’re upholding the principle that bigger nations can’t bully the small — by opposing Russian aggression, supporting Ukraine’s democracy, and reassuring our NATO allies.

Putin apparently didn’t notice. Ukraine certainly hasn’t noticed that the bullying has stopped. Indeed, the final assault on the Donetsk airport occurred on the day that Obama uttered these words.

Traveling to the south and west, Syria and Iraq are also in flames, and making a liar of Obama.

Back in December I discerned the outlines of a campaign that will culminate with an attack on Mosul. Last week it became clear that this campaign is indeed proceeding. The Kurds, supported by American airpower, are shaping the battlefield and isolating Mosul from the west and south. The Kurds have made advances around Sinjar and Tal Afar, thereby interfering with ISIS supply lines to its Syrian fastness. The US military has indicated, however, that an assault on Mosul will not occur until the summer, when sufficient numbers of Iraqi regulars have been trained.

In Syria meanwhile, the US is pounding Kobani regularly, and the Kurds are painstakingly pushing back ISIS.

The US commander in the region, General Lloyd Austin stated that ISIS had lost approximately 6000 KIA, and was having manpower problems. This theme was picked up by the US ambassador to Iraq, but the Pentagon quickly squelched this discussion, due to Viet Nam body count flashbacks.

But other than attrition and shaping the battlefield around Mosul, there has been scant progress against ISIS. Indeed, ISIS has been expanding rather dramatically throughout Syria, giving the lie to this SOTU statement: “In Iraq and Syria, American leadership — including our military power — is stopping ISIL’s advance.” That’s true to a limited degree in Kobani and Mosul, but flatly wrong elsewhere in Iraq and especially Syria. Don’t even get me started on another Obama delusion: the “success” in Yemen, which has descended into absolute chaos with competing “Death to America” factions, both Shia and Sunni, vying for control.

It’s rather depressing to see the President of the United States do a Baghdad Bob imitation while addressing a joint session of Congress.

In sum, at present it appears that Putin is on the advance in Ukraine and ISIS is at best stalemated in Iraq and Syria. And the West’s leaders, reflecting the indifference of their citizenry, are content to let it happen, or at least do too little to prevent it from happening. In other words, we are in the midst of another low and dishonest decade.

*There is a war of labels in Ukraine. What to call those fighting against the Kiev government? Rebels? Separatists? Pro-Russians? Terrorists (the preferred Ukrainian label)? Russians? The problem is that each label describes a part of the anti-Kiev combatants, but none describes it completely. Yes, there are Ukrainian citizens who are engaged in a separatist rebellion that aims to achieve unification with Russia, and they are advancing Russian interests, making them pro-Russian. Yes, sometimes they employ terrorist methods, though they primarily use conventional military tactics. Yes, there are Russian troops involved, of various types (GRU spetsnaz, artillery and air defense units, armored and infantry elements) in fluctuating numbers. Russian number spiked in August, and appear to be increasing now.

This is  a Russian owned and run operation. The indigenous forces in Donbas obviously obtain massive quantities of Russian ammunition and weapons from Russia, and can’t pay for these arms themselves. Their objectives largely overlap with Putin’s. In addition, there is direct Russian involvement, and that will increase if Putin indeed decides to escalate.

 

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January 18, 2015

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

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

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

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

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

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

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

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

The result will be a simulacrum of the Soviet economy.

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

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

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

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

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

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

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January 13, 2015

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

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

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

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

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

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

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

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

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

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

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January 1, 2015

Will Bomb For Food

Filed under: Economics,Military,Politics,Russia — The Professor @ 2:11 pm

Russia is leasing 12 SU-24 swing wing Fencer fighter-bomber aircraft to Argentina. Argentina is paying with . . . food, specifically beef and wheat. The 1970s-era SU-24 was, um, very similar to the US’s 1960s-era F-111, which the US retired in 1996. (Seriously: look at pictures of the Soviet SU-24 and the American F-111 and it’s hard to tell the difference.)

The UK is unsettled by the transaction, because the jets could threaten the Falklands. And of course Argentina is in such great shape that it can easily afford a few wars of choice. After all, the last one went so, so well.

But look at it this way. If Argentina prevails this time over an emaciated British military, it will conquer islands with 500,000 sheep. Just think of how many weapons the Argentines will be able to lease from Russia in exchange for all that lamb, hogged, mutton and wool. Chile, look out!

I have another suggested trade between the two countries. They should just exchange their currencies. That way, each can obtain more varied wallpaper.

So no, Russia is not isolated. It is a fully paid member of the Drowning Men’s Club, whose desperate members grab onto one another for dear life as they go under once, twice, and yet again. Look at its economic and political allies, such as they are. Argentina, Venezuela, Cuba, North Korea, Syria. Decrepit losers, every one. Hell, even Belarus is looking for ways to escape the embrace of a drowning Russia.

This deal is so revealing. Russia, once the world’s breadbasket, can’t feed itself. But what does it have to trade? Decrepit military equipment from another era, and a derivative design largely lifted from the evil Americans at that. When “Will Bomb For Food” is only a slightly exaggerated characterization of a country’s comparative advantage, it says everything you need to know about Russia’s economy 23 years after the end of the Soviet Union and 15 years after the advent of Putinism.

 

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December 31, 2014

The Oil Price Decline: No Conspiracy Theories Need Apply

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And yeah. I’m looking at you, VVP.

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

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

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December 29, 2014

Three Card Monte, In New York and Moscow

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

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

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

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

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

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

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

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

Me-meep.

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

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