Streetwise Professor

July 23, 2016

For All You Pigeons: Musk Has Announced Master Plan II

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — The Professor @ 11:29 am

Elon Musk just announced his “Master Plan, Part Deux,” AKA boob bait for geeks and posers.

It is just more visionary gasbaggery, and comes at a time when Musk is facing significant head winds: there is a connection here. What headwinds? The proposed Tesla acquisition of SolarCity was not greeted, shall we say, with universal and rapturous applause. To the contrary, the reaction was overwhelmingly negative, sometimes extremely so (present company included)–but the proposed tie up gave even some fanboyz cause to pause. Production problems continue; Tesla ended the resale price guarantee on the Model S (which strongly suggests financial strains); and the company has cut the price on the Model X SUV in the face of lackluster sales. But the biggest set back was the death of a Tesla driver while he was using the “Autopilot” feature, and the SEC’s announcement of an investigation of whether Tesla violated disclosure regulations by keeping the accident quiet until after it had completed its $1.6 billion secondary offering.

It is not a coincidence, comrades, that Musk tweeted that he was thinking of announcing his new “Master Plan” a few hours before the SEC made its announcement. Like all good con artists, Musk needed to distract from the impending bad news.

And that’s the reason for Master Plan II overall. All cons eventually produce cognitive dissonance in the pigeons, when reality clashes with the grandiose promises that the con man had made before. The typical way that the con artist responds is to entrance the pigeons with even more grandiose promises of future glory and riches. If that’s not what Elon is doing here, he’s giving a damn good impression of it.

All I can say is that if you are fool enough to fall for this, you deserve to be suckered, and look elsewhere for sympathy. Look here, and expect this.

As for the “Master Plan” itself, it makes plain that Musk fails to understand some fundamental economic principles that have been recognized since Adam Smith: specialization, division of labor, and gains from trade among specialists, most notably. A guy whose company cannot deliver on crucial aspects of Master Plan I, which Musk says “wasn’t all that complicated,” (most notably, production issues in a narrow line of vehicles), now says that his company will produce every type of vehicle. A guy whose promises about self-driving technology are under tremendous scrutiny promises vast fleets of autonomous vehicles. A guy whose company burns cash like crazy and which is now currently under serious financial strain (with indications that its current capital plans are unaffordable) provides no detail on how this grandiose expansion is going to be financed.

Further, Musk provides no reason to believe that even if each of the pieces of his vision for electric automobiles and autonomous vehicles is eventually realized, that it is efficient for a single company to do all of it. The purported production synergies between electricity generation (via solar), storage, and consumption (in the form of electric automobiles) are particularly unpersuasive.

But reality and economics aren’t the point. Keeping the pigeons’ dreams alive and fighting cognitive dissonance are.

Insofar as the SEC investigation goes, although my initial inclination was to say “it’s about time!” But the Autopilot accident silence is the least of Musk’s disclosure sins. He has a habit of making forward looking statements on Twitter and elsewhere that almost never pan out. The company’s accounting is a nightmare. I cannot think of another CEO who could get away with, and has gotten away with, such conduct in the past without attracting intense SEC scrutiny.

But Elon is a government golden boy, isn’t he? My interest in him started because he was–and is–a master rent seeker who is the beneficiary of massive government largesse (without which Tesla and SolarCity would have cratered long ago). In many ways, governments–notably the US government and the State of California–are his biggest pigeons.

And rather than ending, the government gravy train reckons to continue. Last week the White House announced that the government will provide $4.5 billion in loan guarantees for investments in electric vehicle charging stations. (If you can read the first paragraph of that statement without puking, you have a stronger stomach than I.) Now Tesla will not be the only beneficiary of this–it is a subsidy to all companies with electric vehicle plans–but it is one of the largest, and one of the neediest. One of Elon’s faded promises was to create a vast network of charging stations stretching from sea-to-sea. Per usual, the plan was announced with great fanfare, but the delivery has not met the plans. Also per usual, it takes forensic sleuthing worthy of Sherlock Holmes to figure out exactly how many stations have been rolled out and are in the works.

The rapid spread of the evil internal combustion engine was not impeded by a lack of gas stations: even in a much more primitive economy and a much more primitive financial system, gasoline retailing and wholesaling grew in parallel with the production of autos without government subsidy or central planning. Oil companies saw a profitable investment opportunity, and jumped on it.

Further, even if one argues that there are coordination problems and externalities that are impeding the expansion of charging networks (which I seriously doubt, but entertain to show that this does not necessitate subsidies), these can be addressed by private contract without subsidy. For instance, electric car producers can create a joint venture to invest in power stations. To the extent government has a role, it would be to take a rational approach to the antitrust aspects of such a venture.

So yet again, governments help enable Elon’s con. How long can it go on? With the support of government, and credulous investors, quite a while. But cracks are beginning to show, and it is precisely to paper over those cracks that Musk announced his new Master Plan.

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June 21, 2016

Mating Hemophiliacs Seldom Turns Out Well

Filed under: Climate Change,Economics,Energy — The Professor @ 9:00 pm

I’ve long been an Elon Musk/Tesla skeptic, to put it mildly. I’ve called him out as a crony capitalist who milks subsidies, and as a con man.

Most recently, I said that one Musk company’s (SpaceX) purchase of the debt of another Musk company–Solar City–should raise alarms. Well, today four alarms rang: Tesla bid to take over Solar City, and to pay for the acquisition in Tesla stock. Solar City (SCTY) stock soared on the news: Tesla plunged. The effect of the announcement was market cap negative: Tesla’s value declined more than SCTY’s rose.

Both Solar City and Tesla rely on government subsidies, and crucially, on very dodgy financing models and questionable accounting. Like many other solar firms, Solar City was teetering on the verge of bankruptcy. Such an event would have a direct financial consequence for Musk, and given Elon’s large (and leveraged) ownership stake in Tesla, this would impact Tesla adversely.

Moreover, there’s a serious possibility that a SCTY bankruptcy would reveal a byzantine web of financial connections among Musk’s various ventures. Given the boundary-pushing accounting and tenuous financial condition of all of his companies, there is no doubt a lot hidden that Elon desperately wants to keep hidden.

But perhaps most importantly, a SCTY bankruptcy would undermine Musk’s image as a visionary genius and business colossus. This image is vital to keeping Musk, Inc. going. It is vital because this image is a key element of every con, and if Musk isn’t a con man, he sure does a great impression of one.

One key tell of that is that whenever people start expressing doubts about Tesla, Musk has some grandiose announcement about the next new big thing, even though he hasn’t delivered on the last new big thing, or even the new big thing before that. That’s a classic con man trick.

This is also a vital part of the Tesla funding model. In addition to subsidies, Tesla relies heavily on customer deposits for funding. In order to get those deposits, Tesla has to make promises on production that it has not been able to keep. But enough people are dazzled by Elon’s pitch that they fork over the cash that he needs to keep the endeavor aloft.

I read an investment report that referred to such types as “loss tolerant investors.” That’s a polite way of saying “suckers.”

A major Elon fail would put the con model at risk. So despite the fact that the initial reaction to the deal has been incredulity and outrage, and despite the fact that that reaction was utterly predictable, Musk has plunged ahead. That should give you some idea of his desperation.

In the announcement of the bid, Tesla served up a load of argle-bargle that should make any PR person blanch:

Tesla’s mission has always been tied to sustainability. We seek to accelerate the world’s transition to sustainable transportation by offering increasingly affordable electric vehicles. And in March 2015, we launched Tesla Energy, which through the Powerwall and Powerpack allow homeowners, business owners and utilities to benefit from renewable energy storage.

It’s now time to complete the picture. Tesla customers can drive clean cars and they can use our battery packs to help consume energy more efficiently, but they still need access to the most sustainable energy source that’s available: the sun.

The SolarCity team has built its company into the clear solar industry leader in the residential, commercial and industrial markets, with significant scale and growing customer penetration. They have made it easy for customers to switch to clean energy while still providing the best customer experience. We’ve seen this all firsthand through our partnership with SolarCity on a variety of use cases, including those where SolarCity uses Tesla battery packs as part of its solar projects.

So, we’re excited to announce that Tesla today has made an offer to acquire SolarCity. A copy of Tesla’s offer is provided below.

If completed, we believe that a combination of Tesla and SolarCity would provide significant benefits to our shareholders, customers and employees:

  • We would be the world’s only vertically integrated energy company offering end-to-end clean energy products to our customers. This would start with the car that you drive and the energy that you use to charge it, and would extend to how everything else in your home or business is powered. With your Model S, Model X, or Model 3, your solar panel system, and your Powerwall all in place, you would be able to deploy and consume energy in the most efficient and sustainable way possible, lowering your costs and minimizing your dependence on fossil fuels and the grid.
  • We would be able to expand our addressable market further than either company could do separately. Because of the shared ideals of the companies and our customers, those who are interested in buying Tesla vehicles or Powerwalls are naturally interested in going solar, and the reverse is true as well. When brought together by the high foot traffic that is drawn to Tesla’s stores, everyone should benefit.
  • We would be able to maximize and build on the core competencies of each company. Tesla’s experience in design, engineering, and manufacturing should help continue to advance solar panel technology, including by making solar panels add to the look of your home. Similarly, SolarCity’s wide network of sales and distribution channels and expertise in offering customer-friendly financing products would significantly benefit Tesla and its customers.
  • We would be able to provide the best possible installation service for all of our clean energy products. SolarCity is the best at installing solar panel systems, and that expertise translates seamlessly to the installation of Powerwalls and charging systems for Tesla vehicles.
  • Culturally, this is a great fit. Both companies are driven by a mission of sustainability, innovation, and overcoming any challenges that stand in the way of progress.

Note the appeal to enviro-vanity. “Shared ideals.” “Culture.” Vague synergies: “including by making solar panels add to the look of your home.” Are they serious? Is that the best he can come up with? “Customer-friendly financing products.” Another joke: the unviability of the Solar City financing model is exactly what put the company into its current straits. So extending this unviable financing model to autos is somehow going to do wonders for Tesla? The release mentions charging systems. A few years ago Elon promised thousands. There are currently 616 worldwide, and Elon has faded his original promise to provide free charging: Model S customers will have to pay.

Further, there’s no explanation of how marrying one cash bleeder to another cash bleeder is going to address either company’s fundamental problem . . . which is that they are cash bleeders. Buying Solar City exacerbates the Tesla cash bleeding problem, rather than ameliorating it: the mating of hemophiliacs is unlikely to turn out well.

Indeed, Tesla bleeds cash like a Game of Thrones battle scene. Hence the need to rush out the Model S (and collect deposits) while huge questions about production remain. Hence the repeated returns to the equity markets to issue new stock.

Which will now be harder, because paying for Solar City in stock–and hence diluting existing shareholders substantially–mere weeks after a big equity offering will make investors to whom Musk will have to sell stock in the future to meet his voracious needs for money think twice: will he take their money then dilute them again a few weeks or months later?

This move looks very short sighted, and it almost certainly is. But Musk is doing it because he needs to address very pressing immediate concerns, and he’ll worry about the future ramifications when the future comes.

Musk has made a living off of suckers. Suckers in government (including most notably the federal government, and the states of Nevada and California) who have lavished huge subsidies based the dubious environmental benefits of electric vehicles. Suckers enamored with the technology and performance of Tesla vehicles–despite the questions surrounding Tesla’s ability to produce those vehicles.

To keep the suckers coming, Musk has to perpetuate his image as the Great and Powerful Oz. A major fail–like the bankruptcy of Solar City–threatens to pull back the curtain and demolish that image. Musk needs to prevent that from happening. He needs to buy time, and to buy time, he is having Tesla buy Solar City.

Desperate times call for desperate measures. The proposed purchase of Solar City reeks of desperation, because it facially makes no business sense, and is explicable only as a way to keep a con alive.

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June 8, 2016

The CFTC Puts a Little Less Rat In It

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 7:10 pm

A couple of weeks ago the CFTC voted to revise its position limits regulation. My verdict: it makes the regulation less bad. Sort of like a strawberry tart, without so much rat in it.

The most important part of the revision is to permit exchanges and SEFs to recognize certain non-enumerated hedges as bona fide hedges that don’t count towards the position limit. In the original proposal, only eight hedges were enumerated, and only enumerated hedges were treated as bona fide hedges.

This drew substantial criticism from industry, particularly from end users, because the list of enumerated hedges was quite limited, and failed to incorporate many commonly utilized risk management strategies. Thus, more participants were at risk of being constrained by position limits, even though their purpose for trading was primarily to manage risk.

The CFTC’s fix was to permit market participants to apply annually to an exchange (“designated contract market”) or SEF for a non-enumerated bona fide hedge. The participant submits information about the hedging strategy to the exchange or SEF, which reviews it and determines whether it meets the criteria for bona fide hedges and grants an exemption for positions entered pursuant to this strategy.

This does help hedgers escape limits intended to constrain speculators. But the review process isn’t free. Moreover, the process of application and approval will take some time, which limits the flexibility of market participants. They have to foresee the kinds of strategies they would like to employ well in advance of actually implementing them.

At most this mitigates a harm, and at a cost. The speculative position limit provides no discernible benefit in terms of market stability or manipulation prevention (for which there are superior substitutes), but imposes a heavy compliance burden on all market users, even those who would almost certainly never be constrained by the limit. Moreover, the rule constrains risk transfer, thereby undermining one of the primary purposes of futures and swap markets. The bona fide hedging rule as originally proposed would have constrained risk transfer further, so basically expanding the universe of bona fide hedges removes a piece of rat or two from the tart. But it’s still appalling.

The revision also clarifies the definition of bona fide hedge, eliminating the “incidental test” and the “orderly trading requirement.” As currently proposed, to be a bona fide hedge, a position must reduce price risk. (I deliberately chose that particular link for reasons that I might be at liberty to share sometime.) That is, it cannot be used to manage other risks such as logistics or default risks. This is what the statute says, and was the way that the old regulation 1.3(z)(1) was written and interpreted.

Perhaps the most important result of this process is that it stands as a rebuke to Elizabeth Warren for the calumnies and slanders she heaped upon the Energy and Environmental Markets Advisor Committee, and me personally. One of the main complaints of participants in the EEMAC meetings was that the bona fide hedging rule as originally proposed was unduly restrictive. I dutifully recorded those complaints in the report that I wrote, which caused Senator Warren to lose it. (I cleaned that up. Reluctantly.) (The report is circulating in samizdat form. I will find a link and post.)

Well, apparently all of the Commissioners, including two strong supporters of the position limit rule, Massad and Bowen, found the criticisms persuasive and, to their credit, responded constructively to them. So, Liz, if supporting a broadening of bona fide position limits makes one an industry whore, that epithet applies to the Democratic appointees on the Commission. I presume you will take it up with them in your tempered, reasoned way.

But I note that Ms. Warren has been notably silent on the Commission’s action. Go figure.

It is now likely that the position limit rule will finally slouch its way into the rulebook. This is unfortunate. All that can be said is that due to this action it isn’t as bad as it could have been, and as bad as it is, it is nothing compared to the monstrosity that is being created in Europe.

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June 2, 2016

The Smelly Little Orthodoxy of Warmism, Hating Free Intelligence and Free Debate

Filed under: Climate Change,Economics,Energy,Politics,Regulation — The Professor @ 7:01 pm

One of the most disreputable tactics of those who sound alarms about anthropogenic climate change is to conscript any weather-related disaster to advance their cause. Case in point: the recent wildfires in and around Fort MacMurray, Alberta, Canada:

Experts say climate change is contributing to the wildfires raging across Canada, and the increasing frequency of such fires may overwhelm one of Earth’s most important ecosystems, the boreal forest.

In just over a week, an out of control blaze has charred more than 2,290 square kilometers (884 square miles) of land and forced the evacuation of 100,000 people from Fort McMurray in Alberta, Canada.

Dominated by conifers like pine and spruce, the boreal forest sweeps across Canada, Russia, Alaska and Scandinavia making up about 30 percent of the world’s forest cover, and absorbing a big chunk of carbon from the atmosphere.

As crucial as the boreal forest is at reducing the impact of human-driven fossil fuel emissions, it is also increasingly fragile, and expected to become hotter, drier, and more prone to fires in the future.

“Western Canada, including in particular the region in Alberta containing Fort McMurray, has warmed quite a bit more than the global average,” said scientist Michael Mann, author of “Dire Predictions: Understanding Climate Change.”

With the Arctic region warming twice as fast as the rest of the planet, climate model projections place central and western Canada in the “bullseye of enhanced warming,” he told AFP.

Michael Mann. Of course.

The past months have seen a strong El Nino which has caused anomalous weather throughout the world, and in the western hemisphere in particular. It has brought heavier than normal rains to some areas, and drought to others. My immediate suspicion was that El Nino contributed to the warm dry conditions, low snow pack, etc., that set the stage for the Alberta fires. And indeed, that’s the case.

It’s also necessary to put this in perspective. Even in normal years, there are fires in the boreal forests of Canada. Indeed, about 29,000 square kilometers burn in Canada each year. When I looked at the height of the fires, the Fort MacMurray fire had consumed about 2900 square kilometers, or about 10 percent of the annual average in Canada. This also represents about .015 percent of Canadian boreal forest area.

The fire got attention not so much because of its size, but because it occurred in a populated area (something of a rarity in that area), and one that happens to be a major oil producing center.

But the cause is too important to let facts interfere with the narrative. The fires were dramatic, and to the credulous it is plausible that global warming is to blame. So Mann et al could not let this opportunity pass.

Exploiting weather to raise alarms about climate is not the only disreputable tactic these people employ. Another is to attempt to intimidate through the legal process those who dare challenge their orthodoxy. This tactic has reached a new level in California, where a bill with the Orwellian title “California Climate Science Truth and Accountability Act of 2016” has cleared committees in the state Senate:

“This bill explicitly authorizes district attorneys and the Attorney General to pursue UCL [Unfair Competition Law] claims alleging that a business or organization has directly or indirectly engaged in unfair competition with respect to scientific evidence regarding the existence, extent, or current or future impacts of anthropogenic induced climate change,” says the state Senate Rules Committee’s floor analysis.

What does “engage in unfair competition with respect to scientific evidence” even mean? As an industrial organization economist by training, and practice, I know that the concept of “unfair competition” is slippery at best even in a straightforward economic context, and (speaking of Orwellian) that unfair competition laws have been used primarily to stifle competition rather than promote it. How unfair competition concepts would even apply to scientific debate is beyond me.

But that’s not the point, is it? The point of this law is to utilize another law that has proved very convenient at squelching competitors in the name of competition in order to squelch debate about climate change and climate policy. This is antithetical to science yet is done in the name of science: it is also a perfect example of the thuggery that the warmists routinely resort to when they cannot prevail in an open discussion.

When writing about Dickens, Orwell said something that relates to this issue as well:

It is the face of a man who is always fighting against something, but who fights in the open and is not frightened, the face of a man who is generously angry — in other words, of a nineteenth-century liberal, a free intelligence, a type hated with equal hatred by all the smelly little orthodoxies which are now contending for our souls.

The smelly little orthodoxy epitomized by Michael Mann and Kemala Harris (the AG of CA, and soon to be Senator, who is a leader of the movement to prosecute climate change dissenters) indeed hates free intelligence, and free debate. And nineteenth century liberals, for that matter.

Have the progressives (particularly in California) who shriek about Peter Theil using the legal system to go after Gawker uttered a peep of protest against the employment of the far heavier hand of the state to silence debate about climate change? Not that I’ve heard. Free speech for me, but not for thee, is their motto.

Those who claim that science is undeniably on their side should have no fear of debate, and should not feel compelled to use coercion to stifle that debate. That they do means that they lack confidence in the truth of their message and their ability to persuade. It also means that they have a hearty disrespect for the ability of the American people to listen to and evaluate that debate with intelligence and fairness. In other words, what we are seeing in California is another example of a self-anointed elite that heartily disdains the hoi polloi, believing that it is their right and obligation to use any means necessary to impose their beliefs.

This is a recipe for social strife, especially since the climate change debate is by no means the only place where this attitude is regnant. This is precisely why battle is now raging between elitism and populism. Sad to say, that battle is likely to become even more intense in the coming months and years.

 

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May 29, 2016

To the NYT It Would Be News That Socialism Causes Economic Catastrophe

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — The Professor @ 2:05 pm

Venezuela is on the verge of economic collapse and social disintegration. Here’s the NYT’s diagnosis:

The growing economic crisis — fueled by low prices for oil, the country’s main export; a drought that has crippled Venezuela’s ability to generate hydroelectric power; and a long decline in manufacturing and agricultural production — has turned into an intensely political one for President Nicolás Maduro. This month, he declared a state of emergency, his second this year, and ordered military exercises, citing foreign threats.

Do you see what’s missing? Not a single mention of socialism, Chavism, Bolivarian socialism, etc.

Other countries have suffered similar shocks without descending into dystopian chaos like Venezuela. Many countries in South America, for instance (notably Columbia and Brazil), have suffered from the decline in commodity prices and the drought, and are doing poorly economically, but are not plagued by empty store shelves, myriad shuttered factories and stores, and the imminent threat of social violence. Brazil has suffered from a lack of hydropower due to the drought, but has imported LNG to keep the lights on. Venezuela can’t afford to.

Further, Venezuela’s descent into catastrophe started long ago, and serious problems were clearly manifest in 2014 and before when the price of oil was over $100/bbl and the drought had not reduced hydropower output.

Venezuela’s current crisis had its roots with Chavez’s triumph in the 2002-2003 general strike, and the subsequent firing of 18,000 PDVSA employees. In the years that followed, foreign investors were expropriated, as were domestic businesses, all in the name of socialism. The government has imposed price controls on an every widening array of goods. As shortages increased and inflation spiked, the government increased the scope of price controls and enforced them in a draconian way, including through the dispatching of red shirted goons to seize offending businesses.

The results of all this should have been eminently predictable: shortages and a collapse of economic activity. It is those policies that caused the “long decline in manufacturing and agricultural production.”

If the NYT read it’s own freaking archives, it might have realized that this problem was looming well before the oil price decline and the drought:

Venezuela is one of the world’s top oil producers at a time of soaring energy prices [hahaha], yet shortages of staples like milk, meat and toilet paper are a chronic part of life here, often turning grocery shopping into a hit or miss proposition.

Some residents arrange their calendars around the once-a-week deliveries made to government-subsidized stores like this one, lining up before dawn to buy a single frozen chicken before the stock runs out. Or a couple of bags of flour. Or a bottle of cooking oil. (Emphasis added.)

Mind well the date of the article: April 21, 2012. Four years ago. When the Brent price was about $118/bbl.

This title of the NYT piece is hilarious: “With Venezuelan Food Shortages, Some Blame Price Controls.”

Hey, NYT: by “some” do you mean people with an economics IQ of above 80? (A category which would exclude the editorial staff and most of the news room.)

What is happening in Venezuela is a perfect illustration of something that Adam Smith recognized 240 years ago. It takes perverse government policy to turn an adverse supply or demand shock into shortages and economic catastrophe:

Whoever examines with attention the history of the dearths and famines which have afflicted any part of Europe, during either the course of the present or that of the two preceding centuries, of several of which we have pretty exact accounts, will find, I believe, that a dearth never has arisen from any combination among the inland dealers in corn, nor from any other cause but a real scarcity, occasioned sometimes perhaps, and in some particular places, by the waste of war, but in by far the greatest number of cases by the fault of the seasons; and that a famine has never arisen from any other cause but the violence of government attempting, by improper means, to remedy the inconveniences of a dearth. (Emphasis added.)

That is a perfect description of what is happening in Venezuela.

But various economic morons on the left (but I repeat myself) like Bernie Sanders, Jeremy Corbyn, Sean Penn, and Danny Glover (to name just a few) have been cheering Chavism and Bolivarian socialism for attacking the inequalities spawned by capitalism red in tooth and claw. In a perverse way, it has indeed succeeded in reducing inequality–by making everyone largely equal in their abject misery.

Perhaps there is a silver lining to the food shortages. They reduce the need for toilet paper, which ran out long ago (due to price controls, naturally).

The New York Times prides itself on carrying all the news that’s fit to print. Apparently the news about the impact of price controls hasn’t reached it yet, even though observant folks picked up on it about the time of Diolcetian’s Edict on Prices, a mere 1715 years ago.

This economic cluelessness by the NYT is precisely why its criticism of me doesn’t bother me. Such boundless economic ignorance (which is shared by a vast swathe of its readers, including notably Elizabeth Warren) renders its criticism meaningless. Anyone so stupid, or so ideologically blinded, that they fail to recognize that Venezuela’s problems have everything to do with perverse government policy has nothing to say about economics that is worth paying the slightest heed.

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May 23, 2016

Storing Oil at a Loss? Analysis Akin to the Drunk Looking for His Keys Under the Streetlight

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 12:48 pm

This article claims that “Oil traders are borrowing from banks to store crude at a loss.” Almost certainly not.

The calculation is based on contangos in Brent crude. But the vast bulk of the oil being stored at sea is in Singapore, and is not BFOE, from what I can gather.  This makes all the difference.

This is an example of what has long been a puzzle in economics in which futures prices in a central market (like Brent futures) are at less than full carry but inventories are held at other locations, or in non-deliverable grades (in the central market).  People are puzzled because they don’t take into account transformation costs. It would be impossible for some locations/grades to be at a carry that incentivizes holding inventory while other locations/grades are in backwardation if there are no frictions (costs) in transforming a commodity from one location to another, or from one grade to another: take the stuff out from storage in the market that is at full carry, move it to the central market that is in backwardation, and capture that backwardation (i.e., the premium for immediate consumption/delivery). But if there are frictions, the costs of transforming (e.g., shipping) the commodity to the central market may exceed the backwardation/premium for immediate delivery, making it unprofitable to make that transformation to capture that premium.

This means that a commodity that is costly to transport, or where there are bottlenecks in the logistical or refining processes, will have different forward curves at different locations (or for different grades). Where inventories are held, the price structure will cover storage costs: where the price structure doesn’t cover storage costs, inventories will not be held. Similarly, if some grades of a commodity are stored, the forward curve specific to that grade will cover storage costs.

A good example is Iranian heavy crude in the spring and summer of 2008. At a time when light sweet crudes (WTI and Brent) were in backwardation, and oil prices were reaching record highs, 14 or so supertankers of Iranian crude were swinging at anchor. Why? The demand was for light sweet crude to make low sulphur diesel to meet new European regulations: due to bottlenecks in refining in Europe (European refineries being unable to economically process heavy sour Iranian crude into LSD), there was strong demand for sweet crude that was cheap to refine into LSD, and little was in storage.  As a result,  WTI and Brent prices were high, and their futures curves were in backwardation. However, there was weaker demand for heavy sour crude because of its unsuitability for producing LSD. Also, many refineries that were optimized to process sour Iranian crude were down for maintenance. As a result, Iranian crude sold at a very large discount to WTI and Brent, and the forward price structure for that crude made it economical to store it.

Moving forward to the present, storing non-Brent crude in Asia can be economical even if time spreads do not cover the cost of storage Brent in NW Europe. Even though the lack of carry in the Brent market indicates a high demand for BFOE, the cost of transporting crude from Asia may make it uneconomical to ship it to Europe to meet the high demand for oil there. Moreover, the grades of crude being stored on tankers in Asia may not be competitive with Brent. Similarly, demand is not high enough in Asia to make it profitable to refine all of the supply there. So it is uneconomic to move it to Europe, and it is uneconomic to refine all of it. Therefore, store some of it in Asia even when Brent time spreads are narrow.

Furthermore, the apparent squeezes in Brent mean that some of the demand for it is artificial, and that Brent spreads do not reflect the competitive economics of storage. That is, if there are squeezes or even anticipations of squeezes, Brent calendar spreads are artificially high due to the exercise of market power. It is particularly misguided to use Brent spreads to evaluate the economics of non-Brent storage in this case. (The major reason that squeezes can work is that it is impossible to transform non-Brent crude into Brent.)

Oil traders operate on very thin margins. They are not going to make uneconomic trades. Period. If they are storing oil on ships in Singapore, it is because it pays to do so.

So why the claim that they are storing at a loss?

It’s like the old story of the drunk looking for his car keys under the streetlamp, because the light is better there. It is easy for outsiders to observe Brent spreads, or WTI spreads: just look at a Bloomberg screen, or even futures settlement prices. Singapore spreads, not so much. Traders search to collect information about prices and price structures in an opaque market like Singapore, and can use that to evaluate the economics of storage opportunities. But you or I or journalists or even analysts at Morgan Stanley have a far tougher time doing that.

So the outsiders look under the Brent futures streetlight, and conclude that storing oil doesn’t pay. But the oil isn’t under the streetlight. It’s being stored in the dark. And those who can see in the dark are storing it there because they can see that it pays.

 

 

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May 13, 2016

Surprise, Surprise, Surprise: Guess Who Squeezed (and May be Squeezing) Brent

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 7:44 pm

Cue Gomer Pyle. It is now being reported that Glencore was not just bigfooting fuel oil in Singapore, but it was the firm stomping on Brent as well. It took delivery of 15 or more cargoes of the 37 available for June loading. There is also talk that the firm had accumulated a position in excess of the 37, and had already had contracts to sell Brent to refineries in Asia and Europe.

Thus all the elements of a squeeze were in place. A position bigger than deliverable supply, and a grave pre-dug to bury the corpse. It was able to liquidate some of its position (25 cargoes or so, or more than 15 million barrels) at an artificially high price (as indicated by the flip from contango to backwardation in the last couple of weeks of trading).

The July contract has also flipped into a backwardation, suggesting that the play is on again.

Two (and perhaps three, if Glencore is behind what’s going on now) squeezes in short order is pretty audacious, even for Glencore. Makes me wonder if this is part of the company’s resurrection plan. Trading needs to perform in order to offset the carnage in the mining operation. That means taking more risks. Including regulatory and legal risks. Though truth be told, both the UK and Singapore have been quite supine in responding to market power manipulations for years. For instance, with all the squeezes that have taken place on the LME over the years, what have UK regulators ever done? What have they ever done in Brent? Or in the softs, where some pretty big squeezes have taken place in cocoa and coffee in recent years?

Inspector Clouseau would be proud.

The bigger risks are economic and commercial. Squeezes can be very profitable, but they can go horribly wrong. Recall that Glencore’s qua Glencore’s genesis was Marc Rich’s failed attempt to squeeze the LME zinc market in 1992. Marc Rich & Co. lost around $200 million, which resulted in a coup led by Ivan Glasenbeg that ousted Rich, and the renaming of the company as Glencore.

But desperate times sometimes call for desperate measures. Yasuo Hamanaka comes to mind. When his massive rogue trading operation was teetering on the precipice, needing a big profit in a hurry he carried out a massive corner of LME copper in December 1995. He wrote his co-conspirator “this is our last arms” (quoting from memory). In other words, do or die.

I’m not saying that Glencore’s problems are at all similar to Hamanaka’s, but the company does have big issues, and a need to make a lot of money in a hurry. The kind of issues that can lead big risk takers to take bigger risks, and push the envelope. The envelopes in Brent and Singapore fuel oil are pretty expansive, but Glencore seems to be pushing them nonetheless. Not part of the official resurrection plan, but most likely part of it nonetheless.

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May 10, 2016

Glencore Mucking About in the Dirtiest Market in the World

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 5:30 pm

The WSJ has an interesting story about Glencore big-footing the Singapore fuel oil market:

In a lightly trod corner of the oil market, Glencore PLC is leaving a big footprint.

During two of the past five quarters, the commodities trader has bought up large volumes of fuel oil at Asia’s main trading hub in Singapore at a time of day when it has an outsize effect on an Asia-wide price benchmark.

Trades made during the daily “Platts window”—the final few minutes of trading—are reported to Platts, an energy-price publisher, which uses the data to calculate a daily benchmark used to price millions of barrels of fuel oil across Asia.

In the first quarter, Glencore bought 20.7 million barrels of Singapore-traded fuel oil in the window—44% of all the Platts-window buying—according to the publisher, which is owned by S&P Global Inc. During that period, fuel-oil prices in Singapore rose 7.5%, according to Platts, outpacing Brent crude oil, up 6.2%, and U.S.-traded crude oil, up 3.5%.

“The fuel-oil bull play has been a fairly regular feature of the market-on-close window for many years,” said John Driscoll, chief strategist at JTD Energy Services in Singapore and a former fuel oil-trader. “Singapore is the world’s largest marine-fuels market and serves as the central pricing hub for petroleum products east of Suez. These conditions tend to favor bullish traders who have the resources and conviction to aggressively bid the window for a sustained period of time.”

The Journal soft-pedals what is going on here:

Some traders, shipbrokers and commodity experts say Glencore’s purchases have hallmarks of a trading gambit sometimes employed in the lightly regulated world of fuel-oil trading. In it, traders buy large quantities of physical fuel oil to benefit a separate position elsewhere, such as in the derivatives market or elsewhere in the physical market.

I’ll be a little more blunt. Yes, this looks for all the world like a manipulative play, along the lines of my 2001 Journal of Business piece “Manipulation of Cash-Settled Futures Contracts.” Buy up large quantities in the physical market to drive up the price of a price marker that is used to determine payoffs in cash-settled OTC swaps. (It’s possible to do something similar on the short side.) This works because the supply curve of the physical is upward sloping. Buy a lot, drive the market up the supply curve thereby elevating the price of the physical. If you are also long a derivative with a payoff increasing in the cash price, even though you lose money on the physical play, you can make even more money on the paper position if that position is big enough.

It’s impossible to know for sure, without knowing Glencore’s OTC book, but it is hard to come up with another reason for buying so much during the window.

Those on the other side of the OTC trade (if it exists) know who their counterparty is. It is interesting to note the “ethos” of this market. Nobody is running to court, and nobody is shouting manipulation. The losers take their lumps, and figure that revenge is the best reward.

Platts reacted with its usual blah, blah, blah:

“The Singapore refined-oil-product markets are highly liquid, attracting dozens of buyers and sellers from across the world, and our assessments of those markets remain robust,” Platts said in a statement. “It’s worth highlighting that our rigorous standards in our oil benchmarks are fully open to public scrutiny, and a result of information provided to us on a level playing field.”

As a transactions-based methodology, Platts windows are not vulnerable to some kinds of manipulation (e.g., of the Lie-bor variety) but they are definitely vulnerable to the large purchases or sales of a big trader looking to move the price to benefit an OTC position. The most that Platts can do is provide more delivery capacity to make the supply curve more elastic, but as I show in the 2001 paper, as long as the supply curve is upward sloping, or the demand curve is downward sloping a trader with a big enough derivatives position and a big enough pocketbook has the incentive and ability to manipulate the price.

Once upon a time, in the 90s in particular, the Brent market was periodically squeezed. Platts (and the industry) responded by broadening the Brent basket to include Forties, Oseberg, and Ekofisk. For a while that seemed to have made squeezes harder. But the continued decline of North Sea production has made the market vulnerable again. Indeed, all the signs suggest that the June Brent contract that went off the board last week was squeezed: it went into a steep backwardation during the last few days of trading, and the market returned to contango as soon as that contract expired.

The fact is that market power problems are endemic in commodity markets. The combination of relatively small and constrained physical markets and big paper markets create the opportunity and the incentive to exercise market power. It looks like that happened in Brent, and looks like it is a chronic problem in Singapore FO, reputed to be one of the dirtiest markets in the world.

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May 5, 2016

If You Believe the Official Reason for Cutting Off Chinese Economic Statistics, I Have a Great Wall to Sell You

Filed under: China,Commodities,Economics,Energy,Politics — The Professor @ 9:33 pm

Since October of last year, China’s National Bureau of Statistics has not published detailed data on metals markets. And it’s not just metals:

Data on oil products such as liquefied petroleum gas, naphtha and fuel oil have been withdrawn. So too have regional figures for coal, steel and electricity output.

 

The ostensible reason is that statistics bureau personnel were selling data for personal gain.

If you believe that, I will sell you a large wall. It’s so big they say you can see it from space! Only one like it! I sell it to you for a song.

“Anti-corruption” is the cover/pretext that the Chinese government now uses to eliminate those who have fallen from political favor. The most likely explanation for the “anti-corruption” drive aimed at economic statistics agencies is not to eliminate politically inconvenient people: it is to eliminate politically inconvenient data.

The fraudulence of Chinese official economic statistics is well known. One of the challenges of creating false official statistics for aggregate numbers like GDP growth is making it consistent with data on specific industries or sectors. The divergence between GDP growth and electricity production, for instance, has often been remarked upon.

How to solve this problem? Stop producing the underlying sector/industry/product specific data. How to do that without giving away the real reason? Use the all-purpose excuse: fighting corruption.

This has an air of plausibility: after all, corruption is rife in China. But this really doesn’t pass the smell test, especially given the timing: note that the data embargo started when concerns about the Chinese economy became acute at the end of last year.

The Chinese are desperate to maintain the illusion of 6.7 percent growth, quarter in, quarter out. Maintaining that illusion has become harder and harder as questioning of the consistency of various data sources has become more insistent. Shutting off the flow of sector/industry/product data is a brute force way of dealing with that problem.

This is another signal of the real state of the Chinese economy. The government wouldn’t have jacked up the stimulus unless the true state of affairs was far more dire than official statistics suggest. The government wouldn’t be suppressing data from the primary goods sectors unless it was also giving the lie to the official line.

Bottom line: question everything relating to the economy in China right now. Be especially skeptical about anything done under the banner of fighting corruption. That banner should be a red flag warning that the Chinese Communist Party is trying to suppress inconvenient people, or inconvenient truths. If they say it’s about corruption, it’s really about something else.

 

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April 29, 2016

Rounding Up the Usual Suspects, With Chinese Characteristics

Filed under: China,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 8:32 pm

Commodity prices on Chinese exchanges, especially for ferrous metals, have been skyrocketing in recent weeks. Rebar, iron ore and coking coal have been particularly active, but thermal coal and cotton have been jacked too.

In response, the Chinese authorities are cracking down on speculation.  Exchanges have raised margins in order to attempt to rein in trading. The government is making ominous statements about speculation and manipulation. And we know what can happen to speculators who fall afoul of the government.

Ironically, prices never appear to be just right, by the lights of the Chinese authorities. Last summer, and earlier this year, speculators were allegedly causing stock prices and commodity prices to be too low. Now they are causing commodity prices to be too high.

This is a case of the Chinese authorities playing Claude Rains in Casablanca, and ordering a roundup of the usual suspects. Speculators make convenient targets, and they appear to be the proximate cause: after all, their trades produce the rapidly rising prices.

But the speculators are merely the messengers. If the Chinese authorities want to find the real culprits, they need to look in the mirror, for the speculators are responding to the most recent lurch in Chinese economic policy.

Put simply, after the economic slowdown of the second half of 2015 (a slowdown masked by fraudulent official statistics, but evident nonetheless), the government pushed the panic button and fell back on its standard remedy: injecting a burst of credit.  Some estimates put the Chinese debt to GDP at 237 percent. Since GDP is likely also an overstated measure of national income, due to fraudulent statistics and the fact that the losses on past investments have not been recognized (in part because much of the credit is pumped  into zombie companies that should be bankrupt) this ratio understates the true burden of the debt.

The surge in credit is being extended in large part through extremely fragile and opaque shadow banking channels, but the risk is ending up on bank balance sheets. To engage in regulatory arbitrage of capital rules, banks are disguising loans as “investments” in trust companies and other non-bank intermediaries, who then turn around and lend to corporate borrowers.  Just call a loan a “receivable” and voila, no nasty non performing loan problems.

There is one very reasonable inference to draw from this palpably panicked resort to stimulus, and the fact that many companies in commodity intensive industries are in desperate financial straits and the government is loath to let them go under: today’s stimulus and the implied promise of more in the future whenever the economy stutters will increase the demand for primary commodities. The speculators are drawing this inference, and responding accordingly by bidding up the prices of steel, iron ore, and coal.

Some commentors, including some whom I respect, point out that the increase does not appear to be supported by fundamentals, because steel and coal output, and capacity utilization, appear to be flat. But the markets are forward looking, and the price rises are driven by expectations of a turnaround in these struggling sectors, rather than their current performance. Indeed, the flat performance is one of the factors that has spurred the government to action.

When the Chinese responded to the 2008-2009 crisis by engaging in a massive stimulus program, I said that they were creating a Michael Jackson economy, one that was kept going by artificial means, to the detriment of its long term health. The most recent economic slowdown has engendered a similar response. Its scale is not quite as massive as 2008-2009, but it’s just begun. Furthermore, the earlier stimulus utilized a good portion of the nation’s debt capacity, and even though smaller, the current stimulus risks exhausting that capacity and raising the risk of a banking or financial crisis. It is clear, moreover, each yuan of stimulus today generates a smaller increase in (officially measured) output. Thus, in my view, the current stimulus will only provide a temporary boost to the economy, and indeed, will only aggravate the deep underlying distortions that resulted from past attempts to control the economy. This will make the ultimate reckoning even more painful.

But the speculators realize that the stimulus will raise commodity demand for some time. They further recognize that the stimulus signals that the authorities are backsliding on their pledges to reorient the economy away from heavy industry and investment-driven growth, and this is bullish for primary materials demand going forward: the resort to credit stimulus today makes it more likely that the authorities will continue to resort to it in the future. So they are bidding up prices today based on those predictions.

In other words, as long as the Michael Jackson economy lives and stays hooked, its suppliers will profit.

So yet again, commodity markets and the speculators who trade on them are merely a lurid facade distracting attention from the underlying reality. And the reality in China is that the government cannot kick the stimulus habit. The government may scream about (and worse) the usual suspects, but it is the real cause of the dizzying rise in Chinese commodity prices, and the burst of speculation.

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