Streetwise Professor

December 2, 2016

Lucy Putin?

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 12:53 pm

I was somewhat surprised that OPEC came to an agreement. I will be more surprised if they live up to it: that would be not just going against history, but against basic economics. The incentives to cheat are omnipresent (as the Saudi’s ex-Minister of Petroleum of Petroleum Naimi acknowledged in the aftermath of the announcement). Further, what is the enforcement mechanism? Retaliatory output increases/price cuts (i.e., price wars)? Moreover, given that many OPEC nations are facing acute budgetary strains, the present looms and the future looks very, very far away: consequently, getting some additional revenue today at the risk of losing some revenue a year or two from now when a price war breaks out looks pretty attractive.

The breathless TigerBeat-style reporting of the meeting states that Russia’s last-minute intervention rescued the deal. A few things to keep in mind. Russian oil output has surged in the last few months, meaning that its promise to cut 300,000 bbl/day basically puts its output back to where it was in March. This is in fact pretty much true of the OPEC members too: the deal very much as the feel of simply taking two steps back to reverse the two steps forward that major producers took in the past 9 months (and the two steps forward were no doubt driven in large part to improve bargaining positions in anticipation of the November OPEC meeting).

Moreover, the timing of the Russian commitment is rather hazy. Energy Minister Alexander Novak said Russia would cut “gradually.” That can mean almost anything, meaning that the Russians can say “the cuts are coming! Trust us! We said it would be ‘gradual!'” and that there will be no hard evidence to contradict them.

The most amusing part of this to me is that many are interpreting Putin’s personal involvement as proof that the Russians will indeed cut. “If Putin tells Russian oil companies to cut, they’ll ask ‘how deeply’?”

Seriously?

Call me cynical (yeah, I know), but I find this scenario far more plausible: Putin sweet-talked the Saudis and Iranians to overcome their differences to cut output in order to raise prices, all the while planning to sell as much as possible at the (now 10 percent) higher prices. Breezy promises cost nothing, and even if eventually OPEC members wise up to being duped, in the meantime Russia will be able to sell to capacity at these higher prices. Yes, the OPEC members will be less likely to believe him next time, but Putin’s time horizon is also very short, for a variety of reasons. He’s not getting any younger. And more immediately, the Russian recession is dragging into its third year, and budgetary pressures are mounting (especially since he is committed to maintaining a high level of military spending). The Russian Wealth Fund (one of its two sovereign wealth funds) has been declining inexorably: the rainy day fund is almost empty, and the skies still haven’t cleared. And the presidential election looms in 2018. For Putin, the future is now. The future consequences of making and breaking a promise are not of great importance in such circumstances. But more money in the door today is very, very important.

Russia isn’t like other OPEC producers, which have national oil companies that respond to government orders. Although government-controlled Rosneft is the biggest producer in Russia, there are others, and even Rosneft and Gazpromneft have more autonomy than, say, Saudi Aramco. Yes, Putin could, er, persuade them, but a far more effective (and credible) tool would be to adjust taxes (especially export taxes on both crude and fuels) to give Russia’s producers an incentive to cut output (and especially exports, which is what OPEC members really care about). A tax boost would be a very public signal–and reversing it would be too, making it harder to cheat/renege. (Harder, but not impossible. The government could give stealth tax cuts or rebates. This is Russia, after all.) But I have not seen the possibility of a tax rise even be discussed. That makes me all the more skeptical of Putin’s sincerity.

So my belief is that Putin is stepping into the role that Sechin played in 2009, that is, he is being Lucy beckoning Charlie Brown/OPEC with the football. And Charlie Brown is attempting a mighty boot. We know how that works out.

Even if Putin lives up to his pinky-swear to cut output, Russia has cut a much better deal than the Saudis. The promised Russian cut is about 60 percent of the Saudi cut, yet both get the same (roughly 10 percent) higher price, meaning that (roughly speaking) Russian revenues will rise 40 percent more than than Saudi revenues do–assuming that both adhere to the cuts. The disparity will be greater, to the extent that Russia cheats more than the Saudis.

Time will tell, but what I am predicting is that (a) Russia will not cut anything near 300kbbl/d, and (b) cheating by OPEC members will snowball, meaning that next November’s OPEC meeting will likely be another rancorous effort dedicated to repairing a badly tattered deal, rather than a celebration of the anniversary of a successful and enduring bargain.

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November 15, 2016

Igor Sechin Takes His Revenge

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 12:07 pm

The Bashneft sale to Rosneft (which I wrote several posts about) is a done deal, but apparently there was some unfinished business. Namely, the business of  revenge.

On Monday Economic Development Minister Alexei Ulyukayev was detained for corruption. He allegedly took a $2 million bribe to “allow” the sale. Indeed, Bloomberg claims he was caught in the act:

Ulyukayev, 60, was detained on Monday “in the act” of receiving the cash, said Russia’s Investigative Committee. He was later charged with demanding the money from Rosneft PJSC to allow its purchase last month of the government’s 50 percent stake in regional oil producer Bashneft PJSC, the agency said in a statement. The economy minister denies any wrongdoing, his lawyer Timofei Gridnev told Business FM radio. Investigators moved that he be held under house arrest before he arrived for arraignment Tuesday at Moscow’s Basmanny Court.

Ah, Basmanny justice. Gotta love it.

This all seems quite bizarre. The Bashneft acquisition was clearly a source of intense conflict with the Russian government, with the government ministries–including Ulyukayev–initially expressing opposition. Then there was temporizing, with Putin seeming to come down on both sides of the issue. Then it was decided in Rosneft’s–that is, Igor Sechin’s–favor.

Presumably, Putin was the ultimate decider here. If so, Ulyukayev was in no position to “allow” anything. Maybe he had a chance to make his case, either directly to Putin, or indirectly via Medvedev. But once he lost, he would have been delusional to think he had any leverage over whether the deal would proceed.

Further, the timing is beyond strange. The deal was decided in September, and finalized on October 12, more than a month ago. So, did Ulyukayev give net 30 terms on the bribe? Net 60? Was it half now, half later? Is bribery really done on credit in Russia?

I would also venture that attempting to shake down Sechin and Rosneft is tantamount to suicide. Did Ulyukayev attempt such a risky thing? Did Sechin play along and then facilitate a sting by the Investigative Committee? Or was this a set-up job from the start?

One thing that is almost certainly true is that this is Sechin taking his revenge, and sending a message to others: look at what happens to those who cross me.

The Energy Ministry, under Novak, also opposed the deal initially. I wonder if he is sleeping well.

There are some comic elements to the story. Several stories breathlessly report a law enforcement leak saying that Ulyukayev’s phone had been tapped “for months.” Um, pretty sure it was tapped like forever.

Ulyukayev has a reputation as a “liberal” in Russia, and assorted Western dimwits expressed Shock! Shock! at his arrest. Prominent among these were Anders Aslund and my fellow professor and buddy Michael McFaul. I say dimwits for several reasons. First, is it news to them that the “liberals” in the Russian government are marginalized, and exist at the sufferance of people like Sechin who are in Putin’s inner circle? Second, are they so credulous as to believe that these liberals are untainted by corruption? Puh-lease. Ulyukayev appeared in the Panama Papers. Further, the “liberals” and “reformers” mainly go back to the Yeltsin period, and remember that  Yeltsin elevated Putin in exchange for foregoing any investigation or prosecution of the rife corruption of the Yeltsin administration. Ulyukayev was associated with Gaidar, who was also tied to corruption (although the publicly revealed instances were small beer by Russian standards).

There are no clean hands in Russia. This very fact is what usually keeps people in line, for they know the adage “for my friends, everything: for my enemies, the law!” Everybody is vulnerable to prosecution, because everybody is corrupt: actual prosecution is used sparingly, however, to punish those who have committed a political transgression.

Ulyukayev clearly committed such a transgression, and hence he finds himself in the dock.

There is no reason to be shocked by this. It merely confirms that people like Sechin are the real power. But this is apparently a revelation to alleged Russia experts.

Bashneft is the Hope Diamond of oil companies: it seems to bring bad luck to anyone who touches it. Ural Rakhimov, the son of the boss of Bashkortostan (where the company is located), who profited from the corruptly done privatization of the company in 2002, but who apparently fled Russia when the privatization and subsequent sale came under government scrutiny. Vladimir P. Yevtushenkov, who bought Bashneft from Rakhimov, but then wound up under house arrest for 92 days for allegations related to the privatization: he walked only after the government seized Bashneft shares from Yevtushenkov’s holding company before performing the re-privatization Kabuki that ended with the company being bought by Rosneft. And now Ulyukayev.

Will the skein of bad luck end with Rosneft and Sechin? That’s a good bet, but not a lock. Who knows what changes in power are in store, especially as Putin ages, or if there is some economic or political shock?

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November 9, 2016

Blessed Are Ye Who Are Long Gamma

Filed under: Economics,Energy,Politics,Regulation — The Professor @ 9:03 am

Hillary Clinton made history last night. Just not quite the way she had expected. Rather than “shatter the glass ceiling” (gag), she was crushed as the roof caved in on a complacent, corrupt, and clueless establishment of which she was the exemplar. Donald Trump was the personification of the forces that defeated her and the “elite”, but pretty much only that: either by canny calculation or dumb luck he rode a deep current of popular discontent to achieve a stunning victory that saw at least five, and likely six, strongly Democratic states flip from D to R. The Democrats prevailed only in the leftist strongholds of the P-Coast, the Northeast, The Illinois Salient, and Governmentlandia (Virginia and Maryland). The rest of the country went red. Trump was the effect, not the cause. The vessel that floated on the tide, not the tide itself.

Blessed are ye who are long gamma. Those who have the flexibility and optionality to respond to uncertain developments are the winners here, for there will be uncertainty aplenty. The future with Hillary would have been drearily predictable: the future with Trump will be a wild ride.

Consider few representative areas.

The Supreme Court: Hillary would have chosen rigid leftist ideologues intent on remaking the country–not just its government and economy, but its social fabric. Trump? I have no clue, and either does anyone else. My guess that his court picks generally will be highly idiosyncratic with no unifying philosophical orientation–because Trump lacks one as well.

Government appointments: Hillary would tap from the Empire’s vast array of apparatchiks, most of whom would be statist to the core. The middle and lower level appointments would have teemed with the kinds of political cockroaches revealed in the light of the Podesta emails. As an outsider, Trump has no similar pool of bureaucrats-in-waiting. The transition process will likely be chaotic, and he will have to rely on a Republican establishment that he distrusts (and which distrusts him) to advance candidates. Again, the outcome is wildly unpredictable, and will probably result in a hodgepodge of appointments with no unifying ideology or philosophy, who will often work at cross purposes.

There will be new blood, which is a good thing: people from outside the ranks of the courtiers in DC and the coastal metropolises are desperately needed. These people will inevitably be high variance. But that is an inevitable part of the process of change.

Economic policy: Hillary would have continued the onslaught of regulations that has been producing an Amerisclerosis that rivals Eurosclerosis. Agencies like the EPA would have continued to propose and implement burdensome, growth-sapping regulations. She would have pushed the kinds of taxes on capital that are also inimical to growth (although her ability to get those through Congress would have been a very open question). Trump? He is an economic ignoramus, but it is likely that Congress will temper some of his wackier ideas. Further, he is open to reducing many of the regulatory monstrosities like those that the EPA has imposed, and to removing barriers to energy production and transportation. His tax ideas are unpredictable, but again they are not relentlessly hostile to investment and capital. And a big thing: there is an opportunity to fix Obamacare. Hillary would have fixed it by moving to single payer. There is an opportunity to move away from government control, not doubling down on it.

Regulatory policy and taxes will require cooperation with Congress. The relations between Trump and the Republican leadership are fraught, at best. Idiots like Max Boot are delusional if they think that a Republican House and Senate will give Trump carte blanche. But Trump views himself as a negotiator, and will no doubt engage in negotiations with Congress with zest. The outcome of those negotiations? Impossible to predict. Likely something best described by the old joke: “What is a giraffe? A horse designed by committee [or negotiation].” Again, tremendous uncertainty.

With respect to economic policy, personnel will matter here. Again, Hillary’s appointments to agencies like EPA, SEC, FERC, FTC, FCC, and CFTC would have been tediously predictable statists intent on extending government control over the economy. Trump’s appointments are much more likely to be a very mixed bag, leading to less predictable outcomes. I do think it is likely, however, that there will be many fewer regulatory control freaks. Thus, I expect that at the CFTC, for instance, a Trump commission will jettison economic inanities like Reg AT and position limits.

Foreign policy: Hillary has a strong interventionist, not to say warmongering, streak, and would have almost certainly been more aggressive in Syria than Obama has been, with very sobering consequences (including a substantially increased risk of confrontation with Russia). Trump’s predilections seem much less interventionist, but events, dear boy, events, can lead presidents to do things that they would prefer not to. And given Trump’s mercurial nature, how he will respond to events is wildly unpredictable.

He will have to deal with other major issues, notably China. He will approach these like a negotiator–including, I expect, large doses of bluff and bluster–and the outcomes of these negotiations will be even harder to predict than those of his negotiations with Congress. (One issue that could have both domestic and foreign policy effects is that I conjecture it is likely that the Sequester will die under Trump, whereas it would have continued with a divided government.)

It is clear, therefore, that Trump will disrupt the system, both domestically and internationally, whereas Hillary would have perpetuated it. And I am not unduly concerned about extreme disruptions, because the inherent complexity of the American system of government, the tension between Trump and Congress, and quite frankly, Trump’s limited attention span will temper his more extreme impulses.

Further, shaking up the system is a good thing, for the system is dysfunctional and corrupt. Hillary would have continued our relentless slouch to cryptosocialism and would have cemented the rule of a contemptible and remote establishment: the possibility of an upside is greater with Trump, even if by accident. Hillary would have delivered us sclerosis on purpose.

I would also suggest that a Hillary victory would have increased the likelihood of a bigger cataclysm in the future. She and her acolytes would have disdained and dismissed the forces that in the event propelled Trump to victory. She would have doubled down on the policies that have contributed to our present discontent. As a result, that discontent would have only increased, thereby increasing in turn the likelihood of an even bigger political spasm in the future.

To put things differently: with Trump, we will be on a roller coaster. With Hillary, we would have been on the luge.

I think Trump will be a transitional figure. Transitioning to what, I have no idea. But given the deeply dysfunctional nature of the status quo, transition holds out hope. Shaking up a decrepit and corrupt system creates the possibility for change. Creative Destruction is a possibility with Trump. With Hillary, no.

All this said, the Empire will strike back. It will wage a relentless war from its redoubts in the media, and to a lesser degree, the courts. Look at what the Remain crowd is doing in the UK in its attempt to undo its loss at the polls. That will happen here too: there will be a Thermidor, or at least an attempted one. And that battle will produce uncertainty.

And not all of the Empire’s minions are Democrats: the Republican establishment will fight Trump from within the citadel. This political warfare adds the prospect of even more uncertainty. Again, a reason to be long gamma.

I cannot say I predicted this, because I didn’t. I do think it is fair to say that I limned the outlines of what has transpired. This came in two parts. First, I noted that as with Brexit, this possibility was far more likely than elite opinion believed. A complacent elite sat smugly atop the volcano, blithely ignorant of the pressure of deep popular disdain pushing up the earth under their feet, disdain powered by the financial crisis, bloody and inconclusive wars, and an anemic economy. Talking only to one another, the elite received no feedback about what voters were thinking and feeling.  Existing in an echo chamber made them vulnerable to shock and surprise. Moreover, their contempt for those not in their class also led them to think that such feedback was irrelevant, because these little people didn’t matter. They knew better.

But the little people, largely without voice in the forums in which the elite communicate and interact, nursed their injuries, bided their time, and took their revenge.

Second, Hillary is a horrible person, and a horrible candidate–or should I say deplorable? Look at the vote totals vs. Obama in 2012. To say she underperformed is an extreme understatement. She underperformed because she had nothing new to offer, and indeed, the old conventional liberal stuff she was offering was long past its sell-by date. Add to that her horrible personal packaging (the corruption, the endless scandal, the inveterate lying) and she was crushed by an inarticulate political novice carrying more baggage than the cargo hold of an Airbus A380.

I did not have the courage of my convictions to predict that these two factors would result in a Trump victory. I thought Jacksonian America was too small to prevail. I too was in the thrall of conventional wisdom to some degree.

If you asked me to describe my mood, I would echo the title of a Semisonic song: Feeling strangely fine. Part of that feeling, I must admit somewhat guiltily, is due to schadenfreude: the hysteria of those whom I despise is quite enjoyable to witness. But part of it is that I think I am long gamma, and that the US is long gamma too. The old system and the old establishment have crushed American dynamism. Shaking up that system has more upside than downside, and whatever you think about Trump, you have to know he will shake things up.

I’ll close by quoting about the most un-Trump-like president I can think of: Eisenhower. “If you can’t solve a problem, enlarge it.” In other words, disrupt. Get out of the box. Don’t continue down the same endless path: try something new. The United States has been facing many insoluble problems, political, economic, strategic. The establishment had no clue at how to solve these problems, and their attempts to try the same things expecting different results put us on a slow road to ruin. Or maybe not so slow. A disruption was needed. An overthrow of the elite was imperative. Those things will in some respects enlarge our problems, by creating turmoil. But out of that enlargement there is the prospect of solutions–and yes, the prospect of catastrophe.

I don’t think that Trump himself will be the architect of those solutions. His role will be to tear down–he’s already done that to a considerable degree. Others will have to build up. Who that is, I don’t know. What construction will emerge, I don’t know. But there is far more upside now than there would have been with President Hillary Clinton. And that is reason to feel fine, strangely so or not

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November 8, 2016

WTI Gains on Brent: You Read It Here First!

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

Streetwiseprofessor, August 2011:

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

. . . .

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

Bloomberg, November 2016:

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

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

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

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

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

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

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

ICE’s response was kind of amusing:

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

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

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

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

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

 

 

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October 26, 2016

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

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

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

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

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

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

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

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

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

What China giveth, China might taketh away.

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

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

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

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October 6, 2016

Igor for the Win!, or Privatization With Russian Characteristics

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

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

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

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

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

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

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

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September 26, 2016

Laissez les bons temps rouler!

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 12:07 pm

One of the great myths of commodity futures trading is the “roll return,” which Bloomberg writes about here (bonus SWP quote–but he left out the good stuff!, so I’ll have to fill that in here). Consider the oil market, which is currently in a contango, with the November WTI future ($45.99/bbl) trading below the December ($46.52/bbl). This is supposedly bad for those with a long ETF position, or an index position that includes many commodities in contango, because when the position is “rolled” forward in a couple weeks as the November contracts moves towards expiration, the investor will sell the November contract at a lower price than he buys the December, thereby allegedly causing a loss. The investor could avoid this, supposedly, by holding inventory of the spot commodity.

The flip side of this allegedly occurs when the market is in backwardation: the expiring contract is sold at a higher price than the next deferred contract is bought, thereby supposedly allowing the investor to capture the backwardation, whereas since spot prices tend to be trending down in these conditions, holders of the spot lose.

This is wrong, for two reasons. First, it gets the accounting wrong, by starting in the middle of the investment. The profit or loss on the November crude futures position depends on the difference between the price at which the November was sold in early October and bought in early September, not the difference between the price at which the November is sold and the December is bought in early October. Similarly, in November, the P/L on the December position will be the difference between sell and buy prices for the December futures, not the difference between the prices of the December and January futures in early December.  You need to compare apples to apples: the “roll return” compares apples and oranges.

On average and over time, the investor engaged in this rolling strategy earns the risk premium on oil (or the portfolio of commodities in the index). This is because the futures price is the expected spot price at expiration plus a risk premium. The rolling position receives the spot price at expiration and pays the expected spot price at the time the position is initiated, plus a risk adjustment. On average the spot price parts cancel out, leaving the risk premium.

Second, the expected change in the price of the spot commodity compensates the holder for the costs of carrying inventory, which include financing costs (very small, at present), and warehousing costs, insurance, etc. Net of these costs, the P/L on the position includes a risk premium for exposure to spot price risk, and in a well-functioning market, this will be the same as the risk premium in the corresponding future.

Moving away from commodities illustrates how the alleged difference between a rolled futures position and a spot position is largely chimerical. Consider a position in S&P 500 index futures when the interest rate is above the dividend yield. (Yes, children, that was true once upon a time!) Under this condition, the S&P futures would be in contango, and there would be an apparent roll loss when one sells the expiring contract and buying the first deferred. Similarly, comparing the futures price to the spot index at the time the future is bought, the future will be above the spot, and since at expiration the future and the spot index converge to the same value, the future will apparently underperform the investment in the underlying. But this underperformance is illusory, because it neglects to take into account the cost of carrying the cash index position (which is driven by the difference between the funding rate and the dividend yield). When buys and sells are matched appropriately, and all costs and benefits are accounted for properly, the performance of the two positions is the same.

Conversely, in the current situation using the roll return illogic, the rolled position in S&P futures will apparently outperform an investment in the cash index, because the futures market is in backwardation. But this backwardation exists because the dividend yield exceeds the rate of financing an investment in the cash index. The apparent difference in performance is explained by the fact that the futures position doesn’t capture the dividend yield. Once the cost of carrying the cash index position (which is negative, in this case) is taken into consideration, the performance of the positions is identical.

Back in 1992, Metallgesellschaft blew up precisely because the trader in charge of their oil trading convinced management that a stack-and-roll “hedging” strategy would make money in a backwardated market, because he would be consistently selling the future near expiration for a price that exceeded the next-deferred that he was buying. This “logic” was again comparing apples to oranges. By implementing that “logic” to the tune of millions of barrels, Metallgesellschaft became the charter member of the billion dollar club–it was the first firm to have lost $1 billion trading derivatives.

So don’t obsess about roll returns or try to figure out ways to invest in cash commodities when the market is in a contango/carry. Futures are far more liquid and cheaper to trade, so if you want exposure to commodity prices do it through futures directly or indirectly (e.g., through ETFs or index funds). Decide on the allocation to commodities based on the risk it adds to your portfolio and the risk premium you can earn. Don’t worry about the roll. If you decide that commodities fit in your portfolio, laissez les bon temps roullez!

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August 31, 2016

Sechin Makes His Bashneft Bid

Filed under: Energy,Politics,Russia — The Professor @ 9:13 am

In my most recent post on the Bashneft saga, I surmised that there might be a quid pro quo: Rosneft would be allowed to buy the smaller producer in exchange for a promise to proceed with its long delayed privatization. It appears that something along those lines is what is going on, although whereas I conjectured that Putin made this offer to Sechin, Bloomberg reports that Sechin is pitching the idea to Putin:

Rosneft PJSC chief Igor Sechin, not taking no for an answer, has come up with a proposal to expand his energy empire while helping critics in the Russian government meet their goal of reducing the widest budget deficit in six years.

Sechin, a longtime ally of President Vladimir Putin, has asked the government to let state-run Rosneft buy its controlling stake in smaller oil producer Bashneft PJSC for $5 billion in cash, a premium to the market, according to two senior officials. Russia could then earn another $11 billion by proceeding with its delayed sale of 19.5 percent of Rosneft itself, generating a $16 billion windfall that would cut this year’s projected deficit in half, they said.

Sechin is also proposing to sell off small pieces of Rosneft to multiple investment funds and trading firms, rather than a big chunk to the Chinese or Indians.

This illustrates the transactional nature of Putinism. Presumably other interested parties have submitted their proposals to Putin, who will decide based on a mixture of efficiency, fiscal, and political considerations. The political considerations will focus on the distribution of rents among his retainers in exchange for political support and other services that those favored can provide Putin. Putin is in essence holding an auction, and the technocratic opposition to a Rosneft acquisition (at least before it privatizes) essentially forces Sechin to bid more aggressively.

One interesting aspect of this is the sequencing. If Putin bestows Bashneft on Rosneft in exchange for a promise of a future privatization, would Sechin dare to stall or delay once Bashneft is in hand, resorting to his usual arguments that due to this, that, or the other, the price isn’t right? If Rosneft sells off a stake in exchange for Putin’s promise that it can then acquire Bashneft, might Putin say at a later date: “Things have changed, so I’ve changed my mind”?  Making commitments credible in a personalized, natural state is not an easy thing. And these things get harder, the older Putin gets, as the end game problem looms larger by the day. The ability to evade future performance depends on  the political balance and economic conditions at the time performance is required, and those can shift dramatically.

So this is Sechin’s bid. It will be interesting to see whether Putin accepts it, and the conditions that he imposes in an attempt to make sure that Sechin lives up to his half of the bargain. Those conditions will reveal a good deal about not just Sechin’s current position within the hierarchy, but the degree of trust between the major players in the regime.

 

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August 24, 2016

Ooooh! Look at that Superfast Squirrel!

Filed under: Economics,Energy — The Professor @ 9:33 am

Yesterday Elon Musk announced the introduction of a 100kW battery pack that would create the quickest production car, capable of doing 0-60MPH in 2.5 seconds. But even Musk admits that production volume will be low, due to the cost and complexity of the new pack. Further given that it will add $10k to the price of an already very expensive vehicle, it will do nothing to advance Tesla’s ambitions of becoming a mass production company.

But it gives Elon the opportunity to strut and amaze the technofanboyz. Wow! Even more ludicrous!

But whenever Elon makes a big splash announcement, there is a very high probability that the true intent is to mask some other far less favorable news. And that was the case yesterday. While everybody covered the battery story, and gave it prominence, only a few covered a far more important, but unflattering story, and did so in a perfunctory way. Specifically, in an SEC filing Musk announced that he was buying $65 million of Solar City’s $124 million bond offering. But it gets better! His cousins, the CEO and CTO of Solar City, are each plunking down $17.5 million. Meaning that related insiders are buying more than 80 percent of the bond issue.

In other words, the market won’t touch these bonds with a ten foot pole, but Elon and his cousins must step into the breach. Mind you, this is happening after Tesla has offered to bail out–excuse me, buy out–Solar City. One would think that would be a credit risk positive, right? Apparently one cash bleeder buying another cash bleeder isn’t appetizing to potential bond investors, even in this era of yield famine–the Solar City bonds weren’t drawing any buyers at a yield of 6.5 percent.

Yet again, this illustrates that the Solar City deal is all about propping up a floundering enterprise, all in the name of staving off a reputation damaging failure.

I also wonder where are Elon et al getting the $100 million to pay for the bonds. Is Elon pledging more of his Tesla stock to Goldman, etc., to secure loans to buy the bonds?

There are other indications that Tesla’s financing issues are beginning to bite. Musk noted that

While the P100D Ludicrous is obviously an expensive vehicle, we want to emphasize that every sale helps pay for the smaller and much more affordable Tesla Model 3 that is in development. Without customers willing to buy the expensive Model S and X, we would be unable to fund the smaller, more affordable Model 3 development.

Which means that the company is having difficulty funding Model 3 development and production (and the Gigafactory) through the capital markets. The bond markets are pretty much off-limits now. The company just did a big equity sale, and will issue more shares to buy Solar City. Tesla’s financial infrastructure looks shaky indeed. Further, it’s not as if the Models S and X are flying off the lot: Tesla inventories consist predominately of the more expensive 90kW battery versions.

So don’t get dazzled. Don’t get distracted by the superspeedy squirrel. Elon makes such announcements in order to divert attention from bad news. Indeed, when Musk makes a splash, you should start looking out for what he’s trying to hide.

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August 23, 2016

Carl Icahn Rails Against the Evils of RIN City

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — The Professor @ 12:15 pm

Biofuel Renewable Identification Numbers–“RINs”–are back in the news because of a price spike in June and July (which has abated somewhat). This has led refiners to intensify their complaints about the system. The focus of their efforts at present is to shift the compliance obligation from refiners to blenders. Carl Icahn has been quite outspoken on this. Icahn blames everyone, pretty much, including speculators:

“The RIN market is the quintessential example of a ‘rigged’ market where large gas station chains, big oil companies and large speculators are assured to make windfall profits at the expense of small and midsized independent refineries which have been designated the ‘obligated parties’ to deliver RINs,” Icahn wrote.

“As a result, the RIN market has become ‘the mother of all short squeezes,”‘ he added. “It is not too late to fix this problem if the EPA acts quickly.”

Refiners are indeed hurt by renewable fuel mandates, because it reduces the derived demand for the gasoline they produce. The fact that the compliance burden falls on them is largely irrelevant, however. This is analogous to tax-incidence analysis: the total burden of a tax, and the distribution of a tax, doesn’t depend on who formally pays it. In the case of RINs, the total burden of the biofuels mandate and the distribution of that burden through the marketing chain doesn’t depend crucially on whether the compliance obligation falls on refiners, blenders, or your Aunt Sally.

Warning: There will be math!

A few basic equations describing the equilibrium in the gasoline, ethanol, biodiesel and RINs markets will hopefully help structure the analysis*. First consider the case in which the refiners must acquire RINs:

Screen Shot 2016-08-23 at 10.20.03 AM

Equation (1) is the equilibrium in the retail gasoline market. The retail price of gasoline, at the quantity of gasoline consumed, must equal the cost of blendstock (“BOB”) plus the price of the ethanol blended with it. The R superscript on the BOB price reflects that this is the price when refiners must buy a RIN. This equation assumes that one gallon of fuel at the pump is 90 percent BOB, and 10 percent ethanol. (I’m essentially assuming away blending costs and transportation costs, and a competitive blending industry.) The price of a RIN does not appear here because either the blender buys ethanol ex-RIN, or buys it with a RIN and then sells that to a refiner.

Equation (2) is the equilibrium in (an assumed competitive) ethanol market. The price an ethanol producer receives is the price of ethanol plus the price of a RIN (because the buyer of ethanol gets a RIN that it can sell, and hence is willing to pay more than the energy value of ethanol to obtain it). In equilibrium, this price equals the the marginal cost of producing ethanol. Crucially, with a binding biofuels mandate, the quantity of ethanol produced is determined by the blendwall, which is 10 percent of the total quantity sold at the pump.

Equation (3) is equilibrium in the biodiesel market. When the blendwall binds, the mandate is met by meeting the shortfall between mandate and the blendwall by purchasing RINs generated from the production of biodiesel. Thus, the RIN price is driven to the difference between the cost of producing the marginal gallon of biodiesel, and the price of biodiesel necessary to induce consumption of sufficient biodiesel to sop up the excess production stimulated by the need to obtain RINs. In essence, the price of biodiesel plus the cost of a RIN generated by production of biodiesel must equal the marginal cost of producing it. The amount of biodiesel needed is given by the difference between the mandate quantity and the quantity of ethanol consumed at the blendwall. The parameter a is the amount of biofuel per unit of fuel consumed required by the Renewable Fuel Standard.

Equation (4) is equilibrium in the market for blendstock–this is the price refiners get. The price of BOB equals the marginal cost of producing it, plus the cost of obtaining RINs necessary to meet the compliance obligation. The marginal cost of production depends on the quantity of gasoline produced for domestic consumption (which is 90 percent of the retail quantity of fuel purchased, given a 10 percent blendwall). The price of a RIN is multiplied by a because that is the number of RINs refiners must buy per gallon of BOB they sell.

Equation (5) just says that the value of ethanol qua ethanol is driven by the relative octane values between it and BOB.

The exogenous variables here are the demand curve for retail gasoline; the marginal cost of producing ethanol; the marginal cost of producing BOB (which depends on the price of crude, among other things); the marginal cost of biodiesel production; the demand for biodiesel; and the mandated quantity of RINs (and also the location of the blendwall). Given these variables, prices of BOB, ethanol, RINs, and biodiesel will adjust to determine retail consumption and exports.

Now consider the case when the blender pays for the RINs:

Screen Shot 2016-08-23 at 10.20.25 AM

Equation (6) says that the retail price of fuel is the sum of the value of the BOB and ethanol blended to create it, plus the cost of RINs required to meet the standard. The blender must pay for the RINs, and must be compensated by the price of the fuel. Note that the BOB price has a “B” superscript, which indicates that the BOB price may differ when the blender pays for the RIN from the case where the refiner does.

Without exports, retail consumption, ethanol production, biodiesel production, and BOB production will be the same regardless of where the compliance burden falls. Note that all relevant prices are determined by the equilibrium retail quantity. It is straightforward to show that the same retail quantity will clear the market in both situations, as long as:

Screen Shot 2016-08-23 at 10.20.35 AM

That is, when the refiner pays for the RIN, the BOB price will be higher than when the blender does by the cost of the RINs required to meet the mandate.

Intuitively, if the burden is placed on refiners, in equilibrium they will charge a higher price for BOB in order to cover the cost of complying with the mandate. If the burden is placed on blenders, refiners can sell the same quantity at a lower BOB price (because they don’t have to cover the cost of RINs), but blenders have to mark up the fuel by the cost of the RINs to cover their cost of acquiring them. here the analogy with tax incidence analysis is complete, because in essence the RFS is a tax on the consumption of fossil fuel, and the amount of the tax is the cost of a RIN.

This means that retail prices, consumption, production of ethanol, biodiesel and BOB, refiner margins and blender margins are the same regardless of who has the compliance obligation.

The blenders are complete ciphers here. If refiners have the compliance burden, blenders effectively buy RINs from ethanol producers and sell them to refiners. If the blenders have the burden, they buy RINs from ethanol producers and sell them to consumers. Either way, they break even. The marketing chain is just a little more complicated, and there are additional transactions in the RINs market, when refiners shoulder the compliance obligation.

Under either scenario, the producer surplus (profit, crudely speaking) of the refiners is driven by their marginal cost curves and the quantity of gasoline they produce. In the absence of exports, these things will remain the same regardless of where the burden is placed. Thus, Icahn’s rant is totally off-point.

So what explains the intense opposition of refiners to bearing the compliance obligation? One reason may be fixed administrative costs. If there is a fixed cost of compliance, that will not affect any of the prices or quantities, but will reduce the profit of the party with the obligation by the full amount of the fixed cost. This is likely a relevant concern, but the refiners don’t make it centerpiece of their argument, probably because shifting the fixed cost around has no efficiency effects, but purely distributive ones, and purely distributive arguments aren’t politically persuasive. (Redistributive motives are major drivers of attempts to change regulations, but naked cost shifting arguments look self-serving, so rent seekers attempt to dress up their efforts in efficiency arguments: this is one reason why political arguments over regulations are typically so dishonest.) So refiners may feel obliged to come up with some alternative story to justify shifting the administrative cost burden to others.

There may also be differences in variable administrative costs. Fixed administrative costs won’t affect prices or output (unless they are so burdensome as to cause exit), but variable administrative costs will. Further, placing the compliance obligation on those with higher variable administrative costs will lead to a deadweight loss: consumers will pay more, and refiners will get less.

Another reason may be the seen-unseen effect. When refiners bear the compliance burden, the cost of buying RINs is a line item in their income statement. They see directly the cost of the biofuels mandate, and from an accounting perspective they bear that cost, even though from an economic perspective the sharing of the burden between consumers, refiners, and blenders doesn’t depend on where the obligation falls. What they don’t see–in accounting statements anyways–is that the price for their product is higher when the obligation is theirs. If the obligation is shifted to blenders, they won’t see their bottom line rise by the amount they currently spend on RINS, because their top line will fall by the same amount.

My guess is that Icahn looks at the income statements, and mistakes accounting for economics.

Regardless of the true motive for refiners’ discontent, the current compliance setup is not a nefarious conspiracy of integrated producers, blenders, and speculators to screw poor independent refiners. With the exception of administrative cost burdens (which speculators could care less about, since it will not fall on them regardless), shifting the compliance burden will not affect the market prices of RINs or the net of RINs price that refiners get for their output.

With respect to speculation, as I wrote some time ago, the main stimulus to speculation is not where the compliance burden falls (because again, this doesn’t affect anything relevant to those speculating on RINs prices). Instead, one main stimulus is uncertainty about EPA policy–which as I’ve written, can lead to some weird and potentially destabilizing feedback effects. The simple model sheds light on other drivers of speculation–the exogenous variables mentioned above. To consider one example, a fall in crude oil prices reduces the marginal cost of BOB production. All else equal, this encourages retail consumption, which increases the need for RINs generated from biodiesel, which increases the RINs price.

The Renewable Fuels Association has also raised a stink about speculation and the volatility of RINs prices in a recent letter to the CFTC and the EPA. The RFA (acronyms are running wild!) claims that the price rise that began in May cannot be explained by fundamentals, and therefore must have been caused by speculation or manipulation. No theory of manipulation is advanced (corner/squeeze? trade-based? fraud?), making the RFA letter another example of the Clayton Definition of Manipulation: “any practice that doesn’t suit the person speaking at the moment.” Regarding speculation, the RFA notes that supplies of RINs have been increasing. However, as has been shown in academic research (some by me, some by people like Brian Wright)  that inventories of a storable commodity (which a RIN is) can rise along with prices in a variety of circumstances, including a rise in volatility, or an increase in anticipated future demand. (As an example of the latter case, consider what happened in the corn market when the RFS was passed. Corn prices shot up, and inventories increased too, as consumption of corn was deferred to the future to meet the increased future demand for ethanol. The only way of shifting consumption was to reduce current consumption, which required higher prices.)

In a market like RINs, where there is considerable policy uncertainty, and also (as I’ve noted in past posts) complicated two-way feedbacks between prices and policy, the first potential cause is plausible. Further, since a good deal of the uncertainty relates to future policy, the second cause likely operates too, and indeed, these two causes can reinforce one another.

Unlike in the 2013 episode, there have been no breathless (and clueless) NYT articles about Morgan or Goldman or other banks making bank on RIN speculation. Even if they have, that’s not proof of anything nefarious, just an indication that they are better at plumbing the mysteries of EPA policy.

In sum, the recent screeching from Carl Icahn and others about the recent ramp-up in RIN prices is economically inane, and/or unsupported by evidence. Icahn is particularly misguided: RINs are a tax, and the burden of the tax depends not at all on who formally pays the tax. The costs of the tax are passed upstream to consumers and downstream to producers, regardless of whether consumers pay the tax, producers pay the tax, or someone in the middle pays the tax. As for speculation in RINs it is the product of government policy. Obviously, there wouldn’t be speculation in RINs if there aren’t RINs in the first place. But on a deeper level, speculation is rooted in a mandate that does not correspond with the realities of the vast stock of existing internal combustion engines; the EPA’s erratic attempt to reconcile those irreconcilable things; the details of the RFS system (e.g., the ability to meet the ethanol mandate using biodiesel credits); and the normal vicissitudes of the energy supply and demand.  Speculation is largely a creation of government regulation, ironically, so to complain to the government about it (the EPA in particular) is somewhat perverse. But that’s the world we live in now.

* I highly recommend the various analyses of the RINs and ethanol markets in the University of Illinois’ Farm Doc Daily. Here’s one of their posts on the subject, but there are others that can be found by searching the website. Kudos to Scott Irwin and his colleagues.

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