Streetwise Professor

June 15, 2015

Always Follow the Price Signals. I Did on Brent-WTI.

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 8:18 pm

As a blogger, I am long the option to point out when I call one right. Of course, I am short the option for you all to point out when I call one wrong, but I can’t help it if that option is usually so far out of the money (or if you don’t exercise it when it is in) 😉

I will exercise my option today, after reading this article by Greg Meyer in the FT:

West Texas Intermediate crude, once derided as a broken oil benchmark, is enjoying a comeback.

Volumes of futures tracking the yardstick have averaged 1m contracts a day this year through May, up more than 45 per cent from the same period of 2014, exchange data show. WTI has also sped ahead of volumes in rival Brent crude, less than two years after Brent unseated WTI as the most heavily traded oil futures market.

. . . .

WTI has also regained a more stable connection with global oil prices after suffering glaring discounts because of transport constraints at its delivery point of Cushing, Oklahoma. The gap led some to question WTI as a useful gauge of oil prices.

“I guess the death of the WTI contract was greatly exaggerated,” said Andy Lipow of consultancy Lipow Oil Associates.

But in the past two years, new pipeline capacity of more than 1m barrels a day has relinked Cushing to the US Gulf of Mexico coast, narrowing the discount between Brent and WTI to less than $4 a barrel.

Mark Vonderheide, managing partner of Geneva Energy Markets, a New York trading firm, said: “With WTI once again well connected to the global market, there is renewed interest from hedgers outside the US to trade it. When the spread between WTI and Brent was more than $20 and moving fast, WTI was much more difficult to trade.”

Things have played out exactly as I forecast in August, 2011:

One of the leading crude oil futures contracts–CME Group’s WTI–has been the subject of a drumbeat of criticism for months due to the divergence of WTI prices in Cushing from prices at the Gulf, and from the price of the other main oil benchmark–Brent.  But whereas WTI’s problem is one of logistics that is in the process of being addressed, Brent’s issues are more fundamental ones related to adequate supply, and less amenable to correction.

Indeed, WTI’s “problem” is actually the kind an exchange would like to have.  The divergence between WTI prices in the Midcontinent and waterborne crude prices reflects a surge of production in Canada and North Dakota.  Pipelines are currently lacking to ship this crude to the Gulf of Mexico, and Midcon refineries are running close to full capacity, meaning that the additional supply is backing up in Cushing and depressing prices.

But the yawning gap between the Cushing price at prices at the Gulf is sending a signal that more transportation capacity is needed, and the market is responding with alacrity.  If only the regulators were similarly speedy.

. . . .

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.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

So Brent boosters, enjoy your laugh while it lasts.  It won’t last long, and remember, he who laughs last laughs best.

This really wasn’t that hard a call to make. The price signals were obvious, and its always safe to bet on market participants responding to price signals. That’s exactly what happened. The only surprising thing is that so few publicly employed this logic to predict that the disconnection between WTI and ocean borne crude prices would be self-correcting.

Speaking of not enjoying the laugh, the exchange where Brent is traded-ICE-issued a rather churlish statement:

Atlanta-based ICE blamed the shift on “increased volatility in WTI crude oil prices relative to Brent crude oil prices, which drove more trading by non-commercial firms in WTI, as well as increased financial incentive schemes offered by competitors”.

The first part of this statement is rather incomprehensible. Re-linking WTI improved the contract’s effectiveness as a hedge for crude outside the Mid-continent (PADD 2), which allowed hedgers to take advantage of the WTI liquidity pool, which in turn attracted more speculative interest.

Right now the only potential source of disconnect is the export ban. That is, markets corrected the infrastructure bottleneck, but politics has failed to correct the regulatory bottleneck. When that will happen, I am not so foolish to predict.

 

 

 

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June 13, 2015

Definitive Proof That The New York Times’ David Kocieniewski Is A Total Moron*

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 6:06 pm

Not that further proof is needed, but still.

You may recall that NYT “reporter” (and by “reporter,” I mean “hack”) David Kocieniewski slimed me on the front page of the NYT on 31 December, 2013. In a nutshell, Kocieniewski accused me of being in the pocket of oil traders, and that this had led me to skew my research and policy positions. Specifically, he insinuated that I opposed position limits and defended speculation in energy markets because I had been suborned by oil traders who profited from high prices, like those that occurred in 2008 (before the crash). Kocieniewski’s main piece of “evidence” was that I had written a white paper sponsored by Trafigura. According to Kocieniewski, as an oil trader, Trafigura benefited from high prices.

At the time I pointed out that this demonstrates Kocieniewski’s appalling ignorance, as Trafigura is not a speculator, and is typically short futures (and other derivatives) to hedge its inventories of oil (and other commodities). Companies like Trafigura have no real interest in the direction of oil prices directly. They make money on margins and volumes. The relationship between these variables and the level of flat prices depends on what makes flat prices high or low.  I further said that if anything, commodity traders are likely to prefer a low price environment because (1) low prices reduce working capital needs, which can be punishing when prices are high, and (2) low price environments often create trading opportunities, in particular storage/contango plays that can be very profitable for those with access to storage assets.

Well, imagine my surprise (not!) when I saw this headline and article:

Crude slide bolsters Trafigura’s profits and trading margins

Trafigura has posted record half-year profits and a doubling of trading margins, illustrating how one of the world’s largest commodity trading houses has been a big beneficiary of the collapse in oil prices.

Profits at the group rose almost 40 per cent in the six months to 31 March, reaching $654m, while margins hit 3.1 per cent, as the Switzerland-based company used its global network of traders and storage facilities to buy cheap crude and take advantage of dislocations in the oil market.

. . . .
It was not the only company to benefit. Other trading groups including Vitol, the largest independent oil trader, and Gunvor have posted strong results for this period. Even Shell, BP and Total managed better-than-expected first quarter results thanks to the performance of muscular trading operations.

Wow. In Kocieniewskiworld, “Crude slide bolsters Trafigura’s profits” would be a metaphysical impossibility. Here on earth, that’s an eminently predictable event. Which I predicted. Not that that makes me a genius, just more knowledgeable about commodity markets than David Kocieniewski (which is a very low bar).

Not that there was ever anything to it in the first place, but this pretty much blows to hell the entire premise of Dim Dave’s story. Proof yet again that if you read the NYT for economics stories, you’ll wind up dumber after reading than before.

* As well as an unethical slug who blatantly violated the NYT’s ethics guidelines. Not that his editor gave a damn, making him as much of an unethical slug as Kocieniewski.

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June 11, 2015

The Ethanol Mandate is Enough to Drive Me to Drink

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — The Professor @ 6:13 pm

About 19 months ago I wrote about RINsanity, i.e., the United States’ nutty ethanol (and other biofuel) program. RINsanity has long outlived the phenomenon (Lin-sanity) that inspired the neologism. A couple of weeks ago, the EPA announced the ethanol and biodiesel quotas . . . for 2014. Who said time travel is impossible? That Einstein. What an idiot!  (The EPA also announced quotas for 2015 and 2016.)

In a nutshell, despite protestations to the contrary, the EPA largely conceded to the reality of the E10 “blend wall” (the fact that the vast bulk of auto engines are incapable of burning fuel with more than 10 percent ethanol), and announced quotas that were (a) smaller than the market expected, and (b) smaller than the statutory amounts that Congress specified in its farseeing omniscience 10 years ago. At the same time, the EPA decreed larger quotas for biodiesel.

As a result, the market did the splits. The price of ethanol RIN credits that count towards the ethanol quota plunged, while the price of biodiesel RIN credits that count towards the biodiesel quota rose. Scott Irwin and Darrell Good have all the gory details here. (Those are the guys to follow on this issue, folks. I’m just kibitzing.)

As a result, pretty much everyone is upset. The nauseating biofuel lobby is screaming bloody murder because the ethanol quota is too small, and is threatening to go to court. Those holding ethanol credits are fuming due to the forty plus percent price decline.

This all points out the dysfunctional nature of environmental markets in which the supply is set by some opaque politicized bureaucratic process unhinged from economic reality. (The European CO2 credit market is another classic example.) The Congressional mandate set quotas (supplies) years in advance based on forecasts of future fuel demand that turned out to be wildly incorrect. So the EPA played Mr. Fixit, and through some unknown process, divined what Congress meant to do-really!-and announced some surprising numbers that caused prices to plummet.

The EPA’s reaction? It is shocked! Shocked! to find gambling going on at Rick’s (ethanol served here!):

The EPA didn’t intend for the program to create a speculative market, and an agency spokesperson declined to comment on RIN price movement.

“RINs are used to demonstrate compliance under the Renewable Fuel Standard program,” the EPA said. The agency manages an electronic system that tracks the RINs, but not their prices on the open market.

Earth to EPA! Earth to EPA! (And hey-aren’t you supposed to be earth’s stewards? So what are you doing orbiting Pluto?): if you create a scarce resource (ethanol credits) a market-and yes, one with speculation!-will appear. This is inevitable as the sun rising in the east. Another unintended but metaphysically certain event.

Indeed, the kind of speculation that these markets foster is particularly bizarre, because of the necessity of speculating on the feedback between the market and the EPA’s decisions on the amount of the scarce resource it creates. A big part of the RIN prices is market participants’ expectations about what the EPA will decide. If the EPA’s decision takes the market price into account, in some unknown (and almost certainly unarticulated) way, the reasoning chain becomes mind-numbingly complex very quickly. Mr. Market guesses what the EPA will do. That affects prices. The EPA takes the price, and guesses what this says about what the market knows about fundamentals . . . and what the market thinks about what the EPA is going to do. It adjusts its decision accordingly. Market participants have to make judgments about the feedback between the price and the EPA’s decision, which can affect the EPA’s decision, and on and on, ad infinitum. (This is analogous to Keynes’s beauty contest metaphor, and Soros’s theory of market “reflexivity.” Sign of the apocalypse alert: I gave Keynes and Soros a favorable mention in a single blog post.)

That’s no way to run a market, but the alternatives are  likely worse. One alternative would be to set quotas for years far into the future, and then not adjust them based on the evolution of other fundamentals that cannot be foreseen when the quotas are set.

It’s pretty clear that events like have just rocked the biofuel world are an inherent part of the system. Somewhat arbitrary, inherently difficult to predict (in part because they are politicized), and “reflexive” decisions are a major determinant of supply. These decisions are made at discrete times. It is extremely likely that there will be disconnections between the quantity the market thinks the EPA will select and what the EPA actually chooses. Given the inelasticity of demand for energy products, these supply surprises lead to big price impacts.

All of which goes to show that a better use of ethanol is imbibing it to cope with the craziness of a faux market.

Of course it’s not just that the market is crazy: it’s crazy that there is a market. Ethanol is an economic and environmental and humanitarian monstrosity. Yes, ethanol would play a role without subsidies or mandates. But a much smaller role. Forcing and inducing its use is costly, not environmentally beneficial, and raises the price of food, which hits the poorest the hardest. So this crazy market shouldn’t exist in the first place. I think I need another drink.

 

 

 

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May 29, 2015

I Think I Read These Predictions About the Impending Revolution in LNG Trading Somewhere Before

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 2:42 pm

The FT, Goldman, Jonathan Stern at the Oxford Institute of Energy Research, Vitol, and others are now predicting that the emergence of the US as an LNG exporter, and the looming surplus driven by that plus supplies from Australia, PNG, and elsewhere, are inexorably pushing this commodity away from traditional oil-based long term contracts towards spot trading.

Huh. I remember reading something along those lines last September. Oh, yeah. Here it is. (Also available in Spanish!) I guess it’s more accurate to say I remember writing something exactly along those lines in September.

The opening of the Cheniere* and later the Freeport and Cameron LNG trains in the Gulf will be particularly important. The US is likely to be at the margin in Asia, Latin America and perhaps Europe. Prices are set at the margin, meaning that the LNG pricing mechanism can be integrated into the already robust US/Henry Hub pricing mechanism. Giving the tipping effects discussed in my paper, the transition in the pricing mechanism and the development of a robust spot market is likely to take place relatively rapidly.

I know there is skepticism in the industry about this, but I am pretty confident in my prediction. Experiences in other markets, notably iron ore and to some degree coal, indicate how rapid these transitions can be.

Funny story (to me anyways). I gave the keynote speech at LNG World Asia in Singapore in September, and I laid out my views on this subject. I gave the talk in front of the giant shark tank at the Singapore Aquarium, and I could help but think of Team America, Kim Jung Il, and Hans Blix. I’m sure there were a few people in the audience who would have liked to feed me to the sharks for calling oil-linked pricing “a barbarous relic” and encouraging them to embrace the brave new world of LNG trading.

But whether they like it or not, it’s coming. The inflection point is nigh.

*Full disclosure. Number One Daughter works for Cheniere.

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May 11, 2015

Gazprom Agonistes

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 12:26 pm

It has been a hellish few months for Gazprom. It’s profits were down 86 percent on lower prices and volumes and the weak ruble. Although the ruble has rebounded, the bad price news will persist for several months at least, given the lagged relationship between the price oil and the price of gas in the company’s oil-linked contracts. The company has been a die-hard defender of the link: another example of be careful what you ask for.

Moreover, the EU finally moved against the firm, filing antitrust charges. Although many of the European Commission’s antitrust actions, especially against US tech firms, are a travesty, the Gazprom brief is actually well-grounded. At the core of the case is Gazprom’s pervasive price discrimination, which is made possible by its vertical integration into transportation and contractual terms preventing resale of gas. Absent these measures, a buyer in a low-price country could resell to a higher price country, thereby undercutting Gazprom’s price discrimination strategy.

It is interesting to note that the main rationale for Gazprom’s vertical integration is one which was identified long ago, based on basic price theory, rather than more elaborate transactions cost economics or property rights economics theories of integration. Back in the 1930s  economists identified price discrimination as a rationale for Alcoa’s vertical integration. There was some formal work on this in the 70s.

Gazprom is attempting to argue that as an arm of the Russian state, it is not subject to European competition rules. Good luck with that. There is therefore a decent chance that by negotiation or adverse decision that Gazprom will essentially become a common carrier/have to unbundle gas sales and transportation, and forego destination clauses that limit resale. This will reduce its ability to engage in price discrimination, either for economic or political reasons.

The company is also having problems closer to home, where it is engaged in a battle with an old enemy (Sechin/Rosneft) and some new ones (Timchenko/Novatek), and it is not faring well.

Gazprom and Putin have always held out China as the answer to all its problems. There were new gas “deals” between Russia and China signed during Xi’s visit to the 70th Victory Day celebration. (Somehow I missed the role China, let alone the Chinese Communists, played in defeating the Nazis.) But the word “deal” always has to be in quotes, because they never seem to be finalized. Remember the “deal” closed with such fanfare last May? I expressed skepticism about its firmness, with good reason. There is a dispute over the interest rate on the $25 billion loan that was part of the plan. Minor detail, surely.

Further, Gazprom doesn’t like the eastern route agreed to last year. It involves massive new greenfield investments in gas fields as well as transportation. It has therefore been pushing for a western route (the Altai route) that would take gas from where Gazprom already has it (in western Siberia) to where China doesn’t want it (its western provinces, rather than the more vibrant and populous east). The “deal” agreed to in Moscow relates to this western route, but as is almost always the case, price is still to be determined.

If you don’t have a price, you don’t have a deal. And the Chinese realize they have the whip hand. Further, they are less than enamored with Russia as a negotiating partner. Who could have ever predicted this? I’m shocked! Shocked!:

Chinese and Russian executives and advisers said that in addition to the challenge of negotiating prices acceptable to both sides, energy deals between the countries have also been hampered by mutual distrust and Chinese concerns about antagonising the US.

“The Russians are unreliable. They are always flipping things around for their own interest,” said one Chinese oil executive.

Who knew?

Putin is evidently losing patience with the company, and its boss Alexei Miller, is far less powerful than Sechin and Timchenko. When it was a strategic asset in Europe, and offered real possibilities in Asia, it could defend itself. Now that leverage is diminishing, its future is much cloudier.

The impending new supplies of LNG coming online in the US and Australia dim its future prospects further.

In sum, Gazprom is beset by many agonies. Couldn’t happen to a better company.

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April 18, 2015

A Greek Gas Farce

Filed under: Commodities,Energy,Financial Crisis II,History,Politics,Russia — The Professor @ 11:44 am

Der Spiegel reported that Greek officials claim that the country is on the verge of signing a deal with Russia that would give the Greeks €5 billion upfront, to be repaid from transit fees on a yet-to-be-built Turkish Stream pipeline: the Russians deny any deal. The quoted (but anonymous) Greek official said that this would “turn the tide” for Greece.

Really?

Some thoughts off the top.

First, Greece owes €320 billion, including payments of €30 billion in 2015 alone. It is “scraping the bottom of the barrel” by borrowing from various state entities (e.g., the public transport system) to meet April payroll. It has a budget deficit of €23 billion. Deposits at Greek banks fell by about €20 billion last week. This creates a liability for the Bank of Greece to Target2 (i.e., to the members of the ECB). A measly €5 billion will buy it a few weeks time, at best.

Second, it’s not as if creditors (e.g., the EU and the IMF and Target2 members) are going to give Greece discretion over how to spend this money. And they have many levers to pull. So it would set the stage for more arguments between the creditors and the debtor.

Third, the Russians are likely to write terms that secure the debt and give it priority over other creditors (at least with respect to any future transit fees). (Just remember how tightly the Russians crafted the Yanuk Bonds.) The Euros will flip out over any such terms. This would set up an epic The Good, The Bad, and the Ugly three-way standoff.

Fourth, this initiative would be directly contrary to European energy policy, which is finally attempting to reduce dependence on Russia and limit vulnerability to Russian gasmail and the use of energy as a wedge to create divisions within the EU.

Fifth, what are the odds that the pipeline will get built? The Europeans are against it. It requires the Greeks and the Turks to play well together, and we know how that usually works out. It requires additional investment in infrastructure in Turkey, which is problematic. Further, the Russian track record on these sorts of projects leaves much to be desired.

So what happens if the pipeline isn’t built, or is delayed significantly. No doubt the Russians will anticipate this contingency in the debt agreement, and write things in such a way that they have security or priority, which will just spark another battle with Greece’s European creditors.

In sum, such a deal would hardly be a solution to Greece’s problems. Indeed, it only escalates conflicts between Greece and the EU.

Which may be Putin’s purpose, exactly. Exacerbating Greek-EU conflict over a matter involving Russia directly at a time when Greece could scupper the extension of sanctions against Russia suits Putin perfectly. The fact that the pipeline is as much pipe dream as realistic project doesn’t matter a whit. This is all about stirring trouble. And that’s Putin’s speciality.

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April 4, 2015

The IECA Libels Me: I Am Oddly Flattered

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 10:22 am

The Industrial Energy Consumers of America has submitted a comment letter on the CFTC’s position limit rule making. The letter contains this libel:

If one looks at the agenda from the February 26, 2015 meeting (see below), other than CFTC presenters, every presenter has views that are not consistent with CFTC action to set speculative position limits. Professor Pirrong has a long history of client paid studies in this area and will need to identify who paid for the underlying data and study for his results to be credible on this subject.

If “this area” is the subject of speculation and position limits, this statement is categorically false. I have not done one “client paid study” on these issues. Period.

In fact, most of my writing on speculation has either been in my academic work (as in my 2011 book), or here on the blog. I have been arguing this issue on my own time.

Actually, I did do one client paid study on these issues about 11 or 12 years ago. For the IECA, in fact, which was just certain that the NYMEX’s expanded accountability limits for natural gas had caused volatility to increase. They hired me to study this issue. I did, using methods that I had employed in peer reviewed research, and found that IECA’s firm beliefs were flatly contradicted by the data: data that IECA paid for, analyzed using methods that were disclosed to it. IECA decided not to release the study. Surprise, surprise. So IECA knows from direct experience that my opinions are not for sale.

So just who here is hiding something? Hint: it ain’t me.

I could provide other examples. The GFMA study on commodity traders is a well known case: it was written up in the Financial Times. Another example that is not as well known was my work on a project for the Board of Trade in 1991-1992, in which I studied the delivery mechanism for corn and soybeans. (The resulting report was published as Grain Futures Markets: An Economic Appraisal.) I concluded that the delivery mechanism was subject to manipulation, and recommended the addition of delivery points at economic par differentials to Chicago. This was not the desired answer. On the day I presented my results to the committee of the CBT that commissioned the study, the chief economist of the exchange pressured me to change my recommendations. I refused. The meeting that followed became heated. So heated, in fact, that the head of the committee and I almost literally came to blows when I refused to back down: committee members from Cargill and ADM actually took the guy bodily from the room until he calmed down.

So the track record is abundantly clear: I call them like I see them, even if it isn’t what the client wants to hear.

In fact, it is IECA’s ad hominem that lacks credibility. My white papers for Trafigura are not related to the issue of speculation at all. To the contrary, they are related to the issue of physical commodity trading. I did a study for CME in 2009 on the performance of the WTI futures contract. Nothing related to speculation. Data sources disclosed, and the methodologies are clearly set out. Again, if IECA has specific critiques of any of these analyses, bring it on. Anytime. Anywhere. And they can leave their libelous insinuations behind.

Perhaps IECA head Paul Cicio is still sore over how I smacked him around at a House Ag committee hearing in July 2008. Cicio said it was obvious that speculation had inflated energy prices. He used the metaphor of a swimming pool: if a bunch of speculators jump in, it has to raise the water level. I retorted that this shows the exact opposite, because all the speculators get out of the pool before contracts go spot. Long speculators are sellers of futures as delivery approaches, meaning they are out of the pool (the physical market) as delivery approaches, and hence can’t be inflating spot prices.

If Cicio is still sore, all I have to say is: Get over it.

To reiterate: IECA’s statement in a document submitted to a government regulatory agency is categorically false, and libelous.

And oddly flattering. You don’t go out of your way to libel the irrelevant. The fact that this organization feels compelled to slur me by name and attack my credibility (even though the attack is false) means that they must believe that I pose a threat to them. I sure as hell hope so.

Word to the wise. Don’t bring a wet noodle to a gunfight. (I cleaned that up.) You’re going to lose.

 

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March 23, 2015

The Systemic Risk, or Not, of Commodity Trading Firms

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics,Russia — The Professor @ 2:03 pm

My latest white paper, “Not too big to fail: Systemic Risk, Regulation, and the Economics of Commodity Trading Firms” was released today. A video of me discussing it can be found here (as can my earlier white papers on commodity traders and LNG trading).

The conclusion in a nutshell: commodity trading firms do not pose systemic risks, and therefore it is inappropriate to subject them to bank-like prudential regulations, including capital requirements. Commodity trading firms are not systemically risky because (a) they aren’t really that big, (b) they are not that highly leveraged, (c) their leverage is not fragile, (d) the financial distress of a big trader is unlikely to result in contagious runs on others, or fire sale problems, and (e) their financial performance is not highly pro cyclical. Another way to see it is that banks are fragile because they engage in maturity and liquidity transformations, whereas commodity trading firms don’t: they engage in different transformations altogether.

Commodity traders are in line to be subject to Capital Requirement Directive IV starting in 2017. If the rules turn out to be binding, they will cause firms to de-lever by shrinking, or issue more equity (which may force them to forego private ownership, which aligns the interests of owners and managers). These will be costs, not offset by any systemic benefit. All pain, no gain.

It is my understanding that banks obviously think differently, and are calling for “consistent” regulations across banks, commodity traders, and other intermediaries. Since these firms differ on many dimensions, imposing the same regulations on all makes little sense. Put differently, apropos Emerson, a foolish consistency is the hobgoblin of little minds. Or bankers who want to handicap competitors.

The white paper has received some good coverage, including the Financial Times, Reuters, and Bloomberg. I will be writing more about it when I return to the states later in the week.

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March 17, 2015

The Biggest Loser, Iran Deal Edition: That Would Be Russia

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 11:52 am

I am following around Iranian negotiator Javad Zarif, arriving this morning in Geneva, and then going to Brussels next week. Don’t worry, I won’t go biking. Certainly not in the absurd getup that Zarif’s interlocutor-or should I say Sancho Panza-John Kerry did here on the shores of Lac Leman. The man is obviously immune to mockery.

I am resigned that Sancho-I mean John-and Javad (remember, they are on a first name basis!) will reach some sort of deal that will clear Iran’s path to becoming a nuclear power in the near-to-medium term, with all of the malign consequences that entails. Which leads me to contemplate some of those consequences.

One of which relates to the price of oil (and natural gas), the malignity of which depends on whether you are long or short oil (and gas). Of course, one of the countries that is very long oil (and gas) is Russia, and from its perspective the consequences of a deal will be very malign. Which makes one wonder if Putin (or whoever is really in charge these days!) will attempt to do something to derail it. (Or are they too distracted by the folly in Ukraine? Or by dog fights under the carpet?)

The crucial issue is how rapidly, and by how much, Iranian output will ramp up if a deal is reached. There is both a political dimension to this, and an operational one.

The political issue is how rapidly a deal will result in the dismantling of the myriad sanctions that impede Iran’s ability to sell oil:

“Don’t expect to open the tap on oil,” one Gulf-based Western diplomat told Reuters. It is much easier to lift financial sanctions because so many components of Iran’s oil trade have been targeted, the diplomat said.

. . . .

But for Iran to sell significantly more crude and repatriate hard currency earnings, many U.S. and European restrictions on its shipping, insurance, ports, banking, and oil trade would have to be lifted or waived.

Yet because they represent the bulk of world powers’ leverage over Iran, initial relief would probably be modest, said Zachary Goldman, a former policy advisor at the U.S. Treasury Department’s Office of Terrorism and Financial Intelligence, where he helped develop Iransanctions policy.

Goldman predicted the first step would be to allow Tehran to use more of its foreign currency reserves abroad, now limited to specific bilateral trade.

“It’s discrete, and it doesn’t involve dismantling the architecture of sanctions that has been built up painstakingly over the last five years,” said Goldman, who now heads the Center on Law and Security at New York University.

Even with a nuclear deal, oil sanctions would probably effectively stay in place until early 2016, said Bob McNally, a former White House adviser under George W. Bush and now president of the Rapidan Group energy consultancy.

The operational issue is how rapidly Iran can reactivate its idled fields, and how much damage they have suffered while they have been off-line. The Iranians claim that 1mm barrels per day can come online within months. The IEA concurs:

Turning lots of production back on suddenly can be complicated—and time consuming—even if wells and reservoirs are maintained studiously. It could be even harder in complex Iranian fields that have been pumping for decades.

Still, some analysts have concluded that a good deal of that lost output could return more quickly than often anticipated. The International Energy Agency, for example, has said that it expects a relatively rapid burst of exports if sanctions are lifted.

“They’ve deployed considerable ingenuity in getting around sanctions and keeping fields in tiptop shape. We think Iran could pretty much come back to the market on a dime,” Antoine Halff, head of the IEA’s oil industry and markets division, recently told an audience at the Center for Strategic Studies in Washington.

Perhaps up to 2mm bpd of additional output could come back later. Then there is the issue of how a relaxation or elimination of sanctions would affect output in the long run as (a) western investment flows into the Iranian oil sector, and (b) other producers, and notably OPEC, respond to Iran’s return to the market.

In the short run, the 1mm bpd number  (corresponding to about 1.1 percent of world output) looks reasonable, and given a demand elasticity of approximately 10, that would result in a 10 percent decline in oil prices. Additional flows in the medium term would produce additional declines.

Even if Iran’s return to the market is expected to take some time, due to the aforementioned complications of undoing sanctions, much of the price effect would be immediate. The mechanism is that an anticipated rise in future output reduces the demand to store oil today: the anticipated increase in future output reduces future scarcity relative to current scarcity, reducing the benefit of carrying inventories. There will be de-stocking, which will put downward pressure on spot prices. Moreover, since an increase in expected future output reduces future scarcity relative to current scarcity, future prices will fall more than the spot price, meaning that contango will decline.

Some of the price decline effect may have already occurred due to anticipation of the clinching of a deal: the May Brent price has declined about $10/bbl in the last month. However, the movement in the May-December spread is not consistent with the recent price decline being driven by the market’s estimation that the odds  that Iranian output will increase in the future have risen. The May-December spread has fallen from -$4.47 (contango) to -$6.36. This is consistent with a near-term supply-demand imbalance rather than an anticipated change in the future balance in favor of greater supply. So too is the increase in inventories seen in recent weeks.

Predicting the magnitude of the price response to the announcement of a deal-or the breakdown of negotiations-is difficult because that requires knowing how much has already been priced in. My lack of a yacht that would make a Russian oligarch jealous indicates quite clearly that I lack such penetrating insight. However, the directional effect is pretty clear-down (for a deal, up for a breakdown).

Which is very bad news for the Russian government and economy, which are groaning under the effects of the oil price decline that has already occurred. Indeed, Iran’s return to the market would weigh on prices for years, reducing the odds that Russia could count on a 2009-like rebound to retrieve its fortunes.

Add to this the fact that a lifting of sanctions would open Iran’s vast gas reserves (second only to Russia’s) to be supplied to Europe and Asia, dramatically reducing the profitability of Russian gas sales in the future, and Iran’s return to the energy markets is a near term and long term threat to Russia.

Which makes Putin’s apparent indifference to a deal passing strange. The Russians freak out over developments (e.g., the prospect for an antitrust investigation of Gazprom, or pipsqueak pipeline projects like Nabucco) that pose a much smaller threat than the reemergence of Iran as a major energy producer. But they have not done anything overt to scupper a deal, nor have they unleashed their usual screeching rhetoric.

What gives? Acceptance of the inevitable? A belief that in the long run the deal will actually increase the likelihood of chaos in the Middle East that will redound to Russia’s benefit? Strategic myopia (i.e., an obsession with reassembling Sovokistan, starting with Donbas) that makes the leadership blind to broader strategic considerations? Distraction by internal disputes? Or does Putin (or whoever is calling the shots!) have something up his (their) sleeve(s)?

My aforementioned pining for a super yacht that would make Abramovich turn green again betrays my inability to penetrate such mysteries. But it is quite a puzzle, for at least insofar as the immediate economic consequences are concerned, Russia would be the Biggest Loser from a deal that clears Iran’s return to the oil market.

H/T to @libertylynx for the idea for this post.

 

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March 10, 2015

Resource Rents, Russian Aggression, and the Nature of Putinism

Filed under: Commodities,Economics,Energy,History,Military,Russia — The Professor @ 9:00 pm

This nice piece from the WaPo points out the link between oil prices and Russian aggressiveness:

From this perspective, Russia is not so much an insecure superpower as it is a typical petrostate with a short-term horizon that gets aggressive and ambitious once it accumulates substantive oil revenues. Back in the early 2000s when the price of oil was $25 a barrel, Putin was a friend of the United States and didn’t mind NATO enlargement in 2004. According to Hendrix’s research, this is exactly how petrostates behave when the oil prices are low: In fact, at oil prices below $33 a barrel, oil exporters become much more peaceful than even non-petrostates. Back in 2002 when the Urals price was around $20, in his Address to the Federal Assembly Putin enumerated multiple steps to European integration and active collaboration aimed at creating a single economic space with the European Union among Russia’s top priorities. In 2014 – with the price of oil price around $110 – Putin invaded Ukraine to punish it for the attempts to create that same single economic space with the E.U.

I made these basic points eight years ago, in a post titled “Cocaine Blues.”

The graph depicts Gaddy’s estimates of the energy rents accruing to the Soviet–and Russian–economy. Each of the two spikes in the graph corresponds to a period of Soviet/Russian adventurism. The first shot of oil/cocaine during the 1970s oil shock fueled Soviet aggressiveness around the world. The second oil/cocaine shot–the post-2003 runup in oil prices–is powering Putin’s recent revanchism.

There were some follow up posts on the same theme.

This post from Window on Eurasia quotes a Russian social scientist who disputes the importance of oil prices in explaining Russian behavior in the Putin era. Instead, Vladislav Inozemtsev identifies the lack of formal institutions as the characteristic feature of Putinism.

But these things are not mutually exclusive. Indeed, another SWP theme from about this same time period (2007-2008) is that Russia is a natural state in which Putin uses control over resource rents to maintain a political equilibrium. Resource rents permit personalized rule and impede the development of formal, impersonal institutions.

In other words, in Russia, resource rents, and especially oil/energy rents matter, both for its political structure and evolution, and its behavior as an international actor.

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