Streetwise Professor

July 18, 2014

Sanctions: Pinprick or Sledgehammer Blow, With Little In Between

Filed under: Commodities,Derivatives,Economics,Energy,Military,Politics,Russia — The Professor @ 11:27 pm

Before the massacre over Donetsk, the big Russia-related story was the new sanctions imposed on Wednesday. Although those sanctions were overshadowed by yesterday’s atrocity, the wanton destruction of MH17 raises the possibility that more intense sanctions will be forthcoming. Therefore, it is worthwhile to examine what the US did Wednesday to see what would be necessary to impose truly crippling costs on Russian companies and the Russian economy generally. (Forget what the Euros did. That is so embarrassing that it should be passed over in silence.)

The sanctions imposed Wednesday are very weak beer. (Here is an FAQ from the Treasury outlining them.) They were different than previous sanctions in that these were directed at companies, rather than individuals. Moreover, some of the targeted companies are on the commanding heights of the Russian economy: Rosneft, VTB, Gazprombank, and Novatek. (Notable absences: Gazprom and Sberbank.)

Under the sanctions, “US Persons” (which can include US subsidiaries in foreign countries) are prohibited from buying new debt from or new making loans to these companies with maturities of 90 days. (Existing loans/bonds are not affected.)  US persons are also precluded from buying “new” equity from the financial firms: they can buy new equity from Rosneft and Novatek.

Since US banks are major lenders to foreign companies, this might seem to be a major impediment to the affected companies, and indeed  Rosneft’s and Novatek’s stock prices were both down more than 5 percent on the news. But in my opinion, this reaction is more related to how the announcement raised the likelihood of more severe sanctions in the future, rather than the direct effects of these new sanctions.

That’s because although the sanctions will constrain the capital pool that Rosneft and the others can borrow from, other lenders in Europe and Asia can step into the breach. The sanctions do make it more difficult for the sanctioned companies to borrow dollars even from foreign banks, because although the sanctions do not bar foreign banks and investors from accessing the US dollar clearing system for most transactions, they could be interpreted to make it illegal to process the banned debt and equity deals:

U.S. financial institutions may continue to maintain correspondent accounts and process U.S. dollar-clearing transactions for the persons identified in the directives, so long as those activities do not involve transacting in, providing financing for, or otherwise dealing in prohibited transaction types identified by these directives.

Some have argued that this is a serious constraint that will effectively preclude the sanctioned companies from borrowing dollars other than on a very short-term basis. This is allegedly a big problem for Rosneft, because its export revenues are in dollars, and borrowing in other currencies would expose the company to substantial exchange rate risk.

I disagree, because there are ways around this. A company could borrow in Euros, for instance, and  sell the Euros for dollars. It could then deposit, invest, or spend the dollars just like the proceeds from dollar loans because it would have access to the dollar clearing system. Alternatively, the companies could borrow in Euros and immediately swap the Euros into dollars. This is because derivatives transactions are not included in the sanctions, and the payments on those could also be cleared. This would add some expense and complexity, but not too much.

The sanctions even permit  financial engineering that would allow US banks  effectively to provide credit for the sanctioned firms because derivatives on debt and equity of the sanctioned firms are explicitly exempted from the sanctions. For instance, a US bank could sell credit protection on Rosneft to a European bank that would increase the capacity of the European bank to extend credit to Rosneft. Syndication is one way that US banks can get credit exposure to Rosneft and reduce the amount of credit exposure that foreign banks have to incur, and even though the sanctions preclude US banks from participating in syndicates, the same allocation of credit risk could be implemented through the CDS market. This would permit foreign banks to increase their lending to the sanctioned firms to offset the decline of US direct lending. (This would still involve the need to convert foreign currency into dollars if the sanctioned borrower wanted dollars.)

Unlike real super majors (who can borrow unsecured, or secured by physical assets), Rosneft is unusually dependent on prepaid oil sales for funding, and these agreements are almost exclusively in dollars. This has led to some debate over whether the sanctions will seriously cramp Rosneft’s ability to use prepays.

There are a couple of reasons to doubt this. First, after the initial round of sanctions raised the specter of the imposition of sanctions on Rosneft, many prepay deals were re-worked to include sanctions clauses. For instance, they permit the payment currency to be switched to Euros, or to another currency in the off chance that the Europeans grow a pair and shut Rosneft out of the Euro payment system. Again, as long as access to the dollar system is not blocked altogether, those non-dollar currencies could be converted into dollars.

Second, there is some ambiguity as to whether prepays would even be covered. The sanctions specify the kinds of transactions that are covered:

The term debt includes bonds, loans, extensions of credit, loan guarantees, letters of credit, drafts, bankers acceptances, discount notes or bills, or commercial paper.

It is not obvious that prepays as usually structured would fall into any of these categories, and prepays are not specifically mentioned. A standard prepay structure is for a syndicate of banks to extend a non-recourse loan to a commodity trading firm like Glencore, Vitol, Trafigura, or BP. The trading firm uses the loan proceeds to make a prepayment for oil to Rosneft. In return, the trading firm gets an off take agreement that obligates Rosneft to deliver oil at a discounted price: the discount is effectively an interest payment.

The banks lend to the trading companies, not Rosneft. But (except for a small participation of 5-10 percent by the traders) the banks have the credit exposure. So this does not fall under any of the listed categories, except for perhaps “extension of credit.” Insofar as the trading firm is the borrower who faces the banks, it’s not clear the banks fall afoul of the sanctions even though that banks bear Rosneft’s credit risk. What about the trading firm? It’s not a US person, and a prepayment is not explicitly listed as a type of debt under the sanctions: again, this would turn on the “extensions of credit” provision. Under prepays, payment is usually with an irrevocable letter of credit, but these generally have maturities of less than 90 days, so that’s free of any sanctions problem.

So, there’s a colorable argument that prepays aren’t subject to the sanctions. But there is a colorable argument that they are. Economically they are clearly loans to Rosneft, though done via a trading firm acting as a conduit. But whether they are “debt” legally under the sanctions definition is not clear.

But especially in this regulatory environment, bank (and trading firm) tolerance for ambiguity is  pretty low. So the FUD factor kicks in: even though they could make a plausible legal argument that prepays fall outside the definition of debt under the Treasury rules, the risk of having that argument fail may be sufficient to dissuade them from doing dollar prepays. This is especially true in the post BNP Paribas world. So it is likely that future prepays may be in currencies other than the dollar, and as long as dollar clearing is open to it, Rosneft will just have to convert or swap the Euros or Sterling or Swiss Francs or whatever  into dollars if it really wants to borrow dollars. Again, an inconvenience and an added expense, but not a major hurdle.

All this means that the most recent round of sanctions are  sound and fury, signifying not very much. Indeed, by deliberately avoiding the truly devastating sanction, this round signifies a continued reluctance to hit Putin and Russia where it really hurts. Someone like Putin likely interprets this as a sign of weakness.

What would the devastating sanction that was deliberately avoided be? Cutting off altogether access to the dollar clearing system. Recall that the just-imposed sanctions say “U.S. financial institutions may continue to maintain correspondent accounts and process U.S. dollar-clearing transactions for the persons identified in the directives.” Change that to “U.S. financial institutions are prohibited from maintaining correspondent accounts and processing U.S. dollar-clearing transactions for the persons identified in the directives” and it would be a whole new ballgame. This would mean that the sanctioned companies could not receive, spend, deposit, or invest a dollar. (Well, they could if they could find a bank insane enough to be the next BNP Paribas. Good luck with that.)

I discussed how this would work in a post in March, and the Banker’s Umbrella provided a very readable and definitive discussion about that time. Basically, every dollar transaction, even one handled by a foreign bank, involves a correspondent account at a US bank. Cut off access to those accounts, and the sanctioned company can’t touch a dollar.

This would close off the various workarounds I discussed above. The sanctioned companies would have to restructure their operations and financing pretty dramatically. This would be particularly challenging for Rosneft, given that the currency of choice in oil transactions is the USD. This would be like the sanctions that have been imposed on Iran and on Sudan.

This would represent the only truly powerful sanction. And that’s one of the issues. Anything short of cutting off all access to the dollar market is at most an irritant to the sanctioned companies. Cutting off all access imposes a major cost. There’s not much in between. It’s a choice between a pinprick and a sledgehammer blow, with little in-between.

But if a Rubicon hasn’t been crossed now, with the murder of 298 people and continued battles in places like Luhansk waged by Russian-armed rebels, it’s hard to imagine it will ever be. If Putin and Russia are going to pay a real price for their wanton conduct, the sledgehammer is the only choice.

 

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July 15, 2014

Oil Futures Trading In Troubled Waters

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,HFT,Regulation — The Professor @ 7:16 pm

A recent working paper by Pradeep Yadav, Michel Robe and Vikas Raman tackles a very interesting issue: do electronic market makers (EMMs, typically HFT firms) supply liquidity differently than locals on the floor during its heyday? The paper has attracted a good deal of attention, including this article in Bloomberg.

The most important finding is that EMMs in crude oil futures do tend to reduce liquidity supply during high volatility/stressed periods, whereas crude futures floor locals did not. They explain this by invoking an argument I did 20 years ago in my research comparing the liquidity of floor-based LIFFE to the electronic DTB: the anonymity of electronic markets makes market makers there more vulnerable to adverse selection. From this, the authors conclude that an obligation to supply liquidity may be desirable.

These empirical conclusions seem supported by the data, although as I describe below the scant description of the methodology and some reservations based on my knowledge of the data make me somewhat circumspect in my evaluation.

But my biggest problem with the paper is that it seems to miss the forest for the trees. The really interesting question is whether electronic markets are more liquid than floor markets, and whether the relative liquidity in electronic and floor markets varies between stressed and non-stressed markets. The paper provides some intriguing results that speak to that question, but then the authors ignore it altogether.

Specifically, Table 1 has data on spreads in from the electronic NYMEX crude oil market in 2011, and from the floor NYMEX crude oil market in 2006. The mean and median spreads in the electronic market: .01 percent. Given a roughly $100 price, this corresponds to one tick ($.01) in the crude oil market. The mean and median spreads in the floor market: .35 percent and .25 percent, respectively.

Think about that for a minute. Conservatively, spreads were 25 times higher in the floor market. Even adjusting for the fact that prices in 2011 were almost double than in 2006, we’re talking a 12-fold difference in absolute (rather than percentage) spreads. That is just huge.

So even if EMMs are more likely to run away during stressed market conditions, the electronic market wins hands down in the liquidity race on average. Hell, it’s not even a race. Indeed, the difference is so large I have a hard time believing it, which raises questions about the data and methodologies.

This raises another issue with the paper. The paper compares at the liquidity supply mechanism in electronic and floor markets. Specifically, it examines the behavior of market makers in the two different types of markets. What we are really interested is the outcome of these mechanisms. Therefore, given the rich data set, the authors should compare measures of liquidity in stressed and non-stressed periods, and make comparisons between the electronic and floor markets. What’s more, they should examine a variety of different liquidity measures. There are multiple measures of spreads, some of which specifically measure adverse selection costs. It would be very illuminating to see those measures across trading mechanisms and market environments. Moreover, depth and price impact are also relevant. Let’s see those comparisons too.

It is quite possible that the ratio of liquidity measures in good and bad times is worse in electronic trading than on the floor, but in any given environment, the electronic market is more liquid. That’s what we really want to know about, but the paper is utterly silent on this. I find that puzzling and rather aggravating, actually.

Insofar as the policy recommendation is concerned, as I’ve been writing since at least 2010, the fact that market makers withdraw supply during periods of market stress does not necessarily imply that imposing obligations to make markets even during stressed periods is efficiency enhancing. Such obligations force market makers to incur losses when the constraints bind. Since entry into market making is relatively free, and the market is likely to be competitive (the paper states that there are 52 active EMMS in the sample), raising costs in some state of the world, and reducing returns to market making in these states, will lead to the exit of market making capacity. This will reduce liquidity during unstressed periods, and could even lead to less liquidity supply in stressed periods: fewer firms offering more liquidity than they would otherwise choose due to an obligation may supply less liquidity in aggregate than a larger number of firms that can each reduce liquidity supply during stressed periods (because they are not obligated to supply a minimum amount of liquidity).

In other words, there is no free lunch. Even assuming that EMMs are more likely to reduce supply during stressed periods than locals, it does not follow that a market making obligation is desirable in electronic environments. The putatively higher cost of supplying liquidity in an electronic environment is a feature of that environment. Requiring EMMs to bear that cost means that they have to recoup it at other times. Higher cost is higher cost, and the piper must be paid. The finding of the paper may be necessary to justify a market maker obligation, but it is clearly not sufficient.

There are some other issues that the authors really need to address. The descriptions of the methodologies in the paper are far too scanty. I don’t believe that I could replicate their analysis based on the description in the paper. As an example, they say “Bid-Ask Spreads are calculated as in the prior literature.” Well, there are many papers, and many ways of calculating spreads. Hell, there are multiple measures of spreads. A more detailed statement of the actual calculation is required in order to know exactly what was done, and to replicate it or to explore alternatives.

Comparisons between electronic and open outcry markets are challenging because the nature of the data are very different. We can observe the order book at every instant of time in an electronic market. We can also sequence everything-quotes, cancellations and trades-with exactitude. (In futures markets, anyways. Due to the lack of clock synchronization across trading venues, this is a problem in a fragmented market like US equities.) These factors mean that it is possible to see whether EMMs take liquidity or supply it: since we can observe the quote, we know that if an EMM sells (buys) at the offer (bid) it is supplying liquidity, but if it buys (sells) at the offer (bid) it is consuming liquidity.

Things are not nearly so neat in floor trading data. I have worked quite a bit with exchange Street Books. They convey much less information than the order book and the record of executed trades in electronic markets like Globex. Street Books do not report the prevailing bids and offers, so I don’t see how it is possible to determine definitively whether a local is supplying or consuming liquidity in a particular trade. The mere fact that a local (CTI1) is trading with a customer (CTI4) does not mean the local is supplying liquidity: he could be hitting the bid/lifting the offer of a customer limit order, but since we can’t see order type, we don’t know. Moreover, even to the extent that there are some bids and offers in the time and sales record, they tend to be incomplete (especially during fast markets) and time sequencing is highly problematic. I just don’t see how it is possible to do an apples-to-apples comparison of liquidity supply (and particularly the passivity/aggressiveness of market makers) between floor and electronic markets just due to the differences in data. Nonetheless, the paper purports to do that. Another reason to see more detailed descriptions of methodology and data.

One red flag that indicates that the floor data may have some problems. The reported maximum bid-ask spread in the floor sample is 26.48 percent!!! 26.48 percent? Really? The 75th percentile spread is .47 percent. Given a $60 price, that’s almost 30 ticks. Color me skeptical. Another reason why a much more detailed description of methodologies is essential.

Another technical issue is endogeneity. Liquidity affects volatility, but the paper uses volatility as one of its measures of stressed markets in its study of how stress affects liquidity. This creates an endogeneity (circularity, if you will) problem. It would be preferable to use some instrument for stressed market conditions. Instruments are always hard to come up with, and I don’t have one off the top of my head, but Yanev et al should give some serious thought to identifying/creating such an instrument.

Moreover, the main claim of the paper is that EMMs’ liquidity supply is more sensitive to the toxicity of order flow than locals’ liquidity supply. The authors use order imbalance (CTI4 buys minus CTI4 sells, or the absolute value thereof more precisely), which is one measure of toxicity, but there are others. I would prefer a measure of customer (CTI4) alpha. Toxic (i.e., informed) order flow predicts future price movements, and hence when customer orders realize high alphas, it is likely that customers are more informed than usual and earn positive alphas. It would therefore be interesting to see the sensitivities of liquidity supply in the different trading environments to order flow toxicity as measured by CTI4 alphas.

I will note yet again that market maker actions to cut liquidity supply when adverse selection problems are severe is not necessarily a bad thing. Informed trading can be a form of rent seeking, and if EMMs are better able to detect informed trading and withdraw liquidity when informed trading is rampant, this form of rent seeking may be mitigated. Thus, greater sensitivity to toxicity could be a feature, not a bug.

All that said, I consider this paper a laudable effort that asks serious questions, and attempts to answer them in a rigorous way. The results are interesting and plausible, but the sketchy descriptions of the methodologies gives me reservations about these results. But by far the biggest issue is that of the forest and trees. What is really interesting is whether electronic markets are more or less liquid in different market environments than floor markets. Even if liquidity supply is flightier in electronic markets, they can still outperform floor based markets in both unstressed and stressed environments. The huge disparity in spreads reported in the paper suggests a vast difference in liquidity on average, which suggests a vast difference in liquidity in all different market environments, stressed and unstressed. What we really care about is liquidity outcomes, as measured by spreads, depth, price impact, etc. This is the really interesting issue, but one that the paper does not explore.

But that’s the beauty of academic research, right? Milking the same data for multiple papers. So I suggest that Pradeep, Michel and Vikas keep sitting on that milking stool and keep squeezing that . . . data ;-) Or provide the data to the rest of us out their and let us give it a tug.

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June 19, 2014

From the Files of Captain Obvious: Russia Funds Anti-Fracking Groups

Filed under: Economics,Energy,Politics,Russia — The Professor @ 8:16 pm

NATO Secretary-General Anders Fogh Rasmussen has asserted publicly that Russia is covertly funding and coordinating with anti-fracking environmental groups in Europe:

“I have met allies who can report that Russia, as part of their sophisticated information and disinformation operations, engaged actively with so-called non-governmental organisations – environmental organisations working against shale gas – to maintain European dependence on imported Russian gas,” Mr Rasmussen, former Danish prime minister, told an audience at Chatham House, the international affairs think-tank.

This is a classic KGB MO. One that was employed throughout the Cold War. Then peace and disarmament groups were the primary targets. No doubt the Russians have also covertly supported anti-fracking efforts here in the US, but Europe is the focus of their efforts because increased gas production on that continent competes directly with Russian gas, whereas US production is a very indirect, and somewhat distant, threat.

Europe is totally compromised by Russian influence operations, propaganda, and money.  With a few exceptions (e.g., the antitrust action against Gazprom) Europe has been completely feckless in its dealings with Russia. Its energy policies have been particularly self-destructive, putting the EU at the mercy of Russia for the foreseeable future. Some of these self-inflicted wounds would have been suffered even without direct Russian influence (energiewende, for instance, is largely the product of dreamy German romanticism about energy), but by co-opting European energy companies and manipulating European environmental sensitivities Russia has tightened its grip on European energy markets. It exploits this grip for both economic and political gain, with Ukraine being a prominent example of the latter.

I can only imagine the flack that Rasmussen is going to catch for this. For he has committed a mortal sin: speaking a very embarrassing truth. Killing the messenger is the usual remedy.

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June 18, 2014

SWP Itoldyasopalooza

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

While I’m doing the SWP Itoldyasopalooza, three more items.

First, the CFTC has reopened comments on the position limits proposed rule. The CFTC has taken intense incoming fire on the issue of hedge exemptions in particular, and with good reason. There are many problems, but the most egregious is the restriction on “cross hedges” (e.g., using gas futures as a hedge against electricity price risk).

I discussed this issue in my comment letter to the CFTC. Here’s the gist of the problem. The CFTC calculates the hedging effectiveness (measured by the R2 in a regression) of nearby NG futures for spot electricity prices. It finds the effectiveness is low (i.e., the R2 in the relevant regression is small). Looking past the issue of how some risk reduction is better than nothing, this analysis betrays a complete misunderstanding of electricity pricing and how NG futures are used as hedges.

Spot electricity prices are driven by fuel prices, but the main drivers are short term factors such as load shocks (which are driven by weather) and outages. However, these spot-price drivers mean revert rapidly. A weather or outage shock damps out very quickly.

This means that forward power prices are primarily driven by forward fuel prices, because fuel price shocks are persistent while weather and outage shocks are not. So it makes perfect sense to hedge forward power price exposure with gas futures/forwards. The CFTC analysis totally misses the point. Firms don’t use gas forwards/futures to hedge spot power prices. They are using the more liquid gas futures to hedge forward power prices. This is a classic example of hedgers choosing their hedging instrument to balance liquidity and hedging effectiveness. Gas forwards provide a pretty good hedge of power forward prices, and are are more liquid than power forwards. Yes, power forwards may provide a more effective hedge, but that’s little comfort if they turn out to be roach motels that a hedger can check into, but can’t leave if/when it doesn’t need the hedge any more.

The CFTC  ignores liquidity, by the way. How is that possible?

Market participants have strong incentives to make the liquidity-hedging effectiveness trade off efficiently. They do it all the time. Hedgers live with basis risk (e.g., hedging heavy crude with WTI futures) because of the liquidity benefits of more heavily traded contracts. The CFTC position limit rule substitutes the agency’s judgment for that of market participants who actually bear/internalize the costs and benefits of the trade-off. This is a recipe for inefficiency, made all the more severe by the CFTC’s utter failure to understand the economics of the hedge it uses to justify its rule.

As proposed, the rule suggests that the CFTC is so paranoid about market participants using the hedge exemption to circumvent the limit that it has chosen to sharply limit permissible hedges. This is beyond perverse, because it strikes at the most important function of the derivatives markets: risk transfer.

(This issue is discussed in detail in chapter 8 of my 2011 book. I show that the “load delta” for short term power prices is high, but it is low for forward prices. Conversely, the “fuel price delta” is high for power forward prices, precisely because load/weather/outage shocks damp out quickly. The immediate implication of this is that fuel forwards can provide an effective hedge of forward power prices.)

Second, Simon Johnson opines that “Clearing houses could be the next source of chaos.” Who knew? It would have been nice had Simon stepped out on this 5 years ago.

Third, the one arguably beneficial aspect of Frankendodd and Emir-the creation of swaps data repositories-has been totally-and I mean totally-f*cked up in its implementation. Not content with the creation of a single Tower of Babel, American and European regulators have presided over the creation of several! Well played!

Reportedly, less than 30 percent of OTC deals can be matched by the repositories.

This too was predictable-and predicted (modesty prevents me from mentioning by whom). Repositories are natural monopolies and should be set up as utilities. A single repository minimizes fixed costs, and facilitates coordination and the creation of a standard. I went through this in detail in 2003 when I advocated the creation of an Energy Data Hub. But our betters decided to encourage the creation of multiple repositories (suppositories?) with a hodge-podge of reporting obligations and inconsistent reporting formats.

This brings to mind three quotes. One by Ronald Reagan: “‘I’m from the government and here to help you’ are the 8 scariest words in the English language.” The other two by Casey  Stengel. “Can’t anybody play this game?” and “He has third base so screwed up, nobody can play it right.”

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June 6, 2014

Putinomics: The Gazprom-China Deal

Filed under: China,Commodities,Economics,Energy,Politics,Russia — The Professor @ 6:16 am

Before the financial crisis, Gazprom CEO Alexi Miller boasted that his firm would be the first $1t market cap firm. Six years on, he’s only off by an order of magnitude: the company’s market cap is around $100 billion. Moreover, it sells for a comical 3x earnings (a little less, actually). The company’s capex is notoriously inefficient, and it is frequently cash flow negative. Other than that, it’s a financial marvel.

But that big China deal must surely have provided a boost for the company, right?

Apparently not. The other day Putin mooted the possibility that the company would have to be recapitalized by the state, i.e., receive an additional injection of capital from one of the state investment funds.

If the China deal were indeed favorable to Gazprom, it would have no problem financing the necessary investment in pipelines and greenfield production through the banks and/or the capital markets, rather than through the state. Putin’s suggestion of state funding strongly suggests that the economics and the risks of the deal are not favorable, and the necessary investments could not be funded externally: direct state funding would also suggest that Russian state banks are either unwilling or unable to fund it (or both), which speaks ill for the economics of the deal, and perhaps the financial strength of the banks. A further implication of this is that politics rather than economics was the main driver of the deal (if it exists, in fact), and that as a project intended to achieve state objectives, the state must fund it.

Reinforcing this perceived need for state rather than external funding  is the fact that obtaining outside funding would require Gazprom to divulge many more details of the deal than it has so far. This would be highly embarrassing to Putin and the government and Gazprom if these details show that Russia got the short end of the stick. So keeping the details out of public view by avoiding outside funding also suggests that there is something to hide, namely, that the Chinese exploited Putin’s needs.

If the government indeed recapitalizes Gazprom, it will be just the latest of a long line of economic policy failures. Another example of where politics or corruption/rent seeking has prevented Russia from putting its natural resource firms on a commercially sensible footing, and another example of where state funds that were generated by resource rents in the first place were ploughed back into inefficient state-controlled resource producers, rather than to help diversify the Russian economy.

This, my friends, is Putinomics. This is why Russia will remain on the hamster wheel from hell.

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May 27, 2014

Gazprom Down, Rosneft Up: Cutting the Oil Link, Sucking Up to Sechin

Filed under: Energy,Politics,Russia — The Professor @ 4:23 am

The news and commentary pages have been filled for days with big stories claiming that the (alleged) China-Russia gas deal represents a seismic change not just in energy markets, but in international relations.

I remain skeptical because I still remain unconvinced there is a real deal with price and financing terms nailed down. What’s more, some of the more sober commentary casts doubt about how favorable the economics of the deal are for Russia, even if the reported contours of the deal are correct. Gazprom must develop green fields in east Siberia, and build the pipes to China. This will be quite expensive, and the reported pricing terms may border on the break even. This should not be surprising because the Chinese are hard bargainers, and Putin needed a deal more than they. (Probably the biggest beneficiaries will be the tunnelers at Gazprom, and companies to whom money is tunneled, like the pipe making Rotenberg brothers.)  So I don’t see this deal-if it exists-being the triumph for Russia and Gazprom as the commentariat is trumpeting.

Here is a piece of hard information that is very bad news for Gazprom: Eni has negotiated an end to oil-linked pricing, and the adoption of European hub pricing. This undermines Gazprom’s pricing model, and for this customer alone costs the Russian company about $650 million off the bat. There is a virtuous cycle here that will make the oil-link progressively less defensible. More hub based pricing tends to enhance the liquidity at the hubs, which makes the hub prices more reliable, and thereby reduces the cost of indexing contract prices to hub prices.

On the Rosneft side of the house things are much cheerier. Western company after western company trooped to St. Petersburg to pay court to the sanctioned Igor Sechin. They signed dozens of deals, and ladled on sick making praise for Sechin, Rosneft, and Russia. Bob Dudley from BP was the worst (go figure, given how Sechin has him by the short ones), but he had a lot of competition. Decent people would get a room to engage in such sucking up, but Dudley et al did it in full public view.

BP (and other companies) were obviously undeterred by the US sanctions on Sechin. They said they can deal with Rosneft, and meet with Sechin personally: they just can’t do deals with Sechin personally. Or something. Meaning the sanctions are a joke.

So I would score things Rosneft up, Gazprom down. Would that they were both down, and hard.

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May 21, 2014

Still as Clear as Mud

Filed under: China,Energy,Politics,Russia — The Professor @ 3:21 pm

We all know the real reason Putin did a last hour gas deal with China: he wanted to make me look bad.

For yes, mere hours after I declared my perspicacity in doubting that the widely expected deal would get done, the Russians and Chinese announced that they had reached an agreement. So my powers of prognostication were short-lived. Don’t gloat too much, Vova.

That said, I believe that there is less here than meets the eye. Or at least, there are many outstanding questions.

Although the deal supposedly agrees on pricing, the pricing structure is very opaque. Gazprom’s Miller said the pricing was set, but a “commercial secret.” In other words, he would tell us, but he’d have to kill us.

People are widely quoting a number for the price, based on Gazprom leaks and back of the envelope calculations based on announcements of the notional value of the deal ($400 billion over 30 years) and the quantity (38bcm/year). But as I noted in the post a couple of days ago, there is no way that the parties would set a fixed price for the 30 year term. Instead, they would agree to some indexing formula. Gazprom said that a “base price” had been established, and Putin said that the contract utilizes oil indexing. (In my original post I said this was an important thing to look for. On its own, this is a win for Gazprom, which has been a diehard advocate of oil indexing. But given the lack of any gas hubs in Asia, it’s hard to see what other alternative there is. Perhaps indexing off a European hub, but this would present real problems for Gazprom.)

But all that said, the devil is in the details. Since the price is indexed, any statements about a flat price (e.g., $350/mcm) are based on a huge number of assumptions on the indexing formula. Since nobody knows what that formula is, they have no clue on what the real price is. (And since the oil forward curve doesn’t really go out much beyond 10 years, there would still be incredible uncertainty about the revenues that Russia will realize or could lock in by hedging even if the formula was known: given that the gas will not flow for another 6-7 years, the forward prices that would be input into the formula for the last 20+ years of the 30 year term of the deal can’t be known with any precision.)

And the devil is indeed in the details of these assumptions. There are infinitely many ways to create an oil-indexed formula, and the economic outcomes vary crucially with the exact parameters that are chosen as inputs to the indexing formula. (Indeed, the weights can be made to vary over time.)

Moreover, there are some clues that things aren’t quite as final as the public crowing suggests. Putin says that the Chinese have agreed to front $20 billion towards the construction of new infrastructure, with Russia ponying up $50+ billion. But Gazprom’s Miller says that the “two sides were still in talks over any advance.”

Well wait one cotton picking minute. Upfront payments have to be offset by favorable prices over the life of the deal, to compensate the Chinese for the principal amount of the advance and the interest on it. If the upfront payments haven’t been set there is no bleeping way that all of the pricing terms are set. These terms are interdependent.

That little slip by Miller is, my friends, a huge red flag that this deal isn’t as done as the principals claim. Huge. If that part is still under discussion, the entire thing is still under discussion.

Here is my cynical interpretation (and when Russia is involved, and China is involved, cynicism is the order of the day-and when both are involved, oi!). The failure to reach a deal was so embarrassing to Putin that he was desperate to leave Shanghai with his signature on something. So the parties basically memorialized what they had already agreed to, but there are crucial gaps to be filled, and the negotiations to fill these gaps continue. The basic contours of the deal (e.g., some sort of oil link) are known, but the exact parameters, and the upfront payment, are still TBD. The Chinese accommodated, because letting Putin save face cost them nothing, and could benefit them later.

Gazprom stock popped a couple of percent on the announcement, but given the continued ambiguity, and the past fading of these deals after the initial fanfare, I consider that market reaction to be optimistic. I won’t be convinced that this is real until I see pipe being laid. Talk is cheap, and all we have now is still just talk.

So as far as I am concerned, there are still substantial doubts over the solidity of this deal. The admitted lack of agreement over the upfront payment is telling. Until the parties agree on that, they haven’t really agreed on anything.

In other words, things are still as clear as mud.

 

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May 20, 2014

Don’t Be a Sucker: Sell, Don’t Buy, Russian/Gazprom Hype

Filed under: China,Economics,Energy,Russia — The Professor @ 7:16 pm

I told you to ignore the hype (all of which originated from the Russian side) about an impending Russia-China gas deal. Despite being 98 percent done! Down to one digit! Putin left China with no deal to sell gas to China.

Again: don’t believe it until you see it.

There was the same old-same old blah, blah, blah to rationalize the failure:

According to Xinhua, the Chinese state news agency, after meeting Mr. Xi in Shanghai, Mr. Putin said, “I’m glad to be informed that the two sides have made significant progress in the price negotiation of the east route of the natural gas project.”

A joint statement said that Russian natural gas supplies would start flowing “as soon as possible,” a phrase used after many previous negotiations between Gazprom and the China National Petroleum Corporation, and an indication that the two sides could not close the gap on price in time for the two leaders to announce the deal at their meeting.

The linked NYT article quotes several people who are surprised at the outcome. I really need their contact information. I have some bridges to sell. These people are apparently afflicted with this time it’s different syndrome. But it never is.Yes, there are some differences now, but it’s really not that different.

The most telling thing (which I alluded to in yesterday’s post) is that all of the hype emanated from the Russian side. The Chinese were noticeably silent. Since it takes two to make a contract, this asymmetry was a major tip-off.

One wonders what the Russians hoped to gain by exaggerating the imminence and certainty of a deal.

Did they think that they would embarrass the Chinese into giving in? Why would they think that? That the Chinese would lose face if their guests left empty handed? As if the Chinese care. This is a commercial transaction, and the Chinese realize the Russians need the deal more than they do.  If anything, by trading them like obsequious hosts cringingly sensitive to world opinion, such a strategy would be more likely to tick off the Chinese and make them less likely to deal. If anything, the Chinese want to cultivate a reputation for being hard bargainers and actually expect to benefit from walking away.

Didn’t the Russians think that another failure would make them less likely to believed next time? Apparently not. But as the whole Ukraine episode demonstrates, they say outlandish things that are sure to be disproved with no apparent shame.

Actually, the most plausible explanation is that the Russians were pumping and dumping Gazprom stock. The price moved up as the market became convinced that a deal was impending, and then fell about 3 percent when the sure thing turned out to be not so sure . If Gazprom management and regime figures sold into the rally, they could have covered quite profitably on the selloff.

I say that only half in jest. Because otherwise I am at a loss to explain why the Russians would repeatedly over-hype the prospect for a China deal.

But I am also at a loss to understand how the stock would have rallied on the Russian pumping of the likelihood of a deal. This requires a lot of suckers to believe it.  After 10 years of this farce, you’d think people would wise up and heavily discount Russian assurances.  I guess there are a lot of suckers who want to believe. Charlie Brown lives.

Next time around don’t be a sucker. Sell rumors that Russians are peddling, and maybe-maybe-buy facts of an actual deal.

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May 19, 2014

Russia-China Gas Deals: As Clear as Mud in the Dark

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 12:18 pm

Putin travels to China this week, and the big item on the agenda is the supposed signing of a long-awaited gas deal.

I’ve seen this show many times before, going back to 2004. Much fanfare ahead of the meeting! A deal is signed! But the price is TBD. Meaning there is no real deal. And then the charade occurs again a couple of years later.

So I’ll believe it when I see it.

The Russians, per usual, are doing all the talking about the impending deal. Apparently understanding that those who have seen the earlier episodes will be skeptical about any deal that doesn’t nail down pricing, they are at pains to claim that the pricing is all but set. Deputy Energy Minister Anatoly Yanovsky said the deal is “98 percent completed.” What does that mean anyways? By word count? Meaningless, if the missing 2 percent relates to price. Gazprom’s Alexi Miller says the deal is “one digit” away from completion. Well, which digit kinda matters. Is it in the hundreds column? The tens? The ones? (Or does the single digit refer to an upraised middle finger?)

If a deal does get done, pay close attention to the price. The Chinese have the bargaining power here. As they always have. But now it is greater because this is now part of Russia’s game with Europe and Ukraine. It very much wants to put pressure on the Europeans. So Putin/Gazprom might be willing to take a lower price to further that strategy.

Just as important, look at the formula. The reports I’ve seen are saying that the Russians will sell at a fixed price, in the range of $350-$380/MCM. If the deal is truly at a fixed price, this would be a major concession, as Gazprom is an ardent defender of oil-linked pricing. If it gives up the oil-link, that would be a major concession, and would put oil-linked deals in Europe under greater pressure than is already the case.

This figure is based on leaks from Gazprom, which is kind of appropriate given the massive leakage that occurs from its pipes. Perhaps the leaker is converting an oil-based formula number to a flat price. Moreover, regardless of how arrived at, is this a number for deliveries over the entire 30 year life of the contract, or just for the near term deliveries? I can’t imagine locking into a price over 30 years. There has to be some kind of indexing, but to what? That matters a lot. Moreover, I would not be surprised if  the Chinese agree to near-term prices that are comparable to European prices in order to give Russia a propaganda victory to use in its battle with the Euros, but get more than compensated at the back end through some convoluted pricing formula that is not publicly disclosed.

It is quite possible that it will be very difficult for outsiders to know exactly what terms the parties have agreed to, and to back out a price, or a price structure over the life of the contract. Recall the Rosneft/Transneft-Chinese oil deal that was signed in 2009. The Chinese made an upfront payment to pay for a pipeline, and presumably received a discount on the price. But the pricing terms were not transparent and who got the better of the deal was hard to figure. I wouldn’t be surprised to see the same thing happen here.

Also remember that Russian-Chinese deals are not ended with “and they lived happily ever after.” The Rosneft/Transneft-China ESPO deal has been marked by chronic pricing disputes between the parties. Don’t be surprised if that happens here too. The Chinese are also notorious for re-opening pricing terms after deals are signed. And their performance on contracts generally leaves something to be desired. They are notorious for defaulting on fixed price contracts when spot prices fall below the contract price: for this reason, most iron ore and coal sales to China are on spot terms only. Iran recently canceled a $2.5 billion deal with China to develop an oil field because the Iranians claim the Chinese are not living up to the terms of the deal (though this isn’t related to pricing per se). (H/T Neil C. Levine.) In other words, any deal is just setting the stage for ex post opportunism, by either party or both.

So even if Putin walks away from Beijing beaming a beatific botoxed grin, don’t draw too many conclusions. When two of the least transparent regimes in the world enter into a contract you cannot expect disclosure of the real terms, and the public announcements relating the deal will be intended primarily for propaganda purposes rather than to enlighten the world. When the inscrutable deal with the riddle/mystery/enigma folks, you can’t ever know what is really going on.

Further thoughts (added 5/19/14 at 1730 CDT). If and when a deal is announced, look to see whether there is a take-or-pay clause. The Russians usually insist on these, and they can be a source of major friction between the contracting parties if the price terms in the contract get out of alignment with spot market conditions, as is almost inevitable in a contract that extends over 30 years. I would be surprised if the agreement has take or pay terms and the Chinese also fund the construction of a pipeline upfront. Take-or-pay is usually a mechanism for protecting the party making the investment in the specific asset (like a pipeline or gas field): if the Chinese are funding the project, Gazprom doesn’t need take-or-pay to protect it. If anything, the Chinese would need protection against Gazprom’s opportunism.  If the Chinese indeed provide a substantial sum up front, as has been rumored (with sums of around $20 billion) the pricing terms of the contract become even more important: discounts later on in the life of the contract are necessary to pay the Chinese the principal and interest on the funding. There is no way that Gazprom will get European prices for sales to China if China also finances the investment. If Gazprom boasts that it indeed received European prices for sales to China, and the Chinese fronted the investment, you know there is something being hidden. (This happened with the Rosneft/Transneft deal.)  With respect to pricing, I can’t see any way that the deal would be at a fixed price for 30 years. There must be some sort of indexing. Again, if the boasting is about some price level that is anywhere near what the Russians get currently from Europe, be very suspicious. This is likely part of some sort of Three Card Monte game, with Russia tantalizingly flashing, then palming, the Black Queen to gull the suckers. If the deal is really for thirty years, there must be some sort of indexing mechanism, with a set of discounts, and the details here would be very devilish. Lastly (for now, anyways), I’ll be interested to see if the deal includes some sort of hostage exchange to protect each party against the predations of the other.

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April 30, 2014

Don’t Get Conned By Buffett’s Kindly Grandfather Shtick. He’ll Profit From the Increased Regulation He’s Advocating.

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 7:40 pm

There was another fiery derailment of a train carrying crude oil, this one in Lynchburg, Virginia. Some of the cars plunged into the James River, spilling oil into the stream that runs through Virginia via Richmond to the Chesapeake.

This is just the latest of a spate of such accidents. This is, to some extent, the inevitable consequence of the oil boom in the Bakken and Texas. The boom means that more oil has to move, and rail can adjust most rapidly to accommodate that need. Pipelines are cheaper and safer, but they take a while to build. Unfortunately, regulatory obstacles had impeded the more rapid buildout of pipelines.

To give an idea of how unexpected the oil-by-rail movement is, note that the US government (namely the Energy Information Agency) does not collect data on the volume of rail shipments. It tracks shipments by barge and pipeline, but not rail. Because oil by rail volumes were basically rounding error until the shale oil boom.

The recent spate of accidents has led Warren Buffett to call for stronger regulation, most notably, a requirement for safer rail cars.  Buffett’s Berkshire Hathaway of course owns the nation’s second largest rail carrier, BNSF.

That Warren, always looking out for the public interest, and willing to sacrifice the interests of one of his major holdings to benefit us hoi polloi.

Not.

First, it’s long been known that some firms in an industry can benefit from the imposition of more stringent safety regulations. Yes, these regulations raise everybody’s costs, but some firms’ costs rise more than others. The less-impacted firms have an incentive to press for the regulations in order to raise their rivals’ costs. This raises market price. The effect on price more than offsets the effect on cost for the less cost-impacted firms.

Which means: always look askance at people like Buffett who are calling for regulation of their industry.

And this goes double for Buffett. For in addition to BNSF, Berkshire Hathaway owns the Union Tank Car Company, one of the largest manufacturers of oil tanker railcars. Meaning that some of the costs from requiring the purchase of more robust railcars goes from Buffett’s BNSF pocket into his UTLX pocket. He is, effectively, hedged against the rise in BNSF’s costs that would result from regulations requiring the use of safer cars. What’s more, his UTLX also pockets some of the costs incurred by his rivals. That’s a double win for Buffett. His rivals’ costs go up, raising prices for rail freight which benefits BNSF, and Buffett also books as profit (at UTLX) some of the higher costs his rivals incur.

Great work if you can get it.

So yeah, Buffett’s call for more stringent regulation of oil carrying railcars is totally altruistic. Totally.

It never ceases to amaze me how Buffett’s kindly grandfather shtick fools the world. He is utterly cynical in his actions and public statements. He demonizes derivatives, but engages in some huge exotic options trades. He claims he supports the estate tax out of interest of fairness and equity, not mentioning that his insurance businesses profit immensely from the estate tax (and that he can of course largely circumvent the tax). He has manipulated the silver market. And he poses as a defender of public safety, not mentioning his very strong economic interests in such regulation.

It’s not surprising that Buffett conceals his interests. What’s more surprising, and more discouraging, is that none of the media stories on his calls for tougher regulation that I have seen mention his economic interest. Reporters are either intimidated,  gulled by his shtick, or shockingly ignorant of how Buffett would benefit from rules requiring railroads to upgrade their car fleets.

Just because reporters are credulous dupes doesn’t mean you have to be. Don’t fall for the Buffett shtick. Don’t pay attention to what he says. Evaluate the costs and benefits of increased safety standards on oil-by-rail shipments on the merits.

And don’t limit your analysis to rail shipments alone. Consider too the effects of expediting the approval and building of oil pipelines. Pipelines aren’t perfect, but they have a much better safety record than rail. Not that Grandpa Warren will tell you that.

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