Streetwise Professor

April 18, 2014

Banning Banks From Physical Commodity Trading: The Battle Continues

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 3:33 pm

The battle over bank participation in physical commodities is reaching a climax. The deadline for commenting on potential Federal Reserve regulation of this activity is approaching, and many letters from groups representing banks (‘natch) but also from energy and commodity industry groups plead with the Fed to permit continued bank involvement in the markets. However, on Capitol Hill the sentiment largely runs the other way, and Senators Sherrod Brown and Elizabeth Warren submitted a letter demanding that the Fed defenestrate banks’ commodities businesses.

Most of the Brown-Warren letter is stuff I’ve written about before, so I won’t comment more on it now. But this part stood out to me, and deserves a rebuttal:

Commodities activities present risks that are different from financial-market risks, are idiosyncratic, and have the potential to disrupt more than just the financial system. Global supply chain disruptions can affect industries in the broader economy that rely upon raw materials.

First, from a systemic risk perspective, the fact that commodities risks are idiosyncratic, and different (i.e., less correlated) with other risks in the banking system is a good thing. Diversification is beneficial in this regard.

I have looked at some evidence that speaks directly to this issue. Over the period of the crisis, the profits of the biggest physical commodity trading firms (the Glencores, Cargills, Vitols, etc.) did not suffer the same extreme drop as bank profits. Indeed, with a few exceptions (Bunge) profits of the major commodity trading firms rose from 2008 to 2009, when bank profits were in freefall.

This lack of cyclicality in trading firm profits, which is in stark contrast to the extreme cyclicality in prices (especially for energy and metals) is readily understood. Physical trading is a margin and volume business: these factors, not flat prices, drive profits. Due to the inelasticity of supply and demand for commodities, margins and volumes tend to be much more stable than flat prices. Prices, rather than quantities, tend to bear the bulk of the burden of responding to demand shocks. Moreover, some commodity trading activities-notably storage-tend to be countercyclical, providing a source of profit to physical commodity traders during recessions.

Commodity trading firms actually had more issues when prices spiked in 2008, because it was difficult for them to finance inventories at very high prices, and the low prices of 2009 eased these financing constraints.

The lack of cyclicality, which contrasts starkly to the pronounced cyclicality of earnings in traditional banking and capital market activities, means that physical commodity trading could reduce the systemic risk posed by banks. The effect will not be large, because even for the biggest banks  commodity trading revenues are small relative to those generated by the more traditional activities. But directionally, this lack of cyclicality in physical trading profitability makes it an attractive part of a bank’s portfolio, especially from a systemic risk perspective.

Second, the Brown-Warren warning about disruptions beyond the financial system are vastly overblown. Presumably what they mean is that if a large bank or several large banks with commodity trading operations were to run into financial trouble, this could disrupt global supply chains. But especially for the commodities that banks tend to focus on (particularly energy), they represent a small fraction of total physical market trading activity. If they disappeared overnight, others could step in and handle most of the business at a slightly higher cost. (Not to mention that it is kind of strange to justify driving banks out of the business by saying that if they leave the business it could disrupt global supply chains.)

But even more importantly, we know that even major disruptions in global supply chains are likely to have only trivial impacts on the global economy. Look at the Japanese earthquake and tsunami of 2011. It devastated supply chains throughout Asia, far more than the loss of even several major commodity trading firms could have. Yet the effects on global growth were minimal. Several central banks examined the issue, and found that the catastrophe reduced global growth by around .1 percent for a couple of quarters. Even in Asia, the effect was minor.

As another example, the implosion of the merchant energy sector in the US in 2002 had no marked effect on US economic activity.

Another concern raised about bank participation in physical markets is environmental risk. This is potentially a serious concern, but even there legal protections (notably dealing through subsidiaries that protect a bank or bank holding company from liability) and insurance can sharply reduce the risk that legal exposure arising from an oil spill or the like could threaten the viability of a large financial institution. Also, since different commodity trading activities pose different environmental risks, a blanket restriction on commodity trading activities, some of which are not particularly environmentally risky, is not warranted.

In sum, the Brown-Warren arguments are not persuasive. Financially, the nature of physical commodity trading tends to reduce the cyclicality of of bank profits, which tends to reduce systemic risk. The fears about threats to global supply chains from the failure of any major commodity trader leading to adverse macroeconomic consequences are vastly overblown. Finally, the environmental/legal risk issues can be allocated away from banks through organizational structure and insurance. Since there also complementarities between traditional banking activities and commodity trading (which I discussed in posts from last summer) some commodity producers and consumers would pay higher costs if they could not enter into physical trading deals with banks: this is one reason why some of these producers and consumers object to limitations on bank participation in these markets. It’s hard to see the benefits of a ban (or restriction), but some costs are evident.

I doubt that will matter much in the end though. Commodities are a politically sensitive issue. Banks are a politically sensitive issue. Put them together, and the sensitivities are acute. Meaning that politics will largely drive the outcome.

Update. One other amusing part of the Brown-Warren letter. They say:

Some have argued it is preferable to allow commodities activities and physical asset ownership within the regulated banking system, rather than at the more lightly regulated commodity trading houses. As a general matter, the CFTC maintains authority to police fraud and manipulation in the commodities markets, regardless of the party engaging in such behavior.

So are banks somehow less subject to deterrence by the threat of CFTC action? If the objective  is to reduce the amount of manipulation and fraud, to justify forcing banks to eschew commodity trading it is necessary to argue that banks are  somehow less responsive to CFTC action than commodity trading houses. Maybe, but it’s not obviously true and I’ve seen no evidence that would support my view.

This relates to a point I made in earlier posts, namely, that if the economics are such that banks find it tempting to manipulate, non-banks will also find it tempting. Meaning that moving a business (e.g., metal warehousing) from a bank to a non-bank is unlikely to reduce the amount of manipulation.

One other thing needs to be said in this context. The Brown-Warren point is correct to the extent that it demonstrates that the term “lightly regulated” is used far too sloppily. Yes, trading houses are less subject to less of some kinds of regulation than banks, but they are subject to anti-fraud and anti-manipulation rules just as banks are. Similarly,  environmental laws and anti-trust laws and many other laws apply to these firms. “Lightly regulated” does not apply uniformly to all forms of bad conduct. The fact that commodity traders are not subject to some regulations that banks are (e.g., capital requirements) makes sense, given the differences between them.

Whenever anyone says “unregulated” or “lightly regulated”, I get suspicious and skeptical. Often those using these phrases are playing a shell game.


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March 25, 2014

The Wages of Being a Petrostate: Using the Energy Weapon is Economic Suicide

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

Although the Euros wring their hands at the costs they would bear if serious economic sanctions were imposed on Russia, as I’ve said, there is a huge asymmetry in vulnerability: Russia is substantially more vulnerable to a cutoff in trade, especially the energy trade.  Take gas.  Germany imports about 12b Euros of gas annually.  Its GDP is about 2.5t Euros.  So natural gas expenditures are about .5 percent of GDP, and even a substantial price increase would represent a relatively small burden on German expenditures.  In contrast, Russian energy exports (63 percent of which are to Europe) account for 50 percent of the country’s budget.  So trade restrictions would be an inconvenience for Europe, and pose an existential challenge for Russia.

Such are the wages of being a petrostate.  Using the energy weapon is national economic suicide.

FT Alphaville has a nice overview of this and other asymmetries.

One quibble, related to this:

In response to Iran-style sanctions, Russia could muster one unprecedented measure. It and its allies could stop buying euros, dollars, and Western government debt. However, Western governments should be able to brush this manoeuvre aside.

If it comes to a trade and finance showdown, it won’t have the money to be buying anything.  So a cutoff of purchases of dollars, euros, etc., is not something that Russia could threaten: it would be an inevitable consequence of a trade and finance war.  And Russia is not such a big buyer that it would make all that much of a difference anyways.

The FTA piece also dispatches the fantasy Russians and their fellow travelers are peddling: that China will assist Russia by waging economic combat against the West.  China is a huge dollar and UST long, so it would be an incredible act of economic masochism to dump dollars or Treasuries.  And Russian fantasies aside, China is not that into them.

The asymmetry of power, especially economic power, couldn’t be more obvious.  But that is counterbalanced by an asymmetry in will, and heretofore that has proved the decisive difference.  Putin has wagered that Europe is unwilling to suffer any discomfort to counterattack against Putin’s anschluss.  So far, he has been right.


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March 24, 2014

Abbot and Costello Do Manipulation Enforcement

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 7:36 pm

I heard a hilarious story the other day about an incident that occurred when European Commission investigators raided a trading shop in connection with the Brent investigation.  While going through trader emails and documents, one of the crack investigative team came across numerous documents about trading on ICE.  The investigator was puzzled, so he asked the a lawyer for the trading company: “You trade ice?”  Lawyer: “Yes, we trade on ICE.”  Investigator: “You mean you really trade ice?  Frozen water?”  Lawyer: This is my please-tell-me-you’re-sh*tting-me face.

No prizes for figuring out which was Abbot, and which was Costello.

We are in the best of hands.  The best of hands.

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A Cunning Peasant With a Battleaxe, Fighting Frankendodd

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation,Russia — The Professor @ 10:59 am

That would be me.  At least according to the Google translate version of this profile of me in Neue Zürcher ZeitungIt’s a nice piece, and a fair one (in contrast to some other articles I won’t mention).  Except I am really a mild mannered guy.  Really!

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March 22, 2014

Further Thoughts on Whether Gunvor is Done For

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 4:19 pm

A couple of stray thoughts regarding the Gunvor story.

First, virtually all of the oil trade (and the global commodities trade generally) is done in dollars.  Gunvor needs dollar financing to carry out its trading.  Anything done in dollars puts the provider of the dollar finance in the crosshairs of a panoply of US regulators.

Case in point is RBS, which paid $100 million in settlements to the Fed and the New York Department of Financial Services for violating sanctions on Iran, Burma, Sudan, and Cuba.  One law firm concluded:

A lesson that foreign financial institutions and other multinational companies should draw from these cases is that they continue to face significant risk if they engage in any business related to parties or countries (particularly Iran, Cuba and Sudan) that are restricted under US economic sanctions provisions, even if their activities may have appeared to be lawful at the time.  Such activities create risk when they have even a minimal nexus with the United States, including clearing financial transactions in US dollars, furnishing financial services through institutions in the United States, processing payments through foreign branches of US financial institutions, or knowingly relying on services provided by US persons anywhere in the world to facilitate, participate in, approve, or support restricted transactions.

Foreign persons providing a variety of financial services, including banking, money remittance, insurance, reinsurance, investment, foreign exchange, mortgages and secured transaction/letter of credit services, should recognize the inherent US enforcement risk in concealing or intentionally omitting identifying information from payment messages involving a sanctioned country, entity or person, when the transaction has some nexus to the United States or US persons (including US dollar exchange).  Deceptive activity also formed the basis for part of the recent settlement against Weatherford International Ltd. (see our advisory on Weatherford). [Emphasis added.]

To reiterate.  A “minimal nexus” with the US puts a foreign financial institution at risk when it deals with a sanctioned entity.

Here is an Economist piece on how the US uses merely touching a dollar as a basis for aggressive prosecution.  Here is the Telegraph screeching about how the US has extracted billions of dollars in settlements from British banks for engaging in transactions in dollars.

The basic issue is that any transactions done in US dollars, even between foreign entities, have a US bank involved at some point to process the dollar transactions.  You do a deal in dollars with a US-sanctioned entity, you are at huge risk of prosecution.

The implication is that even if Gunvor deals only with non-US banks, as long as it deals in dollars, if the firm becomes a sanctioned entity anyone who is on the other side of the dollar transaction is at risk.  FUD is most acute with any transaction that touches the dollar.  And you can’t engage in the international oil trade (or commodities trade generally) without dealing in dollars.

Second, a somewhat related issue. Let’s say that Törnqvist really did buy out Timchenko’s shares.  Let’s say he didn’t pay with a note.  Where can Timchenko stash the cash? Paying in Euros or CHF could perhaps avoid the problems discussed above, but even so, what western financial institution wants to take Timchenko’s money?  Even Sberbank might have some reservations.


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March 21, 2014

UST: Putin the Mark of Cain on Gunvor

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 1:20 pm

Just landed at O’Hare on my way back from Brussels and Geneva.  Right before taking off I saw that Gunvor’s bond price tanked at the open.  It closed yesterday yielding 10.9 percent, and spiked at the open to 13 percent.  I understand it is still tanked.

In other words, the market either totally disbelieves the story that Timchenko sold out, or thinks that the sale is irrelevant in determining the company’s vulnerability to sanctions or investigation.

My suspicion is the latter, because of the Treasury’s deviously, devilishly clever strategy.  Recall that UST said that Putin is a part owner of Gunvor.  No hedging about that claim, no “may be a part owner”:  a flat statement that Putin is an investor.  It said that Putin might have access to Gunvor funds.

So regardless of whether Timchenko sold, or commits ritual public suicide tomorrow, Treasury has put the Mark of Cain on the company.  Every counterparty, every lender has to have serious, serious concerns that the company may be sanctioned due to the Putin connection.

The tanking bond price makes it clear that the credit markets have serious doubts about the company’s survival prospects.  No doubt this reflects bankers’ serious reluctance to continue to finance a company that the US government has publicly tied to Putin.

Yes, most of Gunvor’s lenders are European banks, but ask Swiss banks about the joy of taking on the US government when it has an important policy objective in mind.  And think of all the leverage the US has over European banks given the myriad ongoing investigations of Libor, FX, ISDA Fix, and on and on.   Even if the Euros don’t sanction Timchenko (or Gunvor) (and they abstained from doing so today, waiting to announce that until I’d left Brussels, the cowards), the US has plenty of leverage over European banks.

The company has the weekend to try to turn things around.  But that Treasury statement casts a huge shadow.   In the current environment, bankers are afraid of their own shadows, let alone the shadow of a US government with blood in its eyes.

Press coverage of this story has been credulous, especially in the FT.  The stories have uncritically repeated Gunvor’s statements that Timchenko sold at fair value, and that there is no option for Timchenko to repurchase.  But they would say that, wouldn’t they?  And the stories don’t point out that the bond market is basically calling BS on Gunvor.

Speaking of fair value, I know Torbjörn Törnqvist is not an idiot.  He can go through the game tree, and realize that there is large probability that his shares, and the ones he purchased from Timchenko, will be worthless.  Meaning that he won’t have paid Timchenko book value, or anything even close.

Which raises the interesting question: if Timchenko is really just a front man for Putin, as the US government asserts, any big discount comes right out of Putin’s pocket.

Which is pretty much the point, isn’t it?  That’s exactly why UST’s statement is a big flashing neon light arrow pointing right at Putin.

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March 12, 2014

Go Ahead, Make My Day: Here’s a Russian Bluff That’s Easily Called

Filed under: Commodities,Economics,Energy,Politics — The Professor @ 10:32 am

Russian government officials and Duma members  have threatened that if the US and/or EU impose financial sanctions in response to Crimea/Ukraine, Russian corporates will just default on their debt:

A Kremlin aide warned last week that Moscow might refuse to pay off loans to U.S. banks as a retaliation measure against sanctions.

Mikhail Yemelianov from pro-Kremlin party A Just Russia went even further: “If they (the West) freeze our assets, then our companies could stop paying foreign debts. The Russian corporate debt exceeds $700 billion”.


Banks don’t lend to Russia in large sums on an unsecured basis.  One of the things that caused Putin to freak out in 2008-2009 was that Russian companies (notably Deripaska’s Rusal) had pledged stock as collateral against loans.  Putin got Russian government banks (Sberbank, VTB) to extend credit to these companies so they could pay off the loans to western banks, thereby preventing them from defaulting and having large blocks of shares pass out of Russian hands.

I don’t know about all $700 billion of Russian debt, but I do know a bit about loans to one company mentioned in the linked article: Rosneft.

Rosneft borrowed upwards of $10 billion to finance the TNK-BP acquisition.  The structure of the borrowing shows just how dodgy even the biggest, most politically connected, state enterprises are viewed by western banks.

The loans were structured as prepays, and included trading firms Glencore, Vitol, and Trafigura as part of the structures.  Rosneft entered into off-take agreements with the trading firms that obligate the Russian company to deliver oil to them over the next several years.  The trading firms will then sell the oil, and send the receipts from the sales to the lending banks, thereby paying off the loans.  That is, the banks do not trust Rosneft to pay.  Rosneft never touches the money from the oil sales.   It goes from the trading companies directly to the banks.

In other words, Rosneft’s oil is security for the loans.  And as I noted when the deals were done, real supermajors (as opposed to pretend ones) don’t have to pledge such security in order to borrow.

So what would happen if Rosneft carries through on Yemelianov’s threat?

The only way to do that would be to default on the off-take agreements, i.e.,  to fail to deliver the contracted volumes to  Vitol et al.

Good luck with that.  The second Rosneft fails to deliver on the off-takes, and tries to sell  cargoes pledged to the trading companies on the open market, the trading companies will take legal measures to seize those cargoes to enforce their legal rights.  Knowing that, no buyer in his right mind will contract with Rosneft once it has stiffed Vitol, Glencore, and Traf.  Meaning that Rosneft cannot just walk away from its debt, if it ever wants to export a barrel of oil ever again.

In Rosneft’s case, therefore, the threat to walk away is an empty one.  The banks and trading companies have seen to that in the way the deals are structured.  Precisely because they don’t trust Russian companies enough to lend on an unsecured basis.

I don’t know the structure of every loan provided by western banks to Russian corporates.  But the structure of the Rosneft loans tells you that the banks have zero trust with Russian companies, and demand some form of security against the credit extended: the form of security will vary by the borrower and type of loan.  Meaning that Russian corporates that attempt to retaliate against sanctions by defaulting on obligations to western creditors will suffer major, major pain.

So I say: call the Russians’ bluff.  Impose sanctions.  If Putin forces Russian companies to default in response, they-and he-will pay a far higher cost than anything inflicted on the nations sanctioning Russia.

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March 11, 2014

Germany Vows to Supply Gas to Ukraine: Piecrust Promise?

Filed under: Economics,Energy,Politics,Russia — The Professor @ 1:39 pm

German utilities claim to be developing work-arounds that would provide Ukraine with gas in the event Russia cuts off supplies due to non-payment, or as part of an economic war against Ukraine.

Now Germany’s major energy utility companies are developing strategies to help Ukraine fill the shortfall if Moscow decides to cut gas supplies. Companies including RWE and E.on are working on plans to supply Ukraine with weeks’ worth of gas.

Currently, Ukraine taps around half of it gas needs from Russia. But last Friday, Russian Gas monopolist Gazprom threatened to suspend deliveries to Ukraine if the country doesn’t pay its outstanding February bill of €1.7 billion ($2.35 billion).

In an emergency, the flow through Europe’s pipelines could simply be reversed, with gas getting pumped from German reservoirs through the Czech Republic and Slovakia directly to Ukraine. Following this year’s especially mild winter, Germany’s reservoirs are much fuller than usual. Even long-term deliveries would be conceivable at the moment.

Ukraine already signed a framework agreement in 2012 with RWE to make the gas deliveries possible. Under the contract, the company has committed itself to delivering up to 10 billion cubic meters of gas per year to Ukraine, which the country was going to use this summer to fill its reservoirs for the coming winter. But RWE executives say they could provide deliveries much sooner.

RWE currently draws its gas from Norway or the Netherlands, both major suppliers in Western Europe. It would also be possible to redirect Russian gas from the Nord Stream Baltic Sea pipeline — which connects Russia and Germany — through pipelines in the Czech Republic and Slovakia to Ukraine.

Color me skeptical.

The article notes that there are clauses in the contracts with Gazprom that preclude redirection of supplies, but the German utilities claim these are readily circumvented: given that gas in German storage reservoirs comes from multiple sources, how  could Gazprom prove its gas has been redirected?

But this is based on the naive view that Gazprom’s sole (or even preferred) recourse against German supply of Ukraine would be to file a legal action.  It could decide instead to retaliate for German shipments of gas to Ukraine by shutting off gas flowing on the Nordstream and Yamal pipelines. Given no gas would be flowing to Germany via Ukraine, if Gazprom did so the German companies would soon be drawing down their stocks rather heavily and be vulnerable to Gazprom’s  tender mercies going forward.

Would they really be willing to take that risk on behalf of Ukraine?

And there is also the matter of the huge political pressure Russia would exert on Germany if RWE and E.on were to attempt such a thing. After all, former Chancellor Gerhard Schroeder chairs the Nordstream board and still exercises considerable influence in Germany, and Germany has proven quite vulnerable to Russian pressure in the past.  Numerous German businesses would be importuning Merkel not to antagonize Russia.

I strongly suspect that this “plan” and the article about it have been created and planted to give Merkel and Steinmeier political cover: “See! We are doing something to help Ukraine.”  But if called upon to perform on their promises, I would expect the Germans to fold like a cheap suit in the face of Russian threats to cut off gas.  And Putin is playing for keeps here.  Don’t think for a moment he won’t do it even though he would incur a greater economic cost than the Germans (and other European consumers of German gas).

And remember, gas is not the only lever.  Coal is the major alternative to gas, but Germany (and also the UK, to an even greater degree) get a large fraction of their coal supplies through Russia.   This is a real game of chicken, and I am not putting my money on the Germans.

That’s because based on experience, and my perception that Germany is trying to get short run political benefits by dispelling serious doubts about its commitment to Ukraine, I do not consider the proposed plan to be very credible.  Just as the French (and British) made promises to the Poles in 1939, and then left them hanging when Poland called on them to deliver, I think there is a strong possibility that these German promises will be of the piecrust variety: easily made, easily broken.

In other words, Ukraine should not base its plans on the assumption that Germany has its back on gas, or anything else for that matter.

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March 9, 2014

The Energy Weapon

Filed under: Economics,Energy,Politics,Russia — The Professor @ 12:03 pm

There’s a lot of talk about exploiting the US energy boom to undermine Putin and Russia.  This boom may have profound effects in the long run, but there is nothing that can be done now that can materially harm Putin in to punish him for his anschluss in Crimea, or subsequent aggressive moves he may make.

Yes, the US restrictions on exports of natural gas and crude oil are economically idiotic, even absent geopolitical considerations.  But even if those bans were eliminated tomorrow (a huge if, given he who sits in the White House-or golfs in Key Largo, as the case may be) Europe’s energy situation would not change one whit.

It would be possible to start moving large quantities of crude if the export ban were lifted, but this would be largely offset by a decline in US exports of refined products.  A major effect of the ban is to distort where crude is refined, not the total supply of crude and refined products (especially in the short run).  The major effect of the ban at present is to benefit US refiners who refine crude that is selling at below world prices because of the ban and export the products.  One study estimates that eliminating the ban would drop world oil prices by cents not dollars.

With respect to natural gas the situation is even less favorable.  Even if DOE granted all pending LNG export licenses, it will be years before product will start flowing.  Cheniere received the first license, in May, 2011, and its facility will not come on line until late-2015 at the earliest.  The company had a head start because it was converting an existing facility built to import LNG: other facilities will take longer to build because they are starting from scratch.

The long run impact of eliminating the export ban depends on the elasticity of supply of gas in the US.  If it is very elastic at current price levels, then yes, once the ban is lifted world prices will fall substantially, and Russia will be hit hard by that.  If supply is less elastic, the impact will be far smaller.  The elasticity of supply will depend crucially on technological factors, including the suitability of new formations to fracking and horizontal drilling, the depletion rates of wells, and the rate of technological innovation.  All of these factors are quite uncertain, and if the experience of the past decade says anything, it says be leery about making predictions about natural gas supply.

In brief: US energy export policy is stupid, but fixing the stupidity will have no appreciable impact on Russia for years.

Similarly, fixing stupid European policies on energy (e.g., fracking bans, massive renewables subsidies like Energiewende) should be done for reasons independent of geopolitics, and even if done tomorrow will have no material impact on European energy prices or Russian energy revenues for years to come.

The main way to impose substantial costs on Russia today via energy would be to impose trade sanctions.  Given the fact that the oil market is essentially global in scope, and that coordinating a global boycott of Russian oil would be virtually impossible, natural gas is a more feasible target.  Europe could boycott Russian gas  unilaterally, and there is no effective way for Russia to sell that gas to Asia or anywhere else.

There is a substantial asymmetry here.  Russia depends heavily on gas exports.  Approximately 25 percent of the Russian government’s revenue comes from Gazprom. The knock on effect on the Russian economy would likely be huge, as severe fiscal constraints would likely put substantial strains on the Russian banking system.

Yes, Europe would be hurt by higher prices and lower consumption of gas.  But gas comprises a far lower percentage of European expenditures than it does of Russian income, meaning that the hit on Europe would be far smaller.  Moreover, some of the impact could be mitigated by substantially increasing coal imports, increased Norwegian production, and some diversion of LNG from Asia to Europe, especially to the UK (which has excess LNG import capacity and could use LNG to displace North Sea gas which it could then pipe to Europe).   Moreover, winter is ending, and the cost of a supply interruption in the spring and summer would be far less than the cost in the winter.

But I doubt that is going to happen, because of another asymmetry.  The asymmetry in political will.  Old Europe has no stomach for a confrontation with Putin over Crimea, Ukraine, or much of anything else. (And yes, Donald Rumsfeld was an a$$hole-a claim I can vouch for based on family experience-but the Old Europe vs. New Europe formulation does capture an essential truth, especially where Russia is involved.) This lack of intestinal fortitude means that Old Europe-and especially Germany-is unwilling to pay any price to punish Putin.  Talk is free, and that’s all they are willing to pay.

And don’t think for a moment that Putin hasn’t based his plans on exactly that calculation.

In an attempt to scare off any attempt at sanctions, Russia has threatened retaliation: Lavrov has told Kerry any such moves will “boomerang.”  Other Russian officials have said that Russia can insulate itself from the west, thereby making it immune to any sanctions.

The retaliation that has been threatened includes expropriation of the assets of western companies.  A quite predictable Russian reaction, and typically self-destructive.  Any such expropriation would just cement Russia’s reputation as a lawless country where foreign investors rush in where angels fear to tread.  Russian equity valuations would crater, and direct investment would too.  Capital flight would accelerate.  The costs inflicted on Russia would dwarf those inflicted on the US and Europe, and would last for years.

Other that that, a great plan!  Another major asymmetry: any Russian retaliation would harm Russia far more than Europe or the US.  Some boomerang.

It reminds me of the old joke about the genie who grants the muzhik one wish, with one condition: anything the muzhik wishes for he gets, but his neighbor gets double. The muzhik thinks for a minute, then says: “I wish that you pluck out one of my eyes.”

All that said, I do not think that economic sanctions in the form of boycotting Russian energy or other exports, or cutting off imports (e.g., of drilling equipment) are the most effective, or the least costly, way of imposing costs on Putin and the elite on whom he depends. As I have said since Georgia, 2008, the best way to attack Putin and the elite is to go after their money in the west. (This policy is getting widespread publicity now.  I will lay claim to being a very early advocate.)

Such a measure is targeted on those who make the decisions, rather than Russia and Russians generally: as such, it could not be used by Putin to claim that the west was waging a war on Russia.  Indeed, it could undermine his political support not just among the elite who would be paying the price for his adventures, but among the broader population who are already disgusted by corruption and who would be unlikely to have any sympathy for that corruption being exposed, and the ill-gotten gains being seized.  The cost on western economies would very small indeed.  It would represent a victory for the rule of law.

But this would impose some costs on some very connected people in the west.  Moreover, precisely because it would strike so deeply at Putin it would cause him to lose his sh*t, and fear of that causes the Euros to shrink away from it in terror.

But this is something the US can pursue unilaterally.  Yes, given that most dirty Russian money is in Europe or the Caribbean, these measures would be much more effective if the Europeans participated. But the US still can wield considerable power (note how it forced Switzerland to heel on tax issues-not something that I agree with, btw, just pointing out that the US has leverage) and indeed, the mere threat of exposing what it uncovers could make the Europeans think twice.

But again, there is a lack of will.  Hope drives policy: “If we concede Crimea to Putin, he will stop.”

In sum, there is a powerful policy tool at our disposal.  A far better tool than is available in most such circumstances.  Other tools (sanctions) are more costly.  Yet other supposed tools-increasing US energy exports-are chimerical.

If we’re serious, we’ll use it.  But I have my doubts that we’re serious. If Europe (and to a lesser degree the US) has demonstrated anything in recent years, it is that they are past masters at kicking the can.  Crimea, Ukraine, and Putin are likely to be just another can.

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March 6, 2014

Perfidious Exxon

Filed under: Commodities,Energy,Politics,Russia — The Professor @ 6:26 pm

ExxonMobil’s CEO Rex Tillerson (whose first name gives you an idea of his self-image) has decided to suspend offshore gas exploration projects in Ukraine, while continuing extensive cooperation with Russia (including a project very close to Crimea).

Talk about shivving someone when they are down.  Although any project like that the one that Exxon shelved would only produce years from now, if ever, a necessary condition for Ukraine to escape the Russian yoke is that it reduce its dependence on Russian energy, particularly Russian natural gas.  The Exxon decision makes that prospect ever more unlikely.  Ukraine’s bargaining power vis a vis Putin has just taken a big hit.  The Exxon betrayal also has huge symbolic importance: it indicates that energy companies are likely to deal with the devil-Putin-and willingly throw Ukraine on his tender mercies.  This will further convince Ukraine, and the Euros, that the country’s only option is to kneel before Don Vladimir.

Tillerson claims that he has no qualms about continuing to work with Russia, because he perceives no political risk:

“As for the current situation, obviously it’s early days,” he said. “There’s been no impact on any activities or plans at this point, nor would we expect there to be any, barring governments taking steps beyond our control.

“In terms of our view of country risk, geopolitical risk, other than things like sanctions, we don’t see any new challenges out of the current situation,” he said.

If you don’t see any new challenges relating to political risks in Russia arising from this situation, Rex, you need to get an eye test.  The substantial sell-off in Russian stocks was all about political risk.  And a victory in Ukraine would embolden Putin and make him more likely to expropriate western energy companies, including Exxon.

But maybe Tillerson’s vision is just fine. As I wrote about a couple of years ago, Exxon has tried to manage that expropriation risk by tying its ventures in Russia to cooperating with Rosneft in the Gulf of Mexico in what is effectively an exchange of hostages: if Russia takes from Exxon in Russia, Exxon can retaliate against Rosneft here. Maybe that’s what convinced Tillerson he can deal with the devil.  He gets the devil’s goodwill by abandoning Ukraine, and feels confident that the hostage he holds in the GOM will protect XOM against future Russian predations.

Arguably this is a smart bargain from the perspective of Exxon shareholders. But there are huge externalities here. Ukraine is obviously a big loser.  But so are other investors in Russia who are not so fortunate as to have valuable hostages as does Exxon.  But US national interests, and the interests of myriad US allies, notably Poland and the Baltic states, are also severely damaged by Tillerson’s cynical calculation.

This is precisely the circumstance in which it is justifiable, and indeed necessary and desirable, for the government to address a serious collective action problem through the imposition of sanctions on Russia and companies that provide it material and moral support (as Exxon is doing), and through the use of carrots and sticks to cajole companies like Exxon to provide aid and comfort to Ukraine.

But, cynic that I am, I doubt that this will happen.   The reason that Germany and the UK are so adamant against sanctions or any other economic measures against Russia in response to Ukraine is that it hits their businesses’ bottom line, and those businesses are are pressuring their governments very hard to take a soft line on Putin.  No doubt Exxon is doing the same.

Lenin was right about at least one thing, perhaps.  That capitalists would sell you the rope you use to hang them.  Or in this instance, Exxon will gladly sell Russia the rope Putin uses to hang Ukraine.

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