Streetwise Professor

May 25, 2017

OPEC and Inventories: An Exercise in Game Theoretic Futility

Filed under: Commodities,Economics,Energy — The Professor @ 11:37 am

OPEC met today, and agreed to extend its output cuts for another nine months. OPEC’s focus is on “rebalancing the market,” that is, on inducing a decline in world oil stocks to a level well below their current inflated value. This is far easier said than done, and indeed may be impossible because of the inability of OPEC to commit to a path of future output. This is because inventory changes result from changes in the temporal supply and demand balance.

In a competitive market, stocks accumulate when there are unexpected increases in supply or declines in demand, and crucially, these shocks are expected to be highly transitory. Similarly, market participants draw down on stocks when there are unexpected declines in supply or increases in demand that are expected to be highly transitory.

The “transitory” part of the story is very important. It makes sense to store when expected future supply is less than current supply, i.e., when future scarcity is greater than current scarcity. It makes sense to draw down on storage when future scarcity is expected to be low relative to today: why carry inventory to a time of greater abundance? Markets move things from where/when they are abundant to where/when they are scarce. Highly persistent shocks to supply and demand don’t affect the temporal balance, and hence to don’t lead to temporal reallocations. Temporary shocks (or shocks to future supply/demand) also change the temporal balance, and lead to inventory changes.

In my empirical work on the copper market (where inventory data is pretty good), I document that a net supply shock with a half-life of about 1 month drives inventory changes. Much more persistent shocks (e.g., those with a half-life of a year) have virtually no impact on inventory.

Inventories can also decline if expected future supply rises, or expected future demand declines. An increase in expected future supply reduces the future value of oil, and makes it less valuable to hold oil today for future use. Or to put it another way, it is desirable to smooth consumption, so if expected future supply (and hence future consumption) goes up, it makes sense to increase consumption today. This can only be done by drawing down on inventory. (Time travel that would allow bringing the abundant future supply back to the present would do the same thing, but alas, that’s impossible.)

OPEC’s desire to cause a drawdown in inventory would therefore require it to commit to a path of output. Further, this path would involve bigger cuts today than in the future in order to cause a temporal imbalance involving an increase in future supply relative to current supply.

But it is unlikely that this commitment could be credible, precisely because of the reason that OPEC gives for fretting about inventories: that they constrain its pricing power. Assume that inventories do drop substantially. According to its own logic, OPEC would feel less constrained about cutting output even further because non-OPEC supplies (in the form of stocks) have declined. Thus, if inventories indeed fall, OPEC’s logic implies that it would cut output further in the future.

But this path is inconsistent with the path that would be necessary to induce the inventory decline in the first place. Indeed, market participants, looking forward to what OPEC would do in the event that stocks were to decline substantially, would choose to hold on to inventories rather than consume them. Meaning that OPEC would fail in its objective of reducing stocks. In the game between OPEC and other market participants, OPEC’s own rhetoric about inventories and supply/demand balance severely undercuts its ability to cause others to consume inventories rather than continue to hold them.

In sum, OPEC is likely to have little if any ability to influence inventories. To influence inventories, it would have to commit to an output path, but that commitment is not subgame perfect/time consistent.

Instead, inventories will be driven by factors outside of OPEC’s control, namely, unexpected transitory changes in supply and demand. But the effect of even those shocks will depend on how market participants believe OPEC will behave when inventories are low. The supply changes will mainly result from shocks to non-OPEC producers (e.g., US shale producers) and to politically unstable OPEC nations like Libya, Nigeria, and Venezuela. Inventory changes may also result from information about the durability of output cut agreements and cheating: a surprise increase in the estimates of future cheating would tend to cause inventories to decline today. Thus, perversely from OPEC’s perspective, its wish of lower inventories may come true only when it is widely believed that OPEC output discipline will soon collapse.

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May 8, 2017

Whatever Igor Wants, Igor Gets: Primitive Capital Accumulation, a la Sechin

Filed under: Economics,Energy,Politics,Russia — The Professor @ 7:34 pm

Apparently winning the “auction” for Bashneft (after it was widely claimed by Putin, and others, that a sale of the company to Rosneft would be a sham privatization) wasn’t enough for Igor Sechin. Igor is now after MOAR, and is using the “legal” process to get it. Rosneft has filed suit against the former owner of Bashneft, Vladimir Evtushenkov’s holding company Sistema, and is asking for a cool $1.9 billion. News of the suit knocked almost 40 percent off of Sistema’s stock price.

The grounds of the lawsuit are unclear.

In the past Sechin has complained about a sale of a Bashneft asset, oil services company Targin, to Sistema at an allegedly knock-down price. He has also criticized contracts between Targin and Bashneft entered into after the sale as unduly favorable to Sistema.

Both of these allegations are plausible. This is Russia, after all, and related-party transactions and Credit Mobilier-like contracting scams are classic ways of tunneling assets.

Recently Rosneft has had to spend $100 million to address safety problems at Bashneft refineries. Rosneft claims that it has found “irregularities.”

If commercial and legal logic mattered (a big if, I know), the alleged shenanigans involving Targin would not be grounds for a suit, and it would be hard to imagine how Rosneft would have standing. Recall that Bashneft was seized by the state in 2014, and Rosneft bought it from the government. So any uneconomic transactions in 2014 or earlier would not harm Rosneft: it would have known that Targin was not included, and what the contracts were. So Rosneft was not harmed by what happened before the company was nationalized.

Failure to detect “irregularities” at the refineries would suggest a lack of due diligence if these were not discovered prior to buying from the state, or if they were known, they would have been reflected in the price. Again, it is hard to see how Rosneft could have been defrauded. Further, there’s a big difference between a $100 million repair bill and a $1.9 billion legal claim.

But does it matter, really? Any legal claim is almost surely a pretext to expropriate a politically vulnerable oligarch who is, shall we say, Без крыши. And this strategy is in Rosneft’s DNA. After all, the company was built primarily on the assets seized from Yukos, and another big asset–TNK-BP–was obtained only after a campaign of pressure against BP (although the Russian AAR consortium held their own and were paid in cash). Put differently, Rosneft was built by  what Marxists called primitive capital accumulation–force and fraud, sometimes operating under the color of legal authority.

But there is a price to be paid for this. It shows that Russia remains a fraught place for investors with assets that come under the covetous eyes of Sechin, or others like him. This depresses valuations for Russian companies, and is a serious drag on investment. No wonder year in and year out Russia is notable for the small share of investment, which runs about 18 percent of GDP, very low for a country in its stage of development. (The world rate is about 24 percent.)

But whatever Igor wants, Igor gets, evidently. Even though what’s good for Igor isn’t good for Russia.

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April 21, 2017

The Left Loses Its Mind (Again!) Over Citgo and Trump

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 5:23 pm

Donald Trump is the left’s Theory of Everything. To be more precise, it is the left’s Theory of Everything Bad.

Latest (nut) case in point: Rachel Maddow is blaming Trump for the riots in Venezuela. No-really!

The theory: the Federal Election Commission revealed that Citgo, a US subsidiary of Venezuela’s national oil company/basketcase PDVSA had donated $500,000 to Trump’s inauguration. According to Maddow, this sent Venezuela’s citizenry, which is reeling under an economic catastrophe wrought by Chavez, Maduro, and “Bolivarian Socialism”–a cause that the left from Bernie Sanders to Danny Glover to many others has swooned over for years–into paroxysms of rage at the thought that their national patrimony was paying to honor the evil Trump.

To start with, there have been violent protests in Venezuela for years. The country is facing economic collapse. PDVSA has been looted by the Chavistas for going on 15 years now, and is a complete wreck. $500K is chump change compared to what the leftist darlings have stolen from the company, or destroyed through their grotesque mismanagement–would that the left shown equal concern over THAT. The country is on the verge of hyperinflation. There are food lines. There is no toilet paper–unless you count the currency the Venezuelan central bank is cranking out like nobody’s business. I could go on and on.

So no, Rachel. The Citgo contribution to the inaugural fund–which represents less than .5 percent of the total raised–is not even a piece of dust on the straw on the camels back: the camel’s back was broken long ago, by the vanguard of socialism that Rachel Maddow and her crowd lionized for years. The rage of the Venezuelan people is directed precisely where it should be: at Maduro, the Bolivarian revolution, and the dirt-napping Chavez.

Maddow’s attempt to lay Venezuela’s social explosion at Trump’s feet is very revealing. She and her ilk think that everything is about us–the US that is. Everything. And now in the minds of her and her ilk, everything in the US is all about Trump. So everything everywhere is all about Trump, and supposedly everyone in the world is as obsessed with Trump as they are, and blame him for all that is bad in the world, like they do.

This is clinical solipsism, broadcast live on MSNBC and CNN daily.

And in fact, Rachel should be ecstatic at Citgo’s donation. The company wasn’t spending the money of the Venezuelan people–it was spending Igor Sechin’s money! Rosneft brilliantly–brilliantly I say!–lent PDVSA $5 billion, and negotiated a 50 percent stake in Citgo as partial security. (Rosneft’s brilliance is only surpassed by the Chinese, who lent Venezuela $55 billion. Hahahaha. Good luck collecting on that one Xi! Well played.) Given PDVSA’s parlous condition, it is highly likely that Rosneft will get control of Citgo, meaning that every dollar it spends now is a dollar less in Igor’s pocket.

So the left should be happy! Trump has picked Russia’s pocket!

But no, they are also obsessing about the possibility that Rosneft will get control of Citgo’s US refineries (which represent a whopping ~2.5 percent of US refining capacity) and its gas stations (who cares?). The refineries ain’t going anywhere, so the impact on the US market will be nil. Anything Rosneft would do in operating these refineries that could hurt the US would hurt Rosneft even more. So don’t count on it happening, and if it does, it would be another own goal that weakens Russia.

Again, the left should be experiencing schadenfreude, not panic. Rosneft lent large money to a deadbeat. It’s not going to get paid back so it is seizing assets, and will end up losing money. Playing repo man is hardly the road to riches. It just mitigates the losses from making a bad loan, and it is the bad loan that is the real story here.

But to figure that out would require actual thinking, which is not exactly the strong point of Rachel, et al. Because they have everything figured out. Trump did it! And if Trump is connected, it’s bad!

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March 11, 2017

One Degree of Idiocy: Michael Weiss Expounds on Trump-Putin Connections

Filed under: Energy,Politics,Russia — The Professor @ 9:59 pm

Some years ago, “Six Degrees of Kevin Bacon” was somewhat popular. The object of the game was to connect any randomly chosen actor to Kevin Bacon in six movies or less.

Today, the game that is all the range in DC and the media is Six Degrees of Donald Trump. The main difference is that the starting point is not any randomly chosen individual, but one very specific individual: Vladimir Putin.

Not surprisingly, the most  demented and absurd entry in this game was submitted by Michael Weiss of the Daily Beast. Here’s how it goes. Putin is connected to Gazprom. Gazprom was a participant in a consortium (which also included European energy giants Shell, ENGIE, Winterhall, OMV, and Uniper) to build the Nordstream 2 pipeline. This consortium hired McClarty Associates as a lobbyist. McClarty employs ex-US diplomat Richard Burt. Burt made suggestions about Russia policy that a third party passed on to Trump. As a bonus connection, Burt attended two dinners hosted by Jeff Sessions, and wrote white papers for him.

Burt has never met Trump. Like many in the foreign policy establishment, Burt advocates a pragmatic approach to Russia. He was engaged in diplomacy with the USSR while in the Reagan administration (hardly a hotbed of commsymps and Russophiles), and shockingly, has continued to do business in Russia in the past 30 years. But apparently under the Oceania Has Always Been at War With Eastasia mindset that dominates DC at present, this is tantamount to Burt being a Russian puppet (a view that requires the consignment of most of the history of that period, not least of all that of the Obama administration 2009-2014, to the Memory Hole).

As far as connections are concerned, this is about as tenuous as one can get. The headline (“The Kremlin’s Gas Company Has a Man in Trumpland”) is a vast overstatement. For one thing, Burt is barely in Trumpland. Indeed, although the article says that the connection offers “Republican bona fides,” it is almost certain that was not the reason for hiring McClarty. Astoundingly, the article fails to note that said McClarty himself is a Clintonoid: Mack McClarty is from an old-time Arkansas political family, was closely connected to Bill Clinton in Arkansas, and was Clinton’s first chief of staff. Weiss ominously starts his piece with a recounting of the importance of having a krysha (“roof”, i.e., political protection) and insinuates that hiring Burt was intended to obtain a roof in the Trump administration. But if anything, it would have been an entree into a Clinton administration–which, of course, everybody figured was an inevitability.

Furthermore, perhaps Weiss hasn’t noticed, but “Republican bona fides” are hardly a ticket into Trumpland. Trump’s relationship with the party establishment varies between the hostile and the transactional.

And the timing is all wrong: the contract was signed before Trump was even the Republican nominee, and at a time when no one figured he would be the party’s candidate, let alone president. Talk about a deep out-of-the-money option.

It’s also rather bizarre that the connection between Burt and Gazprom also involves several very large European companies, and a purely European issue. There is nary an American company involved, and the matter is an intramural European spat pitting eastern vs. western EU countries. Wouldn’t you think that if you are trying to buy influence in the United States, you’d engage McClarty/Burt on an issue that would allow them to interact with US officials and politicians?

Further, if you are going to buy a krysha in the Trump administration, dontcha think you’d want to hire somebody who, you know, actually knows Trump?

But our Mikey is not deterred by such pesky details. He has a connection between Putin and Trump, and he is going to flog it for all it’s worth. Which isn’t much.

Of course the details of the Burt-Trump (non-) connection alone wouldn’t make for much of an article, especially for Weiss, who typically drones on paragraph after endless paragraph. So he adds gratuitous ad hominem attacks on Burt, such as comparing him to the late Russian UN ambassador Vitaly Churkin (career diplomats are a type–who knew?), and trotting out Bill Browder, who snarked about how gauche the Russian influence efforts were back in the bad old days (you know, when he was on the make in Russia) and yet again drags out the corpse of his lawyer, Sergei Magnitsky, in order to score political points.

Weiss also notes that McClarty has been retained by a Mikhail Fridman company in the UK, but fails to point out that Fridman is hardly a Putin pet. Indeed, Fridman took on Sechin, and came out the winner. But in Weiss’ worldview–which makes that of a 1950s John Bircher look nuanced by comparison–all them Russkies are Putin pawns.

And the anti-Trump establishment should at least get its story straight. On the same day that Weiss’ article appeared, Foreign Policy ran a piece claiming that Tillerson is a weak Secretary of State (the weakest ever, in fact!) because he doesn’t have Trump’s ear. So Trump ignores his own Secretary of State but somehow a guy whom he has never met and who has no position in the administration exerts some great influence over him? And weren’t we told a month ago that Tillerson was going to be Putin’s cat’s paw in the Trump administration because of his extensive dealings there (including with Gazprom in Sakhalin I)? But now he’s a nobody? Damn, that Memory Hole is getting a helluva workout.

Indeed, if the Burt connection (such as it is) and the like are the best that these people can come up with, they are doing a great job of showing how limited and tenuous Trump’s ties to Russia are. And remember the whole point of the Kevin Bacon game: it was a cutesy way of illustrating the “six degrees of association” theory, which posits that any two people in the world are separated by no more than six acquaintances. Any two people, no matter how obscure. Play Six Degrees of Vladimir Putin using yourself as the terminal connection: I bet you could connect with Vlad in six steps or less. I know I can. And does make me some sort of Putinoid? Hardly, as anyone who has read this blog knows.

When major international figures are involved, moreover, there are inevitably multiple such connections, often involving less than six steps. So finding a connection is about as earth shattering as finding sand on a beach. Furthermore, when considering a figure like Trump, he has myriad connections to other figures, many of whom may have interests and views contrary to Putin’s/Russia’s, or orthogonal thereto. Ignoring all these other contrary connections and focusing monomaniacally on ties to Putin and Russia when attempting to predict or explain Trump’s motivations is beyond asinine. In econometrics, this is called omitted variable bias–if you omit relevant variables, you get a very biased estimate of the influence of the ones you include.

But this is what passes for journalism in the United States right now: parlor games posing as deep analysis, latent with dark meanings.

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March 10, 2017

US Shale Puts the Saudis and OPEC in Zugzwang

Filed under: Commodities,Derivatives,Economics,Energy,Politics — The Professor @ 2:55 pm

This was CERA Week in Houston, and the Saudis and OPEC provided the comedic entertainment for the assembled oil industry luminaries.

It is quite evident that the speed and intensity of the U-turn in US oil production has unsettled the Saudis, and they don’t know quite what to do about it. So they were left with making empty threats.

My favorite was when Saudi Energy Minister Khalid al-Falih said there would be no “free rides” for US shale producers (and non-OPEC producers generally). Further, he said OPEC “will not bear the burden of free riders,” and “[w]e can’t do what we did in the ’80s and ’90s by swinging millions of barrels in response to market condition.”

Um, what is OPEC going to do about US free riders? Bomb the Permian? If it cuts output, and prices rise as a result, US E&P activity will pick up, and damn quick. The resulting replacement of a good deal of the OPEC output cut will limit the price impact thereof. The best place to be is outside a cartel that cuts output: you can get the benefit of the higher prices, and produce to the max. That’s what is happening in the US right now. OPEC has no credible way of showing off, or threatening to show off, free riders.

As for not doing what they did in the ’80s, well that’s exactly OPEC’s problem. It’s not the ’80s anymore. Now if it tries to “swing millions of barrels” to raise price, there is a fairly elastic and rapidly responding source of supply that can replace a large fraction of those barrels, thereby limiting the price impact of the OPEC swingers, baby.

Falih’s advisers were also trying to scare the US producers. Or something:

“One of the advisors said that OPEC would not take the hit for the rise in U.S. shale production,” a U.S. executive who was at the meeting told Reuters. “He said we and other shale producers should not automatically assume OPEC will extend the cuts.”

Presumably they are threatening a return to their predatory pricing strategy (euphemistically referred to as “defending market share”) that worked out so well for them the last time. Or perhaps it is just a concession that US supply is so elastic that it makes the demand for OPEC oil so elastic that output cuts are a losing proposition and will not endure. Either way, it means that OPEC is coming to the realization that continuing output cuts are unlikely to work. Meaning they won’t happen.

OPEC also floated cooperation with US producers on output. Mr. al-Falih, meet Senator Sherman! And if the antitrust laws didn’t make US participation in an agreement a non-starter, it would be almost impossible to cartelize the US industry given the largely free entry into E&P and the fungibility of technology, human capital, land, services, and labor. Maybe OPEC should hold talks with the Texas Railroad Commission instead.

Finally, in another laugh riot, OPEC canoodled with hedge funds. Apparently under the delusion that financial players play a material role in setting the price of physical barrels, rather than the price of risk. Disabling speculation could materially help OPEC only by raising the cost of hedging, which would tend to raise the costs of E&P firms, especially the more financially stretched ones. (Along these lines, I would argue that the big increase in net long speculative positions in recent months is not due to speculators pushing themselves into the market, but instead they have been pulled into the market by increased hedging activity that has occurred due to the increase in drilling activity in the US.)

Oil prices were down hard this week, from a $53 handle to a (at the time of this writing) $49.50 price. The first down-leg was due to the surprise spike in US inventories, but the continued weakness could well reflect the OPEC and Saudi messaging at CERA Week. The pathetic performance signaled deep strategic weakness, and suggests that the Saudis et al realize they are in zugzwang: regardless of what they do with regards to output, they are going to regret doing it.

My heart bleeds. Bleeds, I tells ya!


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March 3, 2017

The Rocks Didn’t Go Anywhere. Go Figure.

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 2:58 pm

The conventional wisdom during the oil price collapse that started in mid-2014 and which accelerated starting in November of that year when the Saudis decided not to cut output was that the Kingdom was engaged in a predatory pricing strategy intended to drive out US shale producers. I mocked this in real time. Nothing really special about that analysis: economists have known for a long time that predatory strategies are almost never rational. They are irrational because the predator has to incur losses to cause its competitors to reduce production, but the competitors’ resources are unlikely to leave the industry permanently: they can come flooding back in when the predator attempts to restrict output to raise prices. Thus, the predator suffers all the pain at selling at low prices, but cannot recoup these losses by selling at higher prices later.

In the case of shale, the rocks weren’t going anywhere. Obviously. When prices fell, companies just drilled fewer wells–a lot fewer wells–but the rocks remained. The knowledge of where the right rocks were remained too. The knowledge of how to drill the rocks didn’t disappear. Idled rigs went into storage. Yes, some labor (including some skilled labor left), but this resource is pretty flexible and can come back quickly when demand goes up. E&P companies incurred financial losses, and some experienced financial distress and even bankruptcy, but this did not drive them out of the industry permanently, and did not drive out the human and physical capital that these firms employed. New capital required to drill new wells is available to E&P firms based on future prospects, not past failures. Indeed, one of the functions of bankruptcy and restructuring of distressed firms is to clean up balance sheets so that old debt doesn’t impede the ability of firms to take on positive NPV projects.

In sum, even though drilling activity plummeted along with prices, the resources needed to ramp up production weren’t destroyed or driven out of the industry. They were only waiting for more favorable prices. The industry went into hibernation: it didn’t die.

OPEC’s decision to cut output to raise prices–and the Saudis going beyond their share of output cuts to strengthen OPEC’s effect–provided the opportunity the industry had been waiting for. It rapidly awoke from its slumbers. Rig counts did a U-turn, up 90 percent in 9 months. And so has output. John Kemp reports:

U.S. crude oil production appears to be rising strongly thanks to increased shale drilling as well as rising offshore output from the Gulf of Mexico.

Production averaged almost 9 million barrels per day (bpd) in the four weeks to Feb. 24, according to the latest weekly estimates published by the Energy Information Administration.

Production has been on an upward trend since hitting a cyclical low of 8.5 million bpd in September (“Weekly Petroleum Status Report”, EIA, March 1).

Javier Blas chimes in:

“North American oil companies are going to increase their spending by 25 percent in 2017 compared to last year,” said Daniel Yergin, the oil historian-cum-consultant who hosts the CERAWeek. “The increase reflects the magnetism of U.S. shale.”

U.S. benchmark West Texas Intermediate traded at $52.79 a barrel on Friday. Futures bounced between $51.22 and $54.94 in February.

So far this year, U.S. energy companies have raised $10.5 billion in fresh equity, with shale and oil service groups drawing the most investment, the best start of the year since at least 1999 and equal to a third of what the sector raised in the whole of 2015. [A clear indication that “debt overhang” is not constraining the ability to access capital to fund drilling programs, which would have been the only way the Saudi strategy had a prayer of working.]

In Midland, the Texas city at the center of the Permian basin, the activity rush is palpable, as is the threat of higher costs for shale companies. The county’s active-rig total ranks second in the U.S., behind only Reeves County further to the west.

“You could see the town’s energy is back,” said Alan Means, founder of Cambrian Management Ltd., a Midland-based firm that operates more than 200 oil wells in the Permian across Texas and New Mexico. “The rigs are up again, the fracking crews are busier and the highway traffic is increasing.”

As activity rises, the man-camps in the town outskirts are flush again, with workers arriving from the Bakken in Montana and North Dakota, and from as far way as Canada. The 1,000-bed Permian Lodging camp is now 100 percent full, up from 65 percent in July, according to camp owner Ralph McIngvale. [See how quickly labor resources can return?]

Shale firms have also become more efficient.

In sum, the predatory strategy hasn’t made shale go away. Now, the longer the Saudis and the rest of OPEC (and the non-OPEC countries that have joined in) hold down output, the larger the fraction of that output loss will be redeemed by resurgent shale production in the US.

In other words, shale makes the the demand for OPEC (and non-OPEC cooperators’) oil pretty elastic. This raises serious questions about the rationality of the output cuts from the perspective of the cutters, especially the big countries like Saudi Arabia (which has cut substantially–more than it promised) and Russia (whose cooperation is more equivocal). This, in turn, makes the durability of the cuts problematic.

The quick turnaround in US shale provides a new data point for the Saudis, Russians, et al. Their dreams that they could make rocks disappear–or that they could make it permanently unattractive to extract oil from their rocks–have proved chimerical. Persisting in output cuts will become progressively less profitable, and indeed, is likely to be downright unprofitable soon. What’s the over-under on how long until they figure that rocks will outlast them, and give up the output cut game?

Teaser: I am currently slogging through oil well data (tens of thousands of wells in all the major basins) in a study of the sources of productivity gains in shale production. Hopefully I will be able to report some results soon. Initial results are particularly ominous for OPEC. I am finding evidence of learning-by-doing in both oil and gas. That is, drilling wells today generates knowledge that enhances future productivity and lowers future costs. This means that the increased shale output resulting from OPEC’s current attempt to prop up prices will increase the US shale industry’s future productivity, making it even harder for OPEC to keep prices high months or years from now.

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March 1, 2017

Ivan Glasenberg: Mistaking Luck for Genius?

Filed under: China,Commodities,Economics,Energy — The Professor @ 8:58 pm

Glencore is back from the brink, posting a $1.4 billion profit for 2016. When I first read about the 2016 results, I wondered aloud to a friend whether Ivan Glasenberg would have learned something from the company’s near death experience, or instead would consider the fall someone else’s fault, and the resurrection the result of his genius. I should have known it would be the latter.

Glasenberg has been gloating about the 2016 results, and flaunting them as some sort of vindication. He is openly musing about paying a $20 billion dividend to the company’s “long suffering shareholders,” and is looking for acquisitions, including in North American grain trading.

The fact is that Glencore and Ivan Glasenberg were (and are) just along for a ride on the commodity price roller coaster, which is located at a Chinese amusement park. When the roller coaster plunged as the Chinese economy shuddered in 2015, Glencore plunged along with it. Now, in large part due to Chinese policy moves that have caused the prices of coal and other raw materials to climb again, Glencore has rebounded. Management genius had nothing to do with it.

Well, that’s not completely true. Glasenberg made the conscious choice to transform Glencore from a trading firm that was basically flat price neutral to a mining firm with a big exposure to the flat prices of coal and copper in particular. So the big drop and the rebound are the result of his choice.

When Glencore was in peril in 2015, I said that its fate was dependent on commodity prices, and hence on Chinese policy, rather than any decision that management can make. I said that Glencore was along for the ride. That turned out to be true. It remains true going forward. That was the fundamental strategic choice that has shaped and will continue to shape its performance. Management can at best optimize performance over the cycle, but the cycle will dominate.

Prior to 2015, Glencore management did not optimize. The firm was over-leveraged: it continued to operate with trading-firm like leverage levels even though it faced bigger commodity price risks. Glasenberg/Glencore have cut down on debt in the past year, and this reduces the likelihood of a repeat of 2015–if they stick to a lower leverage policy going forward. But the fact is that the biggest driver of Glencore’s fate is not decisions made in Baar, but the whims of policymakers in Beijing.

It is interesting to compare Glasenberg’s crowing to the more muted tones of other mining firms which have also profited from the rebound. The managements of these other firms apparently realize that what the cycle giveth, the cycle can taketh away. Is Peabody Coal’s management preening over the company’s rebound? No. They are silently grateful that factors outside of their control have turned their way. Similarly, Noble eked out a profit, but its management isn’t breaking their arms patting themselves on the back.

Traders typically make deals of relatively short duration, and it is possible to evaluate trading decisions and trading acumen based on P/L. But by transforming Glencore into a mining company with a  supersized trading arm, Glasenberg purposefully made a very long term trade with a duration of years (decades, even): quarterly or even annual fluctuations in P/L tell you little about the wisdom of such a trade. It is therefore rather disturbing to watch Glasenberg gloat on the basis of a profitable year driven by a cyclical turn with which he had exactly zero to do with.

And let’s put this in perspective. Glencore lost $5 billion in 2015. 2016 made up less than 30 percent of that loss. There is still a long way to go to determine whether the big, multi-year trade that Glencore made a few years ago was a smart play or not.

Perhaps Glasenberg still has a trader’s mindset, and a trader’s time horizon, suited for a transaction cycle measured in weeks or months, not years or decades. If so, the company might be in for a big future fall, because its guiding light is apt to mistake luck for skill.

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February 20, 2017

Trolling Brent

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 10:14 am

Platts has announced the first major change in the Brent crude assessment process in a decade, adding Troll crude to the “Brent” stream:

A decline in supply from North Sea fields has led to concerns that physical volumes could become too thin and hence at times could be accumulated in the hands of just a few players, making the benchmark vulnerable to manipulation.

Platts said on Monday it would add Norway’s Troll crude to the four British and Norwegian crudes it already uses to assess dated Brent from Jan 1. 2018. This will join Brent, Forties, Oseberg and Ekofisk, or BFOE as they are known.

This is likely a stopgap measure, and Platts is considering more radical moves in the future:

It is also investigating a more radical plan to account for a possible larger drop-off in North Sea output over the next decade that would allow oil delivered from as far afield as west Africa and Central Asia to contribute to setting North Sea prices.

But the move is controversial, as this from the FT article shows:

If this is not addressed first, one source at a big North Sea trader said, the introduction of another grade to BFOE could make “an assessment that is unhedgeable, hence not fit for purpose”. “We don’t see any urgency to add grades today,” he added. Changes to Brent shifts the balance of power in North Sea trading. The addition of Troll makes Statoil the biggest contributor of supplies to the grades supporting Brent, overtaking Shell. Some big North Sea traders had expressed concern Statoil would have an advantage in understanding the balance of supply and demand in the region as it sends a large amount of Troll crude to its Mongstad refinery, Norway’s largest.

The statement about “an assessment that is unhedgeable, hence not fit for purpose” is BS, and exactly the kind of thing one always hears when contracts are redesigned. The fact is that contract redesigns have distributive effects, even if they improve a contract’s functioning, and the losers always whinge. Part of the distributive effect relates to issues like giving a company like Statoil an edge . . . that previously Shell and the other big North Sea producers had. But part of the distributive effect is that a contract with inadequate deliverable supply is a playground for big traders, who can more easily corner, squeeze, and hug such a contract.

Insofar as hedging is concerned, the main issue is how well the Brent contract performs as a hedge (and a pricing benchmark) for out-of-position (i.e., non-North Sea) crude, which represents the main use of Brent paper trades. Reducing deliverable supply constraints which contribute to pricing anomalies (and notably, anomalous moves in the basis) unambiguously improves the functioning of the contract for out-of-position players. Yeah, those hedging BFOE get slightly worse hedging performance, but that is a trivial consideration given that the very reason for changing the benchmark is the decline in BFOE production–which now represents less than 1 percent of world output. Why should the hair on the end of the tail wag the dog?

Insofar as the competition with WTI is concerned, the combination of larger US supplies, the construction of pipelines to move supplies from the Midcon (PADDII) to the Gulf (PADDIII)  and the lifting of the export ban have restored and in fact strengthened the connection of WTI prices to seaborne crude prices. US barrels are now going to both Europe and Asia, and US crude has effectively become the marginal barrel in most major markets, meaning that it is determining price and that WTI is an effective hedge (especially for the lighter grades). And by the way, the WTI delivery mechanism is much more robust and transparent than the baroque (and at times broken) Brent pricing mechanism.

As if to add an exclamation point to the story, Bloomberg reports that in recent months Shell has been bigfooting–or would that be trolling?–the market with big trades that have arguably distorted spreads. It got to the point that even firms like Vitol (which are notoriously loath to call foul, lest someone point fingers at them) raised the issue with Shell:

While none of those interviewed said Shell did anything illegal, they said the company violated the unspoken rules governing the market, which is lightly regulated. Executives of several trading rivals, including Vitol Group BV, the world’s top independent oil merchant, raised objections with counterparts at Shell last year, according to market participants.

What are the odds that Mr. Fit for Purpose is a Shell trader?

All of this is as I predicted, almost six years ago, when everyone was shoveling dirt on WTI and declaring Brent the Benchmark of the Forever Future:

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

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

That’s exactly how things have worked out, even down to the point about the difficulties of getting the big boys to play together (a lesson gained through extensive personal experience, some of which is detailed in the post). Just call me Craignac the Magnificent. At least when it comes to commodity contract design 😉

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February 15, 2017

Never Argue From a Price Change, Oil Market Edition

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 9:19 pm

In the FT, Greg Meyer ponders a puzzle: “A mystery is confounding the US oil market: when inventories rise, prices rise, too.”

Yes, it is normally the case that inventories and prices, and inventories and the spot-deferred spread, move in opposite directions. But this does not have to be the case.

The typical case is based on the following economic logic. Inventories respond mainly to current, and temporary, supply and demand shocks. If current demand falls, and this demand shock is anticipated to be temporary, then current availability rises relative to expected future availability. The efficient way to respond to this is to store more today because the commodity is abundant today relative to what is expected in the future, and efficient allocations move resources from where they are relatively abundant to where they are relatively scarce. Storage increases expected future availability, which depresses expected future prices. The nearby price must fall relative to the expected future price in order to encourage storage, and together the fall in the expected future price and the fall in the nearby price relative to the expected future price causes the nearby price to fall.

A similar story holds with respect to a temporary increase in current supply.

Parenthetically, the temporary nature of the shock is important in driving the change in storage because this causes a change in relative availability that is necessary to make it optimal to store more. A shock that is anticipated to persist does not change current availability relative to expected future availability, so there is no benefit to shifting resources through time via storage. A persistent shock causes a parallel shift (roughly) in the forward curve, and no change in storage. In my academic research, I show that in a dynamic storage model supply/demand shocks with a very short half-life (on the order of 30 days) drive storage behavior, and that very persistent shocks drive the overall level of prices.

But there are other kinds of shocks. One kind of shock is to anticipated future demand or supply. Let’s say supply is expected to decline in the future. This increase in expected future scarcity can be mitigated by storing more today (i.e., reducing current consumption). This spreads the effect of the anticipated future supply loss over time, and thereby smooths consumption in an efficient way. The only way to reduce current consumption in order to increase inventories is to increase the spot price. So in this scenario, (a) inventories and prices move in the same direction, and (b) inventories and calendar spread (deferred minus nearby) move in opposite directions in order to reward the higher amount of storage.

Here’s a real world example. The Energy Policy Act of 2005 mandated increased use of renewable fuels–notably ethanol–in future years. This caused an increase in anticipated future demand for corn used to produce ethanol. When the act was passed, the supply of corn was basically fixed. One way of responding to the expected increase in future corn demand was to store more immediately (thereby carrying current supplies into the future when demand was going to be higher). Given the fixed supply, the only way to achieve this higher storage (and hence reduced current consumption) was for prices to rise.

Therefore, one explanation for the positive co-movement between prices and inventories is a shock to the expected future supply/demand balance. For example, an increased likelihood that OPEC will extend its supply cuts beyond April could produce this result.

Another kind of shock that can lead to a positive co-movement between spot prices and inventories is a shock to supply/demand volatility: I discussed this in an early blog post, and later analyzed this formally in my 2011 book. (A good example of the synergy between blogging and rigorous research, BTW.)

The intuition is this. Inventories are a way of insuring against uncertainty: putting something aside for a rainy day, as it were. If fundamental economic uncertainty goes up, it is efficient to hold more inventory. Since supply is fixed in the short run, the only way to increase inventory is to reduce current consumption. The only way to increase current consumption is for spot prices to rise. Moreover, to compensate increased inventory holding, futures prices must rise relative to spot prices. Therefore, for this kind of shock (like a shock to future demand) the forward curve rises and becomes steeper (i.e., increased contango).

So although the positive co-movement between spot prices and inventory may be unusual, it can occur in a rational, efficient market. It depends on the underlying driving shock. The typical case occurs when shocks to current supply/demand dominate. The more unusual case occurs when the shocks are to expected future supply and demand, or to fundamental volatility.

This relates directly to something I mentioned in the “kill the economists” post yesterday. Specifically: never argue from a price change. It is necessary to understand what is causing the price change. When there are multiple shocks that can affect prices (e.g., supply and demand shocks; current or future shocks; shocks to supply/demand volatility as well as to the level of supply/demand), just looking at the pice movement is not sufficient to draw conclusions about either its effect, or its cause. Indeed, it is even misleading to talk about the “effect” of the price change, because the price change is itself the endogenous effect of underlying causes/shocks.

The usual way to sort out what is going on is to look at quantities as well as prices. For instance, in a simple supply-demand model if you see prices go down, that could be because supply rose or demand fell. You can figure out which only by observing quantity: if you see quantity fall, for instance, you know that a demand decline caused the movements.

This means that the recent co-movements in oil inventories and prices reflects market participants’ assessment that the supply/demand balance is expected to tighten in the future, or that fundamental uncertainty is going up, or both.




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February 4, 2017

The Regulatory Road to Hell

One of the most encouraging aspects of the new administration is its apparent commitment to rollback a good deal of regulation. Pretty much the entire gamut of regulation is under examination, and even Trump’s nominee for the Supreme Court, Neil Gorsuch, represents a threat to the administrative state due to his criticism of Chevron Deference (under which federal courts are loath to question the substance of regulations issued by US agencies).

The coverage of the impending regulatory rollback is less that informative, however. Virtually every story about a regulation under threat frames the issue around the regulation’s intent. The Fiduciary Rule “requires financial advisers to act in the best interests of their clients.” The Stream Protection Rule prevents companies from “dumping mining waste into streams and waterways.” The SEC rule on reporting of payments to foreign governments by energy and minerals firms “aim[s] to address the ‘resource curse,’ in which oil and mineral wealth in resource-rich countries flows to government officials and the upper classes, rather than to low-income people.” Dodd-Frank is intended prevent another financial crisis. And on and on.

Who could be against any of these things, right? This sort of framing therefore makes those questioning the regulations out to be ogres, or worse, favoring financial skullduggery, rampant pollution, bribery and corruption, and reckless behavior that threatens the entire economy.

But as the old saying goes, the road to hell is paved with good intentions, and that is definitely true of regulation. Regulations often have unintended consequences–many of which are directly contrary to the stated intent. Furthermore, regulations entail costs as well as benefits, and just focusing on the benefits gives a completely warped understanding of the desirability of a regulation.

Take Frankendodd. It is bursting with unintended consequences. Most notably, quite predictably (and predicted here, early and often) the huge increase in regulatory overhead actually favors consolidation in the financial sector, and reinforces the TBTF problem. It also has been devastating to smaller community banks.

DFA also works at cross purposes. Consider the interaction between the leverage ratio, which is intended to insure that banks are sufficiently capitalized, and the clearing mandate, which is intended to reduce systemic risk arising from the derivatives markets. The interpretation of the leverage ratio (notably, treating customer margins held by FCMs as an FCM asset which increases the amount of capital it must hold due to the leverage ratio) makes offering clearing services more expensive. This is exacerbating the marked consolidation among FCMs, which is contrary to the stated purpose of Dodd-Frank. Moreover, it means that some customers will not be able to find clearing firms, or will find using derivatives to manage risk prohibitively expensive. This undermines the ability of the derivatives markets to allocate risk efficiently.

Therefore, to describe regulations by their intentions, rather than their effects, is highly misleading. Many of the effects are unintended, and directly contrary to the explicit intent.

One of the effects of regulation is that they impose costs, both direct and indirect.  A realistic appraisal of regulation requires a thorough evaluation of both benefits and costs. Such evaluations are almost completely lacking in the media coverage, except to cite some industry source complaining about the cost burden. But in the context of most articles, this comes off as special pleading, and therefore suspect.

Unfortunately, much cost benefit analysis–especially that carried out by the regulatory agencies themselves–is a bad joke. Indeed, since the agencies in question often have an institutional or ideological interest in their regulations, their “analyses” should be treated as a form of special pleading of little more reliability than the complaints of the regulated. The proposed position limits regulation provides one good example of this. Costs are defined extremely narrowly, benefits very broadly. Indirect impacts are almost completely ignored.

As another example, Tyler Cowen takes a look into the risible cost benefit analysis behind the Stream Protection Rule, and finds it seriously wanting. Even though he is sympathetic to the goals of the regulation, and even to the largely tacit but very real meta-intent (reducing the use of coal in order to advance  the climate change agenda), he is repelled by the shoddiness of the analysis.

Most agency cost benefit analysis is analogous to asking pupils to grade their own work, and gosh darn it, wouldn’t you know, everybody’s an A student!

This is particularly problematic under Chevron Deference, because courts seldom evaluate the substance of the regulations or the regulators’ analyses. There is no real judicial check and balance on regulators.

The metastasizing regulatory and administrative state is a very real threat to economic prosperity and growth, and to individual freedom. The lazy habit of describing regulations and regulators by their intent, rather than their effects, shields them from the skeptical scrutiny that they deserve, and facilitates this dangerous growth. If the Trump administration and Congress proceed with their stated plans to pare back the Obama administration’s myriad and massive regulatory expansion, this intent-focused coverage will be one of the biggest obstacles that they will face.  The media is the regulators’ most reliable paving contractor  for the highway to hell.

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