Streetwise Professor

June 26, 2008

Oh Yeah? You and What Navy?

Filed under: Military,Politics,Russia — The Professor @ 9:29 am

More bluster from the Russian military, this time over the Arctic:

“After several countries contested Russia’s rights for the resource-rich continental shelf in the Arctic, we have immediately started the revision of our combat training programs for military units that may be deployed in the Arctic in case of a potential conflict,” Lt. Gen. Vladimir Shamanov, who heads the Defense Ministry’s combat training directorate, told the Krasnaya Zvezda (Red Star) newspaper. . . .

Meanwhile, the Defense Ministry has already announced plans to expand the presence of the Russian Navy in the world’s oceans, including the Arctic, and extend the operational range of submarines deployed in the northern latitudes.

The last paragraph is particularly choice. Even by the standards of the shambolic Russian military, the Navy is incredibly decrepit. Its submarines–even its boomers–seldom patrol. Its lone carrier is a floating wreck:

Every time the Kutzenov enters blue water, its main engines fail, and the ship must be towed to a shipyard for major overhaul. In short, it is not now, nor ever has been, a dependable combat asset.

Recently, a Russian repair auxiliary vessel (!) had to be towed in the Aegean when its engines failed. The Arctic is a little more challenging than the Aegean, no?

The Russian navy’s ability to contest the Arctic–in the unlikely event–is virtually nil. Certainly it has nothing to fear from the Danish navy, and the Canadian navy has cratered about as badly as the Russian, but it wouldn’t stand a chance against the US navy in the Arctic, or anywhere else.

This not to mention that if global warming really occurs (not that I’m betting on it, but the conflict over resources is most likely to occur if the northern regions warm), its northern airbases would be unusable morasses.

So, yet again, we see military posin’. Big talk with no ability whatsoever to back it up. In the event that Russia tries to push it in the Arctic, it would be inevitably forced into a humiliating climb down. So why does it persist in confrontational approaches, when, when push comes to shove, it could not prevail? Habit? Delusion? Such disdain for the west that they believe that their bluster will cause any potential adversary to back down? Whatever the reason, it’s pretty pathetic. Again.

James Hamilton’s Analysis of Speculative Influence: A Counterexample?

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — The Professor @ 3:54 am

James Hamilton is a world-class econometrician who has done pathbreaking work on the relations between oil prices and the real economy. Recently, he has blogged extensively about the potential contribution of speculation to the price of oil. Although he argues that most of the runup is fundamentals-driven, he is open to the suggestion that the increase in price since January is not primarily the result of fundamentals, but is instead speculative in origin. He is sensitive to the objection that a speculative distortion in prices should also manifest itself in increases in stocks. He attempts to counter this criticism with an example:

A much more important way in which the spot price of crude would affect the refiner’s demand for the product is through an intertemporal calculation. Given my customers’ demand, I’m going to need to buy the product sooner or later. If you charge me a lower price today than you’re going to charge me next month, I’d choose to buy more today to put it into inventory. If you charge me a higher price today, I’d rather run down my inventory and buy the oil next month, and of course the futures market allows me an opportunity to lock in a price for doing just that. Thus by far the most important factor in refiner’s demand for July oil will be the August futures price. If my production plans left me willing to buy July oil for $124.25/barrel when August oil was selling for $124/barrel, I’ll probably want to buy July oil for $126.25/barrel now that I’m forced to pay $126/barrel for August oil. Thus to a first approximation, the spot price would move by exactly the same amount as the near-term futures price. A $1 increase in the August futures price would shift the demand curve for July spot oil up by $1. In this fashion, an ever-increasing volume of speculative purchases of the near-term futures contracts would drive the spot price up with them.

There are two fundamental problems with this example, one logical the other empirical.

With regards to the logical problem. The premise of the hypothetical reminds me of the old Steve Martin routine “How to make a million dollars without paying taxes! First, make a million dollars.” That is, James pulls the $1 increase in the August price out of a hat, like a magician producing a rabbit. But why would an increase in speculative futures purchases lead to a dollar increase in the price of the August contract? Setting aside that the speculators might be informed–in which case, the price response is likely rational and efficient–why would other market participants believe that an (uninformed) speculator’s purchase should lead to an increase in the price of oil in August? Perhaps they anticipate that the August contract will be offset, but the speculator will buy even more for September delivery. This just kicks the can down the road a bit. Due to the ultimate connection between the futures price and the price of physical oil (that results from the delivery mechanism) the only way an uninformed speculative purchase will lead to a price increase is if market participants anticipate that some portion of the speculator’s purchase will not be offset. That instead, the speculator will take delivery of oil, and USE THAT OIL INEFFICIENTLY.

Inefficient use can occur as a result of a corner or squeeze. The speculators could squeeze some future contract, causing distortions in the production and transportation of oil. (A squeezer demands excessive deliveries, and essentially forces the delivery market up the supply curve to outputs beyond the competitive equilibrium point.) The problem here is that many speculators are unlikely to execute a squeeze, although A Speculator might do so. Multiple speculators may collectively have the ability to squeeze the contract, but they also face a collective action problem. Each one reasons: if everybody else is going to take to many deliveries to drive up prices, why should I go along? Why don’t I just liquidate my entire position at the artificially high price, and let everybody else bury the corpse (i.e., dispose of the excessive deliveries at a depressed post-squeeze price.) Individual rationality of the speculators results in a non-cooperative equilibrium where no squeeze takes place. Thus, given that myriad hedge funds, pension funds, investment banks, etc., make up the speculative crowd, unless one or two of them possess market power it is highly unlikely that anticipation of a squeeze could cause the price to rise in response to an increase in speculative purchases.

Another story is that somewhere along the line, speculators will take excessive deliveries, and just hoard the oil, keeping it off the market to enhance the price. This scenario also faces the prisoners’ dilemma issue, and another problem as well. Even for an individual speculator, it is difficult–and arguably impossible–to make a credible commitment to carry out this inefficient action. This is analogous to the Coase durable goods monopoly problem. (My 1993 Journal of Business paper discusses this issue in detail in the section titled “Pure Monopoly Manipulation.”)

That is, once he takes delivery and liquidates his futures position (at a high price), why should he just hold onto the commodity he received via delivery, reducing consumption below its efficient level and elevating price going forward? He would rationally sell the good, driving down its price to the efficient competitive level. But, forward looking counterparties, recognizing the speculator’s inability to precommit to the inefficient policy, would conjecture that he will not carry through on his threat, and hence are willing to sell the future at the competitive price today. The long would like to precommit to holding supplies off the market, but this is problematic, not to say impossible.

In a nutshell: distortion in the futures price today via the mechanism of speculative purchases requires an anticipation that the speculators will somehow take actions (a corner or hoarding) that reduce consumption below its efficient level in the future. There is no credible reason to believe that a large number of speculators can do this. Index funds that roll all their positions deterministically definitely cannot do this–they are effectively precommited NOT to take delivery. Ditto for those rading cash settled instruments, such as ICE WTI futures, or swaps (although the holders of such instruments could have an incentive to distort the physical market to enhance the value of their derivatives position.)

James’s example also poses other difficulties. The expectation that speculators will somehow take actions in the physical market that reduce supplies in the future (and such an expectation is a necessary condition for the price to move today, per the hypothetical) will induce immediate real responses. An anticipated increase in the demand for oil in the future will induce, at the margin, a decline in current consumption and an increase in current output, and an increase in stocks, in order to meet the anticipated future demand. That is, it is unrealistic to argue, as James’s example suggests, that an increase in future demand for the physical product will not lead to an increase in current inventories.

The empirical difficulty relates to the prediction inherent in the example: that there is a one-for-one relationship between the change in the spot and futures prices, especially when the market is in backwardation (as James deliberately specifies in the example, as he explains in his responses to comments). I have produced empirical evidence for industrial metals (J. of Bus., 1994) and oil (J. Futures Markets, 1996) that shows that when the market is in backwardation: (a) the correlation between spot and futures is well below one, and (b) the spot volatility is higher than the futures volatility. This implies that if one regresses the futures price change against the spot price change, the coefficient on the latter will be less than one–and often substantially so (e.g., on the order of .75 or .8). (Of course, if the regression is run the other way, the coefficient could be bigger or less than one, but in practice the coefficient is still less than one because the correlation effect dominates.)

Futures and spot move one-for-one when the market is in full carry (or nearly so)–but only because inventories (which are large when the market is in a carry) provides an intertemporal connection between spot and futures prices. This link is attenuated when the market is in backwardation. (I’ve also demonstrated this theoretically/numerically in solving dynamic storage models.) But when the market is in backwardation, the one-to-one relationship between spot and futures moves is unlikely to be observed in practice. Thus, if one treats the example seriously, as a source of empirical predictions about comovements of spot and futures prices, it is refuted by the data.

While musing about contango and backwardation, it is interesting to note that back in 2005-2006 those blaming speculation for distorting prices pointed to the strong contango as evidence that funds trading progressively more in the back end of the curve were distorting prices. These voices were notably silent when the market returned to backwardation last July. If anything, it appears that more activity is moving to the back end of the curve–so why did the contango go away? Moreover, although the price runup post-Katrina was accompanied by an increase in inventories–which is it at least superficially consistent with the price distortion story–the recent price runup was not accompanied by a jump in stocks. (And, as I said in my “Dance the Contango” post that is so loved by spam commentors, and in my recent working paper formalizing that intuition, in a world with stochastic fundamental volatility a positive co-movement in stocks and prices can occur in a rational expectations equilibrium, and hence is not necessarily a smoking gun of speculative distortion.)

In conclusion, I find James’s example unpersuasive. Although an increase in stocks that accompanies an increase in prices does not necessarily indicate speculative distortion, it is hard to imagine how the speculators could force prices above the competitive level without having to get their wingtips dirty with holdings of the gooey black stuff.

June 24, 2008

A Gas Cartel?

Filed under: Energy,Politics,Russia — The Professor @ 10:38 am

Edward Lucas and Bob Amsterdam both offer recent comments on the potential for an OPEC-like cartel for natural gas.

In a book review in the WSJ, Edward writes:

[Marshall Goldman] also sees no danger of an international natural-gas cartel forming along the lines of the Organization of Petroleum Exporting Countries, one that would presumably include Turkmenistan, Venezuela and Trinidad.

Russia would never let its decision-making be affected by others, Mr. Goldman says. That may be true in the case of price-setting (where the economics are quite different from the oil market, because oil is traded on the spot market, whereas the international gas business is mainly based on long-term contracts). But a possible Organization of Gas Exporting Countries could still help bolster Russia’s position by consolidating producer power in exploration, pipeline routes and the market for liquefied natural gas.

Yes, oil is currently traded on a spot market–but it wasn’t always so. The spot oil market began during the second oil shock of 1979, with the abrogation of equity agreements between Mideast producers and the “seven sisters” oil companies. Contracts are made to be broken, and something similar could well occur in LNG if producing nations found it to be in their interest.

Moreover, contracting choices are endogenous. Long term contracting makes sense when there are relatively few potential consumers and producers of LNG. Under these circumstances, individual buyers and sellers are locked into bilateral relationships characterized by huge investments in specific assets. As more LNG production facilities and ports are created, however, the lock in problem is mitigated. Put differently, the market is “thicker”–and thick markets can support spot contracting.

Indeed, the spot market for LNG is developing apace, and the flexibility of spot market contracting is increasingly recognized as an important source of value for producers. Thus, although it is correct to say as a historical observation that LNG is bought and sold under long term contracts, this is unlikely to be an accurate forecast of how the market will look even 5 years hence. A cartel could effectively control such a spot market for LNG, and affect pricing for all natural gas, even that delivered by traditional pipelines.

Robert writes:

Such a cartel would not function in the same manner as OPEC – and this is the most frequent sticking point for critics who say there is nothing to worry about. Given the regional nature of natural gas (LNG is still not produced in high enough quantities to generate a spot market), it is unlikely that cooperating exporters could ever achieve production quotas in order to put supply pressures on price.

As I just noted, this statement is becoming increasingly obsolete. Natural gas is becoming less and less a regional market. And what’s important to remember is that prices are set on the margin–and for most major consuming regions LNG is, or will soon become, the marginal fuel. Even if a particular market receives the bulk of its gas from a traditional pipeline, its marginal source, and the only alternative source for major supply increases, is or will soon be LNG. The price of this marginal/alternative source will limit the price that the traditional supplier–Gazprom, say–can charge.

Hence, even if LNG volumes are smaller than volumes delivered through traditional pipes, it is becoming sufficiently important to be a major determinant of the profitability of traditional operators like Gazprom. That firm’s market power will depend in large part on the potential competition from LNG. Hence, the firm has a tremendous incentive to take actions–most importantly, the formation of a gas cartel–that would reduce competition from this source.

Britain is a case in point. At the UH-GEMI energy trading conference in March, Davis Thames from Cheniere (which ran into some financial problems in May) noted that Britain is building LNG capacity that is (if memory serves) about 9 times what its LNG imports are likely to be in the near to medium term. Why would this possibly make sense? If the LNG market is competitive, this excess capacity would sharply constrain the ability of a traditional pipeline supplier to hold up Britain for a higher price. In other words, the capacity would greatly increase British negotiating leverage–if the LNG market is sufficiently competitive and liquid.

But if it is not . . . the traditional suppliers–most notably Gazprom–would have tremendous market power despite the consumer investment in LNG ports. Hence, throttling competition in LNG is essential to Gazprom as a means of maintaining its market dominance.

When appraising the prospects for a gas cartel, I therefore take very little solace in differences between the market for oil and the market for LNG. The oil market once looked not too different from the LNG market; the oil spot market only blossomed during the second oil shock, and with the increasing diversity of LNG supply sources and demand sinks, the LNG spot market is developing and will continue to mature and grow. Since LNG is becoming, and will almost certainly be, the marginal, price setting source of gas for most consumers, it is the most important competitor for traditional pipe-in-the-ground (or under-the-sea) operators, most notably Gazprom. Gazprom therefore has a tremendous incentive to facilitate formation of a gas cartel, and exporters of LNG could profit from its formation. Hence, in my view, such a cartel is a matter of serious concern. Unfortunately, as seen too often in Central Asia, major consumers in Europe and the US don’t seem to be taking the threat seriously, and are running the risk that OGEC will do to the gas market what OPEC did for oil.

June 19, 2008

Suppose you were an idiot, and suppose you were a member of Congress; but I repeat myself.

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 9:12 am

The words are, of course, Mark Twain’s. And almost a century after rumors of his death were no longer exaggerations, Congress daily works assiduously to bring his joke to life. Especially with regards to energy policy. Case in point: Rep. Maurice Hinchey (D for do you even need to ask, NY) has called for nationalization of US oil refineries. Methinks that even that ultimate cynic Twain would be amazed at such gobsmacking stupidity.

Another case in point; the mindless blather about energy speculation, and the various vacuous proposals to curb it. I’ve blogged on this subject many times, and will return to it again soon, but here I will limit myself to repeating a point I’ve made before: these assertions are based on bad economics and no evidence–always a great basis for effective policy.

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