Streetwise Professor

July 28, 2008

Dodging A Bullet

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 9:22 am

It looks like the energy markets have dodged a bullet; the Stop Excessive Energy Speculation Act (S. 3268) has failed a cloture vote, and is in limbo despite an earlier 94-0 vote in favor of cloture on the motion to proceed. This sparked a Harry Reid hissy fit (always music to my ears.)

And a good thing too. Although not including some of the most damaging proposals that have been mooted, such as draconian increases in margin or the outright banning of large financial institutions from the energy derivatives markets, it was plenty bad enough.

Some of the bill’s greatest misses include:

  • Designating some market participants as “nonlegitimate hedge traders” and limiting the designation of “legitimate hedge traders” to those entities that actually produce or consume physical petroleum or natural gas.
  • Establishing an advisory committee consisting of legitimate hedge traders only to make recommendations to the CFTC on position limits applicable to nonlegitimate hedgers and speculators.
  • Extending position limits to OTC markets.
  • Giving the CFTC the authority to intervene in the OTC market in the event of “a major market disturbance.”

All of these measures are pernicious. The would do nothing to reduce manipulation or improve the efficiency of the energy markets or reduce prices, but would reduce the effectiveness of these markets as risk transfer and price discovery mechanisms and raise compliance costs.

The creation of a separate caste of hedgers–”nonlegitimate”–makes no sense economically. Financial institutions that use the energy markets as part of a portfolio management strategy are as legitimate hedgers as an oil company or an airline. Even the very language “nonlegitimate” is tendentious and offensive.

Moreover, it is a dangerous precedent to give one group of market users a say over what other market users can do. The favored group is likely to use its power to benefit its own members to the detriment of the unfavored ones. Note that many firms that could fit in the “legitimate hedger” category speculate too, and could exploit the powers vested in the advisory committee to favor themselves at the expense of other competitors in the supply of risk bearing services. Similarly, long hedgers (airlines, as an example) would benefit if long speculation, or long portfolio hedging, is constrained. (Long speculators offset the effect of short hedging pressure, and thereby cause the futures price to rise relative to the expected spot price. Long hedgers benefit from a fall in the futures price relative to the expected spot price, and hence would benefit from constrianing other longs in the market.) These entities could also use their position on the advisory committee to advance their interests at the expense of short hedgers and long speculators.

Since speculative limits designed to make speculation more costly are detrimental to the efficient operation of the market (by constraining the ability of the markets to shift risk), extension of these limits to the OTC market will impair the effectiveness of the markets as risk management tools. Moreover, the CFTC (and its fox-in-the-henhouse “legitimate hedger” advisory board) are charged with the responsibility of setting position limits to eliminate “excessive” speculation. Good luck with that. These limits will just become another political and regulatory football over which competing interests will squabble.

The extension of emergency authority to the OTC market is a particularly scary expansion of regulatory authority. Here’s the language in full:

GENERAL.—In the case of a major market disturbance, as determined by the Commission, the Commission may require any trader subject to the reporting requirements described in paragraph (3) to take such action as the Commission considers to be necessary to maintain or restore orderly trading in any contract listed for trading on a registered entity, including—
”(i) the liquidation of any over-the counter transaction; and
”(ii) the fixing of any limit that may apply to a market position involving any over-the-counter transaction acquired in good faith before the date of the determination of the Commission.

The definition of “major market disturbance” is extremely broad and vague:

  • `(C) MAJOR MARKET DISTURBANCE- The term `major market disturbance’ means any disturbance in a commodity market that disrupts the liquidity and price discovery function of that market from accurately reflecting the forces of supply and demand for a commodity, including–
  • `(i) a threatened or actual market manipulation or corner;
  • `(ii) excessive speculation;
  • `(iii) nonlegitimate hedge trading; and
  • `(iv) any action of the United States or a foreign government that affects a commodity.

In other words, not only does this provision permit the CFTC to intervene in the event of a corner–a real manipulation–it gives the Commission the authority to interfere directly in the market whenever in its infinite wisdom it deems that “excessive speculation” (where excessive is evidently in the eye of the beholder, and is not defined and is not capable of being defined) or “nonlegitimate hedging” is distorting prices. This in effect gives the Commission the authority to second guess the market. Moreover, since regulators are subject to pressure from organized interests who may benefit from an intervention, this opens the door to all sorts of influence activities and will undermine the certainty of contract in the energy markets. Think of it; somebody makes a bad trade, begins to howl about excessive speculation distorting the markets, and just might succeed in buffaloing the CFTC into forcing liquidation of the offending contracts. Great. Read my 1995 JLE piece on self-regulation of commodity markets for a few examples of how these powers can be used to make mischief.

In all honesty I doubt that the CFTC would use these powers. But they are there, and an activist Commission or one subject to intense lobbying or Congressional pressure could well use them, and wreak tremendous havoc in the markets. This is a really bad idea.

I would oppose this provision even if its application was limited to “(i) a threatened or actual market manipulation or corner.” As I have argued for well over a decade in my academic research, it is best to address corners and real manipulations ex post. The likelihood of a wrongful intervention is much greater (due to the lack of good information and the difficult of making decisions under time pressure) when a regulator attempts to intervene while a corner is in progress. Moreover, the regulator is likely to intervene only when the price distortions resulting from the exercise of market power are large, so early intervention is unlikely to mitigate price distortions all that much. Manipulation is perfectly suited for deterrence through harm-based sanctions, like those imposed on BP in the aftermath of its propane adventure. It is inefficient to rely on emergency authority, and its extension to the OTC markets is a bad idea.

Advocates of this type of regulation make ominous allusions to the dangers of “dark markets” not subject to constant government observation and meddling. Like small children, paranoics, and control freaks, they appear to be phobic about things that consenting adults might do out of their sight.

I, for one, am not scared of the dark, or most of the things that go on in the “dark” OTC markets. One thing is for sure; if a real manipulation takes place, it will come to the light in short order. As Frank Easterbrook has written, an undetected manipulation is an unsuccessful manipulation. If somebody corners the market, it will not remain a secret, its perpetrators will be known to other market participants–and to the authorities shortly thereafter. That is the time to bring the legal guns to bear. Until that time, let adults do in the dark what they will.

The BP propane episode is a perfect example of this. It is hard to conceive of a darker, more obscure corner of the energy market than propane. It is traded almost exclusively OTC, and trading activity in that commodity is dwarfed by that for other energy commodities. BP’s actions soon sparked the outcry from affected market participants, and soon parallel civil and criminal investigations were commenced. One trader plead guilty to a felony, and sometime thereafter the company entered into a deferred prosecution agreement with the government and agreed to pay a large civil fine and criminal penalty. We’re talking 9 figures.

It is far better to devote scarce enforcement resources to investigate instances of real potential harm that occur relatively infrequently, rather than spend resources to monitor all market activity on an ongoing basis, since most of that activity is benign at worst, and beneficial at best, and hence most of the resources devoted to oversight are wasted.

In sum, Harry Reid’s pet energy speculation bill is a disastrous piece of legislation. It is built on a foundation of anti-speculation animus that has no basis in economic theory or empirical evidence. It mandates a tremendous expansion of regulatory authority that cannot be used for good, but which has the potential to be used to distort markets, to intervene when intervention is unjustified, and compromise the surety of contract. Hopefully the bill is dead. But just to make sure, let’s drive a stake through its heart and shoot it with a silver bullet and repeatedly drive an M-1 Abrams over it repeatedly.

They Want to ‘Git while the Gittin’s Good

Filed under: Economics,Energy,Politics,Russia — The Professor @ 5:47 am

The battle royale between BP and the AAR Group over BP-TNK is reaching a climax with Robert Dudley’s decision to leave Russia and attempt to run the country from an undisclosed location (shades of Dick Cheney, circa 2001). Like many things that happen in Russia, the events are somewhat inscrutable. This London Times article seems to offer the most sensible interpretation: namely, the Russians want their money out of Russia.

It explains many of the details that have emerged from the murk. For instance, one bone of contention between the parties is allegedly that BP wants to manage the BP-TNK properties for the long term, investing substantial amounts in new technology and using more conservative production techniques, whereas the AAR gang has been looking to maximize output even though this compromises the long term productivity of the company’s wells. Relatedly, BP technical staff has been a particular focus of official harassment. Furthermore, another argument has raged over investment outside of Russia. BP wants to focus on inside Russia, the AAR oligarchs are pressing to invest outside of the country. A last clue is that one proposal floated by the Russian side to end the stalemate–an exchange of TNK shares for BP shares.

All of this is consistent with a desire by the Russian partners to maximize short term cash flow and/or get their money out–and out of the country. If that doesn’t speak volumes about the rule of law and the security of property in Russia, I don’t know what does.

The game being played by the Kremlin/White House (theirs, not ours) is more difficult to fathom. One hypothesis, advanced in Steve LeVine’s excellent blog is that AAR believes/believed that BP is trying to sell them out by doing a deal with Gazprom. I think that most likely that the government isn’t taking one side or the other, but is setting the two against one another like scorpions in a bottle. Once the battle is over, the government/Gazprom/Rosneft or some combination thereof will swoop in to claim the spoils. Or perhaps the relatively standoffish approach of officialdom reflects a stalemate in a battle between contending clans.

One thing for certain is that in the end, BP will emerge bloodied, and perhaps, as LeVine posits, a takeover target. Another is that the end of legal nihilism is far, far into the future.

July 27, 2008

Necessary Condition

Filed under: Military,Politics — The Professor @ 10:09 pm

The Air Force is incorrigible. It overpromises what air power can do in the advance of wars; claims that air power is responsible for every victory; and rationalizes every failure of air power as the result of its misuse by misunderstanding civilians and army types. The latest case in point is this gem from Rick Andres, Special Assistant to just unceremoniously fired Secretary of the Air Force Michael Wynne:

Something I’ve often heard Rick say, and I believe he is correct, is that the Army does not understand air power. Often their plans minimize its use, and their after action reports under report its effectiveness. Case in point, the surge in Iraq. While sitting in Ricks E ring office, he asked me point blank whether or not I believed a 20% increase (or “surge”) in troop strength could really make much difference to the situation. It was obviously a baited question, but it wasn’t one I had to think about much. To my mind, the increase could not have been that effective; there had to have been some fundamental doctrinal change in order for that small an increase to have had the dramatic effect that it’s had. Prior to this discussion, I’d already been pondering the issue for some time.

Sadly, civilians like me who do not have a clearance are left to fend for themselves when it comes to gathering information. Between the coverage of American Idol contestants and Britney Spears’ mental condition, we’re occasionally treated to an update of what’s going on in the world. Taken at face value, all we ever needed in Iraq was an extra 20% troop strength and we’d have had the place stabilized years ago. Unfortunately the penetrating analysis of CNN only goes about that far, but the more discerning among us know that that cannot possibly be the whole story.

But the Army hasn’t helped the perception. According to them, those extra boots on the ground was all that it took to better stabilize the country. Patraeus has even said as much in his testimony to congress and in the reports he’s signed off on in the field. So here is where Rick drops the bomb.

Rick’s office was unconvinced. So they initiated an investigation to see exactly what had changed, other than boots on the ground. As is turned out, not only had the number of troops on the ground increased by 20%, but air strike missions had also increased by 400%. What’s more, air munitions released had increased by over 1000%, all since the beginning of the surge.

What had changed was clear. It wasn’t the extra boots on the ground that was turning the tide, it was the increase in HUMINT and the ability to hit a target with precision munitions from the air within a time frame of only 7 minutes. Gatherings as small as only 3 insurgents were being targeted for strikes, while predators and forces on the ground monitored the movements of any suspected insurgent. This aggressive doctrinal change was preventing insurgents from gathering, planning, and pulling off operations. It was classic COIN (Counterinsurgency) operations, conducted almost entirely from the air. But if we accept the Army’s version of things, it never happened.

To the logically challenged: the increase in manpower was a necessary condition for the increase in HUMINT. Increasing combat manpower was a precondition for taking the initiative against the insurgents in Iraq. What Petraeus did was put all elements of American power to work in an integrated operational plan. Obviously he understood the role of HUMINT and air power–this is self-evident from the very fact that Mr. Andreas touts, namely, the increased use of both throughout the surge campaign. But these elements would not have been sufficient without the increase in groundpounders, and the more aggressive employment of American (and Iraqi) infantry and armor. Indeed, the increase in American ground presence was necessary to develop the additional HUMINT, and created a virtuous cycle. More troops, more aggressively employed, wrested the initiative from the enemy, and increased the take of prisoners, informants, and documentary and electronic information. These in turn led to better targeting of fires and raids, which generated more intelligence . . .

The overall mistake that Andreas makes is to reduce the Surge to the increase in manpower. It was much more than that. The Air Force was a major part of what was accomplished, and Andreas slanders Petraeus for not understanding the role of intelligence and air power when the evidence–the very evidence that Andreas cites–proves the exact opposite. He developed an operational plan that used these tools brilliantly–and also recognized that this operational plan required additional elements of combat power above and beyond air power. And Bush, to his credit, had the political courage to commit these elements.

This is what makes Petraeus different than the Air Force. Like all great commanders, he recognizes that success on the battlefield requires the integrated employment of complementary arms. Fires alone do not win battles. Close combat alone does not win battles. Intelligence alone does not win battles. But fires (delivered from the sky or from artillery) integrated with aggressive employment of armor and infantry, all guided by accurate intelligence, is a deadly combination. Monoculture militaries do not win battles. Combined armed militaries don’t either, if those arms do not work together. The Air Force hasn’t learned this lesson in the 60 odd years of its existence, and the peevish remarks of an aide to a disgraced service secretary are just another illustration of that fact. The Jupiter Complex lives.

Mr. Andreas is not the only person challenged by the basic logical concept of a necessary condition. Someone far more consequential–Barack Obama–is too. In his effort to distract attention from his demonstrably wrong ex ante judgment on the efficacy of Petraeus’s strategy, Obama has argued that the Anbar Awakening, and its extension to the remainder of the Iraq, rather than the Surge, was the key to victory–a victory that Obama said repeatedly was impossible. (His recent Orwellian attempts to rewrite history would make the editors of Soviet encyclopedias proud.)

Two points. First, since the Anbar Awakening began before the Surge–and that indeed is the crux of Obama’s argument about the irrelevance of the Surge–if it was such an obvious turning point, why was Obama such a defeatist in 2006-2007?

Second, the Awakening depended on the aggressive actions of the US Marines in Anbar, and its extension beyond the borders of Anbar also required the protection provided by American troops. The insertion of additional combat brigades, and the more aggressive use of those troops and the forces already there, were necessary to provide the security required to make Sunni tribal leaders confident to cast their lot with us. They certainly weren’t going to do it by themselves. Only when they became confident that we had their backs, and that they could call on our cavalry, were they willing to take on Al Qaeda.

In other words, the Awakening movement was just another complementary element in an overall operational plan. It wasn’t a sufficient condition for victory, any more than just dropping more bombs was.

So the truth about the Surge is this. Many factors contributed to victory. The brilliance of the Surge is that it identified these factors, integrated their employment in ways that exploited the advantages in each, and amassed all elements of American and Iraqi combat power in a focused way. The Surge was much more than the sum of its parts, and it was certainly much more than the increase in American ground strength. But that increase was the keystone in the arch, the element without which all of the others would have been wasted–the necessary condition.

Don’t Look Here For Sympathy

Filed under: Economics,Energy,Politics,Russia — The Professor @ 9:02 pm

The Russian equity market is in freefall in the aftermath of Vlad the Expropriator’s most recent outburst–this one directed at steel and coal giant Mechel, whose COO (chief oligarchic officer) had the temerity to decline the honor of attending an audience with His Eminence. For this dis , Putin sicced prosecutors on the company to investigate allegations of . . . who cares? The specific allegations are meaningless. The new oprichniki will find something, and Igor Zyuzin and his company will soon sample the delights of “the dictatorship of law.” And this in the same week in which BP’s Robert Dudley decided that discretion was the better part of valor, fleeing Russia rather than try another spin at Russian Legal Roulette.

Western investors were Shocked! Shocked! upon hearing the news:

Investors said Thursday’s events underlined the risk borne by Russia that, until now, had largely been masked by record-high prices for the commodities and oil that Russia produces in abundance.

“The place looks rotten to the core. It always did, but it was masked by high commodity prices,” said one fund manager who asked for his name not to be used.

WRONG! Russia’s rottenness was never masked by anything, let alone high commodity prices. It was there for anyone with eyes to see. Those that didn’t see it, didn’t want to see it. Salivating at the prospect of getting a seat on the Russian Rent Express, these investors, investment bankers, and fund managers ignored the stench of corruption that one can smell clearly here in the heart of the US. Like the classic mark in any con, they let their greed overcome their common sense.

Indeed, this fund manager’s diagnosis is 180 degrees from the truth. High commodity prices did not mask the rottenness–they fed it! The stream of rents flowing from Russia’s oil and gas empowered a corrupt elite to do anything it willed; these rents freed the siloviki from the constraints of domestic politics and permitted them to undermine totally Russia’s already weak legal safeguards for person and property. And the enabling behavior of fools like the wisely-anonymous “fund manager” only moved the process along.

Another anonymous codependent, a “sales trader at a major Western bank,” offered this pearl of wisdom: “The Russian government doesn’t care about foreign investors. It cares about its national security and, if foreign investment gets stomped on, then so be it.”

WRONG AGAIN! National security hasn’t a goddam thing to do with it. It’s all about one thing, and one thing only–the wealth and the power of Putin and the clans. It’s about their personal security, their personal wealth and power, the country be damned. All this yammering about making Russia strong, about restoring Russian greatness, is a joke. It is the Russian equivalent of boob-bait, intended to exploit the prejudices of the Russian populace and distract their attention from the accumulation of power and wealth by the ruling clique.

I have no sympathy whatsoever for any investor in Russia who, post-Yukos, post-Sakhalin II, post-Hermitage, post-corporate raiding, tried to get rich in Russia on the hope that the crocodile wouldn’t eat them. In one of my earliest posts, A Fool and His Money, I wrote:

[W]estern banks insistence that “their participation means that the deal will meet their exacting standards” won’t amount to squat if Putin decides to flex his muscle.

This raises the question-what are the incentives to expropriate, and what incentives cut the other way? If Putin were interested in building a reputation for avoiding expropriation in order to attract western capital, he might abstain from aggressive action. However, if anything, Putin seems fixed on-indeed, almost obsessed with-using control of Russian energy assets to exert geopolitical influence. He seems far more interested in control than attracting foreign capital. Moreover, revenues from $70 oil and expensive gas are filling Kremlin and Russian oil company coffers, limiting their need for external capital. Given these circumstances, the lure of increasing Kremlin control over Russian energy production and distribution, likely through its chosen vehicle Gazprom, seems irresistable-especially if it also allows the fleecing of foreigners to the tune of tens of billions of dollars. Even though commodities/energy are hot now and likely to get hotter, all in all, I’d rather take my chances on three card monte.

Sadly, I predict that soon enough those pigeons who avoided being the crocodile’s lunch this time around will be back, cash in hand, and that soon enough I will be able to write another told-you-so post.

July 17, 2008

Chris Cox’s Short-Sighted Reasoning

Filed under: Economics,Politics — The Professor @ 9:48 am

Two seemingly unrelated events–Tony Snow’s death and the SEC’s banning of short selling of Fannie and Freddie stock–are connected in my mind. And the connection is–Hillary Clinton. No, really. This may seem like a shaggy dog story, but these disparate threads are indeed connected. Bear with me.

In 1993, while I was an Assistant Professor at the Michigan Business School, a small Chicago think tank (now defunct) called Catalyst Institute retained me to quantify the effect of Hillary and Bill Clinton’s speeches and statements about pharmaceutical companies on the prices of pharmaceutical stocks. I did a standard event study, and showed rigorously what everybody pretty much knew; their harsh criticism of drug companies caused an economically large, and statistically significant, decline in the prices of these stocks. Catalyst circulated the study under the title Political Rhetoric and Stock Price Volatility. (I put the study aside, but in 2001 Sara Ellison and Wally Mullins refined the econometrics and published the results in the JLE. Bully for them.)

That’s where Tony Snow came in. He had learned that Hillary Clinton had retained an interest in a hedge fund (!) that short-sold medical stocks. He wrote a nationally syndicated column on the subject, and used my study–and cited me by name–to show that Hillary could have profited from these short sales when her criticisms of the drug industry drove down stock prices. Rush Limbaugh read the column on his program, repeating my name several times.

The story soon developed into a minor controversy. Hillary was subjected to a formal ethics inquiry (which exonerated her.) Vince Foster was working on the matter when he died. This connection injected the issue into the Senate Whitewater investigations–earning me a footnote in the Senate Whitewater Report Part I: The Vince Foster Phase. (All of this probably explains why I was soon an ex-Assistant Professor at the Michigan Business School, but that’s a story for another day.)

Seeking to make political hay of the issue, a group of Republican congressmen asked me to come to DC to explain my study and its implications to them. The group was led by Bob Livingston of Louisiana (later a victim of the Clinton impeachment battle); George Gekas of Pennsylvania; Joe Barton of Texas–and Chris Cox, of California.

I gave an overview of my study, but then the Congressmen called the owner of a small medical device company whose stock Hillary’s hedge fund had sold short. The businessman complained that this short selling had caused his company’s stock to crater, costing him a lot of money. That got Cox rolling. Although supposedly a sophisticated securities lawyer, Cox apparently believed that short selling is an pernicious practice. He went on at some length discussing how short selling was inherently disreputable. I was mildly shocked that a supposedly market-savvy individual would hold such prejudices against short selling.

Flash forward to 2008. Chris Cox–now head of the SEC–apparently still believes that short selling is a disreputable practice. Today Cox announced restrictions on short selling of 19 financial stocks, and raised the possibility that the restrictions would be extended to all stocks.

The impetus for the new rules is purportedly that some short sellers had profited by spreading false rumors about Bear Stearns, and these rumors contributed to the bank’s meltdown. If that’s true, it’s the rumor spreading that is the crime–not the short selling per se–and deserves prosecution. Blanket restrictions on all short selling is overkill. Short selling can actually contribute to price discovery. If stocks are overvalued, informed short sellers can help push them towards a proper valuation. Does the SEC prefer that overvalued stocks remain that way, so that buyers overpay?

Given my 1993 experience with Chris Cox, I have my suspicions that the new short selling restrictions aren’t based on any empirical evidence or deep economic reasoning–instead they are a reflection of Cox’s anti-shorting prejudices (and the prejudices of like-minded folks at the SEC)–prejudices that he displayed in 1993.

But hey, maybe there’s an upside. This could be just the thing to light a fire under single stock futures at ChicagoOne!

July 14, 2008

Mr. SWP Goes to Washington

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 9:34 am

I gave testimony on the role of speculation in energy markets before the House Agriculture Committee on Friday, 10 July. Here’s my written testimony. I will post a link to the transcript as soon as it appears.

It was an interesting experience. I doubt I changed any Congressional minds, but I think I did provide a framework that may help policymakers sort through the issues. The key lesson I tried to hammer home was that it is imperative to distinguish between the derivative markets and the physical markets. These markets perform different functions. Derivatives markets are markets for risk, and speculative and hedging activities in these markets will affect the price of risk. Absent any use of the derivatives markets to distort the physical market–as during a squeeze, for instance–even very large scale speculation in the derivatives market is unlikely to have an impact on the prices in the physical market (except insofar as that speculation is informed, and therefore influences expectations about future spot prices.)

The other point I tried to emphasize–and this is what I think made the biggest impression, at least on some–is that if “excessive” speculation truly screws up prices, these price distortions necessarily manifest themselves in the form of distortions in quantities; in inventories, in output, in consumption. The reason prices are important is that they direct the flow of resources. If prices are distorted, resource flows will be distorted too. Heretofore, there is no credible evidence of distortions in quantities. Hence, in my view, there is no credible evidence that speculation has been “excessive” in any meaningful (economic) sense of the word.

SWP in the WSJ

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — The Professor @ 9:25 am

My OpEd on oil speculation ran in Friday’s (7/11) Wall Street Journal.

Commodity Speculation–The (Entirely Beneficial) Role of Index and Pension Funds

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 9:23 am

Index funds and pension funds are the most recent bêtes noir in the commodity speculation debate. These participants are primarily long, are supposedly relatively insensitive to price (which is an assertion, rather than something for which reliable evidence has been produced), and hence according to critics are driving up prices of oil and grain. And by “prices,” critics mean the prices of physical commodities that consumers buy.

These arguments fail to grasp important aspects of the operation of derivative and commodity markets, and ignore the benefits these market participants can reap from trading in the commodity markets.

The main error in the argument is that it does not recognize that there are multiple markets for commodities, some of which are markets for the physical commodity proper, and some of which are for commodity price risks. Derivatives markets serve the latter purpose, and fund investors almost exclusively restrict their activities to those markets, and hence affect only the prices for commodity price risks rather than the prices of commodities themselves.

Virtually all index investors and pension funds do not participate in any way in the physical market. If they are in futures, they roll their positions prior to delivery. If they gain commodity exposure through swaps, they are pure price takers, and even if their counterparties hedge some of the index exposure through the futures markets, these firms also roll prior to delivery and hence do not contribute any demand for physical commodities. Hence, they cannot affect—or in particular, elevate—the price of any physical commodity.

But, the critics reply, since these funds are buying, they HAVE TO make prices higher than they would otherwise be. In addressing this criticism, it is necessary to be precise and ask: what price? Clearly, all else equal, with more buying interest, the futures price will be higher than it would be without it (unless the supply of offsetting positions is perfectly elastic, as may be the case). But it is important to recognize that this buying raises the futures price relative to the expected spot price. Since index traders and index funds are likely uninformed, their buying does not systematically convey bullish information to the market, and hence does not affect the expected spot price; and if these trades have any information content, they should have an impact on prices, and this impact is beneficial.

By moving the futures price relative to the expected spot price, index/fund trading (a) does not elevate the prices consumers pay for physical commodities; and (b) affects the RISK PREMIUM embedded in futures prices, and hence the trend in the futures price for a particular contract up to the expiration date. In other words, the price that fund traders affect is the price of risk, not the spot price of oil or gas or corn.

In a Keynesian “normal backwardation” type model, in which speculators are not diversified and hence idiosyncratic risk affects futures prices, and hedgers are net short, the addition of new long speculators causes the futures price to rise relative to the expected spot price, reducing the discount in the futures price and the upward trend in the price. Their entry also displaces some other long speculators who find that the greater competition from the index/fund investors reduces the profits they earn from their trading. In this model, these other longs only participate if the futures price is below the expected spot price. Hence, as long as any of these traders remain, the futures price must remain below the expected spot price, but by a smaller amount. All that the entry of index funds does is replace one set of long speculators with another that bears the commodity price risk at lower cost, reduces the risk adjustment in futures prices, and therefore makes the net short hedgers better off. This is not Pareto improving—the displaced long speculators and some long hedgers are made worse off—but overall surplus rises because risk is borne at a lower cost. So, what’s the problem? None that I can see.

It is theoretically possible that that long index/fund participation can be so great that it completely displaces other long speculators. That is, fund trading causes the futures price to rise above the expected spot price, meaning that all other long speculators leave the market. Again, though—so what? This hurts those speculators and some long hedgers, but benefits short hedgers even more. (I should also add there is no evidence that this has in fact happened. There are still long speculators in the markets other than the index funds, so evidently they have not all been displaced.)

The theoretical possibility that participation of index/fund investors causes the sign of the risk premium to flip also points out that it is dubious to call these folks “speculators” in any event. They are really hedgers, in the very real sense that they are buying futures to reduce risk exposure. They are buying futures for diversification reasons—that is a risk reducing trade, and hence it is legitimately referred to as a hedge. They are not traditional hedgers, to be sure, but again—so what? Investors are people too. Why should they be denied the opportunity to use the commodity markets to reduce their risks? Why should they be considered inferior to other long hedgers who just happen to participate in the physical markets? Suspicion of these non-physical long hedgers seems to be an example of what Thomas Sowell once termed “the physical fallacy” in his excellent book Knowledge and Decisions.

Indeed, the presence of index/fund investors in the commodity markets serves to integrate the financial and commodity markets. This integration ensures that risks are priced consistently across the two markets. Indeed, the flow of funds from portfolio investors (who may include hedge funds too) from traditional equity and fixed income investments to commodity markets is likely a reflection of a mispricing of risks across these markets. In essence, this flow is serving to arbitrage away a differential in risk prices across previously segmented markets. Again—this is a feature, not a bug.

My work (with Martin Jermakyan) on electricity prices shows that incomplete integration can impose very large costs on hedgers. Electricity is probably an extreme case, but due to incomplete integration forward prices are substantially above expected spot prices. This is a symptom of inefficient risk pricing and risk allocation.

If all the markets are completely integrated, risk premia in commodity prices will be driven purely by the covariation between those prices and the market pricing kernel. The composition of market participants would be completely irrelevant. Barring one group from participating in the market would just open up a profit opportunity for somebody else without having the slightest effect on risk prices.

However, restricting the participation of portfolio investors may impede integration of the commodity, stock, and bond markets. In this case, risks will be priced inefficiently and risks and capital will be allocated inefficiently. Why is that considered desirable?

The main things to remember in this debate are: (a) since fund investors do not participate in the delivery market, they cannot be influencing physical market prices, except to the extent that by improving risk allocation they are making hedging more efficient and thereby beneficially affecting investment and stockholding decisions, and (b) the main effect of index/fund participation is to affect risk premia in futures prices (i.e., the relation between futures and expected spot prices), and in a way that improves the efficiency of risk allocation. Index/fund participation facilitates the integration of commodity and financial markets. This helps rationalize the pricing of risk. Again—a good thing.

The entire debate over speculation in commodity markets, at least the political side of that debate, is largely devoid of good economic reasoning. This goes in spades for the debate over the role of index funds and pension funds in the market. The “they buy therefore they drive up prices therefore they should be banned” syllogism is completely bogus. It is bogus because fund buying does not in the first instance drive up physical prices, and hence does not affect the price that we all pay at the pump. It is bogus because fund participation affects risk premia—the relation between futures prices and expected spot prices rather than spot prices or expected spot prices. It is bogus because it affects risk premia in a good way. It ensures consistent pricing of risk across markets and the efficient allocation of risks across markets.

Some people may be hurt by this flow of capital—but it is not the people that politicians are allegedly defending, such as individual consumers. Traditional speculators who earned rents in less-integrated markets are hurt. Long hedgers in markets dominated by short hedgers may be hurt, but their losses are more than offset by the gains of short hedgers and the fund investors themselves.

More generally, I have yet to hear anyone—anyone—present a credible case that there is a true (rather than pecuniary) externality that results from the entry of a new class of participants into the commodity markets. Absent such an externality, the free flow of capital across markets will have a beneficial effect, rather than a baleful one. Index and pension fund investors participate in the commodity markets because it improves their risk-return tradeoffs. This is a bad thing? Competition and the free flow of capital facilitates the efficient pricing of risk. This is a bad thing? These flows do not affect, let alone distort, the physical markets except insofar as improving the allocation of risk improves the efficiency of investment and inventory decisions. So this is a bad thing?

When one understands the very basic finance of index/fund participation in commodity derivatives, it is evident that restrictions on their participation in the market, either through position limits or (in the extreme) banning them altogether are extremely misguided. Extremely. Their participation should be encouraged, not limited. Derivatives markets are first and foremost markets for risk, and index/fund investors in commodities are just using those markets for the very purpose of managing risk. By doing so, they are improving the allocation of risk and its pricing across all markets—stocks, bonds, real estate, and commodities. They bear commodity price risk at a lower cost than others. This is unambiguously a good. Unambiguously. Will Congress understand this? Sadly, there is considerable room for doubt.

July 3, 2008

No Surprises Here

Filed under: Derivatives,Economics,Energy,Exchanges — The Professor @ 3:08 am

Over my extended European sojourn, the Antitrust Division of the USDOJ gave its approval to the CME’s acquisition of NYMEX. During the height of the kerfuffle over the Antitrust Division’s letter on exchange ownership of clearing, it was widely conjectured that this signaled that the Division would fight the deal. I disagreed, arguing that the Division would have to approve it if it wanted to maintain even a shred of dignity. There is no way it could approve the CME-CBT tie up in June ’07 and turn around in June ’08 and disapprove CME-NYMEX. And approve it did. One curious thing. There is no announcement of the decision on the Anti Trust Division website, even though there was such an announcement when it approved the CBT deal. Now, that’s interesting.

National Pride–Built on a Foundation of Quicksand

Filed under: Economics,Energy,Politics,Russia,Sports — The Professor @ 12:52 am

Russians can indeed be proud of their recent sports accomplishments, with their victory in the World Hockey Championship and their stellar performance in Euro 2008; a friend tells me that the latter was a unifying experience, with the nation cheering in unison–literally–during and after the early-morning victory over Holland.

The achievements on the ice and the football field are feeding an already burgeoning sense of national accomplishment; a sense that the humiliations of the past are over, and that the future is Russia’s for the taking. This sentiment manifests itself in myriad ways, most notably in geopolitics. Russia is putting extreme pressure on some neighbors, notably the Baltic states and Georgia, and more subtle (but intense nonetheless) pressure on others, notably Ukraine, the Central Asian states, and even Mongolia. Medvedev and Lavrov are also pronouncing on the need for a new international political and economic architecture that will raise Russia’s profile and diminish that of the US, and to a lesser degree, the EU. (This can be seen as just another Russian divide-and-conquer/disaggregation play.) Russia is also taking a bold line with the Europeans, who are never very solid in the best of times, and who are distracted and perhaps even teetering on the brink of chaos in the aftermath of the Irish vote on the Madrid Treaty. The US is constrained by the disarray of its European allies, the continuing (though dramatically improving) situation in Iraq; economic woes; divisive partisanship; and the upcoming elections. As a result, Russian aggressiveness and revanchism are facing only feeble opposition. No wonder that Putin and the siloviki feel emboldened.

But it is necessary to take the longer view. When one does so, it is evident that Russia’s current advances are powered by high energy prices and built on a foundation of quicksand, and hence are unlikely to persist long into the future. Russia suffers from several debilitating structural weaknesses, some of which I have touched on in SWP before, but which are worth remembering.

Three such weaknesses are readily apparent: institutions, demographics, and infrastructure.

Russia’s weak institutions are well known. Headline events, such as Yukos, or Sakhalin, or as of late, BP-TNK provide spectacular illustrations of the precarious state of property rights. It is widely acknowledged–by Russians and outsiders both–that corruption is worse today than even during the 90s–perhaps by an order of magnitude. Even President Medvedev acknowledges the “legal nihilism” of his country.

But this article describing a Levada Center poll shows how deep the institutional rot is in Russia, and how it affects not just foreigners or out-of-favor oligarchs, but every Russian. According to the poll, about half of the Russian middle class contemplates emigration, primarily because of their palpable sense of vulnerability to the predations of the state:

Only 13 percent of those polled by Levada Center agreed with the statement that Russia had entered a period of protracted stability, while 59 percent said the situation could change for the worse at any moment. Around 76 percent of those polled said that they could not protect themselves from the arbitrary actions of the authorities, in particular the police, and around 65 percent said they were not sure that they could protect their rights and interests in court.

“Despite the fact that Russians are not delighted by this situation, it appears that they have resigned themselves to it,” wrote Nezavisimaya gazeta. “Many of the respondents believe that they cannot influence the political processes in the country and are prepared to use dishonest and unlawful means for the resolution of conflicts and problems. The readiness to give bribes and to use personal contacts is very high within the Russian middle class.” Indeed, around half of the respondents in Levada Center polls have said that if they were falsely accused of not paying taxes, it would be better to use bribes to resolve the problem than to take it to court. The respondents indicated that they were prepared to act similarly in more “neutral” situations. For example,
59 percent said that they would pay for medical services, which in theory are provided at no cost. . . .

Asked why they were considering leaving Russia, 86 percent cited the desire to get a greater guarantee for a stable and safe future; 79 percent cited a desire to live under conditions in which the rule of law, rights and freedom prevailed;
69 percent cited the desire to avoid governmental lawlessness; and 83 percent cited the desire to enjoy better and more comfortable living conditions.
According to Nezavisimaya gazeta, the Levada Center’s researchers believe that the high level of desire to leave Russia is evidence of serious social malaise.

“The central feature of the consciousness of the middle class is a feeling of the in-betweenness [sic] of its own existence and a radical collision of the way of life with the way of thinking,” Dubin told Nezavisimaya gazeta. He added that without radical changes in society, the prospects for Russia’s middle class to grow and transform into a wide and stable social stratum seem doubtful (Nezavisimaya gazeta, June 27).

By design, the poll focused on those most likely to have thrived as a result of Russia’s economic rebound. Even among this restricted sample, the effects of institutional weakness are manifest. This is hardly conducive to the formation of trust and social capital that facilitates exchange and investment in human or physical capital. This bodes ill for Russian growth.

The fears expressed in the poll are anything but groundless. This article from the Guardian details the practice of corporate raiding a la Russe, which puts a whole new meaning on the phrase “hostile takeover.” Through a combination of force and fraud, often abetted by–or committed by–corrupt state organs, the raiders confiscate the assets of successful firms that attract their attention, often leaving the firm’s owner in jail. This is a tax on success and capital (accumulate no capital–no risk of expropriation!), and it is well known that capital taxes are extremely detrimental to growth. Now, this tax is not paid with certainty; not all successful entrepreneurs are subjected to the tender mercies of these latter-day Mongol hordes. Instead, it is, well, a Russian Roulette tax; you lose everything with some non-trivial probability. Again, hardly conducive to encouraging small business growth. (Another reason, perhaps, that small business formation in Russia is notoriously low.)

Need more evidence? Consider this Business Week piece describing the results of a poll conducted by my friend Sergei Guriev and Igor Fayukin, his colleague at the New Economic School:

The study’s participants believe “the lack of political competition and restrictions on political, economic and personal freedoms” are “a serious problem for the country.” The vast majority are concerned about Russia’s declining population, but also see corruption, the lack of an independent and effective judiciary and a disregard for citizens’ rights by the authorities as the leading challenges in the near future.”

Executives think the solution to corruption and state inefficiency can be found through “broader political change in the country.” One respondent said that the situationrequires the “liberalization of civil society, a reduction of barriers for business, and the modernization of government institutions in accordance with the aspirations and business and civil society.”

“In the eyes of many, the current problems are connected with the low level of competition in the country,” the study’s authors write. Another of their respondents thought what is needed is “more competition, a fight against the fusion of government and business and against monopolization.”

One might argue that other nations–notably China–have weak institutions as compared to the US and Europe, but have prospered in recent years. There appears to me to be a significant difference between China and Russia, however. China is ruled by what Mancur Olson called “stationary bandits.” Yeah, the Chinese bureaucrats and party elite steal, but they are sufficiently confident in the security of their positions that they take a relatively long view, and discipline their short run rapacity to increase their long run take; due to the security of their tenure, China’s new mandarins have an incentive to encourage growth. Russia in the 90s was beset by roving bandits, who knew that their long run prospects were dim, so they took everything they could, the future be damned. Things are a little better now (this is one of the wages of Putinesque “stability”), but as the raiding and confiscations and widespread sense of personal insecurity before the agents of the state demonstrate, roving banditry and short termism are still rife in Russia. (An example: it has been mooted that one source of conflict between BP and the Russian partners in TNK is that the latter want to maximize the short term revenues from the company’s properties, whereas the former wants to use techniques to conserve the oil reservoirs in order to maximize their long run potential.) Another potential difference is that Chinese businessmen have been more successful at organizing to advance their interests, whereas the atomization of Russian society has prevented the coalescence of any corporate resistance to the state’s predations.

With regards to demographics, although the government has crowed about increased birth rates, the overall picture is still grim. According to a recent report by the Russian State Statistical Service as reported in ITAR-TASS, Russia’s permanent population fell .07 percent in the first 4 months of 2008, corresponding to a .21 percent annual decrease. Although this figure is lower than the .5 percent decrease experienced throughout the 1990s and early-2000s, it is still hardly a sign of a healthy country. Indeed, immigration has cushioned the effect of continuing low birth rates and high death rates: “In the first four months of the year, the statistics service reported 547,100 births and 725,200 deaths, Prime Tass said.” Although the birth rate is up slightly, so is the death rate. And, as is widely understood, a good portion of the increased birthrate is a demographic fluke as the last large generation of Russian women is reaching childbearing age. Although the statistics do not say this explicitly, it should also be recognized that the educational and skill level of most of the immigrants and a disproportionate number of the childbearing families is below that of those dying–because immigrants and those having children are disproportionately from the more backward regions of the former-USSR and the more backward regions of Russia. Some baby boom. Some demographic rebound; more like a dead cat bounce.

Russia’s infrastructure woes are also widely acknowledged. I can’t find the cite (probably JRL), but I remember reading that the mileage (kilometerage?) of paved roads in Russia has actually declined in recent years. It is widely recognized that the railroad system is in desperate need of maintenance and expansion. In a country as large as Russia, infrastructure is crucial.

Of course, the government has announced grandiose plans to improve Russian infrastructure. The challenge is translating those airy promises into economically productive investment. The institutional deficit is one obstacle to achieving anything substantive; large infrastructure projects are especially vulnerable to corruption that inflates costs, not just in Russia, but in Russia the problem will be especially daunting. Moreover, the Edifice Complex and political considerations tend to divert too many resources to “prestige” projects and megadevelopments; the Sochi Olympics and the fantastical plans for a tunnel between Siberia and Alaska being conspicuous examples. Russian tendencies towards giganticism and the above-noted Russian desire to proclaim Russia’s resurgence in blingy ways will only exacerbate these problems. My prediction?: Infrastructure spending will indeed expand, but the social return on this investment will be very low. The private return–to those feeding at the trough–will be high indeed.

Other problems abound, but many fit comfortably in the categories just defined. Health care and public health are appalling in Russia, for instance, but this is really one of the sources of the demographic meltdown described above, and the intransigence of the problem reflects Russia’s institutional deficit.

So, to repeat old themes: Russia is never as strong as she looks, and her current strengths and successes are likely to be transitory as the institutional, demographic, and economic foundations for long run success are decrepit; the bleak long run prospects arguably contribute to the short term focus that characterizes Russian business and government; Russian aggressiveness is fueled by remarkable events in the commodities markets, the volatility of which make a very tenuous basis for long term success; and, in the end, no amount of chest thumping or prestige projects today will defer indefinitely a very painful future crash.

Russia would be much better served by a focus inwards on its pressing structural problems rather than by its current attempts to achieve some simulacrum of great power status. Not going to happen, unfortunately. And given that, Europe in particular should recognize Russia’s debilitating and deep seated weaknesses, and abandon its cringing and pusillanimous posture towards its eastern neighbor. This only feeds Russia’s presumptions and enables its dysfunctional political and economic culture.

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