Streetwise Professor

September 30, 2009

Nobody Takes, Nobody Pays

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 8:17 pm

The gas trade in Eurasia is conducted primarily under “take-or-pay” contracts, which obligate the buyer to pay for the contracted amount, regardless of whether they take the gas or not.  The Russians buy from Turkmenistan under take-or-pays, and sell to Ukraine and Eastern and Western Europe under such contracts.

Problem is, nobody is taking or paying.  Ukraine renegotiated its take-or-pays under the threat of neither taking nor paying.  Russia infamously balked on its take-or-pay obligations to Turkmenistan, and in so doing, caused an explosion in Turkmenistan’s pipeline system.  Both countries are still at loggerheads.  Now Europe is balking at paying the Russians:

Europe’s three largest purchasers of Russian gas – German E.ON, Italian ENI and Turkish Botas – have all challenged Gazprom over paying for deliveries of gas that they contracted for but did not take due to reduced demand in 2009.

These three, along with other European companies, all have long term “take or pay” contracts with Gazprom. According to  Kommersant Daily the total amount due to the Russian concern is approximately $2.8 billion.

The European’s point out that Russia made a deal with Ukraine that released the later from paying the full sum of contracted gas earlier this year and they insist on the same treatment. The companies also point out that Russia did not pay Turkmenistan any compensation whatsoever after it ceased taking delivery of Turkmen gas in April.

Once upon a time take-or-pays were common in the US too.  An excellent paper by Scott Masten and Keith Crocker in the AER in 1985 argued on classical transactions cost economics grounds that these contracts were to protect site specific investments in gas wells.  In those days, gas was purchased by pipelines that both transported the gas, and served as merchants: they bought the gas at the wellhead and sold it to industrial users and municipal utilities.  Given the natural monopoly aspects of gas transportation, this “bundling” of merchant and transport functions created a potential for holdup.  Once a well was in the ground, the (usually one) pipeline capable of shipping the gas could opportunistically demand a lower price, particularly when demand was low.  Masten and Crocker showed that take-or-pay was like a pre-packaged expectations damages clause that gave the parties an incentive to perform when the buyer would otherwise have an incentive to breach.

Seismic shifts in the gas business resulting from the perverse effect of price controls; the energy price shock of the 1970s; and the subsequent deregulation of gas prices by Reagan in the 1980s; combined to wreak havoc with these contracts in the 1980s.  Many pipelines had entered into huge take-or-pays in the 1970s when there were widespread fears of gas shortages and energy prices skyrocketed.  When prices plummeted, these contracts were extremely burdensome to the buyers, who sought any way to escape their obligations.  Moreover, the disparity between contract prices and market prices provided incentives for end users to try to buy gas directly from producers, and somehow secure the ability to transport the gas.

In the end, the entire structure of natural gas regulation collapsed.  Starting in 1986, the Federal Energy Regulatory Commission passed a series of orders that “unbundled” the merchant and transportation functions of pipelines.  Essentially, pipelines became regulated common carriers obligated to provide open access transportation to anyone who was willing to pay the tariff rate.

Soon thereafter, a vibrant gas market developed.  In place of negotiated contracts between big buyers and big sellers, there developed a whole array of markets, including daily markets, monthly markets, longer-term markets, futures markets, and swap markets.  Long term, take-or-pay contracts went the way of the dodo because every seller could contract directly with many buyers (who could get access to transportation), reducing the potential for holdup and opportunistic breach.

In brief, take-or-pay was largely an artifact of the integration of the pipeline transportation and marketing of gas.  Once pipelines became open access common carriers, these contracts became unnecessary, and buyers and sellers relied on more market-like arrangements.

Nothing like that is in prospect in contracting for pipeline-transported gas in Eurasia.   This is primarily true because the mother of all bundled gas companies–Gazprom–sits at the center of everything.  Indeed, Gazprom wants to extend its integrated activities into downstream marketing.

With an integrated Gazprom in the middle, European buyers cannot contract with Turkmenistan directly, meaning that the Turkmen need some contractual protection against expropriation.  Similarly, with all its specific investments in pipelines and producing fields, Gazprom is potentially vulnerable to holdup and opportunistic, inefficient breach, by buyers.  There is unlikely to be any prospect for the development of a vibrant gas market resembling that of the US anytime soon given the integrated, monopolistic market structure, particularly in Russia.

This also means that pricing mechanisms in contracts will have to rely on relatively inefficient proxies, like lagged oil prices.

But, as current events demonstrate, and as events in the US in the early-80s showed, take or pay contracts are also subject to breach when contract prices diverge from market values.

Things are not likely to change for the foreseeable future because Putin has announced his intention to retain the integrated, export monopoly structure of Gazprom:

Russia will maintain gas giant Gazprom’s (GAZP.MM) export monopoly in the medium term but will seek to liberalise the domestic gas market, Prime Minister Vladimir Putin said on Tuesday.

“In the near future we will try to liberalise the domestic market…, will try to liberalise access to pipelines. But the monopoly for sales on external market will be maintained…in the medium term for sure,” Putin said.

If in the long run we’re all dead, I guess in the medium run we’re all old.

It is an interesting question as to why Russia relies on an export monopoly to extract rents, rather than other mechanisms.  For instance, as in the oil market, Russia could permit open access to its pipelines and permit direct contracting between buyers and sellers, but charge a hefty export tax.  It does something analogous to this in oil.  Alternatively, it could permit direct contracting and open access common carriage, but instead of setting tariffs at levels sufficient to provide a competitive rate of return, it could set them at monopolistic levels and extract rents that way.

Both mechanisms would like be more efficient than the current system, with an integrated export monopolist.  These mechanisms would involve deadweight losses from monopoly/monopsony pricing, but would mitigate the transactions costs associated with the current structure.  Under these schemes, markets for gas could develop that would price efficiently, and which would be more flexible and less susceptible to the kinds of misalignments so evident today.  That is, transactional hazards would be mitigated under such alternatives.

So why not do it?  I have some cynical explanations.  Most importantly, the current opaque and convoluted system maximizes the potential to siphon off rents to private/siloviki pockets–or should I say the private accounts of public officials?  The tax alternative would result in monies going to the government; not that government monies are immune from theft, but it is likely easier to divert the money directly from Gazprom.  Moreover, it would give more folks a license to look into the company’s operations.  It would also expose those in Gazprom who do shady things to try to circumvent the taxes to the risk of ending up in a jail cell next to Khordovsky.

Similarly, the creation of efficient markets and fixed tariffs would make Gazprom’s finances much more transparent.  People would have a better idea of Gazprom’s real revenues, and the efficiency of its operations.  The company’s finances would be a lot simpler, and given this simplicity it would be easier to detect the diversion or tunneling of funds.   Put differently, an unbundled pipeline company with a regulated tariff provides fewer–though not zero–opportunities for theft than an immense corporate octopus engaged in all sorts of opaque deals.  The merchant function in particular permits all sorts of deals with shady intermediaries that can be–and almost certainly are–used to divert monies into silovik pockets.

Given these realities, it is likely that the Eurasian pipeline gas market will continue to be burdened by high transactions costs and inefficient contracting practices.  Contractual breaches and supply cutoffs will be chronic, especially when gas values move a lot one way or another.  In contrast, the open access US market has shown its ability to deal efficiently and rapidly with extreme shocks to supply and demand conditions.  But Gazprom ain’t going open access in the medium term, and in my view, in the long term either barring some miraculous change in the political economy of Russia.

The EU Report

Filed under: Military,Politics,Russia — The Professor @ 3:00 pm

The EU Report on the Russo-Georgian War is out.  Theoretically, anyways.  The report is huge, and apparently the server is overloaded, as it has proved impossible for me to download even the introduction (3.7 MB), let alone the even more massive (31.2 MB) Volume II.  I don’t want to rely on press reports or summaries, so I’ll defer posting on this until (a) I can download the report, and (b) I have sufficient time to digest it.

September 29, 2009

Going to the Punk Rock Show

Filed under: Uncategorized — The Professor @ 8:51 pm

Sunday night I took my HS daughter and her best friend to the Social Distortion concert in beautiful downtown Sauget, Illinois.  (My idea, BTW.)  The venue, a club called Pop’s, is nestled on the banks of the broad Mississippi–and right between a Penthouse club and a Dream Girls establishment, and across the street from the Big River Zinc smelter.  When we got out of the car, my daughter said “What’s that smell?”  Damned if I knew.  Damned if I wanted to know.

Despite the rather seedy environs, the club was OK, although the crowd was not what my daughter and her friend were expecting.  Knowing the location of the venue, and the band (which had an album titled “White Lightning, White Heat, White Trash”) I had sort of an idea what it would be like, so I wore a “Heroes of the Confederacy” t-shirt that my Dad won at a Civil War Roundtable fundraiser–to blend in, dontcha know.  Good choice.  The guy in front of me had a shirt that said “White Trash and Proud of It!”

Funniest moment.  I went into the men’s room, where a kid–six years old, I’d guess–was washing his hands.  (There were more than a few kids younger, some a lot younger, than my charges.)  He had big, thick geek glasses–and full punk regalia.  Blue Mohawk.  (Gen-u-ine, real deal, Mohawk.)  Black t-shirt.  Metal-studded belt.  Straight-leg jeans.  Black Chuck Taylors.  When he turned to dry his hands, he noticed that the towel dispenser was about 5 feet off the ground.  I noticed his dilemma, pulled off some towels, and handed them to him.  He looked at me with that Mohawk, staring wide-eyed through those thick glasses, and said in this sweet six-year old voice: “Thanks, friend!”  I swear, it was like an episode of L’il Rascals Go Punk.

Perhaps not surprisingly, given that Social D’s heyday was in the mid-90s, the crowd had a strong forty-ish contingent, and was pretty well behaved.  Of course, there were a few knucklehead rowdies that security hustled off very quickly.  Half of those shown the door were women who looked like they outweighed the bouncers–and the bouncers, of course, were not small.  At the sight of these, er, ladies, being frog marched with their arms pinned behind their backs, exercising their salty vocabularies, my girls stared wide-eyed for a minute, and then began cracking up.  Quite educational, I do say.

As for the concert, it was very good, even though I couldn’t stay for the whole thing: being a very responsible parent and chaperone, I split at 11 to get the kids home at a reasonable hour on a school night.  Even the warmup bands (especially The Strangers) were good, and Social D was excellent.  Not quite as good as Rancid, but then I’m partial to Rancid.  It was interesting that the band was very faithful–almost to the note faithful–to their CDs in their live performance.  Very little improv or variation. That’s not bad, since I like the songs as they are on the albums.

I did really like the wall-of-sound feel of the band, and Mike Ness was an excellent entertainer.  Unlike Rancid, which showcases not just Tim Armstrong but Lars Fredrickson and Matt Freeman (their excellent bassist), Social D is really the Mike Ness Band.  It’s definitely his group, and his show.  You always wonder if somebody on a long tour is just going to dial it in, but Social D didn’t.  The entire band was working it, and Ness was definitely emotionally engaged with his edgy, gritty material.  Good show, and hopefully I’ll be able to see them again soon not on a school night;-)

Friday night, my college daughter and I go to Chicago (actually, DeKalb, about 60 miles west, near where my grandparents lived when I was growing up) to see our favorite band–the Smoking Popes.  And the Pixies are in Chicago in November.  Thinking about that one; always wanted to see them, and I’m a huge Frank Black fan.

Getting the Vapors on Carbon Derivatives

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 7:56 pm

Congressional proposals regarding derivatives on carbon dioxide subject these products to the most onerous regulatory regime: they require trading on exchange, just like derivatives on agricultural products.  This probably reflects the fact that those legislators who are most concerned about carbon vapor are the same ones who get the vapors from derivatives.

The International Emissions Trading Association has warned against such a cramped regulatory regime:

The rules for buying and selling pollution credits under a proposed U.S. “cap-and- trade” program shouldn’t be tougher than those being debated in Congress for other markets, the  International Emissions Trading Association said today.

Geneva-based IETA, whose members include  Chevron Corp.,American Electric Power Co. and  Goldman Sachs Group Inc., said in a  report that “future financial services reform legislation should supersede the carbon market oversight provisions” of any cap-and-trade legislation that passes Congress

. . . .

Some lawmakers have expressed concern that a new U.S. carbon market may be more vulnerable than others to manipulation and fraud. They are considering special rules for the cap-and- trade program that would restrict OTC dealing in futures and other derivatives contracts, block the involvement of banks and impose price controls.

‘Out of Step’

These proposals are “out of step” with the new regulations being considered for other markets, IETA said. The group said concerns over manipulation and fraud can be dealt with through “stringent disclosure requirements of all OTC transactions” to the Commodity Futures Trading Commission.

The group said while lax oversight can enable fraud, “overly cumbersome oversight rules can discourage market participation, stifle investment, raise compliance costs, and threaten the program’s environmental performance.

The IETA concerns are quite sensible: the very onerous regulations in the Waxman-Markey (ACES) bill are not.

I’ve written in detail about the problems with the ACES regulatory scheme in a piece for the Brookings Institution that will be coming out in a volume later this fall.  It is available online now (follow the link).

Here are some of the arguments I make there, in brief:

Manipulation of carbon derivatives would not be impossible: even though the costs of delivery are theoretically zero (involving only book entries), just as in Treasury markets there will be frictions that can be exploited by a manipulator.  However, it is better to deter such manipulations ex post than attempt to prevent them by imposing tight trading regulations.

Moreover, an exchange trading requirement will prevent many market participants from realizing the risk management benefits of derivatives.  Most firms that face carbon price risk (in the event of the adoption of a cap and trade scheme) will face long-lived exposures that interact in a complex way with other risk exposures.  For instance, in a cap and trade world a power plant faces risks from power prices, fuel prices, and the quantity of power generated, as well as carbon prices.  Moreover, these exposures are likely to be non-linear in nature (due to the options inherent in plant operations, like the ability to turn it on and off, and perhaps fuel switching options).  In addition, they are likely to be very long-lived, because the plant is long-lived.

In contrast, most liquid exchange traded derivatives are simple, vanilla, linear products (forwards) with short maturities, or simple vanilla options with shorter maturities.  These are not well-suited to managing the complex risks that many carbon-intensive companies are likely to face.

Furthermore, the costs of rigid mark-to-market collateralization are high, and many market users could avoid these costs by trading customized OTC products.

This all means that requiring only exchange trading of carbon derivatives is likely to greatly increase the costs, and reduce the effectiveness, of carbon price risk management.  This will force firms exposed to carbon risk to bear risks that cost more for them to incur than it would cost the potential counterparties of customized derivatives.  By impeding efficient risk transfer, onerous regulations will increase the costs of a cap and trade system.

This is bad public policy.  Congress should be looking for ways to mitigate the costs of a CO2 trading system, not increasing them.  Impeding carbon risk management would do just that.

Another Lap in the Dark Pools

Filed under: Economics,Exchanges,Politics — The Professor @ 4:11 pm

Regulators seem really, really scared of the dark.  Members of Congress speak in ominous tones about “dark markets” when referring to OTC markets.  Another “dark” subject that has been the subject of horror stories in the recent past–”dark pools”–is making a reappearance.  Last week the Federation of Securities Exchanges wrote a letter to regulators demanding that dark pools be regulated more extensively, and that measures be implemented to move more trading onto exchanges.  In today’s FT, Jeremy Grant reports on regulatory pique at dark pools:

Dark pools operated by banks should improve pre and post-trade transparency and should operate under a more formal structure, the head of Europe’s umbrella group for securities regulators has said.

The comments, by Eddy Wymeersch, chairman of the Committee of European Securities Regulators, are the first by a top regulator since a spat has developed between the banks and some of Europe’s biggest exchanges over the bank’s “crossing networks”, a type of dark pool. Dark pools allow the matching of large blocks of shares without prices being revealed until after trades are completed.

Regulators on both sides of the Atlantic are studying them amid questions over their transparency.

. . . .

Mr Wymeersch said bank dark pools should “at least have post-trade transparency and also, if possible, have pre-trade transparency. They should organise themselves as MTFs, or something similar”.

“It’s a question of reliability of valuation in the entire system,” Mr Wymeersch told the FT at a European Commission conference on over-the-counter derivatives in Brussels.

He said he was “concerned” at the amount of off-exchange equities trading that takes place on crossing netwo

The criticism about dark pools relates to issues of transparency and fragmentation.  It is commonly argued that by fragmenting trading and liquidity, and in particular by siphoning off relatively uninformed order flow, dark pools degrade price discovery on exchanges.

This may be true, but it raises the question as to why it would occur, and if it is necessarily inefficient (relative to realistic alternatives).  I’ve written about this a good deal in my academic research, including a paper published in the Journal of Law Economics and Organization, another in Regulation Magazine, and a couple of working papers, and have raised some issues that most policy discussions overlook.  I’ll try to recap them briefly here.

Dark pools are essentially venues where large traders send orders in the belief that their orders would have a smaller price impact if executed in the dark pool, than if submitted to the exchange. That is, these traders believe that their orders will be less costly to execute.

That is quite possible if dark pools operate effective mechanisms for screening out relatively informed traders.  The crossing networks described above are one way of doing that.  Those submitting orders to crossing networks are not guaranteed an execution; only if there is a contra order that can be matched will the order be executed.  Moreover, crossing networks frequently cross orders periodically, rather than continuously.  These features are unattractive to an informed trader.  If I think I have very good information, I want to make sure that order is executed.  Moreover, if the information is likely to become public shortly, I don’t want to take the risk it will come out before the next cross.

This means that crossing networks can help separate uninformed block traders from informed traders.  As a result, the crossing network is less susceptible to adverse selection; this tends to reduce price impact of large orders.

In this respect, dark pools that screen out informed traders in order to reduce trading costs for large, uninformed traders (e.g., index funds) are no different than upstairs block markets that have been around for decades.  Upstairs block trading was a way of reducing execution costs by screening out the informed: if somebody “bagged the street” and traded a big block right before information was released, that somebody wouldn’t be able to trade blocks again anytime soon.

Theoretically, this “cream skimming” makes markets that don’t screen less liquid: there are fewer uninformed traders (because some have been skimmed off by the dark pools) on the exchanges that don’t screen, so adverse selection problems are more severe there.

Similar issues arise in other activities that draw regulator suspicion, such as payment for order flow and internalization.  Market makers like to internalize orders that they know are less likely to be informed, and send the others onto the exchange.  Similarly, they buy order flow that is likely to be uninformed and execute those orders.

In a world where exchanges are perfectly competitive, this cream skimming would be inefficient because it causes an negative externality imposed on those who trade on exchanges.  But that’s not likely to be the real world in which we operate.  Traditionally, exchanges limited participation (for instance, the number of members on the NYSE didn’t change from 1929 on–it remained at 1366, if memory serves, during that entire period).  Entry barriers reduce competition in market making.  Now, exchanges likely have some market power due to the network effects of liquidity, and can exploit that market power by charging supercompetitive prices.

My academic work shows that in such a world, cream skimming (e.g., the formation of dark pools) is profitable, and what’s more, it can improve efficiency in the sense that it reduces total investor trading costs.  Those that trade on exchanges are made worse off because their trading costs go up, but the execution costs of those who can take advantage of the third market that screens out the informed fall by a larger amount.

These effects occur because the competitive impact of dark pools more than offsets the negative externality.  Dark pools (and other off-exchange venues) enhance competition, reducing deadweight losses arising from market power.

Moreover, dark pools/third markets can reduce the return to informed trading.  Since some expenditures to become informed are pure rent seeking (the informed just extract a rent from the uninformed), reducing the incentive to collect information reduces rent seeking costs.

Thus, the pros and cons of dark pools or other off exchange trading venues that “fragment” trading depend crucially on the competitiveness of exchange trading.  Given that the network effects of liquidity are likely to confer market power on a dominant exchange, it is quite possible, and indeed probable in my view, that dark pools/third markets/off-exchange trading venues are a “second best” response to this market power.  If this is the case, constraining third markets/dark pools may just enhance exchange market power by disabling their competitors.  No wonder exchanges are the most outspoken in their criticisms of dark pools, and the biggest cheerleaders for more regulation.  Go figure!

Put differently, dark pools and other off exchange venues compete against exchanges, and since exchanges are likely to possess market power, this competition can improve welfare even if these dark pools create a negative (liquidity) externality.  That is, the arguments against dark pools focus on the negative externality, which would lead to inefficiency if the market were otherwise perfectly competitive.  But once deviations from perfect competition are admitted, the efficiency case against dark pools and other off-exchange venues fails.  The cost of externality may be smaller than the benefit of greater competition.

This means that any evaluation of the effect of dark pools, and the costs of benefits of alternative regulatory actions, is an inherently complicated exercise.  You can’t just say, “dark pools create a negative externality” and stop there.  You have to evaluate the trade-offs between the liquidity externalities and the competitive effects.  This is a very challenging task, and one that is likely beyond the capability of regulators to get right.

Suffice it to say that the complaints of exchange operators about dark pools should not be taken at face value.  Their gripes are self-interested.  Hobbling dark pools would reduce the competition they face.

Getting market structure right in securities markets is hard because of the network/liquidity effects.  Ham-handed regulatory interventions based on simplistic analyses of externalities and transparency are likely to make things worse, rather than better.

September 28, 2009

I’ve Seen This Movie Before

Filed under: Economics,Financial crisis,Politics — The Professor @ 8:31 pm

The Federal Deposit Insurance Corporation is running out of money, and is thinking of ways to get it, like getting banks to prepay future deposit insurance premia and special assessments.

I know we’re not quite there yet, but this brings to mind events of 20+ years ago, during the S&L crisis.  In the late-1970s and early-to-mid 1980s, many S&Ls were insolvent, and the Federal Savings and Loan Insurance Corporation (FSLIC) didn’t have the money to seize them, and pay acquirers to take them over.  (An insolvent thrift’s deposit liabilities exceeded its assets.  To get somebody to take over the deposit liabilities, FSLIC had to pay the difference between liabilities and assets out of the insurance fund.)  Congress steadfastly refused to provide the money needed to replenish the FSLIC fund, so FSLIC resorted to various measures to keep going.  Mainly, it created “regulatory capital” out of thin air to permit insolvent thrifts to keep operating.  A bad thing, that, because such “zombies” had an incentive to double down and gamble their way out of insolvency.  Many didn’t, and lost even more money, thereby increasing the size of the financial hole FSLIC had to fill.

Another thing FSLIC did was sell off insolvent thrifts and instead of giving the acquirers a lump sum to cover the hole in the balance sheet of the acquired thrift, promised them a stream of payments (“yield maintenance,” for instance) that covered the difference between the cost of funding the deposits and the earnings on the bad assets.  It did this in a slug of deals in December, 1988.

Problem was that FSLIC grossly underestimated the cost of this financial support to the Treasury.  The assistance was tax advantaged, but FSLIC didn’t take this into account.  Moreover, in calculating the costs of the deals, it assumed that the acquirers would work out and sell the bad assets quickly, shortening the time that the government had to provide the support.  But since (due in part to the tax advantage) the assistance effectively paid an above market rate of return as long as the bad assets were on the books, the acquirers had the incentive to milk the assistance for as long as possible, thereby inflating the costs far above what the government estimated.

(Along with three colleagues, the late Vic Bernard and Roger Kormendi, and current dean of the U Chicago B-School, Ted Snyder, I performed an evaluation of the December ’88 deals that showed how badly the FSLIC blundered.  In retrospect, the numbers–in the billions–seem like chump change compared to what’s gone on in banking recently.)

A big part of the problem is that middling level government folks, well meaning to be sure, were matched up against heavyweights like the Bass brothers when negotiating these deals.  It wasn’t a fair game, by far.  The financial sharpshooters had no problems structuring deals that were very profitable to them, and very costly to the government.  It was an asymmetric information problem writ large.

Moral of the story: when government guarantors run short of money to cover their obligations in a timely, final way, they can do very stupid, costly, things.  Starved of the necessary funds by Congress, FSLIC fed moral hazard problems, and entered into hasty, cash-conserving transactions that provided benefits to acquirers that proved very hard for the government to value, and which wound up being very expensive.  These measures made the insolvency problem worse, and inflated the cost of resolving it.

FDIC doesn’t appear to be in such straits yet, but the fact that it is looking for “creative” ways to fund itself raises red flags.  The FSLIC experience suggests that it would be better to provide FDIC with the funds it needs today to meet its obligations to insured depositors, rather than rely on creativity which, in the stress inherent in these circumstances, can lead to decisions that make sense to FDIC in the short run, but which are very costly in the long run (and in present value terms).  That is, just as with businesses, cash flow problems can lead government guarantors to make inefficient, costly decisions.  Better to grasp the nettle now, give FDIC the wherewithal to meet its obligations, and figure out how to claw back the money from the banking industry later.

September 27, 2009

It’s Enough to Make Me Long For the Days of Strategery

Filed under: Military,Politics — The Professor @ 2:03 pm

Obama’s Red Queen strategy first-resources later statement that I excoriated last week was not a mistake, a slip of the tongue.  It is official administration policy:

The White House says it wants to review the entire strategy for the region before considering McChrystal’s request.

“Right now the focus is on the strategic assessment itself. It (the troop request) will be shelved until such time that the  White House is ready,” a defense official said in Washington.

“It is not going to be addressed, or reviewed, or analyzed until the White House is ready to begin discussing it.”

Only a strategic boob, oaf, or knave–or somebody who just doesn’t give a damn–would say something so cosmically stupid.

Again: you cannot disconnect strategic decisions from considerations regarding the resources required to implement available alternatives.  No how, no way.  It is a logical impossibility.  The “strategic assessment itself” does not reside in some vacuum, some clean room, isolated from messy realities about resources and costs.  Strategy is all about trade-offs involving objectives and costs.

Read that last sentence again.  The administration will not address, review, or analyze the request for resources to implement a strategic plan the administration allegedly approved in March until it completes a new strategic review.  How can you possibly give something a “complete review” when you leave out a critical component of that review?

Mental image: Obama and his security team (heaven help us), with their fingers in their ears, yelling “I can’t hear you!”

The amazing thing is that the administration apparently thinks that this is a convincing story.  Are they that stupid, or do they think we are?

Sadly, I think the answer to that last question is: “Both.”

They’re Always Asking “More, More, More”

Filed under: Commodities,Economics,Energy,Military,Politics — The Professor @ 9:59 am

The joys of dealing with Putin’s Russia.

First, from Stratfor:

The Israelis also understand the Russia factor. Russia is engaged in an ongoing struggle to win Washington’s recognition of its influence in the former Soviet region. So far, the United States hasn’t given Russia what it wants. Consequently, Russia continues to flaunt the leverage it has with the United States over its ties to Iran. Not only can Russia completely destroy the effectiveness of a U.S.- led sanctions regime, but it can provide Iran with critical weapons systems that could seriously complicate an attack against Iran down the road. The Israelis simply are not seeing the value in delaying much longer.

Israel therefore is leaning heavily on the United States to reach some sort of compromise with Moscow and bring the Russians in line on the Iran issue.

Russian President Dmitri Medvedev made a statement on Wednesday that might indicate that such a compromise has a chance — however slight — of happening. “I told the president of the United States that we think it necessary to help Iran make the right decision,” Medvedev said, with just the right touch of ambiguity. “As for various types of sanctions, Russia’s position is very simple, and I spoke about it recently. Sanctions rarely lead to productive results, but in some cases, the use of sanctions is inevitable. Ultimately, this is a matter of choice, and we are prepared to continue cooperating with the U.S. administration on issues relating to Iran’s peaceful nuclear program, as well as other matters.”

This is a notable shift in tone coming out of Moscow, but does not yet signify that a deal has been made between the Americans and the Russians that would alleviate the crisis over Iran. Our Russian sources are hinting that something bigger may be under way, but they also have made it clear that this is just the beginning of negotiations. One source in particular has indicated that thus far, Washington is at least considering a Russian demand to postpone the U.S. deployment of a Patriot air defense battery in Poland. In return, Moscow would stick to its pledge to delay delivery of the S-300 strategic air defense system to Iran. In essence, this would be a mutual commitment to postpone commitment to their strategic allies.

A few comments.

First, many US commentors and Obama cheerleaders have seized on Medvedev’s words–which Stratfor rightly characterizes as ambiguous–like drowning men grasping at straws.  Note: (a) Medvedev doesn’t matter, Putin does, (b) there is so much wiggle room in this statement it means nothing, and (c) there are more examples of Russian now-you-see-it-now-you-don’t, Lucy-and-the-football dekes than it is possible to count.  There’s a sucker born every minute, and anyone who relies on Medvedev’s words is a sucker indeed.

Second, note Medvedev’s use of the phrase “Iran’s peaceful nuclear program.”  That is, he does not even concede acknowledge that Iran’s program is explicitly intended to develop a nuclear weapon.  Given Russia’s enabling of Iran’s nuclear ambitions, this isn’t surprising.  But note that this formulation gives Russia a perfect escape valve from supporting any sanctions: why would you impose sanctions on a “peaceful” program.  Until Russia officially and unambiguously acknowledges that Iran’s nuclear program is military in nature, there is no reason whatsoever to place any reliance on Russian support against Iran.

Third, note the disgusting, revolting immoral equivalence here.  Iran=Poland.  On the one hand: A totalitarian dictatorship that supports terrorism; a virulently anti-American and anti-Western regime; a Holocaust celebrator (not denier); an aggressive, irredentist nation; a crazed, millenarian theocracy.  On the other: a democracy that has supported the battle against terror and tyranny; pro-Western and pro-American; a nation that has grappled with its anti-Semitic past; a nation that is merely looking to defend itself from the predations of outsiders rather than dominate others; a religious, but politically secular country.

Contra Obama, and pace Mark Steyn: Nations should be–must be–defined by their differences.  The differences between Iran and Poland are so stark that the foregoing list barely even scratches the surface.  To treat Poland as a bargaining chip with the Russians in dealing with Iran is beyond disgusting.

And note: the Russians will just take any concession and ask for more.   Note very well: when it comes to Eastern Europe, the former Soviet space, and Poland in particular, Russia wants the United States to make very public concessions so as to undermine American credibility among these nations, all the better to induce them to reach an accommodation with Russia: an accommodation that will effectively concede Russian suzerainty.

Iran is important.  But to make concessions to Russia in the vain hope of making progress on containing the Iranians would be a strategic mistake of historic dimensions, not to mention a deep stain on American honor.  (How’s that for Jacksonian, Steve?)

Russian grabbiness is not limited to the diplomatic sphere.  It also extends to energy.  (You’re shocked to read this, I’m sure.)  Yes, Putin the Spider (too bad his first name isn’t Boris) is more than willing to lure Western energy firms into his Arctic web, but on his terms:

This looks like a proposal to form a cartel-type arrangement of gas (mainly LNG) exporters through price-formation and market share allocation. Russia would provide the gas resources while international companies would provide the technology and, presumably, share in a commercial bonanza through this arrangement. Moscow probably hopes that some international companies would vie with each other to be picked for the project on this basis.

The conditions for participation would, however, force the international companies to turn over to Gazprom their own competitive assets and lose some of their revenue sources. As spelled out by Shmatko and Economic Development Minister Elvira Nabiullina, international strategic partners in this project would be asked to: transfer Western technologies for the manufacturing of advanced drilling equipment, onshore and offshore, to Russia; allow Gazprom direct access to gas markets in consumer countries, using the distribution networks of partner companies; recognize a right for Russian companies to acquire energy infrastructure on territories of consumer countries; and assist Gazprom with marketing methods and personnel training (Interfax, RBK, September 24).

So, Russia gives access to Yamal in exchange for: money, technology, expertise, access to Western domestic markets (which Putin knows will be protected by Western legal norms), marketing, and training.  And, rest assured, that access to Yamal and the goodies of the cartel arrangement can be taken away at a whim–and likely will be taken away once the gas actually flows.

In other words: asynchronous performance.  The Western companies do everything today: the Russians “promise” to do something later.  Another sucker’s game.

Will there be any suckers to play?  Sad to say, the answer is likely “yes.”  I would hope that anti-trust authorities in nations intending to import Yamal gas, and in nations whose companies would participate in the project, will subject any such agreement to intense scrutiny.

The energy majors–and the Europeans–would be much better advised to do things like ramp up exploration of shale gas in Europe than invest huge sums in Yamal.

One has to have some grudging admiration for Russia’s aggressive negotiating, given its fundamental economic, demographic, political, and social weaknesses.  By the same token, one has to have nothing but disdain for those who seem more than willing to be duped and pushed around by a has-been giant with feet of clay.

September 25, 2009

Vladimir Putin, Comic

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 4:20 pm

Russians have a reputation for being a dour, humorless people.  I know this is wrong.  There are some great Russian comedians; and no, I’m not talking about Yakov Smirnov.  Take Vladimir Putin–please.

Consider this comic classic: “Putin seeks stable and long term partners for Arctic investments“:

Russia wants foreign energy majors for “stable and long-term” partnerships to develop gas deposits on the Arctic peninsula of Yamal, a region with enough gas in the ground to satisfy world demand for five years.

Prime Minister Vladimir Putin, hosting executives from several international energy companies on Thursday, said Russia would consider tax breaks to encourage development of gas fields in the region. State giant Gazprom (GAZP.MM) backed the move.

“We would like you to consider yourselves participants in our undertaking,” Putin told a meeting in Salekhard, the capital of the Yamalo-Nenets region. “The main condition from our side is that partnerships should be stable and long-term.”

“The main condition from our side is that partnerships should be stable and long-term.”  From “our” (i.e, the Russian) side.  Stop it!  You’re killing me!  You’re one of the great dead-pan comics of all time!

Uhm, Vladimir.  Any “short-termism,” any “instability” that has plagued past western energy investments (and other investments, cf. Telenor), has one source, and one source only: your side.  Russian opportunism and expropriation.  And not just directed against foreigners, but against the unfavored in Russia too (most notably Khodorkovsky).

The Telegraph opines that this reflects Putin’s desperation, given Gazprom’s financial difficulties and limited technological expertise:

No doubt his guests salivated at the idea of getting a piece of the action. By 2020, Yamal is estimated to be capable of yielding up to 300bn cubic meters of gas annually. This compares with a total annual Russian production that currently stands at around 550bcm. State-owned Gazprom spends around 25pc of its capex on the Yamal fields.

But Gazprom is running late, and it’s running short – of both technology and money. It needs foreigners. The aim is to use the Yamal resources to become a major player of liquefied natural gas – which can be exported anywhere without the need for pipelines. Hence Putin’s friendly hand.

. . . .

But Western companies should pause and think. They’ve been burnt before – as when Shell was bullied out of the Sakhalin-2 gas project three years ago. Since then, the legal framework under which Western companies operate hasn’t improved a bit.

What has changed is Putin’s need for foreign capital and expertise. This would be a good thing if it were accompanied by more than words to reassure investors that their money is safe and that they can plan on staying in Russia for the long term, without the hassle of corrupt bureaucrats and judges. Westerners must seize the chance to extract serious concessions from Russia before they rush head-first into the great gas hope, in what otherwise risks being a triumph of greed over experience.

In one of my earliest SWP posts, I noted that fools and their money are soon parted, and that companies would be foolish to invest in specific assets in Russia–particularly in the energy sector, or any other sector deemed strategic.  With the experiences of Yukos, Telenor, Shell, TNK-BP, and arguably now Exxon behind them, western investors have to know that the likelihood that they will be parted from their money is very high if they fall for Putin’s come hither look, and get entangled with Gazprom in Yamal or anywhere else.

Put differently, Putin is the spider, and any investor would be the fly.  Putin may be desperate now, but once there is pipe in the ground and the gas is flowing, his (or his successors) desperation will disappear, and the temptation to expropriate will be irresistable.   Once caught in the Russian web, any foreign energy investor is likely to be the spider’s meal, sooner or later.

Like the Telegraph says, absent credible, enforceable legal safeguards, western investors should avoid Putin’s blandishments like the plague.  The existence of a resource is a necessary, but by no means a sufficient, condition for a profitable investment.  To profit, you must be able to protect the asset against the predations of the state.  These protections are completely absent in Russia.  STAY AWAY.

It is sometimes argued that, echoing Willie Sutton, energy majors have to invest in Russia because that’s where the oil and gas are.  But, Russia is the Willie Sutton of nations: it will rob energy investors because, as Willie said, that’s where the money is.  But only if they are foolish enough to put it in Putin’s reach.  If they do, it will be no laughing matter.

September 24, 2009

Externalities

Filed under: Military,Politics,Russia — The Professor @ 9:14 pm

In response to my post on Obama’s unilateral termination of the Eastern European BMD program, several commentors suggested that the quid pro quo was Russian logistical support (i.e., transit rights) for American/NATO efforts in Afghanistan.  To which I commented:

I see. Russia extracts favors from those who are fighting and dying to protect its southern flank. Very nice. No wonder Russia is so admired around the world.

To which AK/DR/SO/PFG replied:

And another thought in relation to this… The US is not fighting there FOR Russia (though it aids both Russia and Iran inadvertently by doing so, ironically), but because it stepped / was forced into that quagmire. So Russia has nothing to lose by doing this, because NATO’s (increasingly the US) decision to stay in or leave Afghanistan does not depend on Russia, but on their judgments of when the mission has been accomplished.

I agree that the US’s motive in Afghanistan is not to help Russia.  But, thinking about it from an economic perspective, as even the-commentor-of-many-names notes, Russia is the beneficiary of an positive externality.  And, one should subsidize positive externalities, not tax them.  A/K argues, perhaps too cleverly, that Russia is inframarginal to the US decision; that is, the Russian tax will not affect the US decision on whether to stay in Afghanistan or not.  Maybe.  Maybe not.  But by raising the price of logistical support, Russia will induce the US to use less efficient and effective alternatives, thereby, for instance, weakening the US efforts against the heroin trade that Medvedev has expressed such concern about.  And Russia should not believe that it can be so delicate in its attempt to extract surplus from the US that it will not, in the end, leave.

And, what’s more, it reflects Russia’s extreme short-sightedness.  Taking advantage of current circumstances in Afghanistan may fill the denizens of the Kremlin with glee, looking backwards as they tend to do rather than forward, but unless the world ends tomorrow, or soon thereafter, they might find reason to regret extracting their pound of flesh today.  For the possible effects on Russian emanating from Afghanistan, or from the bad will it engenders going forward.  Not exactly the smartest move for a dying nation with tenuous economic and social prospects.

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