Streetwise Professor

March 27, 2017

No, I Haven’t Gone Soft on Putin: It’s That I Understand Who the Real Menace Is

Filed under: Politics,Russia — The Professor @ 9:09 pm

I spoke to my uncle over the weekend. He asked me, in all seriousness: “You haven’t written anything about Vlad lately. You going soft?”

My answer: “No–not going soft. But there are so many know-nothing lunatics shrieking about Putin that I don’t want to run the risk of being lumped in with them or confused with them or giving them any credence.” (If you think “know-nothing lunatic” is too strong, check out the Twitter timelines of Louise Mensch or John Schindler. You’ll see I’m actually being overly generous.)

And here’s the truly perverse thing about the hysteria. The lunatics are Putin’s most useful allies. If he really desired to create havoc in the American political system–which I would have no problem believing–in his wildest dreams he couldn’t have done the amount of damage that is now being wreaked by the Democrats and the media (I repeat myself, I know). They are using Putin and Russia as the pretext to carry out their own political vendettas, and to express their rage at losing a race that they just knew was in their pocket.  By massively overreacting to rather pitiful allegations (Podesta’s emails–really?) for purely partisan reasons they are doing far worse harm to the US than Putin could have ever hoped of doing.

I know Putin has an obsession with the US, and would love nothing more to undermine it. But his best sappers are unwitting ones, and Americans to boot. And bizarrely, they are doing their sabotage in the name of fighting Putin. I have never seen anything so demented and destructive in all my living days: it is so twisted it is difficult to explain it. Given that, it is far more important that I go after them, and leave Putin out of it. They are the immediate menace, and fighting them is not only justified in its own right, it is also the most direct way of depriving Putin of a chance to weaken the US.

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Seeing the OTC Derivatives Markets (and the Financial Markets) Like a State

Filed under: Clearing,Derivatives,Economics,Regulation — The Professor @ 12:07 pm

In the years since the financial crisis, and in particular the period preceding and immediately following the passage of Frankendodd, I can’t tell you how many times I saw diagrams that looked like this:

YellenCCPDiagram_1

YellenCCPDiagram_2

The top diagram is a schematic representation of an OTC derivatives market, with a tangle of bilateral connections between counterparties. The second is a picture of a hub-and-spoke trading network with a CCP serving as the hub. (These particular versions of this comparison are from a 2013 Janet Yellen speech.)

These diagrams came to mind when re-reading James Scott’s Seeing Like a State and his Two Cheers for Anarchism. Scott argues that states have an obsession with making the societies they rule over “legible” in order to make them easier to tax, regulate, and control. States are confounded by evolved complexity and emergent orders: such systems are difficult to comprehend, and what cannot be comprehended cannot be easily ruled. So states attempt to impose schemes to simplify such complex orders. Examples that Scott gives include standardization of language and suppression of dialects; standardization of land tenure, measurements, and property rights; cadastral censuses; population censuses; the imposition of familial names; and urban renewal (e.g., Hausmann’s/Napoleon III’s massive reconstruction of Paris). These things make a populace easier to tax, conscript, and control.

Complex realities of emergent orders are too difficult to map. So states conceive of a mental map that is legible to them, and then impose rules on society to force it to conform with this mental map.

Looking back at the debate over OTC markets generally, and clearing, centralized execution, and trade reporting in particular, it is clear that legislators and regulators (including central banks) found these markets to be illegible. Figures like the first one–which are themselves a greatly simplified representation of OTC reality–were bewildering and disturbing to them. The second figure was much more comprehensible, and much more comforting: not just because they could comprehend it better, but because it gave them the sense that they could impose an order that would be easier to monitor and control. The emergent order was frightening in its wildness: the sense of imposing order and control was deeply comforting.

But as Scott notes, attempts to impose control on emergent orders (which in Scott’s books include both social and natural orders, e.g., forests) themselves carry great risks because although hard to comprehend, these orders evolved the way they did for a reason, and the parts interact in poorly understood–and sometimes completely not understood–ways. Attempts to make reality fit a simple mental map can cause the system to react in unpredicted and unpredictable ways, many of which are perverse.

My criticism of the attempts to “reform” OTC markets was largely predicated on my view that the regulators’ simple mental maps did great violence to complex reality. Even though these “reform” efforts were framed as ways of reducing systemic risk, they were fatally flawed because they were profoundly unsystemic in their understanding of the financial system. My critique focused specifically on the confident assertions based on the diagrams presented above. By focusing only on the OTC derivatives market, and ignoring the myriad connections of this market to other parts of the financial market, regulators could not have possibly comprehended the systemic implications of what they were doing. Indeed, even the portrayal of the OTC market alone was comically simplistic. The fallacy of composition played a role here too: the regulators thought they could reform the system piece-by-piece, without thinking seriously about how these pieces interacted in non-linear ways.

The regulators were guilty of the hubris illustrated beautifully by the parable of Chesterton’s Fence:

In the matter of reforming things, as distinct from deforming them, there is one plain and simple principle; a principle which will probably be called a paradox. There exists in such a case a certain institution or law; let us say, for the sake of simplicity, a fence or gate erected across a road. The more modern type of reformer goes gaily up to it and says, “I don’t see the use of this; let us clear it away.” To which the more intelligent type of reformer will do well to answer: “If you don’t see the use of it, I certainly won’t let you clear it away. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.

In other words, the regulators should have understood the system and why it evolved the way that it did before leaping in to “reform” it. As Chesterton says, such attempts at reformation quite frequently result in deformation.

Somewhat belatedly, there are efforts underway to map the financial system more accurately. The work of Richard Bookstaber and various colleagues under the auspices of the Office of Financial Research to create multilayer maps of the financial system is certainly a vast improvement on the childish stick figure depictions of Janet Yellen, Gary Gensler, Timmy Geithner, Chris Dodd, Barney Frank et al. But even these more sophisticated maps are extreme abstractions, not least because they cannot capture incentives, the distribution of information among myriad market participants, and the motivations and behaviors of these participants. Think of embedding these maps in the most complicated extensive form large-N player game you can imagine, and you might have some inkling of how inadequate any schematic representation of the financial system is likely to be. When you combine this with the fact that in complex systems, even slight changes in initial conditions can result in completely different outcomes, the futility of “seeing like a state” in this context becomes apparent. The map of initial conditions is inevitably crude, making it an unreliable guide to understanding the system’s future behavior.

In my view, Scott goes too far. There is no doubt that some state-driven standardization has dramatically reduced transactions costs and opened up new possibilities for wealth-enhancing exchanges (at some cost, yes, but these costs are almost certainly less than the benefit), but Scott looks askance at virtually all such interventions. Thus, I do not exclude the possibility of true reform. But Scott’s warning about the dangers of forcing complex emergent orders to conform to simplified, “legible”, mental constructs must be taken seriously, and should inform any attempt to intervene in something like the financial system. Alas, this did not happen when legislators and regulators embarked on their crusade to reorganize wholesale the world financial system. It is frightening indeed to contemplate that this crusade was guided by such crude mental maps such as those supposedly illustrating the virtues of moving from an emergent bilateral OTC market to a tamed hub-and-spoke cleared one.

PS. I was very disappointed by this presentation by James Scott. He comes off as a doctrinaire leftist anthropologist (but I repeat myself), which is definitely not the case in his books. Indeed, the juxtaposition of Chesterton and Scott shows how deeply conservative Scott is (in the literal sense of the word).

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March 26, 2017

Counting the Days Until Jerry Brown Raises the Confederate Flag Over Sacramento

Filed under: History,Politics — The Professor @ 8:44 pm

For more than a century, progressives have tried to read the 9th and 10th Amendments out of the Constitution. Some conservatives and libertarians periodically attempted to argue that the amendments could be used as a check on federal power: whenever they did so, the left assailed them as extremist cranks–that is when they did not accuse them of racism and other reprobate tendencies:

[Senator Mike] Lee is a “Tenther,” part of a new extremist movement that seeks to brand all major federal legislation — not only labor regulation, but environmental laws, gun control laws, and Social Security and Medicare — as violations of the “rights” of states as supposedly spelled out in the Tenth Amendment.

But that view is soooo pre-Trump. Post-20 January, 2017, the progressive left is enamored with these amendments, and is seizing upon them as a talisman to ward off the evil Trump spirits. Want proof? Look no further than Governor Moonbeam himself, Jerry Brown:

Despite some recent threats from the president to use federal funding as a “weapon” against the state if it voted to become a sanctuary state, the Democratic Gov. Jerry Brown gave a tough rebuttal in an interview on NBC’s “Meet the Press” this week from the nation’s capital.

“We do have something called the ninth and the 10th amendment,” Brown said.

“The federal government just can’t arbitrarily for political reasons punish the State of California, that’s number one,” he said.

Jerry Brown, Tenther. I wait with bated breath for The Atlantic to label him an extremist fellow traveler of Mike Lee.

Under Brown’s leadership, California is moving to become a “sanctuary state”. As such, it would not be able to prevent the operation of federal law enforcement of immigration laws, but it would bar local and state cooperation with such efforts. In response, Trump has threatened to pull federal funding, and it is this that Brown considers a violation of the amendments that his ilk previously considered Constitutional dead letters appealed to only by right wing freaks.

The sanctuary state movement (which includes Maryland as well) edges very close to advocating nullification of federal immigration laws: it is interesting to note that nullifiers on the right routinely appeal to the 10th Amendment. To do so in defiance of a Jacksonian president is quite risky, in light of how it worked out for South Carolina in the 1830s in its conflict with the original Jacksonian. Like Jackson, Trump may well take up the challenge. Because of his personality. Because immigration is one of his signature issues. Because he is on firm legal ground, since courts have been decidedly hostile to 10th Amendment based claims (although I would not be surprised if leftist judges followed the example of Brown and find a strange new respect for the 10th). And since politically it should cost little: California (and Maryland and other states likely to pursue sanctuary legislation) aren’t going to vote for Trump  anyways. This is the kind of fight someone like Trump relishes.

But regardless of whether Brown and Trump come to legal blows over sanctuary status, it is beyond amusing to see progressives man the 10th Amendment barricades. I expect any day now that Jerry Brown will take up the states rights banner, and raise the Confederate flag over Sacramento. Even if he doesn’t go quite that far, the mere fact that he cites amendments that the left once scorned and which the hardcore right embraced demonstrates just how thoroughly Trump has scrambled American politics.

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March 24, 2017

Creative Destruction and Industry Life Cycles, HFT Edition

Filed under: Derivatives,Economics,Exchanges,Regulation — The Professor @ 11:56 am

No worries, folks: I’m not dead! Just a little hiatus while in Geneva for my annual teaching gig at Université de Genève, followed by a side trip for a seminar (to be released as a webinar) at ESSEC. The world didn’t collapse without my close attention, but at times it looked like a close run thing. But then again, I was restricted to watching CNN so my perception may be a little bit warped. Well, not a little bit: I have to say that I knew CNN was bad, but I didn’t know how bad until I watched a bit while on the road. Appalling doesn’t even come close to describing it. Strident, tendentious, unrelentingly biased, snide. I switched over to RT to get more reasonable coverage. Yes. It was that bad.

There are so many allegations regarding surveillance swirling about that only fools would rush in to comment on that now. I’ll be an angel for once in the hope that some actual verifiable facts come out.

So for my return, I’ll just comment on a set of HFT-related stories that came out during my trip. One is Alex Osipovich’s story on HFT traders falling on hard times. Another is that Virtu is bidding for KCG. A third one is that Quantlabs (a Houston outfit) is buying one-time HFT high flyer Teza. And finally, one that pre-dates my trip, but fits the theme: Thomas Peterffy’s Interactive Brokers Group is exiting options market making.

Alex’s story repeats Tabb Group data documenting a roughly 85 percent drop in HFT revenues in US equity trading. The Virtu-KCG proposed tie-up and the Quantlabs-Teza consummated one are indications of consolidation that is typical of maturing industries, and a shift it the business model of these firms. The Quantlabs-Teza story is particularly interesting. It suggests that it is no longer possible (or at least remunerative) to get a competitive edge via speed alone. Instead, the focus is shifting to extracting information from the vast flow of data generated in modern markets. Speed will matter here–he who analyzes faster, all else equal, will have an edge. But the margin for innovation will shift from hardware to data analytics software (presumably paired with specialized hardware optimized to use it).

None of these developments is surprising. They are part of the natural life cycle of a new industry. Indeed, I discussed this over two years ago:

In fact, HFT has followed the trajectory of any technological innovation in a highly competitive environment. At its inception, it was a dramatically innovative way of performing longstanding functions undertaken by intermediaries in financial markets: market making and arbitrage. It did so much more efficiently than incumbents did, and so rapidly it displaced the old-style intermediaries. During this transitional period, the first-movers earned supernormal profits because of cost and speed advantages over the old school intermediaries. HFT market share expanded dramatically, and the profits attracted expansion in the capital and capacity of the first-movers, and the entry of new firms. And as day follows night, this entry of new HFT capacity and the intensification of competition dissipated these profits. This is basic economics in action.

. . . .

Whether it is by the entry of a new destructively creative technology, or the inexorable forces of entry and expansion in a technologically static setting, one expects profits earned by firms in one wave of creative destruction to decline.  That’s what we’re seeing in HFT.  It was definitely a disruptive technology that reaped substantial profits at the time of its introduction, but those profits are eroding.

That shouldn’t be a surprise.  But it no doubt is to many of those who have made apocalyptic predictions about the machines taking over the earth.  Or the markets, anyways.

Or, as Herb Stein famously said as a caution against extrapolating from current trends, “If something cannot go on forever, it will stop.” Those making dire predictions about HFT were largely extrapolating from the events of 2008-2010, and ignored the natural economic forces that constrain growth and dissipate profits. HFT is now a normal, competitive business earning normal, competitive profits.  And hopefully this reality will eventually sink in, and the hysteria surrounding HFT will fade away just as its profits did.

The rise and fall of Peterffy/Interactive illustrates Schumpeterian creative destruction in action. Interactive was part of a wave of innovation that displaced the floor. Now it can’t compete against HFT. And as the other articles show, HFT is in the maturation stage during which profits are competed away (ironically, a phenomenon that was central to Marx’s analysis, and which Schumpeter’s theory was specifically intended to address).

This reminds me of a set of conversations I had with a very prominent trader. In the 1990s he said he was glad to see that the markets were becoming computerized because he was “tired of being fucked by the floor.” About 10 years later, he lamented to me how he was being “fucked by HFT.” Now HFT is an industry earning “normal” profits (in the economics lexicon) due to intensifying competition and technological maturation: the fuckers are fucking each other now, I guess.

One interesting public policy issue in the Peterffy story is the role played by internalization of order flow in undermining the economics of Interactive: there is also an internalization angle to the Virtu-KCG story, because one reason for Virtu to buy KCG is to obtain the latter’s juicy retail order flow. I’ve been writing about this (and related) subjects for going on 20 years, and it’s complicated.

Internalization (and other trading in non-lit/exchange venues) reduces liquidity on exchanges, which raises trading costs there and reduces the informativeness of prices. Those factors are usually cited as criticism of off-exchange execution, but there are other considerations. Retail order flow (likely uninformed) gets executed more cheaply, as it should because it it less costly (due to the fact that it poses less of an adverse selection risk). (Who benefits from this cheaper execution is a matter of controversy.) Furthermore, as I pointed out in a 2002 Journal of Law, Economics and Organization paper, off-exchange venues provide competition for exchanges that often have market power (though this is less likely to be the case in post-RegNMS which made inter-exchange competition much more intense). Finally, some (and arguably a lot of) informed trading is rent seeking: by reducing the ability of informed traders to extract rents from uninformed traders, internalization (and dark markets) reduce the incentives to invest excessively in information collection (an incentive Hirshleifer the Elder noted in the 1970s).

Securities and derivatives market structure is fascinating, and it presents many interesting analytical challenges. But these markets, and the firms that operate in them, are not immune to the basic forces of innovation, imitation, and entry that economists have understood for a long time (but which too many have forgotten, alas). We are seeing those forces at work in real time, and the fates of firms like Interactive and Teza, and the HFT sector overall, are living illustrations.

 

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March 11, 2017

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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March 10, 2017

US Shale Puts the Saudis and OPEC in Zugzwang

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

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

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

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

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

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

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

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

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

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

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

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

My heart bleeds. Bleeds, I tells ya!

 

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March 4, 2017

Obama v. Trump: Strictly Correct & Misleading v. Not Strictly Correct But Fundamentally True

Filed under: Politics — The Professor @ 8:45 pm

I won’t comment in detail on the substance of today’s latest outbreak of our fevered politics: Trump’s accusation that Obama ordered wiretapping of Trump Tower and the Trump campaign. I will just mention one fact that strongly supports the veracity of Trump’s allegation: namely, the very narrow–and lawyerly–“denials” emanating from the Obama camp.

Obama and his surrogates–notably the slug (or is he a cockroach?) Ben Rhodes–harrumph that Obama could not unilaterally order electronic surveillance. Well, yes, it is the case that Obama did not personally issue the order: the FISA court did so. But even if that is literally correct, it is also true that the FISA court would not unilaterally issue such an order: it would only do so in response to a request from the executive branch. Thus, Obama is clearly implicated even if he did not issue the order. He could have ordered his subordinates to make the request to the court, or could have approved a subordinate’s request to seek an order. Maybe he merely hinted, a la Henry II–“will no one rid me of this turbulent candidate?” (And “turbulent” is a good adjective to apply to Trump.) But regardless, there is no way that such a request to the court in such a fraught and weighty matter would have proceeded without Obama’s acquiescence.

I therefore consider that the substance of Trump’s charge–that he was surveilled at behest of Obama has been admitted by the principals.

This episode illustrates a broader point that is definitely useful to keep in mind. What Obama and his minions (and the Democrats and many in the media) say is likely to be correct, strictly speaking, but fundamentally misleading. In contrast, what Trump says is often incorrect, strictly speaking, but captures the fundamental truth. I would wager that is the case here.

The lawyer word games are not limited to this episode. The entire Sessions imbroglio smacks of scumbag lawyer tactics. The Unfunny Clown, Senator Al Franken, asked (in a convoluted way) a very narrow question (which was related to an even narrower written question in a set of interrogatories) about Session’s interactions with the Russians. Sessions answered the question–which was not an unconditional query about contacts with the Russians, but which related to very specific types of contacts and discussions. Franken and the Democrats then accused Sessions of perjury because the Senator (and then-Attorney General designate) had met with the Russian ambassador to the US on two occasions. Asking a narrow question, and then claiming the answer was a false response to a broader question (that was not asked) is a sleazy lawyer trick (and one that has been tried on me, BTW).

One last thing. Why did Trump push this button today? I can think of offensive and defensive reasons. Offensively, he might want to gain the initiative in the war against Obama and the intelligence community. Defensively, this could be an excellent way of derailing the Russia hysteria, and the calls for an investigation. If it turns out that there was an FBI investigation, and it turned up nothing, then there is no justification for further investigation, whether by Congress or law enforcement. So it could actually help Trump if the FBI and the intelligence community were forced to acknowledge that they had investigated, to no avail. By raising the issue, Trump is pressuring the FBI to put up or shut up.

Figuring out Trump’s reasoning is always hard, but it is worth remembering that he is often at his most clever when he appears to be at his most unhinged and outrageous. So stay tuned. This isn’t over. By a long shot. And given that Trump has emerged triumphant whenever his foes have declared him to be dead meat, I would be very nervous right now if I were Barry or Ben or anyone in the IC.

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March 3, 2017

The Rocks Didn’t Go Anywhere. Go Figure.

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

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

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

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

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

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

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

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

Javier Blas chimes in:

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

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

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

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

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

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

Shale firms have also become more efficient.

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

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

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

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

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March 2, 2017

The Politicization of the Death of CPO Ryan Owens

Filed under: Military,Politics — The Professor @ 4:00 pm

Today the WaPoo serves as ventriloquist dummy for ex-Obama NSC staffer Colin (with an “i”) Kahl. Kahl continues his criticism of Trump’s handling of the planning and approval process for the mission in Yemen that resulted in the death of SEAL Ryan Owen. The gravamen of Kahl’s criticism is that the Obama administration engaged in much more internal debate at high levels, including at the presidential level, before approving such a mission. Kahl insinuates that the (allegedly) perfunctory process was a cause of the deadly outcome of the mission.

However, as I noted in my first post on the Yemen raid, there were multiple special operations mission in the Obama era that resulted in casualties and deaths among American special operators. Thus, more extensive internal debate is obviously not a sufficient condition for avoiding casualties. The fact is that these sorts of operations are inherently dangerous, and go wrong with some regularity. By failing to point out that reality, and the reality that a more “hands-on, deliberative process used by the previous administration” did not suffice to avoid American casualties in multiple cases, Kahl is lying by omission, and the WaPoo is facilitating that lie.

Further, Kahl and his WaPoo mouthpieces fail to point out that extensive internal debate, and senior involvement in the planning and approval process to the point of micromanagement, has its costs too. It must be pointed out that while Obama and his senior aides fretted about what to do about ISIS in 2014, the group ran amok and conquered much of Iraq and Syria. There was a clear case where Hamlet-like indecisiveness resulted in a result that was far more catastrophic than the failure of a particular special operations raid to go according to plan. Indeed, some of the raids resulting in American casualties undertaken by the Obama administration wouldn’t have been needed if the Obama administration had checked ISIS in the summer of 2014, instead of deciding that it was the JV and letting it go on a rampage.

The micromanagement continued throughout the Obama administration. This inevitably reduced the effectiveness of the war on ISIS, the cost of which is written in blood. Pace Bastiat, one has to consider the unseen in war as well as in economics.

The issue of the Yemen raid and the death of Ryan Owen required the WaPoo’s emergency intervention because it is widely recognized (even by Van Jones, for crissakes) that Trump’s recognition of his widow at his speech before Congress on Tuesday was a powerful moment that resonated with Americans. The left, and assorted non-left Trump haters (e.g., bloated, drunken, unemployed flashers who pontificate on security matters on Twitter), have worked themselves into a frenzy in an attempt to discredit this moment.

This has taken two tacks. One is the Kahl tack–to claim that Trump is responsible for Owens’ death through shoddy planning. The other is to claim that Trump somehow used Mrs. Owens, or even forced her to appear. Kahl’s tack is fundamentally dishonest (as discussed above) and the other tack is just disgusting. Carryn Owens was obviously deeply moved and appreciative. She wanted to be there, and wanted her husband’s sacrifice to be recognized. As to how she could have been forced to appear (as alleged by aforementioned bloated flasher), I have no clue. Insofar as using is concerned, Trump invited scrutiny of the events leading up to Owens’ death, and obviously believes he has nothing to hide, and that recognizing Owens’ sacrifice was more important: recall that Trump met Owen’s body when it was returned to the US.

If there is politicization of the death of CPO, that is coming primarily from the left in its unrelenting war on Trump, in which all is fair.

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March 1, 2017

Ivan Glasenberg: Mistaking Luck for Genius?

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

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

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

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

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

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

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

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

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

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

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

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