Streetwise Professor

May 23, 2016

Storing Oil at a Loss? Analysis Akin to the Drunk Looking for His Keys Under the Streetlight

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 12:48 pm

This article claims that “Oil traders are borrowing from banks to store crude at a loss.” Almost certainly not.

The calculation is based on contangos in Brent crude. But the vast bulk of the oil being stored at sea is in Singapore, and is not BFOE, from what I can gather.  This makes all the difference.

This is an example of what has long been a puzzle in economics in which futures prices in a central market (like Brent futures) are at less than full carry but inventories are held at other locations, or in non-deliverable grades (in the central market).  People are puzzled because they don’t take into account transformation costs. It would be impossible for some locations/grades to be at a carry that incentivizes holding inventory while other locations/grades are in backwardation if there are no frictions (costs) in transforming a commodity from one location to another, or from one grade to another: take the stuff out from storage in the market that is at full carry, move it to the central market that is in backwardation, and capture that backwardation (i.e., the premium for immediate consumption/delivery). But if there are frictions, the costs of transforming (e.g., shipping) the commodity to the central market may exceed the backwardation/premium for immediate delivery, making it unprofitable to make that transformation to capture that premium.

This means that a commodity that is costly to transport, or where there are bottlenecks in the logistical or refining processes, will have different forward curves at different locations (or for different grades). Where inventories are held, the price structure will cover storage costs: where the price structure doesn’t cover storage costs, inventories will not be held. Similarly, if some grades of a commodity are stored, the forward curve specific to that grade will cover storage costs.

A good example is Iranian heavy crude in the spring and summer of 2008. At a time when light sweet crudes (WTI and Brent) were in backwardation, and oil prices were reaching record highs, 14 or so supertankers of Iranian crude were swinging at anchor. Why? The demand was for light sweet crude to make low sulphur diesel to meet new European regulations: due to bottlenecks in refining in Europe (European refineries being unable to economically process heavy sour Iranian crude into LSD), there was strong demand for sweet crude that was cheap to refine into LSD, and little was in storage.  As a result,  WTI and Brent prices were high, and their futures curves were in backwardation. However, there was weaker demand for heavy sour crude because of its unsuitability for producing LSD. Also, many refineries that were optimized to process sour Iranian crude were down for maintenance. As a result, Iranian crude sold at a very large discount to WTI and Brent, and the forward price structure for that crude made it economical to store it.

Moving forward to the present, storing non-Brent crude in Asia can be economical even if time spreads do not cover the cost of storage Brent in NW Europe. Even though the lack of carry in the Brent market indicates a high demand for BFOE, the cost of transporting crude from Asia may make it uneconomical to ship it to Europe to meet the high demand for oil there. Moreover, the grades of crude being stored on tankers in Asia may not be competitive with Brent. Similarly, demand is not high enough in Asia to make it profitable to refine all of the supply there. So it is uneconomic to move it to Europe, and it is uneconomic to refine all of it. Therefore, store some of it in Asia even when Brent time spreads are narrow.

Furthermore, the apparent squeezes in Brent mean that some of the demand for it is artificial, and that Brent spreads do not reflect the competitive economics of storage. That is, if there are squeezes or even anticipations of squeezes, Brent calendar spreads are artificially high due to the exercise of market power. It is particularly misguided to use Brent spreads to evaluate the economics of non-Brent storage in this case. (The major reason that squeezes can work is that it is impossible to transform non-Brent crude into Brent.)

Oil traders operate on very thin margins. They are not going to make uneconomic trades. Period. If they are storing oil on ships in Singapore, it is because it pays to do so.

So why the claim that they are storing at a loss?

It’s like the old story of the drunk looking for his car keys under the streetlamp, because the light is better there. It is easy for outsiders to observe Brent spreads, or WTI spreads: just look at a Bloomberg screen, or even futures settlement prices. Singapore spreads, not so much. Traders search to collect information about prices and price structures in an opaque market like Singapore, and can use that to evaluate the economics of storage opportunities. But you or I or journalists or even analysts at Morgan Stanley have a far tougher time doing that.

So the outsiders look under the Brent futures streetlight, and conclude that storing oil doesn’t pay. But the oil isn’t under the streetlight. It’s being stored in the dark. And those who can see in the dark are storing it there because they can see that it pays.

 

 

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May 13, 2016

Surprise, Surprise, Surprise: Guess Who Squeezed (and May be Squeezing) Brent

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 7:44 pm

Cue Gomer Pyle. It is now being reported that Glencore was not just bigfooting fuel oil in Singapore, but it was the firm stomping on Brent as well. It took delivery of 15 or more cargoes of the 37 available for June loading. There is also talk that the firm had accumulated a position in excess of the 37, and had already had contracts to sell Brent to refineries in Asia and Europe.

Thus all the elements of a squeeze were in place. A position bigger than deliverable supply, and a grave pre-dug to bury the corpse. It was able to liquidate some of its position (25 cargoes or so, or more than 15 million barrels) at an artificially high price (as indicated by the flip from contango to backwardation in the last couple of weeks of trading).

The July contract has also flipped into a backwardation, suggesting that the play is on again.

Two (and perhaps three, if Glencore is behind what’s going on now) squeezes in short order is pretty audacious, even for Glencore. Makes me wonder if this is part of the company’s resurrection plan. Trading needs to perform in order to offset the carnage in the mining operation. That means taking more risks. Including regulatory and legal risks. Though truth be told, both the UK and Singapore have been quite supine in responding to market power manipulations for years. For instance, with all the squeezes that have taken place on the LME over the years, what have UK regulators ever done? What have they ever done in Brent? Or in the softs, where some pretty big squeezes have taken place in cocoa and coffee in recent years?

Inspector Clouseau would be proud.

The bigger risks are economic and commercial. Squeezes can be very profitable, but they can go horribly wrong. Recall that Glencore’s qua Glencore’s genesis was Marc Rich’s failed attempt to squeeze the LME zinc market in 1992. Marc Rich & Co. lost around $200 million, which resulted in a coup led by Ivan Glasenbeg that ousted Rich, and the renaming of the company as Glencore.

But desperate times sometimes call for desperate measures. Yasuo Hamanaka comes to mind. When his massive rogue trading operation was teetering on the precipice, needing a big profit in a hurry he carried out a massive corner of LME copper in December 1995. He wrote his co-conspirator “this is our last arms” (quoting from memory). In other words, do or die.

I’m not saying that Glencore’s problems are at all similar to Hamanaka’s, but the company does have big issues, and a need to make a lot of money in a hurry. The kind of issues that can lead big risk takers to take bigger risks, and push the envelope. The envelopes in Brent and Singapore fuel oil are pretty expansive, but Glencore seems to be pushing them nonetheless. Not part of the official resurrection plan, but most likely part of it nonetheless.

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May 10, 2016

A Poster Child for the Devolution of American Conservatism Beats Trump With a Leftist Stick

Filed under: History,Politics — The Professor @ 6:22 pm

Trump’s triumph is sending establishment Republicans (on Capitol Hill, ex-Bushies, and writers at publications like the National Review and Weekly Standard) into paroxysms of apoplexy. A recent example is a WaPo piece by ex-Bush speechwriter (and relentless self-promoter) Michael Gerson. It makes for nauseating reading, even if you are not a Trump acolyte (and I am not).

The gravamen of Gerson’s gripe:

What common views or traits unite the most visible Trump partisans? A group including Limbaugh and Christie is not defined primarily by ideology. Rather, the Trumpians share a disdain for “country-club” Republicans (though former House speaker John Boehner apparently likes Trump because they were golfing buddies). They tend to be white and middle-aged. They are filled with resentment.

Above all, they detest weakness in themselves and others. The country, in their view, has grown soft and feeble. Their opponents are losers, lacking in energy. Rather than despising bullying — as Ryan, Romney and all the Bushes do — they elevate it. The strong must take power, defy political correctness, humiliate and defeat their opponents, and reverse the nation’s slide toward mediocrity.

The most annoying part about this is that Gerson–like other Republican Trump critics–uses a line of attack that the left has used against Republicans forever to attack Trump: “they tend to be white and middle-aged. They are filled with resentment.” Every time–every bleeping time–the Republicans have won big in an election (e.g., 1994, 2014) the left has attempted to de-legitimize the victory by claiming it is nothing but the tantrum of privileged, middle-aged whites. (Remember Peter Jennings’ verdict on the Gingrich-led Republican insurgency of 1994?)

And gee, last time I checked, George W. Bush (for whom Gerson wrote) didn’t exactly assemble a New Rainbow Coalition.

What makes things even more irritating is that after regurgitating the standard leftist/Democrat attack on Republicans, many of the anti-Trump crowd also scream “he’s not a real conservative!” No, he probably isn’t, but please tell me just how is using the leftist stick to beat Trump conservative?

Gerson has one thing sort of right: “The great Republican crackup has begun.”

There is a Republican crackup. One problem with Gerson’s sentence is the tense. The crackup began some time ago, and has been ongoing. Gerson also fails to identify who is responsible for the crackup. If he were honest, he would have to quote Pogo: “We have met the enemy, and he is us.”

For the rise of Trump is the direct result of the abject failure of the Republican Party generally, and the Bush Dynasty in particular. For decades they have failed to articulate a coherent, principled, intellectually compelling, or popular governing vision, or a practical program to implement it. For decades they have failed to produce any appealing leaders or candidates.

They are the ones who created the vacuum that Trump has filled with his bombast and outsized personality. And how did they respond to his insurgency? Not with a positive vision. Not with a coherent, reasoned, and appealing alternative to address the issues that Trump (perhaps opportunistically, but clearly astutely) has run on, which obviously strike a deep chord with many who voted reliably Republican in the past.

But never count on this crowd for honesty, or searching self-appraisal. Instead, they have responded with insults–all the while attacking Trump for his insult comic style. They have responded with ad hominem and invective, not with a positive program that could appeal to Trump’s supporters.

And rather than recognize that the failure of their attacks to resonate is a damning verdict on their shortcomings, they respond with attacks on the voters with whom they have failed to connect. Their reactions are all variations on “the people have spoken. The bastards.”

Paul Johnson–as solid as a conservative as there is–is much more astute about these things than Gerson, or the NRO gang, or the whiners on Capitol Hill:

For these reasons it’s good news that Donald Trump is doing so well in the American political primaries. He is vulgar, abusive, nasty, rude, boorish and outrageous. He is also saying what he thinks and, more important, teaching Americans how to think for themselves again.

. . . .

No one could be a bigger contrast to the spineless, pusillanimous and underdeserving Barack Obama, who has never done a thing for himself and is entirely the creation of reverse discrimination. The fact that he was elected President–not once, but twice–shows how deep-set the rot is and how far along the road to national impotence the country has traveled.

Under Obama the U.S.–by far the richest and most productive nation on earth–has been outsmarted, outmaneuvered and made to appear a second-class power by Vladimir Putin’s Russia. America has presented itself as a victim of political and economic Alzheimer’s disease, a case of national debility and geopolitical collapse.

I’m not saying Trump is the cure. In fact, I’m pretty sure he’s not. But I am sure that the #neverTrump crowd is a major part of the disease. The unprincipled and whiney way they have responded to his trouncing them is proof of that.

If Trump could actually send this lot into oblivion, he will have performed a valuable service. Perhaps then something better could take its place. I fear, however, that the establishment Republicans will survive a Trump defeat like cockroaches surviving a nuclear holocaust. Indeed, they are likely to mutate, and come back even more malign, saying “I told you so” over and over again, and seeing vindication in what in reality is a damning condemnation: Trump’s defeat would not be a victory for conservatism, or classical liberalism, but for the governing class and the dead hand of the state. I predict the establishment Republicans who survive in the dark, damp recesses of DC will be the New Bourbons, learning nothing, and forgetting nothing.

Because  if it happens, Trump’s defeat would not clear the way for a viable alternative to the perverse political correctness that Johnson attacks, or the prevalent liberalism that dominates current American politics. It would just represent a continuation of the American political devolution–especially on the right–of the last 30-odd years.  A devolution of which people like Michael Gerson are the poster children.

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Glencore Mucking About in the Dirtiest Market in the World

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 5:30 pm

The WSJ has an interesting story about Glencore big-footing the Singapore fuel oil market:

In a lightly trod corner of the oil market, Glencore PLC is leaving a big footprint.

During two of the past five quarters, the commodities trader has bought up large volumes of fuel oil at Asia’s main trading hub in Singapore at a time of day when it has an outsize effect on an Asia-wide price benchmark.

Trades made during the daily “Platts window”—the final few minutes of trading—are reported to Platts, an energy-price publisher, which uses the data to calculate a daily benchmark used to price millions of barrels of fuel oil across Asia.

In the first quarter, Glencore bought 20.7 million barrels of Singapore-traded fuel oil in the window—44% of all the Platts-window buying—according to the publisher, which is owned by S&P Global Inc. During that period, fuel-oil prices in Singapore rose 7.5%, according to Platts, outpacing Brent crude oil, up 6.2%, and U.S.-traded crude oil, up 3.5%.

“The fuel-oil bull play has been a fairly regular feature of the market-on-close window for many years,” said John Driscoll, chief strategist at JTD Energy Services in Singapore and a former fuel oil-trader. “Singapore is the world’s largest marine-fuels market and serves as the central pricing hub for petroleum products east of Suez. These conditions tend to favor bullish traders who have the resources and conviction to aggressively bid the window for a sustained period of time.”

The Journal soft-pedals what is going on here:

Some traders, shipbrokers and commodity experts say Glencore’s purchases have hallmarks of a trading gambit sometimes employed in the lightly regulated world of fuel-oil trading. In it, traders buy large quantities of physical fuel oil to benefit a separate position elsewhere, such as in the derivatives market or elsewhere in the physical market.

I’ll be a little more blunt. Yes, this looks for all the world like a manipulative play, along the lines of my 2001 Journal of Business piece “Manipulation of Cash-Settled Futures Contracts.” Buy up large quantities in the physical market to drive up the price of a price marker that is used to determine payoffs in cash-settled OTC swaps. (It’s possible to do something similar on the short side.) This works because the supply curve of the physical is upward sloping. Buy a lot, drive the market up the supply curve thereby elevating the price of the physical. If you are also long a derivative with a payoff increasing in the cash price, even though you lose money on the physical play, you can make even more money on the paper position if that position is big enough.

It’s impossible to know for sure, without knowing Glencore’s OTC book, but it is hard to come up with another reason for buying so much during the window.

Those on the other side of the OTC trade (if it exists) know who their counterparty is. It is interesting to note the “ethos” of this market. Nobody is running to court, and nobody is shouting manipulation. The losers take their lumps, and figure that revenge is the best reward.

Platts reacted with its usual blah, blah, blah:

“The Singapore refined-oil-product markets are highly liquid, attracting dozens of buyers and sellers from across the world, and our assessments of those markets remain robust,” Platts said in a statement. “It’s worth highlighting that our rigorous standards in our oil benchmarks are fully open to public scrutiny, and a result of information provided to us on a level playing field.”

As a transactions-based methodology, Platts windows are not vulnerable to some kinds of manipulation (e.g., of the Lie-bor variety) but they are definitely vulnerable to the large purchases or sales of a big trader looking to move the price to benefit an OTC position. The most that Platts can do is provide more delivery capacity to make the supply curve more elastic, but as I show in the 2001 paper, as long as the supply curve is upward sloping, or the demand curve is downward sloping a trader with a big enough derivatives position and a big enough pocketbook has the incentive and ability to manipulate the price.

Once upon a time, in the 90s in particular, the Brent market was periodically squeezed. Platts (and the industry) responded by broadening the Brent basket to include Forties, Oseberg, and Ekofisk. For a while that seemed to have made squeezes harder. But the continued decline of North Sea production has made the market vulnerable again. Indeed, all the signs suggest that the June Brent contract that went off the board last week was squeezed: it went into a steep backwardation during the last few days of trading, and the market returned to contango as soon as that contract expired.

The fact is that market power problems are endemic in commodity markets. The combination of relatively small and constrained physical markets and big paper markets create the opportunity and the incentive to exercise market power. It looks like that happened in Brent, and looks like it is a chronic problem in Singapore FO, reputed to be one of the dirtiest markets in the world.

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May 5, 2016

If You Believe the Official Reason for Cutting Off Chinese Economic Statistics, I Have a Great Wall to Sell You

Filed under: China,Commodities,Economics,Energy,Politics — The Professor @ 9:33 pm

Since October of last year, China’s National Bureau of Statistics has not published detailed data on metals markets. And it’s not just metals:

Data on oil products such as liquefied petroleum gas, naphtha and fuel oil have been withdrawn. So too have regional figures for coal, steel and electricity output.

 

The ostensible reason is that statistics bureau personnel were selling data for personal gain.

If you believe that, I will sell you a large wall. It’s so big they say you can see it from space! Only one like it! I sell it to you for a song.

“Anti-corruption” is the cover/pretext that the Chinese government now uses to eliminate those who have fallen from political favor. The most likely explanation for the “anti-corruption” drive aimed at economic statistics agencies is not to eliminate politically inconvenient people: it is to eliminate politically inconvenient data.

The fraudulence of Chinese official economic statistics is well known. One of the challenges of creating false official statistics for aggregate numbers like GDP growth is making it consistent with data on specific industries or sectors. The divergence between GDP growth and electricity production, for instance, has often been remarked upon.

How to solve this problem? Stop producing the underlying sector/industry/product specific data. How to do that without giving away the real reason? Use the all-purpose excuse: fighting corruption.

This has an air of plausibility: after all, corruption is rife in China. But this really doesn’t pass the smell test, especially given the timing: note that the data embargo started when concerns about the Chinese economy became acute at the end of last year.

The Chinese are desperate to maintain the illusion of 6.7 percent growth, quarter in, quarter out. Maintaining that illusion has become harder and harder as questioning of the consistency of various data sources has become more insistent. Shutting off the flow of sector/industry/product data is a brute force way of dealing with that problem.

This is another signal of the real state of the Chinese economy. The government wouldn’t have jacked up the stimulus unless the true state of affairs was far more dire than official statistics suggest. The government wouldn’t be suppressing data from the primary goods sectors unless it was also giving the lie to the official line.

Bottom line: question everything relating to the economy in China right now. Be especially skeptical about anything done under the banner of fighting corruption. That banner should be a red flag warning that the Chinese Communist Party is trying to suppress inconvenient people, or inconvenient truths. If they say it’s about corruption, it’s really about something else.

 

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May 4, 2016

Schrödinger’s Combat

Filed under: History,Military,Politics — The Professor @ 7:14 pm

A Navy SEAL was killed in Iraq a couple of days ago. And the administration has handled this with all of the mendacity we have come to expect.

First, there was just a vague announcement that an American serviceman had been killed. Then they acknowledged it was a SEAL, and that he died as a result of “direct fire” (meaning, he was shot, rather than being hit by a mortar, for instance). Then they tried to suggest that he was part of an advise and assist mission.

Now, finally, we get the real story. (I say that with the usual caveats necessary when dealing with this lot.) The SEAL, Charles Keating IV, grandson of the Charles Keating of Keating Five infamy, was part of a quick reaction force that flew in to rescue some Americans who were meeting with Peshmerga forces behind the lines when ISIS mounted a surprise attack. There was an intense hours-long firefight, during which PO1/SO1 Keating was killed.

Sounds like combat to me. But no. You don’t have the intellect to understand the nuance that this administration is capable of. Sayeth Obama spokesman Josh Earnest:

“This is an individual who is not in a combat mission, but he was in a dangerous place,” Earnest told a daily briefing. “And his position came under – under attack. He was armed, trained and prepared to defend himself.”

“Unfortunately, he was killed. And he was killed in combat, but that was not a part of his mission,” he continued. “His mission was specifically to offer advice and assistance to those Iraqi forces that were fighting for their own country.”

Oh! It’s all clear to me now!

That is beyond disgusting. The other day I wrote about Schrödinger’s Clearinghouse. Here we have, courtesy of the Obama administration, Schrödinger’s combat, which is infinitely worse. It both is and isn’t combat, simultaneously.

Unfortunately, in this case the box was opened, and SO1 Keating was dead.

And let’s cut the crap.  The job of SEALs generally, and quick reaction forces in particular, is to engage in combat. Army Special Forces do advising. SEALs do killing. Period. To say that “combat . . . was not a part of his mission” is a mendacious falsehood. Every word. Including  the “a.”

Belay that. Especially the “a.” It was the only part of his mission.

Seriously. Everything Earnest said is a lie. Every fucking thing.

Keating’s “position did not come under attack.” Keating was involved in a counterattack to retake a position ISIS had seized from the Peshmerga. Combat was part of his mission. He was not defending himself. He was involved in a counterattack. He quite definitely was not there to advise and assist. He was there as part of a QRF to save those offering “advice and assistance” to those Iraqi forces. And they aren’t even Iraqi forces, as the term should be understood. They are Kurdish Peshmerga, not Iraqi army troops.

How many lies can one man tell in five sentences? I count five. I’m sure he’ll do better next time. Maybe he’ll make to six or seven.

Obama prefers Schrödinger’s combat so that he can have it both ways. He can appear all butch and claim that he is taking the fight to ISIS, while at the same time claim that he is honoring his pledge not to commit ground forces to Iraq or Syria.

Let’s have some honesty. We can handle the truth. The administration owes the American people an honest  accounting of what is going on. No, not operational details. No, not an order of battle. But an indication of the scope and nature of the commitment, the size of the force, and its missions.

Let’s face facts here. The administration tried to hide the circumstances of SO1 Keating’s death for as long as possible. They went with the modified limited hangout until the Guardian got ahold of video of the battle, taken by a Peshmerga fighter.

This is not acceptable.

Nor is it acceptable that the supine press corps in DC, which is obsessed with Trump, and to a lesser degree Hillary and Bernie, lets the administration–and Obama personally–get away with this deliberate deception and evasion day after day after day. Obama has made one statement recently about commitment of US forces in the fight against ISIS. He usually lets SecDef Carter carry his water. If the White House gets questioned, Earnest handles the questions, lies through his grotesque pie hole, and the press is content to let the story die before the news cycle is over. There is more talk about Obama’s performance at the Throne Sniffers’ Dinner–excuse me, the White House Correspondents’ Dinner–than about his being MIA on the issue of the war against ISIS.

This is particularly disgusting given that the administration is taking its fifth anniversary victory lap over the killing of Osama. That’s history. Read a book about it. It doesn’t matter. What matters is happening on the ground–yes, the ground, where boots tread–in Iraq and Syria. The Most Transparent Administration in History (Most Ironic is more like it) owes us answers. Instead, we get the war reporting version of Schrödinger’s Cat.

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May 2, 2016

Zero Hedge: Zero Class

Filed under: Economics,Politics — The Professor @ 8:13 pm

Bloomberg’s Tracy Alloway and Jake Kawa wrote an expose on Zero Hedge last week. There was not a tremendous amount of new material here. I was disappointed that they didn’t have anything about Daniel Ivandjiiski’s father: I am convinced there is a Warsaw Pact intelligence connection there. The story focused on the revelations of an ex-Tyler Durden, Colin Lokey. Looked provided information that supports what I’d written almost five years ago, namely, that ZH is a Russian information operation:

Lokey, who said he wrote much of the site’s political content, claimed there was pressure to frame issues in a way he felt was disingenuous. “I tried to inject as much truth as I could into my posts, but there’s no room for it. “Russia=good. Obama=idiot. Bashar al-Assad=benevolent leader. John Kerry= dunce. Vladimir Putin=greatest leader in the history of statecraft,” Lokey wrote, describing his take on the website’s politics. Ivandjiiski countered that Lokey could write “anything and everything he wanted directly without anyone writing over it.”

The remaining Tyler Turkeys responded in their typically classy way. I am very proud to be featured in their lead:

Others, such as “academics who defend Wall Street to reap rewards” had taken on a different approach, accusing the website of being a “Russian information operation”, supporting pro-Russian interests, which allegedly involved KGB and even Putin ties, simply because we refused to follow the pro-US script. We are certainly ok with being the object of other’s conspiracy theories, in this case completely false ones since we have never been in contact with anyone in Russia, or the US, or any government for that matter. We have also never accepted a dollar of outside funding from either public or private organization – we have prided ourselves in our financial independence because we have been profitable since inception.

Hilarious. Hey guys: next time use my name!

And seriously. There’s a lot more behind what I wrote than “simply because we refused to follow the pro-US script.” Such a disingenuous non-responsive response is as much as a confirmation as I could imagine.

The Tylers continue to strike their pose as courageous battlers against the corrupt capitalism. Ironically, given that they recycle the laughable NYT bullshit story labeling me a tool of Wall Street, I have inflicted far more real pain on those that ZH claims to fight than they have. Whereas they are all talk, by my rough estimate I have contributed materially to cases in which banks, traders and others have paid in the mid-to-high nine figures to settle. The figure could realistically exceed ten figures in the near future.

After taking a swipe at me, the remaining Tylers turn their attention to Lokey. They quote extensively from his text messages (more class!) and label him as a drug addict and drug dealer, and claim that this discredits him as a source.

Um, he wrote for them for a year while he knowing about his past and his alleged instabilities. Doesn’t that kind of discredit what they published for a year?

Based on Lokey’s account, the Bloomberg piece describes ZH as the web equivalent of a sweat shop. This makes it highly unlikely that the remaining two named Durdens, Ivaandjiiski and Tim Backshall, carried the load prior to Lokey’s arrival. Thus, there are probably other ex-Durdens out there with tales to tell.

ZH is a dodgy operation. Bloomberg has turned over the rock a little. But there is much more to learn. Let’s hope Bloomberg, or someone else, turn over a few more.

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April 29, 2016

Rounding Up the Usual Suspects, With Chinese Characteristics

Filed under: China,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 8:32 pm

Commodity prices on Chinese exchanges, especially for ferrous metals, have been skyrocketing in recent weeks. Rebar, iron ore and coking coal have been particularly active, but thermal coal and cotton have been jacked too.

In response, the Chinese authorities are cracking down on speculation.  Exchanges have raised margins in order to attempt to rein in trading. The government is making ominous statements about speculation and manipulation. And we know what can happen to speculators who fall afoul of the government.

Ironically, prices never appear to be just right, by the lights of the Chinese authorities. Last summer, and earlier this year, speculators were allegedly causing stock prices and commodity prices to be too low. Now they are causing commodity prices to be too high.

This is a case of the Chinese authorities playing Claude Rains in Casablanca, and ordering a roundup of the usual suspects. Speculators make convenient targets, and they appear to be the proximate cause: after all, their trades produce the rapidly rising prices.

But the speculators are merely the messengers. If the Chinese authorities want to find the real culprits, they need to look in the mirror, for the speculators are responding to the most recent lurch in Chinese economic policy.

Put simply, after the economic slowdown of the second half of 2015 (a slowdown masked by fraudulent official statistics, but evident nonetheless), the government pushed the panic button and fell back on its standard remedy: injecting a burst of credit.  Some estimates put the Chinese debt to GDP at 237 percent. Since GDP is likely also an overstated measure of national income, due to fraudulent statistics and the fact that the losses on past investments have not been recognized (in part because much of the credit is pumped  into zombie companies that should be bankrupt) this ratio understates the true burden of the debt.

The surge in credit is being extended in large part through extremely fragile and opaque shadow banking channels, but the risk is ending up on bank balance sheets. To engage in regulatory arbitrage of capital rules, banks are disguising loans as “investments” in trust companies and other non-bank intermediaries, who then turn around and lend to corporate borrowers.  Just call a loan a “receivable” and voila, no nasty non performing loan problems.

There is one very reasonable inference to draw from this palpably panicked resort to stimulus, and the fact that many companies in commodity intensive industries are in desperate financial straits and the government is loath to let them go under: today’s stimulus and the implied promise of more in the future whenever the economy stutters will increase the demand for primary commodities. The speculators are drawing this inference, and responding accordingly by bidding up the prices of steel, iron ore, and coal.

Some commentors, including some whom I respect, point out that the increase does not appear to be supported by fundamentals, because steel and coal output, and capacity utilization, appear to be flat. But the markets are forward looking, and the price rises are driven by expectations of a turnaround in these struggling sectors, rather than their current performance. Indeed, the flat performance is one of the factors that has spurred the government to action.

When the Chinese responded to the 2008-2009 crisis by engaging in a massive stimulus program, I said that they were creating a Michael Jackson economy, one that was kept going by artificial means, to the detriment of its long term health. The most recent economic slowdown has engendered a similar response. Its scale is not quite as massive as 2008-2009, but it’s just begun. Furthermore, the earlier stimulus utilized a good portion of the nation’s debt capacity, and even though smaller, the current stimulus risks exhausting that capacity and raising the risk of a banking or financial crisis. It is clear, moreover, each yuan of stimulus today generates a smaller increase in (officially measured) output. Thus, in my view, the current stimulus will only provide a temporary boost to the economy, and indeed, will only aggravate the deep underlying distortions that resulted from past attempts to control the economy. This will make the ultimate reckoning even more painful.

But the speculators realize that the stimulus will raise commodity demand for some time. They further recognize that the stimulus signals that the authorities are backsliding on their pledges to reorient the economy away from heavy industry and investment-driven growth, and this is bullish for primary materials demand going forward: the resort to credit stimulus today makes it more likely that the authorities will continue to resort to it in the future. So they are bidding up prices today based on those predictions.

In other words, as long as the Michael Jackson economy lives and stays hooked, its suppliers will profit.

So yet again, commodity markets and the speculators who trade on them are merely a lurid facade distracting attention from the underlying reality. And the reality in China is that the government cannot kick the stimulus habit. The government may scream about (and worse) the usual suspects, but it is the real cause of the dizzying rise in Chinese commodity prices, and the burst of speculation.

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April 22, 2016

Schrödinger’s Clearinghouse?

Filed under: Clearing,Derivatives,Exchanges,Regulation — The Professor @ 6:31 pm

Three weeks ago I wrote about, and criticized, LSE CEO Xavier Rolet’s statement that “We can cross margin our over-the-counter clearing with their listed derivatives without merging the clearinghouses, and without comingling the risk-management framework. [Emphasis added.]”  Then three days ago I read Philip Stafford’s article in the FT stating “Deutsche Börse and LSE plan to link clearing houses“:

The two sides are working on common risk management and default frameworks for their market utilities, which risk manage billions of dollars of derivatives trades on the market every day. [Emphasis added.]

The exchanges’ long-term aim is for each customer to become a member of both the LSE-controlled LCH and Deutsche Börse’s Eurex clearing houses. The customers, which are typically banks, would agree to hand over their trading data in return for better risk management of their derivatives, according to two people familiar with the talks.

The planned London-based holding company would instruct the two clearing houses on how to proceed with a default after consultations with central banks, one of the people said. The two sides are discussing their plans with their regulators and customers, one person said.

So how do you have a “common risk management framework” without “commingling the risk-management framework”? Is there some fine verbal distinction I am missing? Or perhaps this is like Schrödinger’s CCP, in a state of quantum superposition, both commingled and uncommingled until someone opens the box.

In my post, I mentioned default management as one reason to integrate the CCPs:

Another part of the “risk management framework” is the management of defaulted positions. Separate management of the risk of components of a defaulted portfolio is highly inefficient. Indeed, part of the justification of portfolio margining is that the combined position is less risky, and that some components effectively hedge other components. Managing the risks of the components separately in the event of a default sacrifices these self-hedging features, and increases the amount of trading necessary to manage the risk of the defaulted position. Since this trading may be necessary during periods of low liquidity, economizing on the amount of trading is very beneficial.

Apparently the recent experience with the default of Maple Bank brought home the benefits of such integration:

One person familiar with the talks highlighted problems created by February’s default of Frankfurt-based bank Maple, which was a member of both exchanges’ clearing houses.

“Right now what you have is a blind process — the liquidation of positions is conducted without co-ordination,” the person said. “Therefore it has a negative price impact in the market as you have two guys running out liquidating positions in the name.”

Huh. Go figure.

“Commingling” makes sense. Coordination is vital, both in daily operations (e.g., setting margins and monitoring to reduce the risk of default) and in extremis (during a default).

Perhaps Rolet was trying to deceive regulators who are so obsessed with too big to fail (sorry, both Eurex and LCH are TBTF already!) and who are blind to the benefits of coordination. If the regulators need to be deceived thus, we are doomed, because then it would be clear they have no clue about the real issues.

One wonders if they will recognize coordination and commingling even after they look in the box. Apparently Rolet thinks not. If they do, Xavier will have a lot of ‘splainin’ to do.

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April 18, 2016

Corn is Chicken Feed, But the Losses from Chinese Malinvestment Aren’t

Filed under: China,Commodities,Economics,Politics — The Professor @ 6:34 pm

The WSJ reports that China could face a $10 billion write-down on the huge corn stocks that it accumulated as part of its efforts over the past years to prop up prices for farmers. Corn is chicken feed, but $10 billion ain’t.

But I think that the moral of this story goes far beyond corn. Chinese agricultural price supports are just one example of the myriad policies that the country has adopted over recent years that distort prices and lead to misallocations of resources. Indeed, the deadweight losses from ag price supports are probably chicken feed in comparison with the waste resulting from distortions in the capital and credit markets that have led to massive malinvestment in industrial capacity (note the huge overcapacity in industries like steel), infrastructure, and housing.

Perhaps the main difference is that the corn inventories are being written down. The corn counted towards national income when it was produced, and writing down the inventories will reduce national income. Alas, the vast bulk of the malinvestments elsewhere will not be marked to market, and reported Chinese national income will be too high as a result.

What’s particularly important is that although the Chinese are apparently recognizing that their agricultural policies were inefficient, they cannot wean themselves from the credit stimulus habit. About 2 years ago I gave talks where I said China faced three alternatives, two of which were bearish for commodities: hard landing, transition to a more market-based, consumer-oriented system, or continued reliance on credit stimulus to keep measured growth high. I further opined that the latter alternative would just defer the choice between the first two for some time.

I did not venture a strong opinion on which alternative would happen, because I believed (and believe) that the choice is ultimately political, and I am in no position to predict with confidence Chinese politics. My sense was (and is), however, that sustaining the status quo was (and is) the most likely outcome. This would involve cranking up the stimulus in the face of any slowdown.

Recent experience suggests that’s the case:

China’s economy slowed further in the beginning of the year, though Beijing’s policies to revive growth with old-style tools such as lending and construction appeared to gain traction in March.

China’s gross domestic product expanded by 6.7% year-over-year in the first quarter, down from a 6.8% gain in the previous quarter, the National Bureau of Statistics said Friday. The figure, the slowest quarterly growth for China since the height of the financial crisis in 2009, was in line with forecasts.

In the past month, some confidence has returned to the world’s second-largest economy, fueled in part by sharp property-price rises in China’s major cities as well as some lessening of currency volatility and capital outflows that spilled over onto global markets last year and early in 2016. In March, China’s foreign-exchange reserves grew for the first time in five months.

Friday’s data release provided signs that a host of stimulus measures put in place over the past 15 months are having some impact—or are at least delivering some short-term gains. Industrial output, retail sales and property investment rose more than expected in March after a weak performance in January and February. Fixed-asset investment also improved.

And lending soared. Chinese financial institutions issued 1.37 trillion yuan ($211.3 billion) in new yuan loans in March, rocketing well past economists’ expectations of around 1.1 trillion yuan, and almost twice February’s volume.

This means more new malinvestment, and more papering over (with credit) the write down (and hence recognition) of past malinvestments.

This credit splurge helps explain the commodities rebound in recent months. But it also shows how tenuous the foundations of that rebound are. It is an artifact of artificially stimulated investment. Eventually, inevitably, the accumulated waste and distortions will bring the entire Chinese economy to a shuddering halt, and perhaps a crash. Eventually the accumulation of distortions becomes so great that a shakeout and rationalization is necessary, and inevitable. China is at best delaying the reckoning.

Corn is a small part of a much bigger picture. But it is a revealing part. It shows how perverse pricing policies lead to inefficient accumulations of capital that eventually become worth far less than the amount invested. Corn is relatively easy to value, and the cost of the malinvestment in corn stocks looks to be about $10 billion. When one considers how many other wasteful investments have been made in China as a result  of its interventionist policies, and the imagination staggers at what the losses would be.

Put differently, China’s performance would look far less stellar if national income accounting was accurate, and realistically marked its past investments to market. Of course, it is this very fact that induces the Chinese authorities to use every trick in the book to prevent that from happening. But there will come a day, because losses this large cannot be concealed forever.

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