Streetwise Professor

July 25, 2007

Putinism Delenda Est! But How?

Filed under: Energy,Russia — The Professor @ 3:56 am

Recent weeks have seen the continuation of the methodical march of Putinism and Russian resource nationalism. BP surrenders Kovytka. Gazprom and the Russian government (is there a difference?) begin making noises about elbowing their way into ExxonMobil’s Sakhalin I project (heretofore largely thought immune to predation). And in today’s Eurasian Daily Monitor, Vlad Socor reports that Transneft–Russia’s oil pipeline monopoly–is squeezing the Caspian Pipeline Consortium through demands for renegotiation of existing deals and demands for new capital, with demands backed up by the old standby–outrageous bills for back taxes.

The craven behavior of BP and Shell in the face of Putin’s predations at their expense has undoubtedly emboldened the Russians to take additional steps. Similarly, the sotto voce responses of the Eurowimps are also music to Putin’s ears. When will Europe awaken to the tightening grip of the Russian python?

The losers here are not just the shareholders of integrated oil majors, or American or European consumers of gasoline and natural gas. Though they may not realize it now, it will soon become apparent to the Russian people that they will be the biggest losers. I have been reading every political economy book that discusses the role of a nation’s resource endowment on its political structure that I can get my hands on. This research emphasizes a theme that I have explored before on SWP, namely that rent intensive economies (notably those with outsized endowments of natural resources) are prone to authoritarianism and dictatorship, and that increasing economic inequality and the suppression of commercial and political activity go hand in hand with growing state control over the natural resource sector. Thus, though the energy boom (and the nickel boom and the copper boom and the aluminum boom and the gold boom) will enrich the “elite” (though referring in that way to the thuggish siloviki who rule Russia sounds discordant) with access to the rents, it will condemn most Russians to a penurious economic future and a deprivation of their civil and political liberties.

To follow Putinism is to watch these theories in action. They describe Russian political developments post-2000 to a “T.” The most depressing thing is that inasmuch as these models characterize stable equilibria as a function of underlying endowments, it is unlikely that Russia will leave this trajectory. Revolution and violence are possible, but the likely results of such an explosion would mainly be (a) much death and destruction, and (b) a replacement of the old set of rent parasites with a new set. So, it is well to wish the destruction of Putinism, it is far harder even to imagine how that can be accomplished.

This is particularly true because Putin is doing the basic blocking and tackling needed to secure an authoritarian regime. The moves to revise the history textbooks provided to Russian primary and secondary students and Putin’s historical revisionism (e.g., his assertions that Russia and the USSR have a pristine record as compared to those blood-stained Americans) represent classical authoritarian moves to control the future by controlling the past. Presenting a unifying historical narrative congenial to the regime and suppressing the voicing of any alternative, more discordant, narrative reduces the costs of maintaining control. Similarly, the harassment and sometimes suppression of any non-state organization that could serve as a focal point for collective action directed against the regime is a traditional means of retaining and strengthening control. The atomization of Russian society, and the replacement of myriad spontaneous and organic links of individuals and groups across society with managed vertical relations intermediated by the state and its creatures (a wheel and spoke vs. a network model of society) cripple the formation of alternative sources of power and influence that can challenge the regime.

Not a happy vision, indeed. But Western nations need to develop a Russian policy based on a sober assessment of current realities, and likely future developments. Happy talk in Kennebunkport, or pitiful plaints about the desire for normal relations with Russia, or craven energy executives opening their wallets just after Putin took their watches, are all manifestations of denial. A denial of the reality of “modern” Russia (which is oh-so-much like not-so-modern Russia, and pre-modern Russia). Until the scales drop from European and American eyes, and they devise policies that deal with realities rather than deny them, Putin will march from triumph to triumph. It is unlikely that Putinsim–which is just a latter-day Russian version of natural resource sustained authoritarianism–can be quashed completely, and Russia transformed into a liberal (in the classical sense) modern state and civil society. However, unified resistance can mitigate its more deleterious consequences (at least for non-Russians.) As long as short sighted, commercial interests drive European policy in particular, however, such resistance is unlikely to arise.

Collective action is needed, but collective action is always difficult due to free riding and rent seeking. The entire justification for a European Union is its purported ability to facilitate collective action on matters of common interest and concern. Insofar as Russia policy is concerned, it has failed miserably in this task. The “interests” of individual states, and more shockingly, individual companies within these states (most notably German and Italian), have precluded any robust collective response to Putin’s march. Until that changes, Putin wins, and Russians (and myriad others) lose.

Old Bull Bull

Filed under: Military,Politics — The Professor @ 2:59 am

I am having a difficult time figuring out the “logic” (if one may call it that) in the Old Bull Republican (with an emphasis on the “bull”) senators’ calls for a change in American strategy in Iraq. If I understand them correctly, they want to short circuit the surge, withdraw American forces from intensive action in Iraq’s Indian Country to more secure bases, from where they would engage in strikes against Al Qaeda. This is couched as being a reasonable middle ground between precipitate withdrawal as advocated by most Democrats, and the current aggressive approach adopted by General Petraeus.

Er, have these guys been paying the slightest bit of attention? This is exactly what we did in 2005-2006, and was Bush’s (and Rumsfeld’s) biggest mistake in the prosecution of the war. Indeed, it is largely responsible for our current predicament.

As I noted in an earlier post, this ceded the initiative to Al Qaeda and other insurgent groups. It also deprived the military of vital information and gave the insurgents secure rear areas where they could plan, train, arm and equip. It also violated every fundamental tenet of counterinsurgency. An effective counterinsurgency must deny the enemy logistical support and access to the population. An effective counterinsurgency must be persistent, gradually (and often bloodily) throttling and choking an insurgency by depriving it of the material, popular, and moral support necessary for its survival.

The Surge is essentially a by-the-book counterinsurgency operation. A persistent American presence in Indian Country is the essence of the strategy. This persistence constrains the insurgents’ operational flexibility, deprives them of the initiative, and forces them to fight for their bases—and suffer large losses as a result—or flee ignominiously. Once Americans secure key areas, Iraqi forces can serve as the agent of persistence, freeing Americans to move on to other hotspots. Although this more aggressive strategy seemingly poses the risk of greater American casualties, in practice casualty rates are falling as the Surge crescendos because we are fighting on our terms using our comparative advantages, rather than letting our opponents choose the time and means of engagement, thereby allowing them to maximize their advantages. Moreover, whereas the casualties incurred in the Surge at least hold out the prospect of helping secure victory, the casualties incurred in the old approach—which is also the “new” approach of our latter-day Ciceros—essentially contributed nothing to a favorable long-run outcome in Iraq.

In brief, the Surge is an effort to retrieve the mistakes of 2005-2006. How bizarre it is, therefore, to see supposedly intelligent people base their attack on a diametrically opposed operational concept by advocating a return to a failed strategy. It makes my head spin. Let me see, Lugar, Domenoci, Voinovich et al have decided that based on the administration’s failures in the last two years that the war in Iraq is lost, and so we should . . . adopt a strategy that is hardly distinguishable from the that employed by the administration during that period. Yeah, that’s the ticket. But hey, I haven’t been a Senator since Hector was a pup, so what do I know?

I’ll Have Both, Please.

Filed under: Military,Politics — The Professor @ 2:45 am

This article states that the Israeli military has come to the conclusion that its neglect of conventional large unit operational and maneuver skills brought on by a decision to focus its attentions on counter-terrorism and counter-guerrilla operations in the territories was a mistake. In light of last summer’s embarrassment in Lebanon, the IDF has now decided to rejuvenate its atrophied—and once formidable—conventional capabilities.

This is probably wise, but points out a problem that seems to have hobbled not just Israel but the United States military; the crippling debates between those who think that unconventional wars are the wave of the future, and hence should be the focus of military preparation, and those who think that traditional conventional “big war” capabilities should be paramount. Currently there is a debate raging within the US military between younger officers with extensive experience in Iraq and Afghanistan who advocate a reorientation of the US armed forces towards “small wars,” and the more senior officers who favor maintaining a formidable conventional, large-war capability. And this is not the first time we’ve had this debate—a similar debate occurred in the Vietnam era.

I am of the belief that both capabilities are important. I further believe that the either-or nature of these debates is extremely counterproductive. The answer to the question “Should we develop large war or small war capabilities” is “Both!”

Historically—and now—these debates revolve around differing predictions of future threats, and these predictions tend to be dominated by immediate circumstances (e.g., our current wars in Iraq and Afghanistan.) The problem is that threats are endogenous. One’s enemies have the ability to respond to your decisions. If you decide to develop one capability and let another erode, your enemy will direct resources to exploit the weaknesses that this erosion creates. This is one reason (unexpected technological change being another) that forecasts about future wars are so often wrong—as the Israelis found out to their discomfort last year.

To be sure, there are distortions in the decision making process. For instance, defense firm lobbying arguably results in the purchase of more high tech, big ticket toys than is optimal. In this environment, spirited advocacy by Young Turks can serve as a valuable counterweight. But the Young Turks’ denigration of such capabilities can go too far. A common criticism of big ticket items is that they are seldom—and sometimes never—used. But you need to consider what would happen if you don’t have them. We spend many billions on the Navy and the Air Force to create capabilities that are not challenged, but if we didn’t build these capabilities, our enemies could challenge our dominance of the skies and seas. That would pose problems, arguably far more serious than the consequences of our putative neglect of small war capabilities in the post-Cold War decades.

The US needs a full spectrum of capabilities to perform its irreplaceable role. It needs big units with big guns and heavy armor and fast planes and big ships. It also needs units expert in small wars.

This raises interesting questions about how these varying capabilities should be fielded. One alternative is to create specialist forces. Back in the day, the Marine Corps was the specialist in small wars, and the Army the specialist in big ones. Another alternative is to field flexible technologies and forces that have both capabilities. For instance, the USMC has developed a vastly improved heavy capability while retaining its small war mentality. Similarly, the Army has responded to conditions in Iraq by developing and augmenting its small wars capabilities.

I don’t presume to know which way (specialization vs. multi-mission capability) is best. But I think that this way of framing the debate (i.e., how to develop the capability to fight both big and small wars) is much more productive than the “Big War vs. Small War” debate that seems to be the norm. Due to the endogeneity of threats, the “winner” of this either-or debate will create a force that is pre-disposed to failure. The enemy gets a vote too, and he almost always votes to behave differently than you assume. If you overdevelop one capability at the expense of others, you can rest assured that you will end up ruing your choice—regardless of the choice you make.

This is just a variation on a well-worn theme in military history. Militaries that are successful, be it tactically, operationally, or strategically, have mutually supporting combined arms capabilities. Any single capability is vulnerable to a countermeasure, but this vulnerability can be mitigated by partnering with a complementary capability. Military monocultures are not highly survivable in the medium or long run no matter how well they do that one thing. The Colonel Sanders (“We only do chicken”) approach is a recipe for failure.

If put on the spot, I would conclude that it is harder to create the capability to go big (i.e., to create effective heavy forces) than it is to create the capability to go small. Indeed, in Iraq the Army has been quite effective at using traditional heavy units–such as heavy artillery outfits–in infantry and counterinsurgency roles. The physical capital intensity of heavy units makes them difficult to create overnight. In contrast, as the American experience in Iraq shows, well-trained and highly motivated soldiers and Marines can be employed effectively in light and counterinsurgency roles if they are operating under a sensible counterinsurgency doctrine with tactics appropriate to the mission. That is, counterinsurgency is human capital intensive, and the human capital can be embodied in doctrine and training. Investing in heavy forces while at the same time developing diverse operational and tactical doctrines applicable to varied missions and training troops to perform multiple missions creates real options for commanders to exploit. The optionality of light forces is not nearly as great.

In this formulation, a crucial thing will be to provide the proper incentives for officers to invest in diverse skills. This is probably where the military has fallen short, with an overemphasis on conventional heavy warfighting skills and a slighting of those outside the Special Warfare community who invest in human capital specific to light and counterinsurgency operations.

NOC, NOC! Who’s There?

Filed under: Commodities,Energy — The Professor @ 2:20 am

I write this on the plane (Business First is the way to go!) returning from a 2 week stay in Beijing, where I taught a course in energy risk management to executives from the two largest Chinese oil companies, Sinopec and PetroChina. My involvement with these two national oil companies (NOCs) sparked some thinking about NOCs in general, and the future role of the private integrated oil majors (IOMs).

It is well known that NOCs are playing an increasingly important role in the world oil and gas markets. Indeed, they increasingly control the reserves, and the access thereto. It is also well known that the NOCs lack the technical expertise of the IOMs, especially when it comes to exploring, developing and operating more challenging fields (e.g., deep water offshore) which will be the source of an increasing fraction of the world’s growing energy needs. Absent access to the technical expertise of IOMs, NOCs will be unable to produce as much oil, with predictable—and unpleasant—implications for oil prices.

Can NOCs obtain the requisite technical expertise under contracts that do not provide an equity share to output? (This is what Russia is trying to do, as with its recent announcement of the deal with Total to develop the Shtokman field.) They can obtain some technical expertise in this way, no doubt, but there are compelling reasons to believe that vertical integration is efficient in oil exploration, development and production. As a result, there will be a substantial efficiency loss when NOCs produce and own output, and acquire technical support via contracts with IOMs that do not extend equity rights to the latter.

Integration is efficient due to the nature of the process of exploring for and developing oil reserves. Especially with regards to technically challenging projects, such as deepwater fields, oil exploration and development are informationally intensive. Moreover, a good deal of this process involves identifying and exploiting real options. As information is produced during the process of exploration and development, it is used to make decisions about how to proceed going forward. The IOM has a substantial advantage not only in generating the information, but in knowing how to utilize that information to make better decisions about the exercise of real options.

There is no way in hell to write a contract that provides the owner of the technical expertise (e.g., an IOM) with the incentive to utilize this information optimally. This is true for a variety of reasons. First, the contingencies are too numerous and too difficult to specify ex ante, hence any contract will be incomplete. Moreover, even if the parties were to attempt to specify such contingencies, due to the technical complexities, they would be nigh impossible for third parties to verify. It is well known that the inability to verify also contributes to incompleteness.

Integration greatly mitigates this problem. The owner of the knowledge captures the value of using it efficiently because it also owns the output—the oil and gas. It internalizes the benefits of better decisions.

It should also be noted that there are arguably far more imposing barriers to transferring information across firm boundaries than within firms (although transfer within firms is not free either.) Again, issues of verifiability and completeness confound addressing information transfer by contract.

Thus, we are confronted with a dispiriting state of affairs. Those who own the reserves are loath to provide equity rights therein to those with the information and expertise. Maximizing the value of those reserves requires allowing those with the information and expertise to utilize that information to exercise the myriad real options in an oil or gas project efficiently. Equity ownership of production—integration—is an efficient way of providing incentives to those with the information and expertise to use it effectively. The incentives are inherently much weaker when the reserve owning NOCs merely contract for services from the IOMs with the information and knowledge. This translates into lower output and higher prices.

Not that equity ownership is a panacea when opportunism is unchecked. Equity rights have never been secure, and they are less so now (witness the expropriations in Russia and Venezuela.)

Is integration gone forever? Probably not. The deadweight losses that will arise as NOCs attempt to acquire IOM expertise without giving equity rights will provide an incentive for a major rethink. For instance, Mexico’s autarkic energy policy is leading the country’s oil industry to a precipice with dire financial consequences for the government. Resource nationalism may feel good, but it don’t pay the bills. Even when this realization dawns on even the most reflexive nationalist demagogue, and reserve owners permit some form of equity participation by those with the know-how, we won’t be in Nirvana due to the tenuous nature of these equity rights when expropriation is a threat.

This all has interesting implications for another subject of interest—energy policy as a response to purported anthropogenic climate change. Proposals for taxation of hydrocarbons (or direct controls on consumption through cap-and-trade or CAFÉ-type policies) are premised on the assumption that it is necessary to raise the costs of oil consumption to offset the effects of environmental/climate externalities. But hydrocarbons are already heavily taxed. Moreover, the foregoing argument implies that the insecurity of property rights in energy production and the inefficiencies of acquiring exploration and development expertise through contract are reducing oil output, and will reduce it even more in the future. These inefficiencies in property rights and organization are effectively implicit taxes on hydrocarbon production. It may well be the case that even when one takes environmental impacts into account, oil and gas output is too low today because the explicit and implicit taxes are bigger than the efficient tax. Certainly, arguing for higher hydrocarbon taxes based on a tacit assumption that environmental externalities are the only distortion in energy production and consumption (which seems to be the case, as existing explicit and implicit taxes are almost never mentioned in this debate) is bad economics.

The distortions arising from insecure and inefficient property rights in oil exploration, development, and production are real, and likely to become larger in the future. These costs should be accounted for in any policy decisions on carbon taxes. So far, I have seen no evidence that this subject has even been mooted, let alone considered seriously. This bodes ill for effective energy policy in an age of climate change hysteria.

July 10, 2007

The End of One Era, the Beginning of Another

Filed under: Derivatives,Energy,Exchanges — The Professor @ 7:17 pm

It’s a bummer (grew up in the 70s? who? me?) to have to read about the approval of the CBT-CME merger from distant China, where I am teaching until mid-July. But it’s good news nonetheless. Things played out pretty well as I forecast, with CME bumping its bid at the last minute, and ICE folding because it just couldn’t afford to overcome the CME’s efficiency advantages. Congratulations to the managements of both exchanges, and to their owner-members.

Although this brings down the curtain on the longest running act in the derivatives business (at least as an independent venture) it is a smart move. Due to mis-steps in the 90s (born out of a futile hope that they could stave off the electronic era by failing to create a viable electronic system and building a huge new trading floor–sorry guys, but Econ 1o1 says sunk costs are sunk), the CBT has been living on borrowed time for years. It never owned its clearing operation, and due to its failure to create and own its own technology, it was inevitable that it would be snapped up post-demutualization by somebody who owned both. And who better than the CME, with a first class clearing operation and arguably the best trading system in the business. The CBT-CME combination was clearly the most efficient way to go.

As I noted in an earlier post, things will develop quickly, and the remaining independent exchanges will soon cease to be such. NYMEX and ICE will soon be the next to go–and for quite handsome prices, thank you. The FT surmises that NYSE-EuroNext will try to snap up NYMEX to break up the CME-NYMEX strategic partnership. I doubt it. That partnership has worked very well, so why should NYMEX migrate to a new platform only months after moving to Globex? Moreover, the clearing efficiencies would be large. As I have said for well over a year, I expect NYMEX to end up in the CME Group ASAP. The natural thing is for NYSE-EuroNext to buy ICE.

That pretty much leaves CBOE, and various small fry, at least in the US. (LSE is another matter altogether). One could see a rationale for CBOE combining with CME, but I think that (a) the CME’s reluctance to suffer any more SEC oversight than it has to, and (b) the lingering rancor over the CBT-CBOE trading rights will make that a difficult deal to do. (Although a marriage might be one way of dealing with that troublesome issue.) So I see CBOE going with NYSE too, although that’s going to have to wait resolution of the trading rights issue.

But those are tomorrow’s stories. Now it is appropriate to reflect on the glorious and colorful–though often contentious–history of the Chicago Board of Trade. Truly a pioneer, the derivatives business as we know it would not exist if it hadn’t blazed the trail for almost a century and a half. In some respects, however, that very historical legacy–the traditions and habits and interests that grow like barnacles on venerable institutions–impaired its ability to lead the industry in the 21st century. Its management made the wise choice of partnering with a younger, more dynamic, and lately more innovative exchange. I fully expect that this partnership will blaze yet more trails, and thereby enhance the efficiency of the financial markets in the 21st century and beyond.

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