Streetwise Professor

Recently Condeleezza Rice met with Turkmenistan’s president Gurbanguly Berdymukhamedov. Energy was high on the agenda. In addition, I understand that a delegation of Turkmen energy personnel visited Houston to meet with US energy companies.

In earlier posts I bemoaned the lack of high level contacts between the US and Turkmenistan, so I am pleased that that the State Department is attempting to rectify this error. Hopefully it is not too late. There are some signs that Putin’s momentum in Central Asia–which looked so unstoppable after his extended state visits there in May–is slowing somewhat. Perhaps continued high level involvement by US and European governments can reverse it altogether. It is in both Turkmenistan’s and Europe’s interest to break Russia’s/Gazprom’s stranglehold on Turkmenistan’s gas reserves. So let’s keep on the pressure.

James Hamilton is a great econometrician, and has written importan tpapers on the relation between oil and the economy. He blogs periodically on the oil market. Yesterday he posted this piece on backwardation. Like my piece, he discusses Ann Davis’s WSJ piece. Overall, I think Hamilton’s take is reasonable, although he does engage in one of my pet peeves, by attributing the increase in storage to the contango in the market. As I noted yesterday, prices and inventories are both endogenous, and determined simultaneously. As the Welfare Theorems show, in a competitive market prices adjust to induce agents to take the first best actions. Therefore, saying that “storage increased because the market moved into contango” is an incomplete analysis. One must push the analysis back one step to understand what economic forces made it optimal to increase the amount of oil in inventory. When talking about forward curves, the key forces are market tightness today relative to expected future tightness.

Hamilton’s post reproduces the graph of oil forward curves (from last week and a year prior) that ran in the WSJ. The interesting thing about the graph is that when the market was in contango a year ago, distant dated forward prices were substantially lower than they are today when the market is backwardated. This illustrates an important point; it is not the level of market tightness per se that drives backwardation or contango. It is tightness today relative to what is expected in the future.

In “Care to Dance the Contango?” I analyzed in some detail the movement of the oil into contango–where prices for future delivery are above nearby “spot” prices. Consistent with the theory of storage, the move to contango coincided with massive increases in the amount of oil in storage.

Now, the market for oil has moved into backwardation–the typical state of the market since the birth of crude futures trading in the early-1980s. And, surprise, surprise, inventories of oil have fallen. The theory of storage strikes again.

This movement in oil inventories and prices was discussed in a recent WSJ article (subscription only). There are glimpses of economic sense in the article, but there is a lot of nonsense too. I doubt that the lay reader could make heads or tails on why inventories have fallen. One problem is that prices and quantities are determined simultaneously, but author Ann Davis makes statements about price structures causing inventory levels. Most importantly, the article Rounds Up the Usual Suspects–speculators–and attributes the movements between contango and backwardation to their whims.

Speculators participate in the market, and big financial firms such as Morgan Stanley have staked out big positions in the physical oil business. But speculators are responding to fundamental economic conditions, not dictating prices to move contrary to levels and structures justified by fundamentals.

As I noted in “Care to Dance,” the move to contango was a rational response to fundamental market conditions. The oil forward curve goes into contango when the current supply is abundant relative to expected future supply (or, put differently, when the current supply/demand balance is less tight than anticipated supply/demand balance.) Given the widespread anticipation in late-2005 of repeated hurricane-caused supply interruptions in the Gulf of Mexico; geopolitical unrest in the Middle East, Nigeria, and Venezuela in 2005-2006; and expectations of robust world growth in the future, as tight as supply conditions were in fall 2005, it was reasonable to believe that supply conditions would become even tighter in the future. Under these conditions, holding higher precautionary inventories was economically efficient; inventories rose accordingly; and the market moved into contango.

In recent months, the most acute fears of future supply disruptions due to hurricanes, political unrest, etc., have dissipated, and the subprime crisis has reduced expectations for future economic growth. Under these conditions, precautionary stocks needn’t be as large. Hence, we’ve seen the drawdown in stocks and the concomitant move of the forward curve into backwardation.

Speculators are an important part of this process. It is their job to assess market conditions and take positions accordingly. They are essentially conveyor belts that transform diffuse information about current and future supply and demand fundamentals into real economic decisions that affect prices and quantities. They are not always right of course, when viewed retrospectively, but that’s because the world is an unpredictable place and the best information today only imperfectly forecasts the future. But speculators are responding to market conditions, and the market is a harsh taskmaster. There are rich rewards to being right, and harsh punishments for being wrong. So, rather than lazily attributing any movement in prices and quantities to the deus ex machina of speculators, it would be far better if journalists and other analysts would think a little more thoroughly about the fundamental economic forces that really drive markets–and speculators.

Putin’s recent announcement about his intention to become prime minister has touched off a good deal of speculation that he will retain his existing dominance over Russian politics but merely change the chair in which he sits. Color me skeptical.

The presidentialism of the Russian political system, established under Yeltsin and solidified under Putin, places all the formal levers of power in the hands of the president. In this system, the prime minister is combination sock puppet and scapegoat–there to dutifully echo the President, and to take the blame when things go wrong. Today, the President controls the two most important sources of power in Russia–the special services and the state media. Although Putin has no doubt placed cronies throughout both, and throughout the other administrative sources of power in Russia, the loyalty of these people is inherently suspect. Particularly in a system like Russia’s, what loyalty there is attaches to the person in power who can reward and punish; transfer those powers from one person to another, and the loyalty transfers with it. In Russia, it is the president that wields these powers, and Putin’s current personal popularity will not change this fact.

Perhaps Putin is so taken by his current popular standing that he believes that the power he wields will adhere to his person, regardless of the office he holds. I doubt this. I think that he knows that he must remain President, and that if he does not, his successor will neuter him–or worse.

Hence, I am putting my money on some scenario likethis one laid out in Eurasia Daily Monitor in an article by Charles Gunn. That is, Putin will utilize some sort of political conjuring trick to adhere to the letter of the constitution, but remain as president for years to come.

Which brings us to another curious development–the public revelation of a “clan war” between rival security services, the FSB and the Russian narcotics police, Gosnarkokontrol. The rivalries between factions within the Kremlin have been widely rumored, but have remained largely below the surface, especially to Western Eyes (apologies to Joseph Conrad.) The fact of the conflict is not surprising–after all, turf wars among mobsters are to be expected. The publicity is something of a surprise . . . but maybe not, when one considers it in the context of succession.

Internecine warfare among Kremlin clans could provide a reason, a pretext, and maybe even part of a plan, for Putin to remain in power. Even if Putin had nothing to do with fomenting, or even publicizing, the conflict, it should make him and others around him acutely aware of the chaos that could await if he is unable to maintain an iron grip upon leaving the Presidency. A weak successor, although attractive to Putin from some perspectives, would be less able to stamp out such infighting, which could quickly spin out of control, thereby endangering the power, the fortunes–and the lives–of the siloviki, Putin included. This is good reason–and at least a good pretext–for Putin to engage in some maneuver to retain power. Moreover, such a move would attract widespread support from many of the siloviki fearing for their lives, fortunes and (choke) sacred honor.

Perhaps Putin had nothing to do with the outbreak of hostilities between FSB and Gosnarkokontrol, and will simply find this a compelling reason to do what is necessary to retain Presidential powers. Perhaps he had nothing to do with the hostilities, but opportunistically encouraged their rather shocking airing in order to build a case, a pretext, for retaining these powers. Or perhaps he actually fomented this incident as a Machiavellian maneuver. I discount, though not completely, this last alternative, but believe that Putin will use this incident and its publicity as part of his campaign to retain power.

A riddle, a mystery, an enigma, indeed.

Examining Figure 2 from this article on the Russian energy economy by Gaddy reminds me of the old Johnny Cash song “Cocaine Blues”:

Early one mornin’ while makin’ the rounds
I took a shot of cocaine and I shot my woman down
I went right home and I went to bed
I stuck that lovin’ .44 beneath my head

Got up next mornin’ and I grabbed that gun
Took a shot of cocaine and away I run
Made a good run but I ran too slow
They overtook me down in Juarez, Mexico

The graph depicts Gaddy’s estimates of the energy rents accruing to the Soviet–and Russian–economy. Each of the two spikes in the graph corresponds to a period of Soviet/Russian adventurism. The first shot of oil/cocaine during the 1970s oil shock fueled Soviet aggressiveness around the world. The second oil/cocaine shot–the post-2003 runup in oil prices–is powering Putin’s recent revanchism.

The thing about cocaine is that what goes up, comes down with crash. After that shot, you feel invincible, but the comedown is brutal and depressing. That’s what happened to Willy Lee, and what’s likely to happen to Putin–or his successor, if there is one–when oil prices come down, as they inevitably will.

This article from Radio Free Europe/Radio Liberty contains several gems. The article summarizes the thesis of a book “Forward to the USSR-2,” which describes Yuri Adropov’s plan to revitalize the USSR–a plan aborted by his death, but probably doomed in any event (for reasons discussed below):

A key part of the purported Andropov plan was to be played by the KGB’s Sixth Directorate, which was concerned with economic-intelligence gathering. This directorate had accumulated masses of classified technologies taken from Soviet innovators and stolen from the West by KGB operatives. This information would be used to spark a scientific-technical revolution that would drive the country’s modernization.

The Andropov”plan” was just a recycling of Lenin’s dictum “Communism equals Soviet power plus electrification of the entire country”: to the Soviet mind, economic progress would be achieved by the centrally directed application of the most advanced technology. Like the Bourbons, the Soviet leadership learned nothing and forgot nothing. Such schemes never result in economic growth. Centralization is antithetical to economic growth. The dynamism of an undirected market process is necessary for true economic advancement. And it is this dynamism that creates the technology in the first place–it is technology that solves problems that people really face, not the problems that bureaucrats imagine that they face. As Hayek pointed out long ago, planners never have the information–or the incentive to use the information–necessary to direct resources to their highest value use.

USSR-2 also includes the following paragraph:

It [the Russian Federation under Putin] is a clandestine state, operating covertly under a seal of secrecy. It is invisible to the West and the majority of Russia. It is a hybrid of the special services, a nearly religious order (a group of people who passionately want to create a Russian miracle), a network of high-technology projects, financial-investment structures, and a web of propaganda…. Figures from this secret state say where to invest money. They choose projects and technologies. They direct investments and plan operations to take over whole branches of industry both on the territory of the late USSR-1 and right up to Europe and the United States. A transnational business network is being built — the USSR-2.

Again, the delusion that an elite can achieve economic growth by choosing “projects and technologies.” They can choose them, all right–but it is nearly certain that they will choose them incorrectly. A priesthood of secret policemen with no true market experience whatsoever, completely isolated from the micro-information of the marketplace, largely immune from market discipline, will never create a miracle, Russian or otherwise. The incentives they face will no doubt be perverse ones. Property rights are inherently tenuous in such a framework, so the siloviki will direct resources to endeavors that maximize the potential for graft and skimming over the very short run–rather than to projects that offer the highest returns to the society at large.

Anyone inside the siloviki or without who actually believes that a centralized, secretive, state-dominated system will actually produce robust economic development is sadly deluded, and in desperate need of a clue as to where to get a clue. Although USSR-2 and the RFERL article about it both suggest that this development is a threat to the West, I actually take great comfort in these disclosures. If this truly represents the thinking of Putin and his ilk, Russia is doomed to remain merely a petro state susceptible to the vicissitudes of the prices of oil and gas. It will not truly provide an enduring threat to the West, for like its Soviet predecessor, its military and diplomatic might will rest on economic quicksand.

I do feel genuine sadness, however, for all those Russians outside the siloviki, who will pay the price for the arrogance and ignorance of their rulers–and they are ruled, not governed, make no mistake about it. Bad habits of rule die hard in Russia, as the long suffering Russian people will find out when oil and gas prices decline and bring the Russian economy down with them.