Streetwise Professor

March 31, 2012

I’m Sure Medvedev Told Putin To Rely on Reason and Remember It’s 2012

Filed under: Politics,Russia,Uncategorized — The Professor @ 8:08 pm

Russia’s soon to be ex-Potemkin president Medvedev gave a condescending lecture to Mitt Romney in response to the Republican presidential candidate’s identification of Russia as America’s pre-eminent geopolitical foe:

Russian President Dmitry Medvedev on Tuesday sharply suggested that Mitt Romney use his head and remember what year he’s living in after the Republican presidential contender said Moscow was America’s “No. 1 geopolitical foe.”

Romney described Russia in those terms while criticizing President Barack Obama for his caught-on-tape remarks to Medvedev that he would have more room to negotiate on missile defense if he is re-elected in November.

During a briefing Tuesday in Seoul, where he and Obama were attending a nuclear security summit, the Russian leader said Romney’s remarks “smacked of Hollywood” and sounded as if they came from the Cold War era.

Medvedev advised the White House hopefuls, including Romney, to “rely on reason, use their heads,” adding, “that’s not harmful for a presidential candidate.” He further said, “It’s 2012, not the mid-1970s, and whatever party he belongs to, he must take the existing realities into account.”

Given that Putin’s presidential campaign was wall-to-wall with snarling Cold War rhetoric straight out of the 1970s-rhetoric far more extensive, virulent, and dramatic than anything Romney said-I’m metaphysically certain that Medvedev called Putin into his office and “sharply” lectured him about the benefits to a presidential candidate of relying on reason; using his head; avoiding language smacking of Hollywood; and taking existing realities into account.

It’s actually quite amusing to imagine how that would have played out.  Probably not that amusing for Medvedev, in the same way that the process of becoming a steer isn’t that amusing for the calf. Which is exactly why it didn’t happen, and never could have happened.

What’s less amusing is the administration’s blindness to the fact that Putin’s rhetoric isn’t rhetoric, and the fact that the lowing steers in the American media (and popular entertainment, like Jay Leno) are also unable-or unwilling-to evaluate Putin’s Russia, and its adversarial posture to the US, with clear-eyed reason.  I’m hardly a Romney fan by any stretch, but on this issue he is far more realistic, and relying far more on reason, than all those carping on him.

And when it comes to Russia, he is certainly far more realistic and reasoned than the man whose job he wants.

March 30, 2012

Exclamation Point

Filed under: Politics,Russia — The Professor @ 9:03 am

US Ambassador to Russia Michael McFaul has had a very rough go of it in his two plus months in Russia.  He has attempted to reach out to the opposition and civil society, such as it is, and has been hounded every step of the way.  It came to a head yesterday, when McFaul accused Russian television station NTV of having access to his schedule, intimating that NTV had broken into his email and phone.  Although the State Department tried to do some damage control, the story has gone viral.

Russian harassment of ambassadors they dislike is not unprecedented.  Indeed, no one should be surprised that this is happening, given Putin’s reascension to the presidency, and the paranoia in the ruling siloviki about the opposition.

But note well that this is the regime of the “Vladimir” that Obama wants the “flexibility” to deal with.  Further note well that this is Putin’s idea of giving our Barry space.

This puts an exclamation point to last night’s post: has Obama whispered a word about the abuse that is being heaped on the official representative of the US government in Russia?  Has he given the faintest indication that this abuse might bode ill for a constructive relationship with Russia?  Has it dawned on him that his behavior and policy invite nothing but derision and scorn from someone like Putin?  That Putin views Obama’s panting desire to make a deal when he has the flexibility to do so as a sign of weakness?  That the provocations directed at McFaul are a test of Obama’s mettle-and that he is failing miserably?

The questions answer themselves.

March 29, 2012

Slow Learner? No Learner

Filed under: Politics,Russia — The Professor @ 10:25 pm

Once upon a time, Obama had a great idea.  He would reset relations with Russia.  The linchpin of his strategy was a plan to focus attention on the alleged reformer Medvedev, and to freeze out Putin, whom Obama publicly dissed as a dinosaur:

On the eve of a trip to Moscow, Barack Obama chided Vladimir Putin,Russia‘s prime minister, today for keeping “one foot in the old ways of doing business”. By contrast, he said Putin’s handpicked successor as president understands that cold war behaviour is outdated.

In a White House interview with The Associated Press, the president said he will meet with both Putin and Dmitry Medvedev, Russia’s president, on his trip, in hopes they can “move in concert in cooperating with us on some critical issues.”

. . . .

Asked why he intends to meet Putin, Obama said the former president “still has a lot of sway … and I think that it’s important that even as we move forward with President Medvedev that Putin understand that the old cold war approaches to US-Russian relations is outdated — that’s it’s time to move forward in a different direction”.

“I think Medvedev understands that. I think Putin has one foot in the old ways of doing business and one foot in the new, and to the extent that we can provide him and the Russian people a clear sense that the US is not seeking an antagonistic relationship but wants cooperation on nuclear non-proliferation, fighting terrorism, energy issues, that we’ll end up having a stronger partner overall in this process,” he said.

Barry and Dmitri became big buddies.  They went out for burgers and everything.

Of course it was all a delusion.  Medvedev was a Potemkin president. No doubt Vladimir and his siloviki pals were doubled over in laughter at Obama’s naiveté and gullibility.

The mask came off in September, when the charade came to an end and Vladimir resumed his rightful place.  Then Vladimir launched into an election campaign during which he fulminated against the United States.  Really, if you followed the campaign, you would have concluded that Vladimir believes that the United States is Russia’s Number One Geopolitical Foe.

And you would have concluded right.

But did the scales fall from Barry’s eyes?  Did he decide that the Reset was based on a faulty premise?  Did he recognize that since a man who by Obama’s own estimation has one foot (three, actually) in the Cold War past, who viscerally hates the US, was going to dominate Russian politics for the foreseeable future, that it was pointless to continue his attempted rapprochement?

Of course not! It’s almost as Barry never noticed.  Barry told Burger Buddy Dmitri-now demoted to Vladimir’s errand boy-to tell Vladimir that after his “last election” he would have flexibility to make a deal that would be to Vladimir’s liking.  Foot in the past? Huh? Meet the new boss, same as the old boss. Putin’s electoral rhetoric? What rhetoric? Obstructionism in Syria that even his own Secretary of State called “despicable”?  Whatever.

We know Barry is a slow learner.  Actually, he is a no learner.  Exhibit 1: energy.  Exhibit 2: this whole Russian fiasco. BHO is proceeding blithely as if nothing has changed.  Well, nothing has really changed, because Putin was always in charge, but Barry apparently didn’t understand that.  So if Obama was sincere in his earlier statements (I know, I know), he should believe that things have changed-and he should adjust course accordingly.   But apparently not.  He is proceeding with his grandiose Russian schemes that were predicated on exploiting an imagined split in the Russian power structure, even though it is now evident even to the dimmest of the dim that said split never existed. And he is willing to do so by actively concealing his intentions from the American people.

It is bad enough to pursue a policy that is based on a delusion that anyone remotely familiar with Russia should have known to be such.  It is beyond bad to continue to pursue that policy once it has been proven to be based on a delusion. And to do so in such a deceptive way staggers the imagination.

But that’s our Barry.

The NYT is of course utterly clueless on the subject, but even the WaPo, normally in the Obama Tank, can’t swallow this. Neither should anybody else in possession of their sanity.

March 28, 2012

I’ll Take the Other Side of That

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

Deutsche Bank and Troika Dialog claim that the odds that Khodorkovsky will be released have risen to 50 percent.  The reasoning of those betting on a release is almost completely economic:

Releasing Khodorkovsky would spur a rally in Russian stocks of 5 percent to 10 percent, Deutsche Bank said in the note. Lissovolik declined to comment further when Bloomberg reached him by phone in Moscow.

“It’s a 50-50 call right now,” said Chris Weafer, chief strategist at Troika Dialog, the investment banking unit of state-run lender OAO Sberbank (SBER).

Micex Index Rises

Chaika’s review “should be completed this weekend and then any cases found to be unsound will go to a presidential commission for final review and recommendation,” Weafer said by phone. “By that time, Putin will be in the Kremlin.”

The Micex Index (INDEXCF) of 30 Russian stocks advanced 1.6 percent to close at 1,565.12 in Moscow, its biggest one-day gain in more than two weeks.

The Russian gauge surged as much as 1.6 percent in August 2008 on a report, later retracted, that Khodorkovsky had been given parole. Medvedev steps aside in May to allow Putin to reclaim the Kremlin spot he occupied from 2000 to 2008.

The new government may want to “make a smash,” by releasing Khodorkovsky, according to Mattias Westman, founder of London-based Prosperity Capital Management, the largest Russia- focused fund manager with about $5 billion in assets.

“It would have a positive effect and would make people reconsider Russia,” Westman said by phone from London. A 5 percent to 10 percent gain for the Micex is not “a bad estimate,” he said.

I think this is nuts. It is best interpreted like Freud interpreted dreams: wish fulfillment by those who want to encourage a rise in stock prices-and a rise in stock trading-in Russia.

It completely discounts the politics, and Khodorkovsky’s imprisonment is all about politics.  110 percent.  In the aftermath of the most unsettling moment in recent Russian political history, do you think Putin would risk releasing Khordorkovsky?  Set aside his visceral hatred of the man.  Just look at the objective reality.  Wide swathes of the Russian public are dissatisfied, and sick of Putin.  But the opposition has failed primarily because it lacked leadership.  Khodorkovsky could provide that leadership.  And he has the money.  And he has reason to go after Putin personally.  Putin has survived in large part by keeping any potential opposition divided and leaderless.  Releasing Khodorkovsky in these fraught and unsettled times?  The upside for Putin is almost zero-the downside is big.  No, Khodorkovsky’s success would not be assured, but the odds of a political crisis are far larger with him free, than with him behind bars.  You really think Putin is going to take that risk?

And know that once released, Khodorkovsky would make every effort to recover what he believes was stolen from him and other Yukos shareholders.  That would strike right at the heart of the siloviki elite and their ill-gotten gains.

So I would definitely short Khodorkovsky’s release at 50-50 odds.  At 10-90 odds even.  I put the odds at virtually zero.

So why the rumor? Great opportunity to sell into the rally brought on by suckers buying based on it.  Another opportunity to part fools and their money.  So I think that this is being floated by people in the Russian government who want to fleece gullible Western dreamers.  And given that business and finance ethics in Russia are epitomized by people like Shuvalov, this is the most likely explanation.

Are we supposed to take investment advice from Deutsche and Troika?  I pass.

March 26, 2012

Should *We* Give Him Some Space?

Filed under: History,Military,Politics,Russia — The Professor @ 7:40 pm

Per usual, the Russians have been throwing hissy fits over US ballistic missile defense plans, which the Russians believe are directed at them.  Medvedev has been warning that the time is fast closing for a deal to be done.  Rogozin has been venting about BMD.  And on and on.

And apparently Obama wants to deal, but feels constrained by, oh, you know, the fact that the American electorate is not nearly so enthusiastic.

In one of the most remarkable videos I have seen in a long time, before a live microphone Obama gives Medvedev the wink-wink, nudge-nudge, say-no-more routine:

President Obama: On all these issues, but particularly missile defense, this, this can be solved but it’s important for him to give me space.

President Medvedev: Yeah, I understand. I understand your message about space. Space for you…

President Obama: This is my last election. After my election I have more flexibility.

President Medvedev: I understand. I will transmit this information to Vladimir.

The body language is even more amazing than the words.  Look at Obama’s reassuring grasp of Medvedev’s arm.

Obama is trying to deceive someone.  He is either deceiving the American people, by his refusal to be honest with his intentions regarding missile defense, or he is attempting to deceive Medvedev (and Putin-the “him” referred to in Obama’s “give me space” remark), by insinuating that he will make a deal after the election.  But even the latter interpretation involves an attempt to dodge the US electorate: if he convinces Russia to tone down its rhetoric on BMD, he takes this issue-and the issue of Russia generally-away as a campaign matter.  This relieves him of the necessity of dealing honestly and forthrightly with a potentially contentious issue, and permits him to avoid accountability for the complete lack of concrete results arising from the vaunted Reset.  If the Russians continue to be cantankerous about missile defense, the Reset looks like a sham.  (Well, it is, but it will be obvious to everyone.) If Putin tones it down, based on Obama’s wink and stroke, Obama can continue to claim that he has improved relationships with Russia.

But given the fact that Obama is obviously playing somebody, do you really believe that Putin will conclude that Obama is playing the American electorate, and not Putin?  Given Putin’s suspicions of the US, I doubt it.

But I think that Americans have to take seriously the possibility that Obama is planning to conceal actively his intentions regarding a second term.  If he is willing to be “flexible” after the election-i.e., if he is willing to do things after the election that are contrary to what he says before it–about Russia and missile defense, what else is he being “flexible”-i.e., lying-about?

In other words, this exchange with Medvedev raises serious additional questions about his sincerity and honesty.  I don’t think he deserves space.  He deserves to be pressed repeatedly on his intentions, and this video provides a perfect pretext for the pressing.

The exchange with Medvedev was also notable for its confirmation of Medvedev as Putin’s errand boy: “I will transmit this information to Vladimir.”  How embarrassing, mainly because Medvedev says that without a trace of embarrassment.  He is well and truly whipped. He has his mind right.  He knows who is boss.

In fact, pretty much anybody paying attention knew who was boss from day 1.  But Obama predicated the Reset on the idea that Medvedev was a rival of Putin’s.  How’s that looking now?

Speaking of missile defense, over the weekend Rogozin the Ridiculous tweeted that “Russian missile systems are able to overcome missile defense of any kind.” To which I responded: “So then why are you so fussed about US ABM system? You should welcome us wasting $ on it. So which is it?”

Which means that Rogozin is also attempting to deceive.  Either his fulminations against US missile defense are deceptive (because these really pose no threat to Russia because its ICBMs are invulnerable) are dishonest or his claims that Russian missiles are invulnerable  are lies.

Sad to say, Rogozin didn’t reply.  I’m shocked.  But a troll did claim that Russia was fussed because “it is indicative of NATO’s arrogant disrespect for Russian sovereignty.” Uhm, American missiles or ABM facilities- on Polish, Romanian and Czech violate Russian sovereignty how, exactly?

March 25, 2012

Bullbusters, Part 2

Filed under: Derivatives,Economics,Energy,Financial crisis,Financial Crisis II,Military — The Professor @ 8:43 pm

An UNCTAD paper by David Bicchetti and Nicolas Maystre analyzing high frequency data from commodity futures markets has received a tremendous amount of attention in the few days since its release. The paper purports to present evidence that high frequency trading has distorted commodity prices, hence the flurry of attention to what is in fact a rather unexceptional paper.  Indeed, the only thing exceptional about it is the authors’ extreme over-interpretation and sensationalization of the results, and their failure to consider seriously more reasonable interpretations of their findings.  Their characterization of their findings borders on academic malpractice, and raises questions about their sincerity.

The empirics are rather straightforward.  Bicchetti and Maystre calculate rolling correlations between EMini S&P 500 futures returns and the returns on 6 commodity futures contracts-WTI, corn, soybean, wheat, sugar, and live cattle.  These correlations are calculated at various frequencies ranging from 1 second to 1 hour.

They find that correlations were typically around zero before jumping substantially around September, 2008. Based on this, they conclude that “the financialization of commodity markets has an impact on the price determination process.  . . . In fact, the strong correlations between different commodities and the S&P 500 at very big frequency are really unlikely to reflect economic fundamentals.”  They further claim that “HFT strategies, in particular the trend-following ones, are playing a role.”

Their basis for this claim is extremely thin.  They note that HFT trading has become increasingly important in recent years.  They note that correlations jumped in 2008.  They conclude that the former caused the latter.


Gee, now what happened in September, 2008?  Let me think.  Think. Think. Think. Oh, I remember now-we had a financial crisis!

Could that maybe explain the change in correlations?

Damn right, it could-and did.  First, note that the correlations between the S&P 500 and commodity prices are going to be driven primarily by whether supply or demand shocks are driving commodity prices.  Take oil as an example.  When supply shocks are important, one would expect zero or even negative correlations between oil prices and stock prices.  An adverse oil supply shock should lead to higher oil prices and lower stock prices.

When demand shocks predominate, however, positive correlations are to be expected.  Adverse aggregate shocks depress both oil prices and stock prices.

Thus, correlations depend on the composition of shocks.  When demand shocks (driven by shocks to income) predominate, correlations should be positive; when commodity-specific supply shocks predominate, correlations should be zero or negative.  (With the ags, since supply shocks are unlikely to be correlated with aggregate income or growth, one would expect near-zero correlations.  With oil, supply shocks can have macro effects, so negative correlations can arise.)

Starting in the fall of 2008 there was a dramatic increase in the flow of information about demand-related shocks.  The predominant feature of those months was a dizzying flow of macroeconomic-related news.  Would major economies be thrown into depression? Would the financial sector collapse?  Would economies recover?  How rapid would the recovery be? What were governments doing to trying to stem the collapse and rekindle growth?  The composition of economic shocks shifted decisively towards demand/income-related shocks that dwarfed commodity-specific supply-related shocks.

In this environment, commodity-specific supply-related information was swamped by systematic demand-related information.  You would expect-clearly-this to lead to positive co-movements between stock prices and commodity prices, because both were being driven by demand related information.

Moreover, financial shocks during the crises that  constrained risk-bearing capacity that were quite prevalent during this period would have affected both stocks and commodities, and in the same way.  These shocks to risk bearing capacity would have affected expected returns on commodities and equities in the same way.  This would have also contributed to substantial positive covariation.

The very discontinuity in the correlations around the time of Lehman supports this view.  Algorithmic trading and HFT trading (they are different) were both growing throughout the mid-to-late-2000s.  There was no discontinuous jump in the utilization of these strategies at the time of Lehman.  But there was a discontinuous jump in the correlations.  A much more plausible interpretation of the data is that a discontinuous change in the nature of economic shocks (becoming predominately economy-wide demand-related shocks) and correlated shocks to risk bearing capacity (that led to correlated shocks in expected returns) attributable to the (discontinuous) financial crisis explains the discontinuous change in correlations.  The authors offer no plausible explanation-none-of how a continuous growth in HFT could lead to a discontinuous jump in correlations precisely in September, 2008.

Indeed, their measure of HFT-the ratio of volumes to trades-flattened out precisely during this period, after having fallen since the beginning of 2007.  If this is a measure of HFT, it should have jumped down discontinuously at the time correlations jumped up if in fact HFT was driving correlatons.  But the exact opposite happened.  The authors let this obvious problem with their interpretation pass in silence.  This is inexcusable.

There is other information in the report that strongly supports the view that fundamentals were in fact driving the correlations.  In particular, the WTI-S&P correlation dropped substantially in January-April, 2011.  This is precisely the period in which the Arab Spring and in particular the outbreak of civil war in Libya led to substantial supply shocks in the oil market.  As noted above, supply shocks for oil should lead to opposite movements in oil prices and stock prices.  An increase in the flow of supply-related information should lead to lower correlations between stock and oil prices.  The Arab Spring and Libyan events led precisely to such an upsurge in supply shocks, and correlations fell exactly as would be expected if fundamentals were actually driving prices.  Under the HFT interpretation, there would have had to have been a drop in HFT utilization during this period, which certainly did not occur.

In sum, the evidence presented in the widely hyped Bicchetti-Maystre paper in fact strongly supports the view that fundamentals were driving commodity and stock prices during the sample period.  In particular, the main piece of evidence that B-M emphasize-the jump of correlations in September, 2008-corresponds to an obvious regime change in which economy-wide shocks that would affect both stock prices and the demand for commodities occurred more frequently and with greater severity.  One would predict-and in fact I did so predict contemporaneously-that such a change would lead to a substantial change in the correlations between stock and commodity prices. (I made this prediction publicly at a symposium held at the Bauer College shortly after the beginning of the crisis, and actually made the conditional prediction in the summer of 2008 that the only thing that would bring down oil prices was a serious economic downturn.)  The change in oil-stock price correlations around the time of the Libyan crisis is also consistent with the hypothesis that price movements reflected information about fundamental supply and demand conditions.

In contrast, there were no discontinuous changes in “financialization” or the utilization of HFT either in September, 2008 or during the Arab Spring/Libyan period.

In sum, the actual evidence presented in the paper strongly supports the hypothesis that fundamentals drive prices.  It does not provide any support for the hypothesis that “financialization” or HFT is distorting prices and overriding the impact of fundamentals.  Indeed, there is strongly contrary evidence.

Thus, although the empirical analysis in this paper is unobjectionable, the interpretation is contrary to the actual results and a reasonable reading of the economic and financial history of this period.  Indeed, the interpretation is so at odds with the data and history that the motives of the authors are open to serious question.  They jump on the anti-financialization, anti-HFT bandwagon even though (a) the actual data does not support that interpretation, and (b) other, quite opposed, interpretations are much more reasonable. Whenever there is a yawning gap between the most reasonable interpretation of an empirical analysis, and the interpretation that the authors advance, one may reasonably question the intellectual honesty of those interpretations.

And I do so question.

I therefore recommend examining the various graphs presented in the paper in light of an understanding of how the composition of economic shocks should affect correlations, and an understanding of what was happening during the sample period of the study.  I further recommend completely disregarding the Bicchetti-Maystre interpretation of their results, because it betrays no understanding of either the economics or the history.

March 24, 2012

Bullbusters, Part I

Filed under: Commodities,Economics,Energy,Military,Politics — The Professor @ 8:24 am

This post on Information Dissemination is going viral (h/t R & LL).  I follow ID on my RSS feed, and it has good stuff about Navy inside baseball, but when it gets to economics, I suggest you take a pass.

Galrahn’s post attempts to pull together disparate strands of information to suggest that an attack on Iran is forthcoming: hence the virulence of the post among the conspiracy minded.  The first strand is information about deployments of US Navy assets to the Persian Gulf (when will they start calling it the Arab Gulf again?).  OK.  That could be legit.

Then he attempts to weave in strands relating to energy.  Starting with China:

So maybe this other relevant activity is just a coincidence, but even as a coincidence it is very interesting. Lets start with China.

The government on Tuesday raised retail prices for gasoline and diesel fuel for the second time in less than six weeks in an attempt to keep pace with soaring crude oil prices.

Chinese motorists are now paying $4.43 a gallon for 90-octane fuel — nearly equal to the $4.45-a-gallon average for mid-grade fuel in California, according to AAA.

The reason provided is found later in the article.

The increase should ease pressure on China’s two main refiners, the state-owned China Petroleum & Chemical Corp. and PetroChina Co., which are not allowed to pass costs on to consumers. The two have reported losing billions of dollars already because of soaring crude prices.

In other words, China is not having a supply or a demand problem right now, what they are having is a ‘losing money’ problem because of the current high costs – and because China price fixes their fuel, they must price fix it relative to the global market.

This is mainly gibberish.  The Sinopec/CNPC battles over pricing with the Chinese government are well-known and have been raging for years.  I’ve written about them on the blog.  This is hardly a new development, and certainly tangentially related at best to what is going on in the PG.

Galrahn then turns to Saudi Arabia increasing output and shipping it to the US.  He discounts the possibility that this is a political favor for Obama intended to keep prices down.  The basis for the discount is an alleged shortage of refinery capacity in the US.  Per Galrahn, the increased oil shipments will not depress gasoline prices in the US because we have a shortage of refinery capacity.  Thus, he concludes that the only reason for the shipments is to add to US stockpiles, which he interprets as a preparation for war.

The sole basis for Galrahn’s claim of a shortage of refining capacity is a Reuters article.  Uhm, data is our friend.

The EIA posts data on refinery capacity utilization.  The most recent data (from December) show that US PADD I (East Coast) refineries are operating at very low levels of capacity utilization.  Very low.  No lack of capacity there.  Indeed, the refinery closure mentioned in the article (Sunoco’s Philly refinery) is due to a lack of buyers.  If refining capacity were the bottleneck, the buyers would be lining up-if Sunoco even wanted to sell.

Refineries in ND, SD, and MN are operating above capacity.  But that’s no surprise.  It’s a manifestation of the Cushing bottleneck.  Refineries in OK and KS are operating at relatively high rates: another manifestation of the buildup of crude in the Midcon.  Gulf Coast refineries are operating at normal rates.

So: no evidence that capacity is the bottleneck in the EIA data.

Price data tell the same story.  Adjusting the Gulf Gasoline Crack for the LLS-WTI differential implies refining margins of about $7-$10/bbl.  The diesel crack is also about $10/bbl. The RBOB-Brent crack is around $15/bbl. These spreads are pretty weak, and hardly symptomatic of a shortage of refining capacity.

So the data completely undermine the basis for Galrahn’s theory.  Crude prices depressing refining margins are the problem, not a lack of refining capacity.  Which means that increasing crude supply available to East Coast and Gulf Coast refineries would reduce gasoline prices.

The fact that the US is exporting some refined products is also inconsistent with a shortage of refining capacity here in the US.

Without that, Galrahn’s big theory goes up in smoke.

That said, the Saudi’s dispatching of a “wall” of VLCCs is curious.  The natural destination of increased Saudi oil output would be Asia, to replace lost Iranian crude.  This does suggest some deal between the US and the Saudis, and one could weave a theory around that, given the Saudi fear and hatred of Iran.

But one cannot, as Galrahn does, bolster this case by claiming that there is no available capacity to refine the additional Saudi oil.

March 22, 2012

Giving New Meaning to the Phrase “Crack Spread”

Filed under: Uncategorized — The Professor @ 10:39 am

Obama is in Stillwater, OK, where I spent a wilderness year before coming to Houston.  He then travels to beautiful Cushing, OK, where he will tout the construction of the Keystone XL Market Link connecting Cushing with the Texas Gulf.

Talk about chutzpah.  Unbelievable.  It is worse than the rooster claiming credit for the sun rising, because the cock doesn’t know any better, but Obama should.

Fact: the US government generally, and Obama and his administration particularly, have nothing to do with the construction of this pipeline.  It is an eminently rational commercial response to price signals.  It is the market in action.  It is what happens when the market is allowed to operate.

If Obama were a thoughtful, fair minded man, rather than a somewhat dim political hack and complete economic ignoramus bent on re-election, instead of conscripting Keystone into his demented narrative about his cockamamie energy policy, he would learn a lesson.  That lesson would be: market participants responding to price signals will undertake the investments necessary to produce and transform energy.  Maybe I should get out of the way and let the market work.

But Obama will never acknowledge any such thing.  The only thing he is invested in is a delusional energy policy that is determined to ride roughshod over price signals.  A policy that is predicated on a worldview that distrusts-and arguably hates-markets.  A policy that is hell-bent on subsidizing losers (the losses being a flashing red-light price signal) and stymieing winners.

And the hits keep on coming.  He wants to tax Chinese solar panels because the Chinese subsidize their production.  Look, solar is one of the biggest losers, but if the Chinese are going to be so generous as to make them less loser-like by selling panels below cost, we should thank them.  It means that the Chinese are bearing some of the cost of our stupidity.

But I forgot.  The solar manufacturing sector is teeming with Obama supporters and donors.  Go figure.

Taking heat on his energy policy, such as it is, Obama had the loathsome and aptly named Jay Carney (who makes me pine for Robert Gibbs!, which is a staggering thought) lecture the world on the subject.  Apparently anyone who disagrees with Obama’s policy has “severely diminished capacity.” (For a suitably outraged response by my eminent colleague Paul Gregory, check this out.)

Want to talk “diminished capacity” Jay?  How about this.  Thus spaketh Obama:

We have subsidized oil companies for a century.  We want to encourage production of oil and gas, and make sure that wherever we’ve got American resources, we are tapping into them.  But they don’t need an additional incentive when gas is $3.75 a gallon, when oil is $1.20 a barrel, $1.25 a barrel.  They don’t need additional incentives.  They are doing fine.

Overlook the confusing of barrels for gallons. Overlook the fact that Obama apparently believes that the gross margin between output price and raw material input cost is profit.  (If so, then WTF are those huge refineries costing billions of dollars virtually within view out my window from where I sit needed for? )

He. Can’t. Even. Do. Arithmetic.


There are 42 gallons in a barrel.  At about $110/barrel (the price of WTI at Cushing), one gallon of oil costs about $2.61: at $120+/barrel (the cost of the marginal barrel of something like LLS that drives the price of gasoline) one gallon of oil costs $3.

Meaning that the gasoline crack (the difference between the price of gasoline and the cost of the oil needed to produce it) is around $.75-$1.00.  A differential that must cover all refining costs (including, in the long run, the return on the immense capital invested in refining) and the costs of bringing the gasoline from the refineries to consumers.  (And by the way, refining is not noted as an extremely profitable business.)

The difference between the price of a gallon of gas and the price of a gallon of oil is not a profit to the seller of gasoline.  And it surely ain’t $2.50/gallon.

But we’re supposed to listen to him pontificate about energy, and have his pathetic flack challenge our intellect, without challenge.

It is a challenge to listen to him speak about energy, actually.  The challenge being keeping breakfast down.

Witnessing Obama hold forth on energy indeed brings the word “crack” to mind, but not in sense of the process of using catalytic processes to refine crude oil.  No, I’m reminded of another product of a chemical refining process, a white crystaline substance known to impair mental function, as in: if his recent speeches reveal what he believes about energy, he must be on crack.

March 17, 2012

The Corps of Financial Engineers

The advocates of mandated OTC derivatives clearing insisted-insisted-that mandated clearing would simplify the market, and reduce dangerous interconnections between financial institutions.  The canonical illustration of this point was something like this, with the first diagram being the messy bilateral, pre-clearing mandate market, and the second being the neat and tidy clearing mandate market:

Uhm, not really. Not at all. These diagrams presume that the only interconnections between OTC derivatives users are via the derivatives markets themselves. In fact, derivatives users are connected via credit and liquidity support mechanisms as well, and the adoption of clearing which results in the unbundling of the credit and liquidity arrangements embedded in derivatives trades will lead to the forging of new connections that will make the post-mandate system as complicated and interconnected and fragile, and perhaps more complicated and interconnected and fragile, then it was before.

These interconnections are of different types.  Some are operational.  Consider this from an illuminating article in Wall Street & Technology:

A new swaps ecosystem needs to be established in order to enable central clearing. “You’re talking about a whole reinvention of the entire market,” says Henry Hunter, global head of product development at MarkitServ, a provider of middleware and online confirmation and affirmation services to the buy and sell sides in the derivatives space. “That’s a massive infrastructure change that is happening over a period of years.”

Wholesale reinventions always go well.  Always.  But it gets better:

“It’s a complicated mess,” says MarkitServ’s Hunter, who notes there could be as many as six different players involved in any trade — the client, the executing broker, an execution venue (i.e., the SEF), a CCP, a clearing member acting for the client, and possibly a clearing member acting for the dealer as well. “Managing that choreography can get complicated, so that’s where the middleware comes in.”

And the mess doesn’t stop there. Clearing brokers have the burden of modifying their electronic trading infrastructures and processing systems. According to Morgan Stanley’s Brock Arnason, executive director and global product manager for the Matrix platform, “The infrastructure that is required to support a clearing business is quite significant.” Clearing brokers must capture their clients’ voice and electronic trades and then run them through validation rules to determine clearing eligibility, he explains.

Think of all the operational linkages described in those short paragraphs.  Think of all the possible problems that can arise, particularly in stressed market conditions.  The financial system is a tightly coupled one as it is, and the rigid schedule on which clearing must work, to initiate trades, close them, and margin them, makes it all the more tightly coupled.  The choreography could very well go wrong, and is most likely to go wrong precisely at the most dangerous time.

In addition to the operational connections, there are financial connections, especially related to collateralization: I’ve written about this extensively on SWP, and in places like my recent J. Applied Corp. Fin. paper.  More from the WS&T article:

One of the most disruptive changes on the buy side under the new derivatives rules will be the need to manage margin calls from the clearinghouses on cleared swaps. “Some clients are going from never having to post initial margin to now always posting margin,” comments Morgan Stanley’s Swankoski. When clearing becomes mandatory, “All clients, big or small, are going to have to post initial margin on their cleared transactions.”

. . . .

To help buy-side firms complete this process, the clearing brokers are looking to provide collateral transformation services, according to Forkan. “They’re now building in services to ensure that organizations that post one type of asset can convert it into another type of asset,” he says. “That is a cost of clearing that the asset management community is going to have to bare. Given the huge investment that the banks have made in technology and infrastructure, they are keen to offer services that generate profit — it’s a large opportunity for the global banks to grab market share among the asset managers that need services.”

To reiterate, the advocates of clearing asserted that collateralization would reduce leverage in the system by preventing the bundling of credit in derivatives trades.  But as I’ve said repeatedly, this will just lead to the substitution of unbundled credit for the proscribed bundled leverage.  Collateral transformation is an example of this.  Moreover, this form of credit, when joined with the rigidity of the margining process for cleared transactions (and for non-cleared trades which Frankendodd requires to be marked-to-market on a daily basis), these new credit arrangements are likely to be more fragile than the bundled ones they replace.

In brief, there will continue to be a dense web of interconnections between market participants-the second diagram above is a very misleading of the post-Frankendodd world, which will continue to look like the first diagram.  Moreover, These interconnections are likely to be even more fragile.

And we’re not finished!  Another point that I’ve made for the past several years is also becoming increasingly recognized.  Namely, the breaking of netting sets will arguably lead to greater complexity, greater collateral demands, and potentially greater total risk exposures.

With respect to operational complexity:

Another big challenge for buy-side firms will be managing their existing bilateral OTC derivatives business alongside cleared swaps to gain a holistic picture of counterparty risk. Since not all trades will be required to be cleared, buy-side firms will have both a bilateral book of trades that they are still managing as well as daily collateral calls for the cleared book of swaps, says Omgeo’s Leveroni. “You will end up with a mixed clearing environment and operational complexity that you didn’t have before,” he cautions.

. . . .

“The buy side is going to struggle with having enough collateral to post for the book of business,” Leveroni says. “This is worrying a lot of people. You want to make sure you manage that collateral right, so you only send cash to the cleared call and you send the corporate bond to your bilateral call. You have to be smart in the collateral you send to each call. Those are the real risks to the buy side.”

With respect to increased needs for collateral, consider this from Matt Leising:

Derivatives users will face significant challenges to meet new collateral requirements as the trades are forced into clearinghouses, according to industry executives.

Investors have pledged about $200 billion to back futures trades around the world, Bill de Leon, a managing director at Pacific Investment Management Co., said today on a panel discussion at the Futures Industry Association annual conference in Boca RatonFlorida. That amount could be 10 times as large for the majority of trades in the $708 trillion over-the-counter derivatives market, he said.

“This is going to be one of the biggest challenges going forward,” said Jeffrey Jennings, the global head of listed derivatives at Credit Suisse AG. Exchanges such as CME Group Inc. (CME) are expanding the collateral they accept to allow corporate bonds to be pledged and are offering to reduce margin across assets like futures and interest-rate swaps. “That’s not going to be enough,” he said.

. . . .

Other plans by brokerages to offer to transform for their customers unacceptable margin into cash or U.S. Treasuries that are accepted by clearinghouses won’t solve the problem, and may add to risk during volatile times, said David Olsen, global head of OTC clearing for JPMorgan Chase & Co. (JPM)

“In my opinion, collateral transformation is really just a marketing term for repo,” he said. The collateral obtained from selling securities to garner cash or Treasuries in the repurchase market don’t fit many type of derivative users, such as pensions, that may have 30-year swaps they need to maintain, he said.

With respect to the fact that fragmentation of clearing across jurisdictions and instruments and the elimination of netting economies across cleared and non-cleared positions (a point I’ve made, as have Duffie-Zhu) consider this very readable paper by David Murphy.

It is not an exaggeration to say that every claim made by Frank, Dodd, Geithner, Gensler, and all the other clearing fanboys and fangirls around the world are extreme exaggerations at best, and often flatly wrong.  New vulnerabilities have been substituted for old.  New interconnections have supplanted those that prevailed in the bilateral world-and many of the new interconnections are more problematic.  Financing and liquidity and credit arrangements remain deeply meshed with derivatives transactions.  Mandated clearing eliminates some netting benefits, while creating others, and it is by no means clear that the mandates have reduced exposures.

The whole top down restructuring of the derivatives markets-which represent a complex, emergent order-does not lead to the replacement of a complex and sometimes chaotic system with a simple and ordered one.  It will result it a new complex system that will emerge in response to the new laws and regulations.  The regulations were motivated, in essence, by fears of the instabilities and non-linearities in the old order: but the new system will have its own instabilities and non-linearities. Indeed, I believe that a mandated, top-down attempt to impose a new order is likely to result in a less supple, more rigid, and less stable system than the (imperfect and sometimes unstable) one it is intended to supplant.

An analogy that comes to mind is the Corps of Engineers.  For decades the Corps has intended to impose order on a complex system of rivers.  The results have been less than happy.  The imposed order has too often proved illusory, and attempts to control the system have resulted in an increased likelihood of catastrophic floods and the destruction of valuable natural ecosystems. Attempts to control complex systems are usually futile, and tend to result in the replacement of more frequent small crises with a few mega-crises (this is a point also made by Taleb and Bookstaber).

In this regard it is always useful to remember Hayek’s warning about the illusion of control: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Chris and Barney and Timmy! and Gary think they know a lot more than they really do.  They see like a state (to use James Scott’s phrase), and as Scott shows, these attempts to re-engineer complex systems from above almost always end in grief.

But as the continued existence and persistence of the Corps of Engineers shows, the illusion of control and the faith that top-down re-engineering of complex systems can work is enduring.  The idea is hard to kill, and ironically, its failures often lead to demands for more and more and more control.  I expect, alas, that this will be the case in the derivatives markets.

March 14, 2012


The Li(e)for investigation is metastasizing at an incredible place.  Both Bloomberg and FT have run long pieces on the problems with the rate-setting mechanism, and how to fix them.  Investigations (10, according to FT) are proceeding around the world, in the US, UK, Europe, Japan, Canada, and Singapore.  There is a criminal investigation in the US.  Numerous banks are scurrying to cooperate in the hopes of receiving leniency-the prisoner’s dilemma in action.

Some of the reporting is confusing.  There are at least two different motives for the alleged misstatements, one likely being more legally fraught for the banks.  The first motive is that during the throes of the crisis, banks had an incentive to misreport the rates at which they could borrow unsecured in order to avoid the perception that they were on the brink.  The other motive is that traders wanted to influence LIBOR in order to advantage derivatives positions tied to LIBOR-the latter likely presents the banks and individual traders  with far more acute legal problems.

Then there remains the issue of what to do about it.  The most obvious remedy is to base LIBOR on actually borrowing transactions, in the same way as is done with EONIA and SONIA overnight (hence the “ON”) borrowings.  This is a reprise of the data hub idea I advocated for energy trades back in 2003(!).

There is pushback against this idea, however.  One argument is that particularly during times of stress only a few banks are actually able to borrow unsecured for 3, 6, or 12 months, so the rate would be based on transactions from a small set of institutions.

I don’t get this objection, frankly.  So it’s better to base the most important reference rates in the world on what banks that cannot borrow unsecured say they could borrow at, than to base it on the rates that banks that actually do borrow unsecured pay?  Really? The first alternative is an oxymoron.  The second might result in rates from only a few banks being used, but far, far better to base an index that is supposed to reflect the actual cost of unsecured borrowing (by those able to do it) as represented by real transactions then to use the oxymoronic fantasy rates of those who can’t do it.

And if nobody can borrow unsecured in any volume-that’s important information in and of itself.  That raises the question of the advisability of basing so many derivatives contracts on something that has an appreciable probability of not existing from time to time. Better to recognize reality than MSU and pretend it’s real.

Here’s a thought: BBA could continue to report a LIBOR based on the traditional methodology, but just modify its name to LIBORGIGO. Truth in advertising, dontcha know.

This raises a broader point.  Cash settlement is often raised as a panacea for contract design.  Delivery-settled contracts have problems-so go to cash settlement! But as I’ve argued since 1990, in many markets cash settlement is problematic due to the opacity of cash markets, and/or the absence of cash market transactions.  Cash settlement works where there is a liquid and vibrant and transparent cash market (e.g., S&P500 stock index futures) or centralized collection of cash transactions prices (e.g., live hogs).  Everywhere else, problematic indeed.

LIBOR is the most pronounced example of that today.  Natural gas was so in the late-90s and early-00s.  Right now, the Platts’ methods for oil price assessments are under considerable scrutiny.  Market participants have always been skeptical (though they often mute their criticism given Platts’s heft), but IOSCO has issued a very critical and questioning appraisal, and raises the question of whether further regulation is necessary.

It’s deja vu all over again, folks.  Been there, done that.  Went through all these issues with the energy data hub in ’03.  I can show you the scars.  I can tell you some stories (e.g., the trade group guy who asked me what it would take to get me to back off with my proposal.)

The fundamental problems are that cash settlement is hard if there aren’t, well, a lot of cash transactions going on.  Even if there are a decent number of cash trades, that doesn’t help if people don’t report.  Given the public good nature of more informative price indices, there are under-incentives to report.  Indeed, it can be worse than that: reporting can be a private bad.

This raises a justification for mandatory reporting, and that is actually one of the defensible parts of Frankendodd.  That can’t fix the problem of a lack of transactions, but it can make the most of the transactions that are there.

But this also points out the value of delivery-settled derivatives.  The ability to make delivery  gives market participants the opportunity to put their money where their mouths are in a way that is impossible with cash settlement, especially cash settlement based on self-reported prices and assessments. Even if delivery doesn’t occur all that much, the ability to make delivery keeps prices honest (noting, of course, that the delivery mechanism can be abused, but further noting that’s a problem that can be addressed by appropriate anti-corner measures.)

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