Streetwise Professor

The FT raises the alarm that hedging by US oil producers will undermine the shale oil boom:

As the US shale revolution transforms global trade in oil, it is also causing upheaval in the derivatives market – and making life harder for America’s shale producers.

The companies behind rising US crude production are selling more of their output in advance to guarantee revenues. That is putting downward pressure on future oil prices – making it harder for those companies to enter crucial hedging contracts.

. . . .

The principal reason for the downward drift in prices, say analysts and traders, is the hedging activities of shale oil producers themselves. As the volume of production in the hands of independent producers grows – EOG, a bellwether independent oil producer, doubled crude and condensate production between 2010 and 2012 – so does their hedging activity.

Um, no.  This is a classic case of someone confusing correlation for causation.  What’s driving down prices is the rise in output: the rise in output is also leading to more hedging activity. Yes, there will come a point where price comes down to a level that some producers will find it better to keep the oil in the ground.  That’s the market in action.

There’s also this fascinating detail:

“There has always been a mismatch between producers and consumers in the futures market, but the increase in production by independents has made it worse,” says Jonathan Whitehead, global head of commodities markets at Société Générale.

Hmm.  Buys and sells are equal in equilibrium.  So just who balances that mismatch?  Think. Think. Think.

Let me venture a wild guess: Speculators?  So you mean that speculators are needed even more now than ever before?  That without speculators hedging would be even more costly, and that would depress oil production?

Who knew?

Putin was photographed handling-and, in fact, kissing-a large pike allegedly caught on a recent trip to Siberia.  The Russian blogosphere immediately erupted, claiming (a) the fish was not nearly as large as Putin’s spokesman Peskov claimed, and (b) the photos were actually taken 5 years ago (based on the fact that Putin was wearing the same garb in the recent photos and in photos from a previous trip).

And, of course, Putin caught the fish-according to Peskov-with a “Czar Lure”, after fishing without luck with less regal tackle.

My rule of thumb is that if Peskov says it, it’s a lie.

Case in point.  Peskov: “Russia has never extradited anyone at any time.”

Russian Prosecutor General website: “Russia extradited 1,011 individuals in 2007.”

None ever.  Over a thousand in one year.  Same diff.  So of course I believe anything Peskov has to say about fish, fowl, or Putin.

Peskov is so egregious that even Jay Carney looks good by comparison, as staggering a thought as that might be.

The fish story is irrelevant, except as an example-as if another were needed-of Putin’s vanity and bizarre obsession with showing the world-or, more precisely, his Russian constituency-of what a studly, manly man he is.  And perhaps to the extent that the immediate skepticism about the story illustrates that Putin’s spin is wearing thin.  As Putin’s chief spinner, the latter development bodes ill for Peskov.

In a somewhat totally pathetic attempt to get Russia to relent on returning Edward Snowden to the US, Attorney General Eric Holder wrote a letter to the Russian government expressing assurances that Snowden would not be subject to the death penalty or torture.  As if Russia really gives a damn about torture.  As this piece from NPR shows, Russia is more than willing to cooperate with the thuggish governments of the ‘Stans to apprehend by force those who have fled to Russia, and to return them to face brutal treatment:

But while the United States and Russia don’t see eye to eye over extradition issues (the two countries don’t have an extradition treaty), Moscow often cooperates with requests from governments in the former Soviet republics of Central Asia.

The human rights group Amnesty International says Russian authorities have unlawfully returned and sometimes forcibly abducted asylum seekers, sending them back to Tajikistan and Uzbekistan, countries accused of widespread human rights abuses.

Many of the suspects are wanted on charges of belonging to banned Islamist groups or sharing extremist literature, claims that human rights groups say are often based on shoddy evidence.

. . . .

Amnesty reports that Tajikistan sought the extradition of 27-year-old Savriddin Dzhurayev on charges that included organizing a criminal conspiracy in 1992.

Russian authorities approved the request, though Dzhurayev was only 7 years old at the time of one of the alleged crimes. After appealing to the European Court of Human Rights, Dzhurayev was released from detention in Russia and granted temporary asylum there — the status Snowden is now seeking.

But Dzhurayev, who denies the charges against him, told his lawyers he was abducted by a group of men in plainclothes while walking in Moscow in 2011.

They forced him into a van, he says, beat him and put him on a plane back to Tajikistan, even though he didn’t have a valid passport. Russian authorities denied playing a role in Dzhurayev’s return. He is now serving a 26-year prison sentence after what Amnesty says was an unfair trial.

Vitaly Ponomarev, director of the Central Asia program at Memorial, a Russian human rights organization, says evidence for charges of illegal religious activity is often obtained using torture.

To avoid ill-treatment, an individual being questioned in Uzbekistan may offer information about someone who no longer lives in the country, thinking this puts the person beyond the authorities’ reach.

“There’s not a citizen of Uzbekistan in Russia who can guarantee he won’t be named by one of his old acquaintances during questioning and wind up on a list of extremists,” Ponomarev said.

Russian authorities cooperate on removals in these cases, he said, because they view the religious element of the accusations with suspicion.

“They consider the presence of such individuals in Russia to be unwanted,” Ponomarev said. “There’s some fear in relationship to Islam.”

Hmm.  Sounds kinda like a War on Islam thing going on there.  What does Glenn Greenwald have to say about that?  Laura Poitras?  After all, the alleged War on Muslims is one of their major obsessions.  I guess it’s OK when Russians wage it.

Carrying out a principled discussion with Russia about Snowden’s return is beyond pointless.  The bleatings of some Russian legislators about torture are just to gull the international left-the Germans especially, most likely-into continuing their focus on the US, and to let Russia pose as some defender of human rights.  Note how this stand complements quite exactly Snowden’s praise for Russia as a defender of human rights.  It’s almost like they could have been written by the same hand or something.

The only thing that matters to the Russians is state interest, and most notably the interests of the security forces.  Holder and Obama could write a letter promising Snowden would get a ticker tape parade down Broadway and a guaranteed win in the Publishers’ Clearinghouse Sweepstakes and it wouldn’t budge Putin in the slightest.  As their cooperation with the ‘Stans not to mention their own use of torture (cf. Magnitsky) demonstrates,  the claims of concern about Snowden being tortured on return to the US only adds hypocritical insult to injury.

No sooner than I had written a post that showed the potential comparative advantage that banks had in dealing in physical commodities did JP Morgan Chase announce that it was throwing in the towel, and exiting the business:

Wall Street’s biggest bank said an “internal review” had concluded it should pursue “strategic alternatives” for its physical commodities operations, which includes assets like its Henry Bath metals warehousing subsidiary and a vast global team trading everything from African crude to Canadian natural gas.

The firm will explore “a sale, spinoff or strategic partnership” for its physical arm, the statement said. It said the bank remained “fully committed” to its traditional financial commodity business, including trading derivatives and its activities in precious metals.

This decision was not the result of any single thing, but the cumulative result of many things.  Greater capital requirements for banks.  The maturation of commodity markets and the resulting flattening out of profits.  The reputational risks of commodities dealing, with multiple regulators on the hunt for manipulation cases, and asking for big dollars to settle them.  And, most recently, the political heat directed at banks’ commodity trading operations.  Morgan’s commodity trading operation was big absolutely, but relatively not as big as Morgan Stanley’s or Goldman’s, and hence more readily expendable.  Morgan decided to get out of the kitchen, rather than stand the heat.  Especially since there is political pressure on all aspects on the banking business, and since navigating the post-Frankendodd, Volcker Rule world will be sufficiently challenging to the core businesses that commodities risks, political and reputational more than financial, just aren’t worth it.

Morgan Stanley has already mooted selling off its commodity arm.  It will be interesting to see what Goldman decides to do, especially in light of the Metro melodrama.  The European banks (notably Deutsche and Barclays) also have some thinking to do.

The exit or downsizing of bank commodity operations will redound to the benefit of the trading houses, and to private equity shops and perhaps hedge funds, including potentially some new entrants.  I doubt it will make the commodities markets more competitive, and indeed, the opposite is more likely to be the case. This turns my minds to thoughts regarding the political economy of the pressure on the banks.  The exit and downsizing also run contrary to the meme that banks have it all their way inside the Beltway.

The banks have done a terrible job of making their case.  Perhaps it would be more accurate to say that they really haven’t made a case at all, likely as a result of hubris.  They know they are doing God’s work (to steal from an old commodities guy, Lloyd Blankfein, who started his career at J Aron), but really need to work on their evangelism.

There is indeed a karmic aspect to this.  Almost instant karma, in fact: following my musing about that by only a few days.  I don’t say that with the least tinge of schadenfreude.  Just stating the obvious.

I wonder what will happen to Blythe Masters, the head of Morgan’s commodity operation.  I know her some.  Most of our interactions were positive, until we butted heads over the report I wrote on commodity trading firms: in fact, she approached me to write the report because she’d liked what I’d written on the blog, and in comments to the CFTC.

I have a distinct recollection of sitting next to her at the JPM commodities conference in October, 2011, and watching the muscles in her jaw bulge as she ground her teeth furiously.  She was obviously very tightly wound.  If she was that intense before a relatively low-key conference presentation, I can only imagine how her jaw is working now.  My guess is that she will stay at Morgan for a decent interval, and then land somewhere else.  Like perhaps a private equity commodity trading shop.

Exit for economic reasons is part of the market process.  Exit driven by political or regulatory pressure is problematic.  Both factors are at work now, but unfortunately political and regulatory issues are predominating.  The result will be less efficient, less competitive commodity markets.  Which is exactly the opposite result that the politicians and regulators baying at banks and nipping at their heels claim to want.  Unintended consequences yet again.

In its 2003 Physical Commodities Trading Order, the Fed permitted bank holding companies (not the depository institutions under the BHC umbrella) to purchase and sell physical commodities because they are “meaningfully connected to a financial activity such that it complements the financial activity.”

I mentioned one example of this the other day in the “Get Physical” post (and don’t worry: I won’t post any Madonna videos!), but want to go  into more detail.  The example is offtake agreements (and relatedly, tolling deals).  In these arrangements, a bank (or other counterparty) agrees to supply inputs (e.g., crude to a refinery, gas to a power plant) and receives delivery of outputs (e.g., gasoline and heating oil, electricity).

Refineries, power plants, and the like typically need to pay for the inputs they process before they receive payment for their outputs.  This creates a need for working capital to finance the timing gap between cash outflows and inflows.

Providing funding for working capital is clearly a traditional banking activity.  One way to do this is for the bank to provide a loan or credit facility, and leave the refiner or power plant to acquire inputs and market outputs, and bear and perhaps manage the price and operational risks associated with those activities.

This exposes the bank providing the funds to risk: adverse movements in prices could put the refiner or generator into financial distress, and perhaps cause a default.  The bank could require the borrower to hedge, but there is a moral hazard: if it doesn’t, or doesn’t do it effectively, the lender bears risk.  The bank can monitor, but this is costly, and often imperfect.

The moral hazard problem can be eliminated by passing the risk on to the lender.  An uptake agreement or tolling deal does this.  These types of deal implicitly provide funding to bride the outflow-inflow gap, and pass the price risks back to the lender.  The lender can manage these risks, and the agency cost in this arrangement is lower: there’s no moral hazard, and no need to monitor.  Thus, bundling price risk management and funding can reduce the cost of funding working capital needs.  This is presumably more valuable for lower credit quality refiners and generators.

There are other potential benefits.  The lender may have a comparative advantage in managing risk due to specialization and expertise in this function: banks and commodity trading firms have a comparative advantage in risk management.  Moreover, they may able to be able to manage risk more cheaply because they run large books: there are economies of scope in risk management.  For instance, a lender doing an uptake deal with a refinery is short crude and long products, but it might have a long crude position based on a trade it executed with producer, and might have a short products position as the result of a swap with an airline or heating oil dealer.  These natural hedges reduce the amount of trading necessary to manage the risks.

Moreover, trading firms specialize in marketing and logistics, and there are scale economies and scope economies in these activities.  It may be cheaper for a big trading shop to provide marketing and logistical services, thereby eliminating the need for the refiner or the power plant to pay the overhead associated with such activities.

Thus, there are strong complementarities that make it beneficial to bundle financing, logistical, and marketing activities for some firms that process commodities.  Who should provide these bundles?  Banks have comparative advantages in funding and risk management, and can develop and staff physical trading operations.  Commodity trading firms are typically more expensive suppliers of financing, but they have strong competencies in marketing and logistics.  So both banks and commodity traders are reasonable suppliers of the bundled services, and thus reasonable counterparties in offtake and tolling deals.

What would be the effect of banning some market participants, like banks, from these activities?  Econ 101 gives the answer.  If these entities currently supply the bundled service-as is the case today-elminating them from the market will shift up the supply curve for this service, and in equilibrium it will be more costly.  Meaning that refiners and power plants will incur higher costs that will be passed upstream (lower prices for inputs) and downstream (higher prices for outputs).  To the extent that restricting participation gives (or enhances) the market power of those who remain in the market, these effects will be exacerbated.

What if some market participants-such as banks-get a subsidy of some sort that allows them to offer these services below cost? That is a source of inefficiency, to be sure: too much of the service is provided in equilibrium, and the beneficiaries of the subsidy have an excessively large market share.  But it does not follow that banning the subsidized from the market is the right policy response.  It’s usually better to eliminate the subsidy, especially in the case of something like a too big to fail subsidy, which has pervasive and perverse effects in all the markets in which the subsidized banks operate.

Evaluating the regulation of bank participation in any market, including the commodity markets, should proceed along similar lines.  The concept of complementarity is the right way to consider these issues, and that principle can be analyzed in particular instances using basic economic analysis.  The survival principle also suggests that if a firm gets market share in a particular business, it is because it is providing that service at lower cost, or delivering higher quality.  If the lower cost is an artifact of some sort of subsidy, eliminate the subsidy, especially when it is a pervasive on that cuts across myriad lines of business.  Populist venting about banks, especially venting based on some cramped understanding of what banking is and predicated on some belief that the involvement of financial institutions in commodity markets is somehow unnatural, is counterproductive.  It is also likely really a mask for some political economy agenda, an effort to benefit one group of firms by handicapping-or eliminating-others.

Earlier in the year I wrote about the obscure, but very important, regulation of futures commissions merchants that essentially requires them to hold enough of their own money to cover shortfalls in customer margin accounts.  This “residual interest” rule has caused a wholesale freakout among FCMs and market participants, and for good reason, as I pointed out in that post.  The rule would not have prevented an MF Global or Peregrine situation-those involved fraud and/or numerous rule violations.  Moreover, the rule puts further strains on the funding liquidity of the futures markets.  There are already new strains aplenty, and liquidity shortages are a major source of systemic risk.  A rule ostensibly designed to protects customers puts the entire system at greater risk.

The near universal opposition of the industry is leaving the CFTC unmoved.  But the CFTC’s response is purely legalistic, and does not even attempt to address the fundamental economic issues:

But on Thursday, at an open meeting of the Agricultural Advisory Committee to the CFTC, regulators were unmoved by the criticism.

The proposed rules, said Ananda Radhakrishnan, director of the CFTC’s division of clearing and risk, merely clarify what the law already says: funds from one customer must not be used to pay for the position or deficit of another customer

“Nobody’s been able to make the argument, with all due respect, that what we are suggesting is not what the law says it is,” Radhakrishnan said. “The arguments we’ve heard … (are) that it’s going to be expensive, the earth is going to fall and so on and so forth. But nobody has done, to my view, a legal analysis saying, ‘your analysis is wrong.'”

Translation: “The law may well be an ass, but we’re rolling with it.”

I have some sympathy, because Congress has handed the CFTC many legislative directives that are at odds with economic common sense, and which are actually contrary to the purposes of the legislation (notably, the reduction of systemic risk).  But where there’s a will, there’s a way.  I get the sense that the CFTC is just hiding behind the legalisms in order to force through a proposal that it-and most likely Gensler-wants.  If it had the will, it could likely find a way to adhere to the law as written but substantially mitigate the negative impacts of the regulation on liquidity, costs, and systemic risk.  The failure to do so, and the appeal to the “Congress made me do it” defense (seen so clearly in the position limits regulation, and repeated in its appeal briefs) strongly suggests that the CFTC doesn’t have a strong economic justification for its regulation, can’t rebut the arguments of the critics, and is playing legal rope-a-dope in order to force through one of Gensler’s (and perhaps the staff’s) bright ideas/obsessions.

The absurdity of the Snowden situation has reached a new level with reports that he has applied to join a group of ex-KGB veterans with the charming name “Friends of the Siloviki.” What better way to battle for human rights and fight for freedom from government surveillance than by associating with veterans of the most repressive and intrusive instrument of state control in modern history?

Speaking of KGB/FSB types, Snowden’s lawyer Kucherena (how did Snowden find him anyways?  Yandex?  The Yellowski Pages? Список Крейга? 😛 Or a “suggestion”/”recommendation” from his minders?) says that Eddie might try to find employment in Russia.  This actually makes some sense of why Snowden chose to go to Russia.  After all, what better place for someone with 1337 hacker skillz to make a killing than Russia? There are great opportunities in both the private and state sectors.

In 2009 I called China the “Michael Jackson economy,” meaning that it was kept going by artificial stimulants, but that inevitably their cumulative effects would cause  serious, and perhaps fatal problems.  They mask the effect of the underlying ailment, and have severe side effects.   China responded to the 2008 financial crisis by engaging in massive stimulus, and has inflated credit bubbles whenever growth stuttered in the past several years.  Moreover, allocation of credit and investment in the economy is subject to substantial direct and indirect government control.  Local governments invest massive amounts in infrastructure and housing projects, and the banking system is tilted to direct credit to large state enterprises that invest primarily in heavy industry-steel manufacture and shipbuilding, for instance.

This “investment” can prop up GDP statistics, but they are recorded at cost, not value.  (I recommend this David Henderson piece about the perversity of GDP fetishism, and how GDP can grossly mis-measure well-being.)

If the investments are ill-conceived, they will not pay for themselves in the future, and economic output and consumption will suffer.  And investments guided primarily by the visible hand in an authoritarian state are almost certainly ill-conceived.  They are driven by considerations like political connections, prestige, and the imperative to maintain employment in existing enterprises and regions to buy labor-and political-peace.  This latter effect is particularly deleterious, as it means that rather than there being a natural corrective mechanism for past mistakes, mistakes tend to be self-perpetuating.

The Wall Street Journal has a fascinating article about one major malinvestment that fits this story almost perfectly.  Yes, it is likely an extreme case, but there are enough similar stories to suggest that that the malivinestment problem in China is severe.  Moreover, the bloated fraction of investment to GDP, and the falling delta between changes in credit and changes in income provide some quantitative support for these anecdotes.  Add in the dodginess of Chinese economic data, and there is serious reason to believe that China is heading for a very rocky period.  When the interactions with the financial system are considered, the prospects look even more dire: when the investments don’t generate sufficient return to pay back the loans, realistic outcomes range from a Japan-like zombie-fication of the banks to a full-blown financial crisis.

China’s new premier is promising 7+ percent GDP growth.  That could be the problem: the only way to get it is to double down on the artificial stimulants, thereby exacerbating the malinvestment problem.  Living with lower GDP growth, and permitting Chinese businesses and individuals to reallocate resources to those that generate value rather than statistics, would be far preferable in the short, medium, and especially long run.

A major adjustment is needed, but I would have little confidence in the Party and the system that created the mess in the first place to manage this adjustment effectively or efficiently.  The political economy suggests that incumbent industries, firms, and interests, all of which have strong political influence, will disproportionately influence government economic policy.  This impedes adjustment, and substantially increases the odds of zombie-fication, of the financial system and entire industries.  China could use some creative destruction, but I do not believe this is politically feasible.

China is one of those few matters on which Krugman and I agree.  Krugman mentions that this could be bad for commodity prices, and that would definitely be true if China goes cold turkey and stops trying to perpetuate its old growth model.  That will lead to a substantial decline in the demand for commodities such as industrial metals, iron ore, coal, and oil.  But if the political economy story is correct, it will attempt to support the existing commodity-intensive structure of production and delay the adjustment process.  In the event, commodity prices will likely fall, because a reprise of 2009’s extreme dosage of stimulants is likely infeasible.  But government attempts to cushion the adjustment process will cushion the impact on commodity prices too.

But it is true that the course of commodity prices will depend crucially on how the Chinese government handles the painful withdrawal from its past stimulus binge.  Cold turkey would be very bearish (how’s that for a mixed metaphor!?!) Hair of the dog far less so.  This implies that a crucial fundamental in commodity markets in coming months and even years, and perhaps the crucial fundamental, will be Chinese politics.

One fascinating thing about the Snowden drama: of late he has blown the whistle much more on Germany, than the US, the self-proclaimed target of his outrage.

Case in point.  This lllooooonnnnngggg piece in-where else?-Der Spiegel detailing alleged extensive cooperation between German intelligence and the NSA, and Merkel’s alleged dishonesty about this cooperation.  An article in which Poitras shares a byline, by the way.

Snowden and the NSA have become causes celebres in Germany: the allegations play on the oh-so-many German complexes regarding their history and Americans, and their history with Americans.  And lo and behold, these allegations come in the midst of Germany’s election campaign.  And Der Spiegel has banged the drum of these allegations longest and loudest.

In the US, the Snowden revelations have not had any real political ramifications.  Yes, there has been outrage on the left and right, but in the middle, the main response has been-“Edward who? NSA what?”

That is definitely not the case in Germany.

Is this focus on Germany a change in course, an opportunistic response to the different public responses to Snowden in the US and Germany?  Or was Germany a primary target all along?

Some dots.  Snowden went to Russia and is in control of Russian intelligence.  (Don’t believe that? Have I got some deals for you!) Putin would prefer many outcomes to a Merkel victory: though she has not been ardently anti-Russian, she is a much harder and more skeptical customer than her possible successors.  An SDP-Green coalition would suit Putin very well, thank you.  Especially when it comes to gas, an area in which Putin and Gazprom are having huge difficulties including a major antitrust investigation of Gazprom, and the potential of fundamental changes in Gazprom’s business model, and the aggressive approach of German utilities to Gazprom’s pricing practices.  A leftist government in Germany would almost certainly tamp down these problems considerably as compared to a continuation of Merkel rule.

Putin said he didn’t want Snowden revealing anything that would harm his “American partners.”  He didn’t say anything about Germany, did he?  Interesting, that.

A case can be made that Putin has put Deutschland Uber Alles in his manipulation of the Snowden affair.  Again, perhaps this was an opportunity that fell into his lap, but perhaps it was the game all along.  Meaning that the biggest casualty of Snowden’s revelations may not be the US and the NSA, but Germany, and particularly the more Russian-skeptic portion of its politics.

Yes, it’s cliche, but cliches become so because they capture essential truths.

So WTF does the Navalny release mean?

I have no answers, but a couple of thoughts.

My initial thought is that there is nothing deep and meaningful here: they are just f*cking with him.  What better way to torture someone by crushing his hopes, then raising them, then crushing them again?  What better way to demonstrate to him (or her) that his (or her) fate is completely at the whim of the authorities?  They are demonstrating to Navalny-and everyone-that freedom or imprisonment is not a matter of law, but purely a matter of the exercise of the will of the authorities.

The more conventional explanation, which I do not discount, is that Navalny’s surprise release is the result of a conflict among clans in Russia, specifically between the siloviki types and those more pragmatic types who believe that arbitrary authoritarianism threatens the system, and all of the goodies that the elite get.  This is plausible.

Let’s work through the implications.  If it is true, it would reflect a fundamental weakening of Putin.  His entire role is to balance the contending elites.  If he cannot keep the dogs from using Navalny as a human tug toy, he has failed in this role.  The squabbling elite will have escaped his control.

Which means that eventually, he will have to intervene.  His power derives to a large extent from the belief that he is the ultimate arbiter.  If this falls under the shadow of doubt, more conflicts will break out.  There will be a positive feedback loop with very negative consequences for Putin.

His intervention may succeed, and restore the equilibrium, or it may fail, in which case the feedback loop will begin to operate inexorably.

Putin has disclaimed any involvement.  But this is out of his control.  If it becomes widely believed that the Navalny release is a palimpsest  of some hidden conflict among the belief, his silence will be interpreted as a sign of weakness, which will become a self-fulfilling prophecy.

So how will he intervene?  If he acts leniently, he will encourage further opposition.  If he acts brutally, he will deter it.  I think his choice is pretty obvious.

But will his choice end the inter-elite conflict?  That’s the crucial question.  The stakes are very high for him.  This is why Navalny really matters: the case is testing the stability of the system, and Putin’s ability to perform his balancing role.