Streetwise Professor

2014 is in the books, and fittingly the last day of the year  saw a fall in the price of oil. The nearly 50 percent decline in oil prices from the end of June to today was the biggest commodities story of the year. This decline has spawned numerous conspiracy theories, which like most conspiracy theories, are pure bunk.

Most of the stories focus on Saudi Arabia and shale oil. In some versions, the Saudis decided to crash the price of oil to drive out competition from US shale production. I analyzed, and dismissed, this story some weeks back. In other versions, the Saudis decided to crash the price of oil in order to strike a blow at its arch enemy Iran, or in some variants, at Iran and Russia (either in cahoots with the US, or to punish Russia for its support of Assad).

Well, to crash prices it is necessary to increase output. The Saudis, however, did not increase output over the past 6 months: it has remained relatively static. This couldn’t be more different from what happened during the 1985-1986 price collapse, to which the most recent decline is often compared. In the early-80s, the Saudis cut output from about 10 million barrels per day (mmbpd) to as low as 3.5 mmbpd in order to maintain prices in the face of rampant cheating on output quotas by other OPEC members. Realizing that it was being the chump, the Saudis increased output about 44 percent. Nothing like that has happened in the past six months.

The other purported cause of the price decline is the increase in US output. This increase is indeed remarkable, but its timing and magnitude doesn’t explain the price decline. US output has been rising inexorably for a couple of years, and the rate of increase has exceeded forecasts, but not by nearly enough to explain the post-June price decline. Since June, US output has risen by about 100kbpd per month. Cumulatively, that’s about 600kbpd, or a less than .7 of world output. Even using an elasticity on the high side of 10*, this could account for about a 7 percent decline in the price. What’s more, some of the US increase has been needed to offset the on again, off again production in Libya and declines in production in Mexico.

Meaning that the focus on the supply side has been totally misplaced. This in turn implies that all of the hyperventilating about S&S-Shale and the Saudis-is wrongheaded.

Instead, the most likely explanation for the price decline is a decline in demand. The fall in price parallels quite closely declines in world GDP forecasts. Chinese manufacturing in particular has slowed. This has been reflected in other commodity prices which are driven by Chinese industrial demand, most notably iron ore, which has fallen almost 50 percent over the last year, and copper, which has fallen by about 15 percent since June. And somehow I don’t think the Australians or Chileans are attempting to punish their economic rivals or geopolitical enemies. They are just along for the ride on the demand train.

The biggest price daily oil price decline occurred the day after Thanksgiving, when OPEC announced it would not cut output. Prices have also declined on days when the Saudis or other Gulf states reiterated their intention to maintain output. But maintaining and increasing output are two different things. The Saudis didn’t announce that they were opening the taps, like they did in 1986. They are just saying they won’t shut them. And as I argued in an earlier post, given their market share and the elasticity of demand for oil, that’s a rational thing to do without having to resort to predatory explanations.

Again, although most analysis focused on supply, the post-Thanksgiving price decline was really attributable to demand too. Market participants were predicting that OPEC would cut output to support prices in the face of falling demand, and this expectation helped to prop up prices. When the expectation was contradicted, prices fell.

I was only surprised that people were surprised that OPEC didn’t cut output. I didn’t see that happening, and I was right: The Saudis only cut output very modestly (by about 3 percent) during the price collapse in the aftermath of Lehman. Where I was wrong was not understanding that it appears that it was almost universally believed that OPEC was almost certain to make a large cut: I was right about the Saudis, but wrong about what everybody thought about the Saudis. This is why I am blogging, rather than sipping Mai Tais on a yacht that would make Abramovich green with envy.

So, it’s not exactly a case of move along, there’s nothing to see here: the price decline is certainly worth watching. It’s just that what you are seeing is not the result of some grand scheme engineered by the Saudis or anybody else. If there is any scheming going on, it is China’s attempt to move to a more sustainable growth model that is less dependent on stimulus-driven investment in industry and infrastructure.

It is certainly the case that the decline in commodity prices generally, and the oil price in particular, could have -and is indeed already having-seismic economic and geopolitical consequences. It is definitely the case that Russia and Iran are going to suffer mightily as a result of the price decline. This may in turn force them to dial back their geopolitical ambitions, although particularly in the case of Russia it could lead to the opposite response by a desperate leadership. But just because these outcomes might be desirable to the US or the Saudis doesn’t mean that the price decline was deliberately engineered to produce them. They are just consequences of broad economic developments that were intended by no one. For the Saudis, the unintended geopolitical consequences at best palliate some serious economic pain.

Given that (unlike in 2008-2009) the demand decline isn’t due to weakness in the US economy, on the whole the US will benefit from the lower oil price, though some regions (like here in Texas and in North Dakota) will obviously suffer. Drilling activity in the US will decline, but this shouldn’t warm Saudi hearts, because if demand rebounds and drives up prices, drilling will rebound too. The oil and the technology aren’t going anywhere: they are on tap for when the price is right.

Recent academic research shows that most of the price variations in oil over the past decades have been demand driven, rather than supply driven. This most recent decline is just another example of that.

Conniving oil ticks and outlandish Texas oilmen make colorful copy , but usually the world is much more prosaic. Oil supply is very inelastic in the short run, so when demand declines even modestly, prices can plunge. This is counterintuitive to most: how can small changes in demand have such huge effects on prices? This leads to speculations about conspiracy, especially when the price changes can shake nations like Russia to their cores. But such speculations are idle. The normal operations of commodity markets routinely produce such price movements. Which is precisely why subjecting grandiose ambitions for geopolitical power to the vicissitudes of commodity prices is the strategy of fools.

And yeah. I’m looking at you, VVP.

Putin may not be having a happy New Year, but I close this post by wishing all my readers all the best for 2015. Enjoy the schadenfreud!

*This elasticity of 10 is related to the sensitivity of oil consumption to prices. Speculative storage makes oil demand more elastic. Indeed, in response to the price decline, visible speculative storage (primarily at Cushing) has increased, and the market has moved into a contango, which is associated with greater storage.

One of the most vivid memories of my early trips to New York was the three card monte games on virtually every corner. The guys would slide their bent cards on the top of cardboard boxes. The most amusing memory is that when a cop would approach one of the card sharps. The hustler running that table would whistle, and you could see others on nearby corners fold up their boxes in a flash and scurry off onto a side street.

Well, they’re back. And like everything else, their games are more expensive. Now you get the privilege of losing $100 when you play: back in the day, it was merely $20.

Speaking of three card monte, it appears that currency traders have figured out the three card monte game that Elvira Nabiullina of the Central Bank of Russia has been playing. The ruble resumed its plunge, declining more than 9 percent today.

As I noted last week, it looks for all the world that the CBR is trying to fool the suckers and hide the black lady with a lot of sleight of hand. Rather than spend reserves officially to prop up the ruble, the CBR is lending dollars to the big banks (VTB and Sberbank) which is lending them to Russian exporters, and the government is ordering the corporates to sell dollars and buy rubles, thereby supporting the currency. See! Reserves stay the same! The country’s finances are healthy!

But if you watch closely, and follow the money and the risk, and you’ll see that the CBR has effectively spent the reserves, or at least put them at significant risk of loss, by replacing dollar liabilities of the US government with dollar liabilities of soon-to-be-junk corporates whose ability to earn dollars to repay the loans has plunged along with the prices of commodities, especially oil.  If that happens, the CBR will have to eat the losses on the collateral posted by the banks (i.e., the loans the banks make to the Russian corporates).

This con game worked for, oh, a good week or so. Today’s big ruble move suggests that market participants are seeing through the scam. So lookout below, and don’t stand under a falling ruble, lest you end up like Wile E. Coyote looking up at the anvil that’s about to drive him into the pavement.

Come to think if it, it amuses me to imagine Putin in the role of Wile E., watching all of his machinations and dreams of conquest come crashing down upon him.

Me-meep.

PS. In the early-80s, the three card monte wager was a little more than 1/2 of the price of a barrel of oil. Today, the price of a barrel of oil is a little more than 1/2 of a three card monte wager. Food for thought.

As part of its efforts to address its looming financial crisis, the Central Bank of Russia announced a new program to assist Russian companies needing dollar and euro financing, and in particular, needing dollars and euros to repay maturing loans. The CBR will lend USD and EUR to banks for 28 to 365 days. The banks, in turn, will lend to exporters and foreign currency borrowers: the banks secure the borrowings with the CBR by pledging as collateral the loans extended to exporters.

On 23 December 2014, the Bank of Russia Board of Directors took a decision to introduce a new instrument — FX loans secured by a pledge of claims on FX loans. This decision aims at expanding credit institutions’ possibilities to manage their own FX liquidity, as well as to refinance external FX loans of Russian exporters, which are soon to be redeemed, given a restricted access to international capital markets. The introduction of the said operations will also be conducive for the exchange rate to return to its fundamental values and to the achievement of demand-and-supply balance in the forex market amid lower exchange rate volatility.

The said operations will be effective until 1 January 2018. The earlier set total maximum amount of credit institutions’ debt to the Bank of Russia equivalent to US$ 50 billion applies to FX repos and FX loans secured by a pledge of claims on FX loans and remains intact.

Note that this program will be in place for more than three years. This is compelling evidence that the CBR expects the crisis to last for some time. Whether the CBR’s resources will last that long is another matter.

Through this mechanism, the CBR is using “credit institutions” as cutouts to lend to Russian corporates. Rather than borrowing FX from foreign banks, the “exporters” will borrow from the CBR via the banks. And who would these exporters be? Well, the biggest are energy producers (Rosneft and Gazprom in particular) and other natural resource firms. Given that Rosneft is sanctioned, and hence is most restricted in its access to foreign debt markets; is an extensive foreign borrower; and due to lower oil prices is facing greater difficulties servicing this debt; it is likely the biggest beneficiary of this program.

Through this action, the CBR is weakening its balance sheet. It will replace $50 billion in low credit risk assets (e.g., US Treasuries) with high credit risk assets from companies like Rosneft (BBB-, and almost certain to be junk soon). Moreover, the CBR is taking on wrong way risk: the loans will be most likely to default or require restructuring precisely when the Russian economy is weakest.

I also suspect that this dovetails with the stealth capital controls, in which the government has commanded state enterprises to reduce their dollar holdings. Some of the dollars that they will spend will be obtained from the CBR via this loan program. This combination of programs therefore allows the CBR to use reserve dollar and euro holdings to support the currency without recognizing declines in official reserve holdings.

Desperate times call for desperate measures, and these measures are desperate indeed.

Putin, the alleged personification of the Russian nation, is conspicuously un-Russian in at least one important way: he is a teetotaler. But I suggest that he become a true embodiment of the narod and take up heavy drinking. It might improve his understanding of economics.

There is no better illustration of Putin’s economic ignorance than his recent call to cap the price of vodka. His reasoning? If the current economic crisis causes its price to rise, Russians will substitute towards samogon:

“The overshoot of vodka prices leads only to increasing consumption of bootleg [spirits],” said Putin, who is known for promoting a healthy lifestyle. “I think the relevant structures [government bodies] should think of that,” he added.

Actually, price controls on vodka will have the opposite effect. Price controls reduce production, leading to shortages. The true price of vodka will rise above the officially sanctioned price.* The higher prices and shortages of licit liquor encourage the production and consumption of homemade moonshine made out of . . . well, you probably don’t want to know. (But if you do.) Alcohol poisonings will likely actually rise rather than fall.

This is Vova’s way of promoting a healthy lifestyle. His misunderstanding and mismanagement of the vodka market is a very symbolic of his misunderstanding and mismanagement of Russia’s economy generally.

No wonder Russians are such prodigious consumers of alcohol, in whatever form that is at hand.

*The “true” price could be the black market price. Alternatively, it could be the controlled price plus whatever costs are incurred (value of time spent in line, bribes, etc.) to get access to vodka at the controlled price. It can also be paid in the form of lower quality. Lower quality, of course, reduces the difference in value between store bought vodka and samogon, inducing a substitution towards the latter.

Seventy years ago, on the night of 24-25 December, 1944, the US 75th Division mounted an assault in attempt to seal stem the German counteroffensive in the Ardennes. One of the men in the 75th was my uncle, Norbert Katarski.  Norbert was crawling along the snowy frozen ground cradling his heavy, water-cooled M1917 machine gun when a tree burst horribly wounded him. He suffered compound fractures of both arms, and numerous shrapnel wounds in his back and legs. One piece of shrapnel traveled ripped through his scalp: a fraction of an inch lower, and he would have been killed.

I told Norbert’s story here. Christmas was always a blessed time for him. Most years, he would give the sanitized version of his experience. Two Christmases before his passing in 2009, he told the story, in all its horrific detail.

Please remember men like Norb, and their sacrifices, while you enjoy your Christmas.

And to all of my readers. Thanks so much for your kind attention over the year. I wish you a very Merry Christmas, and a Happy New Year.

Cheers!

SWP

This is crazy to me: selling massive quantities of volatility when volatility is at very low levels.

Frustrated with buying volatility protection for years with no big payout, investors in 2014 decided to sell volatility protection themselves. Also known as shorting “vol”, the strategy typically entails selling options — a type of derivative that pays out if a particular asset moves by more than a pre-agreed amount.

“Those investors who had been looking to hedge their portfolios in the past, now looking for yield, switched their hedges for speculative short positions,” says Mr Verastegui. “They decided to be on the other side of the trade, and moved from being long to being short vol.”

Bill Gross, the founder and former chief investment officer of Pimco, became the prime exemplar for the trade when he announced at a prominent conference that his firm was betting against sharp market moves.

“We sell insurance, basically, against price movements,” he told Bloomberg News.

While selling volatility was, according to Mr Gross, “part and parcel” of a Pimco investment strategy that rested on sluggish US growth and low interest rates, it nevertheless raised eyebrows among his peers and competitors.

I’ll say. No doubt not only were eyebrows raised in Pimco, but much hair was torn out as well. No doubt this hastened Gross’s departure.

Look at the graph in the article and you can see the risks. Volatility frequently spikes. You sell vol at low levels-and the levels were historically low in the spring and summer-and you have a big risk of getting hammered when volatility spikes. And note that when volatility is at low levels, it doesn’t tend to spike down. It only spikes down after it has spiked up.

Indeed, the spikes in part reflect a positive feedback mechanism. When volatility starts to rise sharply, a lot of the shorts start to feel the pain and liquidate their positions. Due to the relatively limited liquidity in options markets, especially in stressed market conditions, these liquidations push up implied volatilies further, inflicting even greater losses on the shorts.

Shorting options is a widow maker trade. And wouldn’t you know, that many of the financial disasters in history involve shorting options (sometimes embedded in securities, as was the case with Orange County in the early-90s). Usually this is done to reach for yield. Sometimes it is done by those desperate for cash who sell premium to raise it: Nick Leeson and Hamanaka are examples.

Buffet sells long term volatility. That makes some sense. But selling large quantities of short term vol in a low volatility environment is like picking up nickels-hell, pennies-in front of a steamroller. And it looks like Bill Gross got flattened. Or more accurately, Pimco investors got flattened. Bill Gross, of course, made out like a bandit: he was paid $290 million in 2013.

Bowing to the inevitable, Rosneft and Morgan Stanley scuppered their agreement to sell MOST’s energy trading operations to the Russian company. The official explanation was that the deal failed to get approvals from US regulators.

Go figure.

Glad that the Committee on Foreign Investment in the United States,which consists of Treasury, Justice, Homeland Security, Defence, State, Commerce, the US Trade Representative and the Office of Science and Technology Policy, saw off Igor and Co. Putting the FU in CFIUS.

That said, even if the regulatory approvals had been forthcoming, I don’t see how the deal would have worked. As I wrote in September, I didn’t see how a company without access to long term dollar credit (due to sanctions) could operate economically such a credit-intensive business as oil trading. Hell, today Rosneft’s other big announcement was that it paid off some loans it took on when it acquired TNK-BP. When a company announces a loan repayment like it’s some sort of triumph, you know that they aren’t in any position to buy and run a trading business.

Put differently, if CFIUS hadn’t have gotten Rosneft, the sanctions would have.

This might actually be a blessing to Morgan Stanley. The current high volatility, contango, low price environment is actually quite favorable for trading. Low prices reduce working capital needs. Contango makes for profitable storage opportunity. Volatility creates trading opportunities. MOST might actually get more now than Rosneft had agreed to pay.

*Title inspired by Springsteen’s Blinded by the Light.

150 years ago, 22 December, 1864, Sherman captured the city of Savannah, GA. Sherman telegraphed Lincoln: “I beg to present you as a Christmas gift the city of Savannah with 150 heavy guns and plenty of ammunition and also about 25,000 bales of cotton.”

Two Pirrong ancestors (from the distaff side) served in Sherman’s army, one in the 46th Ohio (4th Division, XV Corps, Army of the Tennessee) and the other in the 92nd Ohio (3rd Division, XIV Corps, Army of Georgia).

70 years ago, 22 December, 1944, Brigadier General Anthony McAuliffe, Assistant Division Commander, 101st Airborne Division, responded to a German demand for the surrender of Bastogne with one word: “Nuts!” The Germans were non-plussed by the reply, so the American delivering the message translated it as “Go to hell.”

The 101st held out against intense German assaults until Patton’s Third Army arrived on 27 December. The 101st wasn’t relieved, however. It was ordered onto the offensive, fighting until mid-January in the meat grinder battle to push back the Germans.

I have been named to the CFTC’s Energy and Environmental Markets Advisory Committee, at the invitation of Commissioner Christopher Giancarlo. Given how I was viewed during the Gensler years, this is a sign that the winds have shifted at 1155 21st St. NW. Or maybe it’s a harbinger of the impending apocalypse. It is particularly ironic, given that Frankendodd specifically mandated that the Commission create the EEMAC: there’s a mandate I can get behind!

Kidding aside, I very much appreciate the opportunity to contribute to the debate in a forum that has policymakers’ ears. The position limits issue is still very much on the table: the hedging definitions are particularly challenging, as is how to determine when speculation is causing unwarranted fluctuations in prices. I definitely have things to say about these matters, and will take the opportunity to say them.

* This is the title of the only REM song that doesn’t have me hitting skip or switching channels.

An operational plan is clearly shaping up in Iraq. From 12/15-12/17, coalition air forces carried out 45 strikes on 50 targets in support of Peshmerga forces in Ninewa Province: this is a large number, by comparison with the rest of the air campaign, and it is significant that they were carried out in support of a ground offensive. With the help of this support, the Kurds cleared Mt. Sinjar, and have taken a large part of the city of Sinjar. This is important because the city lies on the main road between ISIS’s positions in Syria and Mosul. Furthermore, Iraqi counterterrorism units parachuted (!) into the Tal Afar airport. Tal Afar lies to the east of Sinjar, and is also on the road from Syria to Mosul. If the airport can be secured, this would serve as a base to support advances east and west.

These moves are obviously intended to isolate Mosul from support from ISIS forces and logistics in Syria.

In the meantime, Iraqi forces have made a concerted effort to take Baiji on the Tigris, and also Tikrit somewhat further south. Controlling, or at least interdicting, the line of the Tigris would isolate Mosul from Anbar, ISIS’s main stronghold in Iraq. For this reason, ISIS is counterattacking hard in Baiji, and is also attacking in Ramadi and elsewhere in Anbar, most likely in an effort to draw off Iraq forces from their operations along the Tigris.

Some Iraqis have expressed a desire to attack Mosul soon, but the US is holding them back. It is evident that in addition to needing time to train up Iraqi troops to some semblance of a military force, the US is taking a methodical approach of isolating Mosul and squeezing it for a while before giving the go ahead for an assault.

The US can also use the interval to attrit ISIS troops in Mosul, and undermine morale. This last is a realistic possibility, as recent reports indicate serious discontent among ISIS fighters. ISIS is demanding its minions to swear featly, and to report regularly to keep them from slipping away. Moreover, it is carrying out exemplary executions of those of doubtful enthusiasm or loyalty.

This is most pronounced in Syria, where ISIS’s insane persistence in attacking Kobani has led to an estimated 1000 ISIS KIA. ISIS fighters in Raqqa are beginning to rebel at being sent to Kobani to become JDAM magnets, and there are reports that after many foreign fighters attempted to desert ISIS summarily executed 100 of them, pour encourager les autres. I guess a lot of the Ali Gs who thought jihad would be a lark involving beheading the defenseless and the acquisition of sex slaves in this life are less enamored with the prospect of 72 virgins in the next.

The new ISIS motto is apparently “The executions will continue until morale improves.” Hardly the sign of a confident force.

Time to turn up the pressure. I’ve said that ISIS is like a shark that needs to keep moving to survive. Recruits flocked to its banners when it appeared unstoppable, and about to realize jihadist fantasies. If its inevitability is proven chimerical, the sunshine beheaders will fall away, leaving the hard core types. It is just at such a time, when enemy morale begins to show cracks, that it is imperative to ramp up the pressure. The air campaign is still too desultory, but it has shown results. Increasing its tempo and intensity would almost certainly expedite the unraveling of ISIS, the first signs of which are now manifest.

Napoleon said the moral to the physical is three to one. Let’s use our physical superiority to pressure ISIS’s moral center of gravity. Bombing the bandwagon is the best way to consign ISIS to oblivion.