Streetwise Professor

The LNG market has taken an even harder fall than the oil market, with prices down from a peak of over $20/mmBTU a couple of years ago to around $4 now. Slower demand growth plus the entry of megaprojects in Australia and the US have done a double whammy. Indeed, some big projects have been canceled of late due to the grim price environment.

Anticipating a growth in supply that was likely outstrip demand growth (but not by as much as has actually happened), in 2014 I predicted that an overhang of cargoes would catalyze the development of the spot market. This is in fact occurring. A larger fraction of the trade is being consummated on a short term basis, and longer term contracts are relying less on oil indexing (which I called a barbarous relic, and analogized to the drunk looking for his car keys under the streetlight) and destination clauses (which limit the ability of buyers to resell gas they don’t need), and more on gas-on-gas pricing and destination flexibility.

This is the beginning of a virtuous cycle by which liquidity begets liquidity, making spot trading even cheaper relative to long term supply contracts. As I referred to it in 2014, whereas in the first 50 years of LNG* it was necessary to rely on long term contracts to achieve security of supply and demand, in the next 50 years liquid markets would provide this security, as has been in the case in oil markets for the last nearly 40 years.

The oil market demonstrates that long term contracts are not necessary to support the financing of very capital intensive upstream energy projects. Further, there will be less of a need for megaprojects for some time (given the supply overhang). What’s more, smaller scale liquefaction facilities are becoming commercially viable. For example, the ex-CEO of Cheniere, Charif Souki, has a well-financed startup that is focusing on developing such projects.

Which means that the next decade of LNG will be an evolution towards a market that looks more like the oil market, or other traded commodity markets.

Some don’t see it that way, and seeing the financial struggles of megaprojects are suggesting a move in the opposite direction. For instance, today in Reuters, Clyde Russell pulls the panic alarm and recommends that LNG firms move to vertical integration:

The industry needs to consider going downstream in order to ensure its long-term viability.

Much like oil companies’ move from producing oil into refining it and then retailing fuels, so too will LNG companies have to find ways to establish a sustainable market that will create and maintain demand for their product.

This means investing in re-gasification terminals in developing nations, along with associated pipeline infrastructure and storages.

It may also mean building gas-fired power plants, transmission grids and or even partnering with companies at the retail level to install gas-powered heating systems in buildings and residences.

In the words of Willy Wonka: “Strike that. Reverse it.” (H/T Number One Daughter.)

There are a lot of reasons for vertical integration, none of which apply in the current LNG market. Neoclassical reasons include double marginalization (monopolies at successive levels of the value chain) or circumventing price controls.

Transactions cost reasons include asset specificity that create a bilateral monopoly problem. A classic example is site specificity, as when a power plant is located at the mouth of a coal mine. This reduces transportation costs, but would subject the mine owner to the opportunism of the power plant owner (and vice versa) if they were separate entities. Integration prevents wasteful haggling over quasi-rents.

These conditions don’t hold in LNG. In fact, the reverse is true. Since LNG can be shipped anywhere in the world, since it is an extremely homogenous commodity, and since there are an increasing number of producers, every producer can deal with many buyers, and every buyer can deal with many sellers. This eliminates double marginalization and asset specificity problems.

Moreover, integration can limit the optionality by tying a seller to a small number of consumers. There is  also a multiple equilibrium issue. If a large fraction of buyers and sellers are tied together via integration (or long term contracts), the spot market is less liquid, making it more costly for the remaining firms to rely on spot sales and purchases: this leads them to integrate (or enter into long term contracts), which reduces of the spot market further.

The LNG market is on the cusp of moving in the opposite direction, which would allow it to exploit optionality more effectively. And optionality is becoming more important as gas generation is becoming more common around the world, not just in Asia and Europe, but in Africa as well. This creates more destination options, and these options are valuable due to uncertainties in supply and demand. To take a recent example, drought in Amazonia has led to an increase in demand for gas generation in Brazil: traders like Trafigura have met the demand by sending cargoes there. When the rains return, the cargoes can find another market. As another example, the Fukushima nuclear disaster led to an increase in the demand for gas in Japan. A Russian supply disruption would lead to a spike in demand in Europe.

Given the inherent variability in gas supply and demand, which vary due to the vagaries of the weather, supply shocks, and myriad other factors, and which are crucially imperfectly correlated geographically, destination options are valuable. Flexibility allows gas to move to places experiencing increases in demand or reductions in supply via pipelines. Vertical integration impedes the ability to exploit these options, and hence destroys value.

Thus, vertical integration is the exact wrong way to go in LNG. The biggest virtue of LNG is that it can be shipped anywhere: why undermine that virtue by constraining shipping options? The deepening of market liquidity, which is proceeding apace, will reduce the transactions costs of exploiting optionality. The silver lining in the current glut of LNG is that is speeding the development of liquidity. Meaning that Clyde Russell’s prescription of vertical integration is the exact wrong response to that glut. The glut increases liquidity. Liquidity enhances optionality. Optionality creates value. Don’t stymie this salutary development. Go with it. It will pay off in both the short term and the long term.

* The first cargo of Algerian LNG was shipped in 1964. The birth of the LNG industry is often dated to that shipment, although LNG had been shipped from the US in the 1950s.

Obama caused a kerfuffle with his remarks in Argentina on Thursday. The most common interpretation of his remarks was that he was drawing an equivalence between communism/socialism and capitalism. Yes, one can interpret his speech that way, but I don’t think that’s the most accurate way to parse it.

Obama was denigrating all ideological frames as interesting subject matter for academic debate, but of little interest or relevance to practical politics:

I guess to make a broader point, so often in the past there’s been a sharp division between left and right, between capitalist and communist or socialist. And especially in the Americas, that’s been a big debate, right? Oh, you know, you’re a capitalist Yankee dog, and oh, you know, you’re some crazy communist that’s going to take away everybody’s property. And I mean, those are interesting intellectual arguments, but I think for your generation, you should be practical and just choose from what works. You don’t have to worry about whether it neatly fits into socialist theory or capitalist theory — you should just decide what works.

In short, he advocated a rigorously pragmatic approach. Or put differently, a Chinese menu theory of government: take one item from menu A, another from menu B, depending on your taste and what “works” for you.

The criticism here should be directed at his vapidity and superficiality and question begging. By what criteria are the things that “work” to be determined? How do liberty, individual autonomy, and reliance on coercion and repression come into play when evaluating what works?

Further, real world decisions always involve trade-offs. Works-Doesn’t Work is binary: trade offs aren’t.

Obama also apparently believes that it is possible to design policies without a theoretical framework. Hayek was closer to the truth when he said without theory the facts are silent. Theories are about causal mechanisms, and policies are all about manipulating cause to achieve particular effects. You can’t make a reasonable evaluation ex ante of what policies will “work” (based on your objective function) without some theoretical framework. Further, those who don’t think deeply about cause and effect when designing policies inevitably unleash unintended consequences that are usually more baleful than beneficial.

All that said, the fact that Obama apparently believes that some socialist or communist policies “work” by any criteria held by non-socialists/communists is revealing. All empirical experience is that explicitly communist and socialist systems have delivered lower standards of living (often dramatically so), less freedom, and more coercion. Further, their alleged virtue–equality–is largely chimerical. There is always a privileged elite in socialist/communist systems, and what equality there is tends to be an equality of misery. What’s more, inequality can be palliated (and is considerably even in the US) by transfer programs that fall well short of communism or socialism. The Bernie worshipping millennial idiots who point to Denmark or Sweden as socialist paradises have no clue: they are welfare states, which is a very different kettle of fish.

The examples from Cuba that Obama cited as things that “work” in a communist system are something of a joke. Non-communist/socialist systems deliver better education and health care than Castro’s Cuba.

Obama was not revealing that he is a closet commie, although he clearly does not think communism is inherently a bad thing. In fact, he was being an old school progressive, making arguments old school progressives have made since Wilson and through FDR. The New Dealers were of a similarly pragmatic bent, and like Obama, openly advocated using policies adopted by fascist or communist countries if they “worked.” Stalin, Hitler, and Mussolini all had admirers among the New Dealers, who believed that they had found better policies than voluntary contract and exchange, and open competition.

When I read Obama’s remarks, I immediately thought of FDR’s speech at Oglethorpe University in May, 1932 (while he was running for president):

Do not confuse objectives with methods. When the Nation becomes substantially united in favor of planning the broad objectives of civilization, then true leadership must unite thought behind definite methods.

The country needs and, unless I mistake its temper, the country demands bold, persistent experimentation. It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something. The millions who are in want will not stand by silently forever while the things to satisfy their needs are within easy reach.

“Bold experimentation” is basically a prescription to try anything and see if it “works.” If one thing doesn’t “work,” (i.e., “if it fails”) try something else. Once the “broad objectives” are defined, any method that achieves those objectives is fair game. Roosevelt in Georgia, like Obama in Argentina, was saying that all methods should be open for consideration and evaluated on purely pragmatic grounds.

Roosevelt was also making a favorable reference to planning, which at the time was associated with the USSR. Like Obama, he was saying don’t rule out a particular policy just because it originates in communism.

Of course, the implementation of this theory of government in the New Deal led to a confused hodge-podge of policies that largely failed to achieve their stated objectives, and indeed, in many cases worsened the nation’s economic crisis: that is, these policies were rife with unintended consequences.

This provides an excellent example of Hayek’s dictum. Those operating based on standard microeconomic (e.g., capitalist) principles/theories rightly predicted that cartelizing product and labor markets would not lead to higher output, and they were right. Contrary to Obama, “capitalist theory” was more than an intellectually interesting subject for classroom debate: it was a very useful guide to evaluating the practical effects of policies, which the New Dealers ignored, to the nation’s detriment.

And those progressives like Wilson, FDR, and now Obama who touted the superiority of pragmatism, and claimed their practicality and independence from theoretical abstractions and systems, were largely fooling themselves. The Pragmatism (note the capitalization) that has infused progressive thought for well over a century isn’t a-theoretical or a-ideological. It is an ideological and philosophical system developed in Germany in the 19th century. Not that Obama gets that.

No, Obama seems to be exactly the kind of man that Keynes so trenchantly described in the General Theory 80 years ago:

Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

What Keynes describes is a form of intellectual conceit common among politicians, and especially progressive ones. That conceit, rather than some soft spot for socialism, is the problem with Obama’s “do what works” nostrum.

The United States Marine Corps is one of the most, if not the most, exceptional and effective military force of its size in history. I dare you to identify an organization with as long and storied a record of bravery, sacrifice, and victory under the most trying conditions. From the decks of the USS Constitution to Tripoli, Mexico City, Belleau Wood, the jungles of Central America, Tarawa, Guadalcanal, Cape Gloucester, Saipan, Peleliu, Iwo Jima, Okinawa, Inchon, Chosin, I Corps, the berms of Kuwait and Kuwait City, Fallujah and many other battlefields the USMC has compiled an unrivaled combat record.

This record is the product, first and foremost, of a unique military culture. Often marginalized and frequently forced to fight for its existence, not on the battlefield, but in the halls of Congress, the Marine Corps over more than two centuries has developed a unique esprit de corps  that would be impossible to recreate from scratch today.

Read Eugene Sledge’s With the Old Breed, and you will understand.

When I was at the Naval Academy, I knew I could never be a Marine in a million years, largely because I knew I could not subsume my identity into that of the Corps.  And that is what the Corps demands. But I was, and am, damn glad that there have been millions of Americans who have been willing to do so. The Marines have performed the amazing feats that they have precisely because they demand the surrender of individuality. It’s not for everybody, but that is fine, because the Marines don’t need and can’t take everybody. Over the centuries, there have been enough.

This is a unique institution which should be defended and preserved. It makes an irreplaceable contribution to the defense of this nation.

But precisely because the Marines’ military culture is a glorious anachronism, a thing from another time, it is hated and despised by the politically correct, and the gender warriors in particular. The Marine Corps has fought the Obama administration’s ideologically-driven campaign to gender-integrate all combat units and specialties. It fought with data. It has insisted that only one metric matters, success on the battlefield, and has concluded that by that metric complete gender integration fails miserably.

This resistance has drawn the ire of arguably the most execrable high ranking member of the Obama administration (quite an accomplishment that), Navy Secretary Ray Mabus. Mabus responded to the Corps’ resistance by ordering the gender integration of Marine basic training–which will be an unmitigated disaster–and further demanded that the Corps rename all job titles to remove the word “man”. Now, there is an official plan to impose “cultural change” on the Corps.

Again, I commend you to read With the Old Breed. Time and again Sledge states bluntly that the only reason that he and his fellow Marines were able to fight and win appalling and grinding battles was the Spartan ethos and unrelenting training that the Marines underwent before hitting the beaches. He hated doing it, but he knew it was the only thing that made it possible for him to come out alive. It is inevitable that gender integration will undermine that ethos, and the rigor of the training.

The Marine Corps–and other branches of the military–should have one overriding objective and one only: to fight and win wars. The unique culture of the Marine Corps has ensured that it has been able to achieve that objective under the most trying conditions imaginable. Why in God’s name would anyone who takes the national defense seriously contemplate changing such an exceptional culture?

The answer, of course, is that people like Mabus and many others in the Obama administration and Congress are more interested in fighting and winning culture and gender wars than shooting wars. This is despicable.

I have often quoted Jefferson Davis’s epitaph for the Confederacy: Died of a Theory. Ray Mabus, Obama, and the other cultural/gender warriors who dominate Washington are hell bent on killing with a theory, an ideology. In this instance, they are hell bent on killing a military culture that has served this country gloriously, and which has produced millions of ordinary leathernecks and jarheads who have fought and bled and died while winning this nation’s wars.

“Died of (or killed by) a theory” is more than a metaphor in the case of the USMC and the Obama administration. People will literally die because of the imposition of a politically correct ideology that will inevitably compromise military effectiveness. And for what?

But those who will die cannot be identified now. They do not have names or faces. For most, they are not even abstractions. And when they die Obama and Mabus and the others will not be held to account. Indeed, they will receive accolades from many for making another successful march through American institutions, in this case, the most successful military institution in the nation’s history.

The latest terrorist atrocity, this time in Brussels, proves yet again that Europe is infested with dens of vipers, which it is largely powerless to control. Perhaps this should be expected in a country like Belgium, which cannot execute raids between the hours of 10 PM and 5 AM, and must ring the doorbell when they do.

Obama’s reaction to these appalling events was appalling in its own way. The most peevish president was obviously immensely annoyed that ugly reality intruded on his Cuban victory lap/holiday. He grudgingly spared a grand total of 51 seconds to address the subject during a scheduled speech in Havana. He then proceeded to take in a baseball game, during which he did the wave with his new besty Raul Castro.

Obama’s remarks, such as they were, displayed his impatience with and indifference to the issue of terrorism. It consisted of the standard bromides, including the old standby of a promise to help bring the perpetrators to justice.

Um. The perpetrators were suicide bombers. They blew themselves up. They are quite clearly well beyond the reach of human justice.

When pressed on the issue today in Argentina, Obama responded with his by now familiar petulance and irritation at the topic.  He has a lot on his plate, he said, by way of rationalizing not giving the matter more attention. Further, in a reprise of another well-worn theme, Obama stated that terrorism is not an existential threat to the US.

This is Obama’s typical false choice/straw man rhetoric in action. There are very few existential threats: if presidents were bound to respond only to existential threats, their plates would be quite empty. Plenty of time for golf and ESPN. Come to think of it . . . . Seriously, though, although Obama thinks Americans are irrationally obsessed with a terrorism threat which in his mind ranks somewhere below the risk of drowning in the bathtub (no, really), although not existential, it is a sufficiently great danger that a more aggressive posture is fully warranted.

It should be said that Obama is doing more than he lets on. But that in itself is a problem. For the second time in recent months, only the death of an American serviceman has forced the administration (though not Obama personally, for he floats above it all, unquestioned by the press) to admit a more extensive involvement in combat in Iraq and Syria. This time, the death of a Marine in an ISIS rocket attack on  firebase in Iraq compelled the Pentagon to concede its existence, which it had previously not acknowledged: if the Marine hadn’t died (with eight more wounded) the firebase would remain a secret. From Americans, anyways. In response to questions arising from the Marine’s death, SecDef Carter was forced to concede that US personnel numbers in Iraq exceeded, by about 50 percent, the authorized number.

So this means that the war against ISIS is more robust than Obama admits. That’s good in a way, but the secrecy is disturbing. It is not for operational reasons: after all, ISIS clearly figured out the base was there, and took it under fire. It is purely to protect Obama personally. Acknowledging more robust campaign would be an admission that his past inaction on ISIS was a mistake. And Obama is constitutionally incapable of admitting error. Sadly, a press that would be baying like hounds on the trail of a fox if a Republican president had done this is silent, and thereby complicit in concealing military action from the American people.

Obama’s terrorism remarks were only one of many low points on his two day visit to Cuba. He spewed one leftist shibboleth about the Communist country after another. It was an extended exercise in moral equivalence between the US and Cuba.

For instance, he said the Cuban Revolution and the American Revolution were quite similar, in that they were both fighting oppression. Even overlooking the fact that the philosophical and political foundations of the two revolutions could not be more different, the obvious difference is that the Cuban Revolution replaced one tyranny with a far worse one, whereas the American revolution gave (in Lincoln’s words) a new birth of liberty. It is deeply insulting to compare the American founding generation to the murderous thugs who led the Cuban uprising, and who continue to grind the country under their geriatric heels almost 60 years later.

Further, Obama said that Cuba had things to teach the US about human rights (!), specifically citing universal health care. Where to begin? Identifying health care as a human right is typically progressive, but leave that aside for the moment. Cuba’s “universal health care” is a sick joke. The elite gets far better treatment than the vast majority of Cubans, who universally get crappy medical treatment: they are equal in the primitiveness of the treatment they get.

The low point in the visit was a photo op in front of the Cuban Interior Ministry, complete with a huge portrait of mass murdering, racist Che looming in the background. Given the meticulous planning that goes into presidential visits, this had to be deliberate: leftist trolling at its worst.

The boycott of Cuba is an anachronism. It is justifiable to jettison it, and to restore relations with Cuba. But that does not require doing what Obama did: validating, and arguably celebrating, a vicious, oppressive regime, while insulting and apologizing for the country that did him the honor of electing him president twice.

Major oil traders have profited handsomely from the low price environment. Today Gunvor released results, showing a big increase in profits to $1.25 billion. A big part of the increase was driven by profits on sales of its Russian assets, but the company’s news release states that earnings from continuing operations were up 10 percent. Gunvor’s results were driven by a 24 percent increase in traded volumes.

Timing is everything. No doubt Gennady Timchenko is cursing US sanctions even more now than in March, 2014. The sanctions preceded by a few months the epic oil price collapse which has boosted oil traders’ profits.

Vitol also released some limited information about its 2015. It did not release profits numbers, but the FT reports that in the 9 months ending September, its profits were $1.25 billion, about 40 percent more than in the comparable period of 2014. Vitol’s volumes were up 13 percent.

These results come on the heels of earlier good trading results from Glencore and Trafigura. Both companies showed large increases in volumes, up 22 percent in the case of Trafigura.

Revenues of all oil traders have declined because price declines have more than offset the effect of rising volumes. But that  just points out that what matters to traders is volumes, not flat price. Indeed, low flat prices can be a boon, because (a) to the extent they are driven by higher output, they are associated with increased volumes, and (b) they reduce working capital burdens.

The increase in trader volumes far outstripped increases in output of crude or refined products. This raises the question of what is driving the increase. It could be that a higher fraction of output is traded now. Alternatively, or additionally, each barrel may turn over more frequently. I don’t know the answer, but I am going to make some inquiries to learn more.

These bumper profits in the face of an oil price collapse proves, as if further proof is needed, the idiocy of David Kocieniewski and other non-specialist journalists and politicians (yeah, Liz, I’m taking the risk of turning to stone, and looking at you). Kocieniewski, you may recall (I sure do!), said that my opposition to position limits and my support of speculation in commodity markets was tainted due to my writing of a white paper for Trafigura, a notorious speculator that profits from high prices:

What Mr. Pirrong has routinely left out of most of his public pronouncements in favor of speculation is that he has reaped financial benefits from speculators and some of the largest players in the commodities business, The New York Times has found.

. . .

While he customarily identifies himself solely as an academic, Mr. Pirrong has been compensated in the last several years by the Chicago Mercantile Exchange, the commodities trading house Trafigura, the Royal Bank of Scotland, and a handful of companies that speculate in energy, according to the disclosure forms.

Except that as the events of the past couple of years demonstrate, physical traders aren’t speculators and don’t have an interest in (let alone the ability to) drive prices higher.

But why let the facts stand in the way of a good story, right?

Most media coverage of hedging is appalling. It tends to focus on the accounting, and not the economics. Unfortunately, managements and analysts too often fall into the same trap.

This WSJ article about hedging by airlines is a case in point:

After decades of spending billions of dollars to hedge against rising fuel costs, more airlines, including some of the world’s largest, are backing off after getting burned by low oil prices.

When oil prices were rising, hedging often paid off for the airlines, helping them reduce their exposure to higher fuel costs. But the speed of the 58% plunge in oil prices since mid-2014 caught the industry by surprise and turned some hedges into big money losers.

Last year, Delta Air Lines Inc., the nation’s No. 2 airline by traffic, racked up hedging losses of $2.3 billion, while United Continental Holdings Inc., the No. 3 carrier, lost $960 million on its bets.

Meanwhile, No. 1-ranked American Airlines Group Inc., which abandoned hedging in 2014, enjoyed cheaper fuel costs than many of its rivals as a result. “Hedging is a rigged game that enriches Wall Street,” said Scott Kirby, the airline’s president, said in an interview.

Now, much of the rest of the industry is rethinking the costly strategy of using complex derivatives to lock in fuel costs, airlines’ second-largest expense after labor.

Roughly speaking, hedgers “lose”–that is, their derivatives positions lose money–about half the time. If the hedge is done properly, that “loss” will be offset by a gain somewhere else on the income statement or balance sheet. The problem is, it’s not identified specifically. In the case of airlines, it shows up as a lower cost of goods sold (fuel expense), but it isn’t identified specifically.

The tendency is to evaluate the wisdom of hedging ex post. But you cannot evaluate hedging that way. You hedge because you don’t know which way prices will go, and because a price move in one direction hurts you more than a price move in the opposite direction of the same magnitude helps you. If you knew which way prices were going to go, you wouldn’t need to hedge.

That is, hedging is valuable for an airline if reducing the variability of profits attributable to fuel cost changes raises average profits. How can this happen? One way is bankruptcy costs. If an airline loses $1 billion due to a fuel price spike, it may go bankrupt, and incur the non-trivial costs associated with bankruptcy: this is a deadweight loss. The airline receives no bonus equivalent in magnitude to bankruptcy costs if it gains $1 billion due a fuel price decline. Therefore, reducing the variability of fuel prices reduces the expected deadweight losses (in this case, expected bankruptcy costs), which is beneficial to shareholders and bondholders.

As another example, an airline that becomes more highly leveraged because of an adverse fuel price movement may underinvest (relative to what an unleveraged firm would) due to “debt overhang”: it underinvests because when it is highly leveraged the benefits of investment accrue to bondholders rather than shareholders. Again, there is unlikely to be a symmetric gain when the company becomes unexpectedly less leveraged due to a favorable fuel price movement. Here, reducing variability reduces the expected losses due to underinvestment.

Hedging can also reduce the costs of providing incentives to management through tying pay to performance. Hedging reduces a source of variability in performance that is outside of managers’ control: since they are risk averse they demand compensation for bearing this risk, so hedging it reduces compensation costs, and makes it cheaper to tie pay and performance.

The problem is, none of these things show up on accounting statements with the clarity of a 9 or 10 figure loss on a derivatives position put on as a hedge. The true gains from hedging are often unseen. The true gains are the disasters avoided that would have occurred in the absence of a hedge. There’s no line for that in the financial statements.

The one saving grace of the WSJ article is that it does mention a relevant consideration in passing, but doesn’t understand its full importance:

Another factor in the hedging pullback: a round of megamergers, capacity cuts and more fuel-efficient aircraft have fattened the industry’s profits, leaving carriers in better financial shape—and less vulnerable to a spike in fuel prices.

Two of the factors that make hedging value-enhance that I mentioned before (bankruptcy costs and underinvestment) are more relevant for highly leveraged firms that are at risk of financial distress. Due to the factors mentioned in foregoing quote, airlines have become less financially distressed, and need to hedge less. But that should have been the focus of the article, rather than the losses on previously undertaken hedges.

And that should be what is driving airlines’ decisions to hedge, although the statement of American Airlines’ president Kirby doesn’t provide much confidence that that is the case, at least insofar as AA is concerned.

Airlines are interesting because they have historically been among the biggest long hedgers in the energy market. This is true because they are one major consumer of fuel that (a) cannot pass on (in the short run, anyways) a large fraction of fuel price increases, and (b) are big enough to make justify incurring the non-trivial fixed costs associated with hedging.

Fuel costs are determined by an airline’s routes and schedule, and fuel consumption is therefore fixed in the short to medium term because an airline cannot expand or contract its schedule willy-nilly, or adjust its aircraft fleet in the short run. Thus, fuel is a fixed cost in the short to medium term. Furthermore, the schedule and the existing fleet determine the supply of seats, and hence (given demand) fares. Since supply and hence fares won’t change in the short to medium term if fuel prices rise or fall, airlines can’t pass on fuel price shocks through higher or lower fares, and hence these price shocks go straight to the bottom line. That increases the benefits for financial hedging: airlines have no self-hedges for fuel prices.

This is to be contrasted to, say, oil refiners. Refiners are able to pass on the bulk of oil price changes via product price changes: pass through provides a self-hedge. Yes, crack spreads contract some when oil prices rise (higher prices->lower consumption->lower utilization->lower margins), but refiners are able to shift most of the crude price changes onto downstream consumers. This reduces the need for financial hedges.

Further, many downstream consumers–gasoline consumers like you and me, for instance–don’t consume in a scale sufficient to justify incurring the fixed costs of managing our exposure to gasoline price changes. Therefore, a large fraction of those who are hurt by rises in the flat price of energy don’t benefit from financial hedging.

Conversely, those hurt by falls in flat prices, firms like oil producers and holders of oil inventories, don’t have self-hedges: they are directly exposed to flat prices. Moreover, they are big enough to find it worthwhile to incur the fixed cost of implementing a hedging program.

This leads to an asymmetry between long and short hedging, which is evident in CFTC commitment of traders data for oil. This asymmetry is why long speculators are essential in these markets. Without long speculators, the (predominant) short hedgers would have no one to take the risk they want to get rid of. This would put downward pressure on futures prices, and increase the risk premium embedded in futures prices.

Which is why airlines have been in the forefront of those hating on speculators. Not because speculators distort prices. But because long speculators compete with long hedgers like airlines to take the other side of short hedgers like oil producers and traders holding oil inventories. This competition reduces the risk premium in futures prices.

This makes it costlier for airlines to hedge, but their higher costs are more than offset by lower hedging costs for producers, stockholders, and other short hedgers. This is why speculators are vital to the commodity markets, and thereby raise prices for producers and reduce costs for consumers.

But apparently this is totally lost on Elizabeth Warren and her ilk. But as the WSJ article shows, ignorance about hedging–and hence about the benefits of speculation–is widespread. Unless and until this ignorance is reduced substantially, policy debates will generate much more heat than light.

Putin has disconcerted many with his abrupt and unexpected announcement that Russia would be removing its “main forces” from Syria. Just what this means is unknown, for he also made plain that it would maintain its main bases there, an air station in Latakia Province, and the shambolic Tartus naval facility. What residual capability will remain is unclear, and it must be noted that planes that fly out today can fly back at some future date, which distinguishes this from the US withdrawal from Iraq.

I consider it somewhat amusing that those who shrieked loudest about Putin getting into Syria are now shrieking loudest about his getting out. I guess they are upset that he will not be so stupid as to get bogged down in a pointless and bloody war that does not advance his strategic objectives.

As someone (surprisingly to some) who was not fussed about Putin getting into Syria, I’m equally indifferent as to his departure. Having no emotional or ideological investment, it is of interest mainly as an opportunity to evaluate his strategies, and his prudence in executing them.

The most obvious explanation is that the risk-reward trade-off no longer favors Russian involvement. On the reward side, Putin has achieved his main objective, and staved off Assad’s destruction. Putin may well prefer that Assad (and Iran) not win decisively: a stalemate may (cynically) advance Russian interests by continuing to make Assad dependent on Russia, and preventing Iran from getting too big for its britches.

The direct costs of this intervention, though not large when compared to American expenditures in the ISIS campaign (let alone what was spent in Iraq and Afghanistan) are nonetheless material given Russia’s straitened economic circumstances. It is not just a choice between guns and butter. Russia has already announced a sizable cut in military procurement, so there is an element of a choice between expending weapons and buying new ones. Putin clearly believes that new weapons will give him leverage in the future, so he is husbanding his limited resources for that purpose, rather than spending a few millions daily to continue high tempo operations in Syria.

On the risk side, pushing the campaign to the point where Assad is on the verge of decisive victory would increase greatly the probability of an open confrontation with Turkey. This would pose large military risks (and costs) even viewed narrowly, and would also result in a highly unpredictable situation with Nato, the US, and the EU. The upsides in such a situation are hard to see, but the downsides are clear and large. Then there are the normal risks attendant to any military operation, including the risk of some strategically irrelevant but spectacular and embarrassing terrorist operation targeted at the Russians. Furthermore, continuing the campaign aggravates relations with the Saudis, which creates economic complications by infusing a geopolitical calculus into delicate negotiations over oil output (which is a first order economic issue to Putin).

Smart gamblers know when to cash in their chips and go home. Putin came to the table with limited objectives, and has achieved them. He can claim victory: why risk losing these gains, when few further gains are in prospect?

Just like his going in was a lot less complicated than people made it out to be, so is his departure: he is leaving because he achieved the limited objectives he set out in October. As for the war in Syria, it will likely continue to grind on and on, in part because Putin wants it that way. His is a cynical move, but since “victory” by either side would likely result in a retaliatory bloodbath (and a war among the “victors” if Assad is toppled), as horrific as the current situation is, it is not demonstrably worse than the alternatives on offer.

We are now well into the Brave New World of clearing and collateral mandates. The US clearing mandate is in place, and the Europeans are on the verge of implementing it. We are also on the cusp of the mandate to collateralize non-cleared swaps.

After years of congratulating themselves on how the Brave New World was going to be so much better than the Bad Old World, the smart set is now coming to grips-grudgingly, slowly-with the dawning realization that not all the financial demons have been slain: here be dragons too. From time to time I’ve written about regulators recognizing this reality. There have been several more examples recently indicating that this has become the new conventional wisdom. For instance, Bloomberg recently editorialized on CCPs becoming the New Too Big to Fail: meet the new systemic risk, not that different from the old systemic risk. The BoE is commencing a review of CCPs, focusing not just on financial risks but operational ones as well. Researchers as Citi are warning that CCPs need more skin in the game. Regulators are warning that CCPs have become a single point of aim for hackers as they have become more central to the financial system. Researchers at three central banks go Down Under back into the not-too-distant past to show how CCPs can get into trouble–and how they can wreak havoc when they try to save themselves. An economist at the Chicago Fed warns that CCPs create new risks as they address old ones. Even the BIS (which had been an unabashed clearing cheerleader) sounds warnings.

I could go on. Suffice it to say that it is now becoming widely recognized that central clearing mandates (and the mandated collateralization of non-cleared derivatives) is not the silver bullet that will slay systemic risk, as someone pointed out more than seven years ago.

This is a good thing, on the whole, but there is a danger. This danger inheres in the framing of the issue as “CCPs are too big to fail, and therefore need to be made fail-safe.”  Yes, the failure of a major CCP is a frightening prospect: as the article linked above about the crisis at the New Zealand Futures and Options Exchange demonstrates, the collapse of even a non-major CCP is not a cheery prospect either.

But the measures employed to prevent failure pose their own dangers. The “loser pays” model is designed to reduce credit risk in derivatives transactions by requiring the posting of initial margins and the payment of variation margins, so that the CCP’s credit exposure is reduced. But balance sheets can be adjusted, and credit exposure through derivatives can be-and will be, to a large extent-replaced by credit exposure elsewhere, meaning that collateralization primarily redistributes credit risk, rather than reduces it.

Furthermore, the nature of the credit can change, and in bad ways. The need to meet large margin calls in the face of large price movements  causes spikes in the demand for credit that are correlated with market disruptions: this liquidity risk is a wrong way risk of the worst sort, because it tends to occur at times when the supply of liquidity is constrained, and it therefore can contribute to liquidity crises/liquidity hoarding and can cause a vicious spiral. In addition, as the article on the NZFOE demonstrates other measures that are intended to save the clearinghouse (partial tearups, in that instance) redistribute default losses in unpredictable ways, and it is by no means clear that those who bear these losses are less systemically important than, or more able to withstand them than, those who would bear them in an uncleared world.

The article on the NZFOE episode points out another salient fact: dealing with a CCP crisis has huge distributive effects. This makes any CCP action the subject of intense politicking and rent seeking by the affected parties, and this inevitably draws in the regulators and the central bankers. This, in turn, will inevitably draw in the politicians. Thus, political considerations, as much or more than economic ones, will drive the response. With supersized CCPs, the political fallout from any measures adopted to save CCPs (including extending credit to permit losers to make margin calls) will be acute and long lived.

Thus, contrary to the way they were hawked in the aftermath of the crisis, CCPs and collateralization mandates are not fire-and-forget measures that reduce burdens on regulators generally, and central banks in particular. They create new burdens, as regulators and central banks will inevitably be forced to resort to extraordinary measures, and in particular extraordinary measures to supply liquidity, to respond to systemic stresses created by the clearing system.

In his academic post-mortem of the clearing during the 1987 Crash, Ben Bernanke forthrightly declared that it was appropriate for the Fed to socialize clearinghouse risks on Black Monday and the following Tuesday. In Bernanke’s view, socializing the risk prevented a more serious crisis.

When you compare the sizes of the CCPs at issue then (CME Clearing, BOTCC, and OCC) to the behemoths of a post-mandate world, you should be sobered. The amount of risk that must be socialized to protect the handful of huge CCPs that currently exist dwarfs the amount that Greenspan (implicitly) took onto the Fed balance sheet in October, 1987.

Put differently, CCPs have become single points of socialization. Anyone who thinks differently, is fooling themselves.

Addendum: The last sentence of the Bernanke article is rather remarkable: “Since it now appears that the Fed is firmly committed to respond when the financial system is threatened, it may be that changes in the clearing and settlement system can be safely restricted to improvements to the technology of clearing and settlement.” The argument in a nutshell is that the Fed’s performance of its role as “insurer of last resort” (Bernanke’s phrase to describe socializing CCP risk) during the Crash of 1987 showed that central banks could readily handle the systemic financial risks associated with clearing. Therefore, managing the financial risks of clearing can easily be delegated to central banks, and CCPs and market users should focus on addressing operational risks.

There is an Alfred E. Newman-esque feel to these remarks, and they betray remarkable hubris about the powers of central banks. I wonder if he thinks the same today. More importantly, I wonder if his successors at the Fed, and their peers around the world, share these views. Given the experience of the past decade, and the massive expansion of derivatives clearing world, I sure as hell hope not.

The biggest news from the exchange world in a long time is the proposed merger between LSE and Eurex. Both entities operate stock exchanges, but that’s a commoditized business these days, and it’s not the real driver of the merger. Instead, LSE’s LCH.Clearnet, and in particular LCH’s SwapClear, are the prizes. LSE and Eurex also both have valuable index businesses, but its hard to see how their value is enhanced through a combination: synergies, if they exist, are modest.

There are potentially large synergies on the clearing side. In particular, the ability to portfolio margin across interest rate products (notably various German government securities futures traded and cleared on Eurex, and Euro-denominated swaps cleared through LCH) would provide cost savings for customers that the merged entities could capture through higher fees. (Which is one reason why some market users are less than thrilled at the merger.)

A potential competitor to buy LSE, ICE, could also exploit these synergies. Indeed, its Euro- and Sterling-denominated short term interest rate futures contracts are arguably a better offset against Euro- and Sterling-denominated swaps than are Bunds or BOBLs.

The CME’s experience suggests that these synergies are not necessarily decisive competitively. The CME clears USD government security and STIRs, as well as USD interest rate swaps, and therefore has the greatest clearing synergies in the largest segment of the world interest rate complex. But LCH has a substantial lead in USD swap clearing.

It is likely that ICE will make a bid for LSE. If it wins, it will have a very strong clearing offering spanning exchange traded contracts, CDS, and IRS. Even if it loses, it can make Eurex pay up, thereby hobbling it as a competitor going forward: even at the current price, the LSE acquisition will strain Eurex’s balance sheet.

CME might also make a bid. Success would give it a veritable monopoly in USD interest rate clearing.

And that’s CME’s biggest obstacle. I doubt European anti-trust authorities would accept the creation of a clearing monopoly, especially since the monopolist would be American. (Just ask Google, Microsoft, etc., about that.) US antitrust authorities are likely to raise objections as well.

From a traditional antitrust perspective, an ICE acquisition would not present many challenges. But don’t put it past the Europeans to engage in protectionism via antitrust, and gin up objections to an ICE purchase.

Interestingly, the prospect of the merger between two huge clearinghouses is making people nervous about the systemic risk implications. CCPs are the new Too Big to Fail, and all that.

Welcome to the party, people. But it’s a little late to start worrying. As I pointed out going back to the 1990s, there are strong economies of scale and scope in clearing, meaning that consolidation is nearly inevitable. With swaps clearing mandates, the scale of clearing has been increased so much, and new scope economies have been created, that the consolidated entities will inevitably be huge, and systemically important.

If I had to handicap, I would put decent odds on the eventual success of a Eurex-LSE combination, but I think ICE has a decent opportunity of prevailing as well.

The most interesting thing about this is what it says about the new dynamics of exchange combinations. In the 2000s, yes, clearing was part of the story, but synergies in execution were important too. Now it’s all about clearing, and OTC clearing in particular. Which means that systemic risk concerns, which were largely overlooked in the pre-crisis exchange mergers, will move front and center.