Streetwise Professor

There is a huge amount of hysteria going on about the diesel market. Tucker Carlson is prominent in flogging this as an impending disaster:

Thanks to the Biden administration’s religious war, this country is about to run out of diesel fuel.https://t.co/51oLY1LDak pic.twitter.com/mwuBQcLu5u

— Tucker Carlson (@TuckerCarlson) October 28, 2022

Like so much of Tucker these days, this is an exaggerated, bowdlerized, and politicized description of what is happening. There is a kernel of truth (more on this below) but it is obscured and distorted by the exaggerations.

First off, it is complete bollocks to say “in 25 days there will be no diesel.” Current inventories–stocks–are about equal to 25 days of consumption. But production continues, at a rate of about 4.8 million barrels per week. So, yes, if US refineries stopped producing right now, in 25 days the US would be out of diesel. But this isn’t France! US refineries will keep chugging along, operating close to capacity, supplying the diesel market.

Stocks v. flows, Tucker, stocks v. flows.

Yes, by historical standards, stocks are very low, although there have been other periods when inventories have been almost this low. But low stocks are not a sign of a broken market, or of impending doom.

Low stocks do happen and periodically should happen in a well-functioning market. That is, “stock outs” regularly occur in competitive markets, for good economic reasons.

Assume that stock outs never occurred. Well that would mean that something was produced but never consumed. That makes no economic sense.

The role of inventories is to buffer temporary (i.e., short term) supply and demand shocks. I emphasize temporary because as I show in my book on the economics of storage, storage is driven by scarcity today relative to expected scarcity in the future. A long term demand or supply shock affects current and expected future scarcity in the same way, and hence don’t trigger a storage response. In contrast, a temporary/transient shock (e.g., a refinery outage) affects current vs. future scarcity, and triggers a storage response.

For example, a refinery outage raises current scarcity relative to future scarcity. Drawing down on stocks mitigates this problem. For an opposite example, a temporary demand decline raises future scarcity relative to current scarcity. This can be mitigated by storage–reducing consumption some today in order to raise consumption in the future (when the good is relatively scarce).

To give some perspective on what “short term” means, in my book, I show that for the copper market inventory movements are driven by shocks with a half life of about a month.

Put differently, storage of a commodity (diesel, copper) is like saving for a rainy day. When it rains, you draw down on inventories. When it rains a lot for an extended period, you can draw inventories to very low levels.

And that’s basically what has happened in the diesel market.

Carlson is right about one thing: the Russian invasion in Ukraine precipitated the situation. This is best seen by looking at diesel crack spreads–the difference between the value of a barrel of diesel (measured by the Gulf Coast price) and the value of a barrel of oil (measured by WTI):

Although the crack was gradually increasing in 2021 (due to the rebound from COVID lockdowns) the spike up corresponds almost precisely with the Russian invasion. After reaching nosebleed levels in late-April, early-May, the crack declined to a still-historically high level and roughly plateaued over the summer, before beginning to widen again in September. This widening is in large part a seasonal phenomenon–heating oil (another middle distillate) demand picks up at that time.

In terms of storage, the initial market response made sense. The war was expected to be of relatively short duration. So draw down on inventories. However, the war has persisted longer than initial expectations, and the policy responses–notably restrictions on Russian exports, including refined products to Europe–have also taken on a semi-permanent cast. So the shock has endured far longer than expected, but the (rational) response of drawing down on stocks has left us in the current situation.

To extend the rainy day example, if you don’t expect it to rain 40 days and 40 nights (or for 9 months) you will draw down on inventories and you’ll go close to zero if the rain lasts longer than expected. That’s what we’ve seen in diesel.

As in any textbook stockout situation, price will adjust to match consumption with productive capacity. Inventories will not buffer subsequent supply and demand shocks, meaning that prices will be pretty volatile: storage dampens volatility.

I should note that low inventory levels can create opportunities for the exercise of market power–manipulations/corners/squeezes. So it is possible that some of the price and spread moves in benchmark prices may reflect more than these tight fundamentals.

Hopefully the hysteria will not trigger idiotic policy responses. The supply shock has been most acute in Europe (because it consumed a lot of Russian middle distillate). This has resulted in a substantial uptick in US exports (diesel and gasoline) to Europe, which has led to suggestions that the US restrict exports, or ban them altogether. This would be beggar–or bugger–thy neighbor, and would actually feed the recent narrative advanced by Manny Macron and others in Europe that the US is exploiting Europe’s energy distress.

Further, this would reduce the returns to refinery capital, reducing the incentive to invest in this sector–which would be a great way of perpetuating the current scarcity.

But this administration, and in particular its (empty) head, somehow think returns to capital are a bad thing:

This is throwing pearls before a swine, but here goes. Investment raises wealth and wages, and lowers prices. People invest only if they expect to earn a return. https://t.co/LjC2zdrlg4

— streetwiseprof (@streetwiseprof) October 28, 2022

Believe it or not, there are even worse proposals than export bans, windfall profits taxes, and restrictions on returning cash to investors bouncing around. In particular, supposedly serious people (who travel in the best of circles) like Columbia’s Jason Bordoff are suggesting nationalization of the US energy industry.

Yeah. That’ll fix things.

What we are seeing in diesel (and in other energy markets as well) is their efficient operation in the face of extreme supply and demand shocks. You may not like the message that prices and stocks are sending–that fundamental conditions are really tight–but suppressing those signals, or other types of intervention like export bans–will make the situation worse, not better.

And yes, energy market (and commodity market generally) conditions should definitely be considered when evaluating how to handle Russia and the war in Ukraine. But that evaluation is not advanced by hysterical statements about the nation grinding to a halt at Thanksgiving because we’ll be out of diesel.

I have long called myself “the Clearing Cassandra” for my repeated and unheeded warnings about the dangers of letting the Trojan Horse of clearing (and the margining of uncleared trades) into the financial citadel. Specifically, clearing/margining can create financial shocks (and indeed financial crises) rather than preventing them (which is the supposed justification for mandating them).

We have seen several examples of this in the past several years, including the COVID (lockdown) shock of March 2020 (a subject of a JACF article of mine) and the recent energy market tremors. The most recent example, and in many ways the most telling one, is the recent instability in the UK that led the Bank of England to intervene to prevent a full-on crisis. The tumult fed a spike in UK government yields and contributed to a plunge in the Pound.

The instability was centered on UK pension funds engaged in a strategy called Liability Directed Investment (LDI)–which should now be renamed Liquidity Danger Investment. In a nutshell, in LDI defined benefit pension funds hedge the interest rate risk in their liabilities through interest rate swaps that are cleared or otherwise margined daily on a mark-to-market basis, rather than investing in fixed income securities that generate cash flows that match the liabilities. The funds hold non-fixed income assets (sometimes referred to as “growth assets”) in lieu of fixed income. (I discuss the whys of that portfolio strategy below.)

On a MTM basis, the funds are hedged: a rise in interest rates causes a decline in the present value of the liabilities, which matches a decline in the value of the swaps. Even if there is a duration match, however, there is not a liquidity match. A rise in interest rates generates no cash inflow on the liabilities (even though they have declined in value), but the clearing/margining of the swaps leads to a variation margin outflow: the funds have to stump up cash to meet VM obligations.

And this has happened in a big way due to interest rate increases driven by central bank tightening and the deteriorating fiscal situation in the UK (which has been exacerbated substantially by the energy situation, and the British government’s commitment to absorb a large fraction of energy costs). This led to big margin calls . . . which the funds did not have cash to cover. So, cue a fire sale: the funds dumped their most liquid assets–UK government gilts–which overwhelmed the risk bearing capacity/liquidity of that market, leading to a further spurt in interest rates . . . which led to more VM obligations. Etc., etc., etc.

In other words, a classic liquidity spiral.

The BofE intervened by buying gilts in massive amounts. This helped stem the spiral, though the problem was so acute that the BofE had to extend its purchases beyond the period it initially announced.

So yet again, central bank intervention was necessary to provide liquidity to put out fires created by margining.

FFS. When will people who should know better figure this out? How many times is it necessary to hit the mule upside the head with a 2×4?

I just returned from France, and while walking by the Banque de France I thought of a conference held there in the fall of 2013 at which I spoke: the conference was co-sponsored by the BdF, BofE, and ECB. It was intended to be a celebration of the passage and implementation of various post-Crisis regulations, clearing mandates most prominent among them.

I did my buzz kill Clearing Cassandra routine, in which I warned very specifically of the liquidity spiral dangers inherent in clearing as a source of financial instability. I got pretty much the same response as the Trojan Cassandra–a blow off, in other words. Indeed, I quite evidently got under some skins. The next speaker was Benoît Cœuré, a member of the ECB governing council. The first half of his talk was a very intemperate–and futile–attempt at rebuttal. Which I took as a compliment.

Alas, events have repeatedly rebutted Cœuré and Gensler and all the other myriad clearing cheerleaders.

The LDI episode has validated other arguments that I made starting in late-2008. Most notably, clearing was touted as a “no credit” system because the clearinghouse does not extend any credit to counterparties: variation margin/mark-to-market is the mechanism that limits CCP credit exposure. Since one (faulty) narrative of the Crisis was that it was the result of credit extended to derivatives counterparties, clearing was repeatedly touted as a way of reducing systemic risk.

Not so fast! I said. Such a view is profoundly unsystemic because it neglects the fact that market participants can substitute other forms of credit for the credit they no longer get via derivatives trades. And indeed, in the recent LDI episode exemplifies a very specific warning I made over a decade ago: those subject to clearing or margining mandates would borrow on the repo market to fund margin obligations, including both initial margin and variation margin.

And indeed the UK funds did exactly that. This actually increased the connectedness of the financial system (contrary to the triumphant assertions of Gensler and others), and this connectedness via the repo channel was another factor that drove the BofE to intervene.

My beard is not quite this long (though it’s getting there) but this is pretty much spot on:

Again: Clearing converts credit risk into liquidity risk. And all financial crises are liquidity crises.

Maybe someday people will figure this out. Hopefully before I snuff it.

And the idiocy of this is especially great with respect to the UK pension funds because they posed relatively little credit risk in the first place. So there was not a substitution of one risk (liquidity risk) for another (credit risk). There was an addition of a new risk with little if any reduction of any other risk.

The LDI strategies were right way risks. Interest rate movements that cause swaps to lose value also increase the value of the funds (by reducing the PV of their liabilities). The funds were not–and are not-leveraged plays on interest rate risk. So the prospects of defaults on derivatives that could be mitigated by clearing were minimal.

Here I have to part ways with someone I usually agree with, John Cochrane, who characterizes the episode as another example of the dangers of leverage. He cites to a BofE document about the LDI episode that indeed mentions leverage, but the story it tells is not the classic lever-up-and-lose-more-when-the-market-moves-against-you one that John suggests. Instead, in figure in the BofE piece that John includes in one of his posts, the increase in interest rates actually makes the pension fund better off in present value terms–even including its LDI-related positions–because its assets go down less in value than its liabilities do. In that sense, the LDI positions are an interest rate hedge. But there is a mismatch in the liquidity impacts.*. It is this liquidity mismatch that causes the problem.

The BofE piece also suggests that the underlying issue here is pension fund underfunding. In essence, the pension funds needed to jack up returns to close their funding gap. So instead of investing in fixed income assets with cash flows that mirrored those of its pension liabilities, the funds invested in higher returning assets like equities. Just investing in fixed income would have locked in the funding gap: investing in equities increased the odds of becoming fully funded. But just investing in equities alone would have subjected the funds to substantial interest rate risk. So the LDI strategies were intended to immunize them against this risk.

Thus, the original sin was the underfunding. LDI was/is not a way of adding interest rate risk through leverage to raise expected returns to close the gap (gambling on interest rate risk for resurrection). Instead it was a way of managing interest rate risk to permit raising returns to close the gap by changing portfolio composition. (No doubt regulators were cool with this because it reduced the probability that pension fund bailouts would be needed, or at least kicked that can down the road, a la US S&L regulators in the 1980s.)

No, the real story here is not the oft-told tale of highly leveraged intermediaries coming to grief when their speculations turn out wrong. Instead, it is a story of how mechanisms intended to limit leverage directly lead to indirect increases in debt and more importantly to increases in liquidity risks. In that way, margining increases systemic risk, rather than reducing it as advertised.

*The BofE document describes an LDI mechanism that is somewhat different than using swaps to manage interest rate risk. Instead, it describes a mechanism whereby positions in gilts are partially funded by repo borrowing. The borrowing is necessary to create a position large enough to create enough duration to match the duration of a fund’s liabilities. But a swap is economically equivalent to a position in the underlying funded by borrowing, so the difference is more apparent than real. Moreover, the liquidity implications of the interest rate hedging mechanism in the BofE document are quite similar to those of a swap.

In an earlier post I said that Putin’s mobilization address was his most unhinged speech ever. That record did not last long: his Friday speech announcing the annexation of four Ukrainian regions was beyond unhinged.

The speech was Castroesque in length. The bulk of it was a jeremiad against the west, and “Anglo-Saxons” in particular. (Apparently he is unaware of American diversity!) He justified his invasion of Ukraine, and the annexations, as a war of survival against a west that is hell bent on subjugating Russia. The speech was a litany of the west’s sins, colonialism and slavery most prominent among them. He conveniently elided over Russia’s imperialism, symbolized today by the disproportionate representation of ethnic groups from Russian republics in those fighting–and dying–in Ukraine, and touted the USSR’s “anti-colonial” record in Africa and elsewhere.

The speech was chock-full of projection, most importantly regarding waging war on civilian populations. There were also the now familiar accusations of Ukrainian Naziism, the betrayal of 1991, and the non-existence of Ukrainian nationhood.

In brief, Putin portrayed the war in Ukraine as an existential conflict waged to defend Russia against Anglo-Saxons attempting to colonize Russia, and to defend the world against such western rapacity. (The reference to the Opium Wars was obviously an attempt to appeal to China, whose ardor for this Ukrainian adventure is obviously waning fast.)

The atmospherics were also bizarre. The images of a dwarfish Putin clasping hands with the hulking mouth breathers leading the sham annexed regions, chanting “Ross-i-ya!” with a demented grin on his face are quite striking–and disturbing. Especially when contrasted to the reality on the ground, where Russian forces continue to reel and rout–the bugout from Izyum being the latest example. “Reservists” are being shoved to the front without even a simulacrum of training, where they will no doubt be slaughtered without changing the battlefield dynamic one iota. Putin is giving no retreat orders and is bossing about formations that have been destroyed or dissolved. Gee, whom does that remind one of?

Tens of thousands of Russian men are fleeing to avoid the press gangs, a visible demonstration of widespread panic. (Kazakhstan–the Russian Canada!) Personal contacts indicate that the panic is widespread even among those who have not fled, but who fear the knock on the door.

The realities of the battlefield and the home front reveal that this is truly an existential conflict–for Putin. He objectively can’t win, but he can’t lose and survive. This creates a tremendous bias towards escalation, with nuclear weapons being his only real escalation option.

There is a considerable debate over whether when push comes to shove Putin will push the button. This is an unanswerable question. Suffice it to say that his Downfall-esque rants in public (one can only imagine what he’s like in private) mean that there is a material probability that he will.

Which poses a grave dilemma to the Anglo-Saxons. (In this respect, Putin is on to something: the continentals are hopelessly ineffectual and along for the ride.) Months ago I wrote that Putin was in zugzwang, i.e., a situation where any move made the situation worse, but one is compelled to move. Well, currently the US is arguably in zugzwang as well. The consequences of letting Putin off the hook or pushing him to the wall are both deeply unsatisfactory.

What is in the US’s opportunity set? The situation on the battlefield does suggest that giving Ukraine a blank weapons check could result in pushing Russia out of most of, and perhaps all, of the occupied portions of the country–including Crimea. But choosing that option is a bet on Putin’s sanity and willingness to go nuclear, and how far up the escalation ladder Putin is willing to go. Conversely, pulling the Ukrainian’s leash will likely result in a continued grinding war with its global and human and economic toll. Brokering a compromise is almost certainly out of the question, given the intransigence of the parties and the completely irreconcilable nature of their demands (though Putin did graciously say that he was willing to accept Ukraine’s capitulation).

The administration is clearly leaning towards–but not completely towards–engineering Russian defeat on the battlefield. Most of the American populace is disengaged. The populist right in the US is engaged but stupidly pro-Russian, because (a) Putin criticized the west’s trans obsession, and (b) the enemy of their enemy (the administration) is their friend. With respect to (a) this is beyond bizarre because these passing references were embedded in a speech that damned the entirety of American history in a way that would make Howard Zinn beam: is the PR buying into that now? (It is also stupid because it validates left narratives about them being Russian puppets.)

The populist right also immediately concluded that the US is responsible for the destruction of the Nord Stream I and II pipelines under the Baltic. The fact is we have no facts, other than that the pipelines suffered catastrophic ruptures, possibly the result of deliberate sabotage. Everything else you read is speculation about motive, which only prove whom the speculators hate most. Those who know ain’t talking, and those talking don’t know.

Although I immediately concluded sabotage, there is reason to doubt this too. This is plausible to me, based on my knowledge of natural gas pipelines and Russian incompetence. (Anybody remember the shitshow of the Russian oil pipelines in spring 2019?)

But again–nobody knows nothing beyond the fact that the pipelines are fucked, so speculation is pointless. And depressingly, given the natures of everyone involved, I can’t say there’s anyone I would trust to reveal the facts.

The populist right is annoying, but largely powerless. Even if the Republicans prevail in the upcoming election, the PR will represent a clamorous but ultimately irrelevant force. Meaning that the US will continue to stumble along, mainly in the direction of pushing an increasingly desperate Putin.

Yes, I can see the upside of that. But I also see considerable downside risk, and indeed the risks are asymmetric. Even as things stand now, beyond nuclear weapons Russia’s military capability has proven even more illusory than a Potemkin village of legend. His conventional threat to Nato is demonstrably non-existent. So the upside to the US and Nato of drubbing Putin further is very limited. But the downside of drubbing him could be serious indeed.

So mutual zugzwang is a not unrealistic description of the current situation.