Streetwise Professor

Igor Sechin, he of the ape drape, has taken to the pages of the Financial Times to diagnose the causes of the recent collapse in oil prices. I am sure you will be  shocked to learn that it is those damned speculators:

In today’s distorted oil markets, prices do not reflect reality. They are driven instead by financial speculation, which outweighs the real-life factors of supply and demand. Financial markets tend to produce economic bubbles, and those bubbles tend to burst. Remember the dotcom bust and the subprime mortgage crisis? Furthermore, they are prone to manipulation. We have not forgotten the rigging of the Libor interest rate benchmark and the gold price.

. . . .

Financial bubbles, market manipulations, excessive regulation, regional disparities — so grotesque are these distortions that you might question whether there is any such thing as an oil “market” at all. There is the semblance of a market: buyers and sellers and prices. But they are performing a charade.

What is to be done? First, financial players should no longer be allowed to have such a big influence on the price of oil. In the US, Senators Carl Levin and John McCain have called for steps to prevent price manipulation, though whether they will be implemented, and when, remains an open question.

In any case, the authorities should go further, ensuring that at least 10 or 15 per cent of oil trades involve actually delivering some physical oil. At present almost all “oil trades” are conducted by financial traders, who exchange nothing but electronic tokens or pieces of paper.

No, condemnations of speculation are not the last refuge of scoundrels attempting to assign blame for sharp movements in commodity prices: they are the first and only refuge. Prices going up? Speculators! Prices going down? Speculators! Poor, poor little companies like doughty Rosneft and even international cartels like OPEC are mere straws at the tossed before the speculative gales.

Sechin’s broadside is refreshingly untainted by anything resembling actual evidence. The closest he comes is to invoke long run considerations, relating to the costs of drilling new wells. But supply and demand are both very inelastic in the short run, meaning that even modest demand or supply shocks can have large price impacts that cause prices to deviate substantially from long run equilibrium values driven by long run average costs.

It is also hard to discern a credible mechanism whereby diffuse and numerous financial speculators could cause prices to be artificially low for a considerable period of time. (It is straightforward to construct models of how a local market can be manipulated downwards, but these are implausible for a global market. Moreover as I showed years ago, markets that are vulnerable to upward manipulation by longs are relatively invulnerable to downward manipulation by shorts.)

And the empirical implications of any such artificiality are sharply inconsistent with what we observe now. Artificially low prices would induce excessive consumption, which would in turn result in a drawdown in inventories. This is the exact opposite of what we see now. Inventories are growing rapidly in the US in particular (where we have the best data). There are projections that Cushing storage capacity will be filled by May. Internationally, traders are leasing supertankers to store oil. These are classic effects of demand declines or supply increases or both that are expected to be transient.

Insofar as requiring some percentage of oil contracts (by which I presume he means futures and swaps) be satisfied by delivery, the mere threat of delivery ties futures prices to physical market fundamentals at contract expiration. What’s more, the fact that paper traders are largely out of the market when contracts go spot means that they cannot directly affect the supply or demand for the physical commodity.

Sechin’s FT piece is based on a presentation he gave at International Petroleum Week. Rosneft thoughtfully, though rather stupidly given the content, posted Sechin’s remarks and slides on its website. It makes for some rather amusing reading. Apparently shale oil companies are like dotcoms, and shale oil was a bubble. According to Igor, US shale producers are overvalued. His evidence? A comparison of EOG and Hess to Lukoil. The market cap of the EOG is substantially higher than Lukoil’s, despite its lower reserves and production, and lack of refining operations. Therefore: Bubble! Overvaluation!

Gee, I wonder if the fact that Lukoil is a Russian company, and that Russian company valuations are substantially below those of international competitors, regardless of the industry, has anything to do with it? In fact, it has everything to do with it. Sechin’s comparison of a US company with a Russian one points out vividly the baleful consequences of Russia’s lawless business climate. It’s not that EOG and other shale producers are bubbles: it’s that Lukoil (and other Russian companies) are black holes.  (It was the very fact that Russia’s lack of property rights, the rule of law, and other institutional supports of a market economy that got me interested in looking at the country in detail in the first place almost a decade ago.)

I was also amused by Sechin’s ringing call for greater transparency in the energy industry. This coming from the CEO of one of the most opaque companies in the most opaque countries in the world.

Reading anything by Sechin purporting to be an objective analysis of markets or market conditions is always good for a chuckle. His FT oped and IPW remarks are no exception. As a market analyst, he makes a better KGB operative. Enjoy!