Streetwise Professor

I of course take some satisfaction from last night’s election results, though I think their practical consequences will be limited, and perhaps fraught. This was an immense repudiation of Obama. The loss was a humiliation of the president, even compared to the 1994, 2006, and 2010 routs of the president’s party. Democrats were crushed at every level of government, from the Senate, to governorships, to the House, to state legislatures. Hell, the Republicans even won governor’s races in Maryland and Massachusetts. Races that had been rated as close (Georgia, Kansas, Kentucky) turned into absolute routs. (Pollsters rank a close second to Obama in The Biggest Loser results from last night.)

It will be amusing to watch Obamabots attempt to ‘splain things in the next few days. After he claimed that his policies were on the ballot-all of his policies-the Dems will no doubt turn themselves into Dervishes in spinning the results to show that they had nothing to do with The One. I was particularly amused that Jay Carney said that Democratic senate candidates would have done better if they had not run away from Obama. Oh, Jay. You still have the ability to say the most outlandish things with a straight face! In truth, if Gardiner or Braley had run as proud supporters of the Obama agenda and leadership, their margins of loss would have doubled.

Practically, however, I think the results will be fairly barren, and may in fact set the stage for a Constitutional crisis, or crises. Obama is still president, and can block any substantive legislation emerging from the solidly Republican Congress. More ominously, given Obama’s personality, ideological rigidity, and hatred of Republicans (and I do think he viscerally hates them), confrontations are inevitable. Obama will not take his whipping and emerge more conciliatory and willing to compromise. To the contrary, to someone of his narcissistic temperament, yesterday’s repudiation is an existential affront that he must confront. He will channel his inner Alinsky, and attempt to use every executive power to achieve results that he cannot implement through legislation. He will double down on the divisive rhetoric and policies that he has employed in the past couple of years. A Constitutional confrontation over immigration, or some other issue (climate?), could well result when Obama attempts to exert executive power unilaterally.

Perhaps most importantly, his obsession with completing a deal with Iran, which has warped virtually every aspect of American foreign policy (Syria most notably) lays the groundwork for confrontation as he will likely attempt to implement it without Congressional approval. The substantive ramifications of such a deal are also very frightening, because they could lead to an even greater crisis in the Middle East and an intensification of the Shia-Sunni/Arab-Persian conflict that is already the source of chaos and misery. It is beyond bizarre that a man who claims to strive for nuclear disarmament is pursuing, Ahab-like, a deal that would likely lead to the nuclearization of the most unstable and conflict-ridden part of the world.

Moreover, the major challenges that the nation faces are still primarily an executive responsibility, as they relate mainly to foreign policy. ISIS is still in Iraq and Syria. Ebola is still in Western Africa. The Mullahs are still in Tehran. Putin is still in Ukraine. And Obama is still in the White House. Given that reality, as emotionally satisfying as yesterday’s verdict is, and as much as it represents a verdict on Obama’s foreign policy failures specifically, it will not fundamentally affect the crises that beset us, and given Obama’s personality, any effect may be for the worse.

I admire  Jeffrey Sprecher. ICE has been an amazing success story, and a lot of that has to do with his rather unique combination of vision and ability to execute.

But he is not above talking his book, and he delivered some self-serving, and in fact anti-competition, remarks in ICE’s earnings call held earlier today:

The head of Intercontinental Exchange, the world’s second-largest exchange group by market value, launched an unusually explicit criticism of its bigger competitor’s business strategy as he touted growth in his flagship oil contract.

Commercial customers such as refineries and airlines propelled this growth “as we see our competitors adopting incentives that attract the type of algorithm . . . trading that typically drives commercial users away,” Mr Sprecher said.

Mr Sprecher said “payment for order flow schemes” such as CME’s expanded the market by “attracting traders that really don’t want to hold the risk of your products but just want . . . to get paid to be there.”

If Mr. Sprecher actually believes that, he should be glad that CME (to speak of competitors plural is rather amusing) is implementing a program that per his telling drives away the paying customers, the commercial users.  That’s doubly true since those commercial users would presumably go to ICE. How is CME supposed to make money giving away trading incentives to traders whose presence those who repel those who pay full fare? If that’s what CME is doing, Mr. Sprecher should remember the old adage about not intervening when your enemy is intent on committing a blunder.

Sprecher was touting the fact that ICE’s Brent contract had now surpassed the older CME WTI contract in open interest. Well, this is good for ICE, certainly, but Sprecher and his exchange really have had very little to do with it: this is further proof that it’s usually better to be lucky, than good. Brent’s relative rise is the result of structural factors, most notably the prolonged logistical bottleneck that isolated WTI from waterborne crudes: that bottleneck is largely gone, replaced instead by a regulatory bottleneck, the US export ban.

ICE should not gloat for too long, though, because it is quite likely that the export ban will go, one way or another. What’s more, the resource base supporting the Brent contract is dwindling, and rapidly, whereas the Midcontinent of the US is experiencing a crisis of abundance, if it is experiencing a crisis at all. Logistical bottlenecks created by such crises tend to be transitory, and even regulatory bottlenecks can be overcome. In a few years, WTI will be deeply connected with the waterborne market, albeit in a non-traditional direction. And Brent will be at the mercy of inexorably declining production, and the ability of Platts and an often fractious community of producers and traders to figure out a contractual fix. (Adding Urals to the Brent basket? Really?) So Brent is riding high now, but over the medium to long term, CME will be one breaking out the shades, because WTI will have the brighter future.

As for incentives offered by upstart markets to unseat incumbents, as CME is attempting to do to ICE in Brent, this is a classic competitive tactic, and almost necessary in futures markets. The network effect of order flow means that (as I say in Gregory Meyer’s FT piece) bigger incumbent contracts have a big competitive advantage. The only way that  a competing contract can possibly build order flow and liquidity is to offer incentives, both to market makers (including HFT and algo traders!) who supply liquidity and to the hedgers and speculators that consume liquidity. (I wrote about this last year. Amusingly, I had forgotten about that post until Greg reminded me of it:-P)

Even that is a dicey proposition. Many have tried, and most have failed. But sometimes the upstart the succeeds, and at other times has forced the incumbent to meet the incentives to keep market share, and that can be expensive for the incumbent. That’s probably what Sprecher really doesn’t like. It’s not that incentives don’t work (as the criticism quoted above suggests): it’s that they just might. And if CME’s incentives work it could be an costly proposition for ICE to respond in kind.

In other words, Sprecher is really criticizing a reasonable competitive tactic, because like any dominant incumbent, he doesn’t like competition. That’s his job, but that kind of criticism cuts no ice with me. Or ICE, either, as much as I admire its achievement.

I avoid the immigration issue like the plague-or Ebola, to update the meme-because (a) I can’t say that I can bring any special knowledge to the subject, and (b) it’s one that inevitably generates more fury than thought, reaction rather than reflection. I make an exception now because of an article that speaks to the Science! debate.

Neil Munro in the Daily Caller has a long article that claims that the currently ongoing EV-D68 enterovirus epidemic was created by, or at least exacerbated by, the influx of children from Mexico and Central America this summer. The evidence is not definitive, but Munro presents enough to show at least that it’s a reasonable hypothesis. And what is science about? Testing hypotheses. And what should scientists do? Test hypotheses.

But if you read Munro’s piece, you will find a shocking lack of interest among scientists to test this particular hypothesis. Indeed, the scientists interviewed recoil in fear at the very thought. What’s more, he shows pretty convincingly that this unscientific lack of curiosity is due to the fact that this subject is politically radioactive, and if the hypothesis were not rejected, it would be very, very politically damaging to Señor Obama. So scientists, who exist in a state of abject dependency on Federal funding, would probably rather inject EV-D68 into their eyeballs with a square needle than investigate seriously such a politically explosive hypothesis.

The correlation between Science! and politics demonstrates that the invocation of Science! by politicians and the politically active is inherently untrustworthy. And of course, this is not limited to Ebola and EV-D68. Global warming or climate change or whatever the label de jour is a particularly prominent example.

I find it sickly ironic that the administration and its defenders invoke Science! as a magic incantation to ward off rational debate. The translation of Science!, when used by an administration hack or flack is “Shut up, you bloody peasant! Defer to your betters, regardless of how asinine they are. Do not question the Great and Powerful Oz.” It has come to the point that an invocation of Science! immediately discredits the sincerity of the invoker. It is especially ironic when the bearer of this message is a liberal arts or J-school grad (or both!) who probably exerted considerable effort to avoid taking a serious science class during their entire education.

Another institution corroded by the acid of politics, especially in recent years.  (Another is civilian-military relations: I will address that dreary story in a future post.)

Ukraine held successful, and remarkably pro-Western, elections last Sunday. The result was a rebuke to Putin, and provided further proof of the adage that you catch more flies with sugar than with gall. Tomorrow, the rump/puppet statelets of Donetsk and Luhansk will hold Soviet-style sham elections, which the Kremlin will duly recognize in violation of the Minsk Protocol signed in September.

Ominously, there are numerous reports of an escalation in the intensity of combat throughout eastern Ukraine (the cease-fire being something of a joke, of course). Further, there are reports of movements of large quantities of new Russian equipment, including SAMs (e.g., S-300s) and MLRS systems considerably more advanced than the scattershot Grads that have been used indiscriminately. There are also indications that the fractious and thuggish rebels are being replaced at key points by Russian regulars.

Something is building here. The timing likely reflects the conscription cycle that led to the faux withdrawal some weeks ago that gave faux hope to those in the west who saw what they desperately wanted to see. Moreover, the passivity of the West, and the distraction of Obama by ISIS (not that he was ever really engaged with Ukraine anyways) give Putin every confidence that another strike would be met with indignant blasts of hot wind from the west, and little else. His prize of Crimea (My precious! My precious! to Gollum-Putin: it’s basically all he has to show for his Herculean labors this year)  is also barely supportable now without access to supplies from the mainland, but will be all but isolated when the slender thread of waterborne transport is frozen shut in a few weeks. Putin needs to open the land routes through the Ukrainian mainland. This requires taking Mariupol, and then continuing to advance west to Kherson.

Russia has markedly increased the intensity of its aerial aggression against Nato countries (including Turkey, which is interesting) and Japan. (Over the summer it carried out mock nuclear strikes on Denmark (!!!) , like those simulated against Sweden and Poland in previous years.) It has bullied Finnish research vessels. (For someone who fulminates about the expansion of Nato, Putin is its best recruiting sergeant.)  It recently tested two nuclear missiles, a Bulava SLBM (which is apparently finally over its serious teething problems) and a Topol ICBM. Putin’s recent rantings in Valdai included sort-of veiled nuclear threats and warnings that “the bear isn’t asking anyone for permission.”

These are all warnings to the west to stand back and not even think about interfering when Putin mounts the next phase of his Novorossiya campaign, likely in the next 10 days-two weeks. These are the wages of the west’s feckless dithering for the past 9 months. This is the price of pusillanimity.

Although this has been rumored for weeks (due to the dogged reporting of Powerline), yesterday the White House admitted that hackers, likely Russian (I’m shocked! Shocked!), had compromised the (allegedly non-classified) computers of the Executive Office of the President.

Did Putin have the hackers insert malware that triggered a popup saying: “Who’s Your Daddy?”

But here’s the best part (and per usual, “best” means “worst”). We didn’t discover this ourselves. An “ally” informed us.

It would be so hilarious if the “ally” is Israel. (Germany would be a close second in hilarity.) It would also be so karmic.

But I guess this isn’t possible, because a confidential administration source said the information came from an ally, and we know what Obama, Kerry, etc. think of Israel, and “ally” isn’t the first word that trips off the tongue.

The hits just keep on coming, don’t they folks? But yes, by all means let’s hear some more lectures about how since “you didn’t build that” we need bigger government, delivered by the least competent administration ever.

In his latest disquisition on Ebola, Obama plumbed new depths of incoherence. Which for him is saying something. He  responded specifically to questions about how to rationalize the military’s policy of quarantining returning servicemen and women from West Africa (though they don’t say the q-word), while adamantly opposing quarantining of civilians. He offered two justifications (I won’t call them “reasons”). The first was that civilians and military personnel have different levels of exposure due to the nature of their work in West Africa:

Well, the military is in a different situation, obviously, because they are, first of all, not treating patients.

So let me get this straight. People with more exposure to infected patients require fewer precautions upon their return. Rrrriiiiiggghhhttt.

The second reason is that the military works for him, so they just have to suck it:

Second of all, they are not there voluntarily.

It’s part of their mission that’s been assigned to them by their commanders and ultimately by me, the commander in chief. So, we don’t expect to have similar rules for our military as we do for civilians. They are already, by definition, if they’re in the military, under more circumscribed conditions.

When we have volunteers who are taking time out from their families, from their loved ones and so forth to go over there because they have very particular expertise to tackle a very difficult job, we to want make sure that, when they come back, that we are prudent, that we are making sure that they are not at risk themselves or at risk of spreading the disease.

Last time I checked, military people were volunteers (and have been since 19-freaking-73), taking time out from their families and loved ones and so forth on extended deployments because they have very particular expertise to tackle difficult jobs. Oh, and in doing so, especially for the last 13 years, have done so in most of the earth’s hell holes at great personal risk.

But I guess they’re not doing God’s work, so they just need to embrace the suck.

If you ever wanted to understand Obama’s true feelings about the military in two paragraphs, now you have it. They start at scorn and go downhill from there.

Don’t think this won’t be noticed, all the way from E-1 to O-10. And there might be some O-11s spinning in their graves.

And of course, there was the obligatory condescending invocation of Science!, this from a guy who despite his resemblance to Urkel never struck me as a guy handy around the Bunsen Burner:

But we don’t want to do things that aren’t based on science and best practices, because, if we do, then we’re just putting another barrier on somebody who’s already doing really important work on our behalf. And that’s not something I think any of us should want to see happen.

And for a bonus Science! lecture, Jocylyn Elders emerged from obscurity to deliver it. (If you guessed “dead” in “dead or alive”, sorry: you lose).

These constant sneering references to Science!, clearly intended to intimidate the peasants into silence, are beyond insufferable. Because whenever Obama speaks about Science!, all I can think of is this:

An Antares spacecraft operated by Orbital Sciences and contracted to NASA to carry supplies to the International Space Station exploded on liftoff in Virginia. A failure for the American space program? Yes. But the major failure may be due to the fact that this craft, like most others operated by US companies, relies on Russian engines. Soviet engines, actually. I mean literally built in Soviet times. They have been refurbed, but Orbital Sciences was supposedly concerned about quality:

The NK-33 engine that powered Antares’ first flight was built decades ago by Russia’s Kuznetsov Design Bureau and is no longer in production. Further, Orbital is uncertain about the quality of Aerojet‘s remaining stockpile of 23 NK-33s, beyond those set aside for NASA’s CRS-1. Aerojet Rocketdyne is Orbital’s primary subcontractor and overhauls the old NK-33 engines into a configuration for Antares, dubbed AJ-26.

The fraught relationship with Russia, and Russian threats (uttered by Rogozin the Ridiculous, true) to cut off supplies of engines to the US has spurred efforts here to develop an American engine. Maybe NASA and the Pentagon should expedite those efforts.

The uniformed military has laid down a major marker in the tussle over Ebola quarantines. The Joint Chiefs of Staff recommended a 21 day quarantine from all service personnel returning from West Africa:

The Joint Chiefs of Staff have recommended to Defense Secretary Chuck Hagel that all troops returning from deployments in West Africa to combat the Ebola virus be quarantined for 21 days, the Pentagon said Tuesday.

Army Gen. Martin Dempsey, the chairman of the Joint Chiefs, delivered the service chiefs’ recommendation to follow the Army’s lead on the policy of 21 days of isolation, said Rear Adm. John Kirby, the Pentagon press secretary.

On Monday, Gen. Ray Odierno, the Army chief of staff, ordered 21 days of isolation and “enhanced monitoring” for Army Maj. Gen. Darryl Williams and 11 other troops who were returning to Italy from leading the initial efforts by the military to contain the Ebola virus in Liberia.

The Army has already ordered a quarantine of its personnel, and Hagel has stated that he will not overrule that decision. Now he has to decide whether to order a quarantine policy for all services:

Kirby said Hagel “supports the decision the Army leadership made” while stressing that Hagel had yet to reach a decision on whether the 21-days isolation rule should apply to all services.

The Pentagon press secretary said there was no timeline for Hagel to make a decision but added that one was expected soon.

Given the administration’s  obvious and almost frenzied opposition to any quarantines or travel bans, this is a major repudiation of Obama policy and judgment. I suspect it reflects a judgment on the civilian leadership that transcends the Ebola issue.

For his part, Obama strode to the WH lawn to tell us that quarantines and travel bans were bad because, Science! And because health workers were doing God’s work. Well, doing God’s work is not incompatible with taking prudent precautions to prevent said workers from infecting God’s children. Quite consistent with it in fact.

Meanwhile we learned some suspiciously suppressed facts about Quarantines are Bad poster nurse Kacia Hickox. Some very interesting facts. Such as that she worked/works for the CDC. And that she was miraculously able to retain a high-powered civil rights attorney almost immediately after being quarantined, and that this said attorney is connected to the White House. There are no coincidences, comrades.

Hickox raised alarms in my mind with her stridency and sense of entitlement, and failure to even acknowledge that as a public health worker, there might be a public health case, rather than a Kacia Hickox case, for quarantining her. How warranted those concerns were. So if you are wondering what Ebola Czar Ron “Flounder” Klain has been doing out of the public eye, wonder no longer.

Back to the JCS. Now Hagel is well and truly between a rock and a hard place. The uniformed military is almost certainly livid over the way the campaign against ISIS is being waged, and the events over the past several years that have led up to it. To have Hagel cave on Ebola to pressure from Obama would only stoke  that anger. Obama has done serious damage to many institutions in this country. Civil-military relations could be yet another.

Matt Levine graciously led his daily linkwrap with a response to my post on his copper column:

It’s not that hard to manipulate copper.

Craig Pirrong, who knows a lot more about commodities markets than I do [aw, shucks], objects to my take on copper. My view is sort of efficient-markets-y: If one person buys up all the copper in the LME warehouses and then tries to raise the price, the much much greater supply of copper that’s not in those warehouses will flow into the warehouses and limit his ability to do that. And I still think that’s broadly true, but broadly true may not be the point. Pirrong quite rightly points out that there’s lots of friction along the way, and the frictions may matter more than the limits in actual fact.

. . . .

So there are limits to cornering, but they may not be binding on an actual economic actor: You can’t push prices up very much, or forvery long, but you may be able to push them up high enough and for long enough to make yourself a lot of money.

I agree fully there are limits to cornering. The supply curve isn’t completely inelastic. People can divert supplies (at some cost) into deliverable position. The cornerer presents the shorts with the choice: pay me to get out of your positions, or incur the cost of making delivery. Since those delivery costs are finite, the amount the cornerer can extract is limited too.

I agree as well that corners typically elevate prices temporarily: after all, the manipulator needs to liquidate his positions in order to cash out, and as soon as that happens price relationships snap back. But that temporary period can last for some time. Weeks, sometimes more.

What’s more, when the temporary price distortions happen matters a lot. Some squeezes occur at the very end of a contract. This is what happened in Indiana Farm Bureau in 1973. A more recent example is the expiry of the October, 2008 crude oil contract, in which prices spiked hugely in the last few minutes of trading.

The economic harm of these last minute squeezes isn’t that large. There are few players in the market, most hedgers have rolled or offset, and the time frame of the price distortion is too short to cause inefficient movements of the commodity.

But other corners are more protracted, and occur at precisely the wrong time.

Specifically, some corners start to distort prices well before expiration, and precisely when hedgers are looking to roll or offset. Short, out-of-position hedgers looking to roll or offset try to buy either spreads or outrights. The large long planning to corner the market doesn’t liquidate. So the hedgers bid up the expiring contract. Long still doesn’t budge. So the shorts bid it up some more. Eventually, the large long relents and sells when prices and spreads get substantially out of line, and the hedgers exit their positions but at a painfully artificial price. I have documented price distortions in some episodes of 10 percent or more. That’s a big deal, especially when one considers the very thin margins on which commodity trading is done. Combine that price distortion with the fact that a large number of shorts pay that distorted price to get out of their positions, and the dollar damages can be large. Depending on the size of the contract, and the magnitude of the distortion, nine or ten figures large.  (I analyze the liquidation/roll process theoretically in a paper titled “Squeeze Play” that appeared in the Journal of Alternative Investments a few years ago.)

But this is all paper trading, right, so real reapers of wheat and miners of copper aren’t damaged, right? Well, for the bigger, more protracted squeezes that’s not right.

Most hedgers are “out-of-position” they are using a futures contract to hedge something that isn’t deliverable. For example, shippers of Brazilian beans or holders of soybean inventories in Iowa use CBT soybean futures as a hedge. They are therefore long the basis. Corners distort the basis: the futures price rises to reflect the frictions and bottlenecks and technical features of the delivery mechanism, but the prices of the vastly larger quantities of the physical traded and held elsewhere may rise little, if at all. So the out-of-position hedgers don’t gain on their inventories, but they pay an inflated price to exit their futures.

This is why corners are a bad thing. They undermine  the most vital function of futures markets: hedging/risk transfer. Hedgers pay the biggest price for corners precisely because the delivery market is only a small sliver of the world market for a commodity, and because the network effects of liquidity cause all hedging activity to tip to a single market (with a very few exceptions). Thus, the very inside baseball details of the delivery process in a specific, localized market have global consequences. That’s why temporary and not very big and localized are not much comfort when it comes to the price distortions associated with market power manipulations.

Gunvor announced plans to sell assets in Russia:

Oil trading house Gunvor is seeking to cut exposure to Russia by selling assets in the country which had long been one the main generators of its growth and profit before the United States imposed sanctions on its co-founder.

. . . .

Now the company, led by the veteran Swedish oil trader, is looking to rebalance its asset portfolio and divest a significant part of business in Russia to acquire new assets in Europe, the United States, Asia and South America.

“Since a significant portion of our investments are in Russia, over time Gunvor will be looking to sell selectively part of those assets. We do not expect this will have any impact on our existing trading activities in Russia,” the company said on Sunday.

I am somewhat amused by the statement that the company “expect this will have any impact on our existing trading activities in Russia,” because it is well known that it has been cutting back on these activities for some time.

Some obvious explanations include a genuine desire to rebalance its asset portfolio, a need for cash due to persistent suspicions about the company leading to constraints on its ability to access the credit markets, and a desire to put paid to those suspicions by cutting back exposure to Russia.

Knowing the way Russia works, I would advance another hypothesis for Gunvor’s actions. It has been told to sell out, because someone covets those assets, and because after Timchenko’s departure (and Putin’s being cashed out?) the company has lost its krysha. Russia is the country of “nice little port you have here. It’d be a shame if something happened to it. Or to you.” When you have something that somebody important wants, you’d better say da! and accept the price offered without complaint. Just ask Vladimir Yevtushenkov.

One of the assets that Gunvor is selling is its stake in the port in Novorossiisk. Wouldn’t you know who expressed an interest in acquiring a stake in the the port there? Yeah. Igor. And Rosneft has oil trading ambitions, and the Ust-Luga port on the Baltic could fit quite nicely into that.

So keep an eye on who buys. Given that this is hardly a peachy time to sell assets in Russia, given the country’s growing economic isolation and the fear of further sanctions, Gunvor’s announcement is quite telling. The buyer is likely to be Russian, and the set of possible buyers is quite limited, which means that Gunvor is not likely to get top dollar for these assets. If Rosneft or another national champion with close connections to Putin ends up being the buyer, my suspicions that Gunvor was pushed out of Russia will be largely confirmed.

Someone at Gunvor told the FT that Russia was “Gunvor’s heritage, not its future.” That’s definitely true. The only question is why. I strongly suspect this is not totally voluntary, and to the extent that it is, it reflects Gunvor’s judgment that the legal and economic and political risks of operating in Russia are no longer worth the candle.