Streetwise Professor

March 23, 2018

Will Chinese Oil Futures Transform the Oil Market? Highly Unlikely, and Like All Things China, They Will Be Hostage to Government Policy Whims

Filed under: China,Derivatives,Economics,Energy,Exchanges,Regulation,Russia — The Professor @ 11:08 am

After literally years of delays and false starts, the International Energy Exchange (a subsidiary of the Shanghai Futures Exchange) will launch its yuan-denominated, China-delivery crude oil futures contract on Monday.

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

Whether it will be a viable and successful contract for commercial market participants is far more doubtful.  Its potential to become an international benchmark is even more remote.

For one thing, most successful commodity futures contracts specify delivery in a major production area that is connected to multiple consumption regions, but the INE contract is at a major consumption location.  This will increase basis risk for non-Chinese commercials, even before taking into account the exchange rate issue.  Considering the cash basis (the cash-futures basis is more complicated), basis risk between a delivery location and a location supplied by that delivery point is driven by variability in transformation costs, most notably transportation costs.   The variance in the basis between two consumption locations supplied by a delivery point is equal to the variance in the difference between the transformation costs to the two locations, which is equal to the sum of the variances, minus 2x the covariance.  This is typically bigger than either of the variances.  Thus, non-Chinese hedgers will typically be worse off using the INE contract than the CME’s WTI or DME’s Oman or ICE’s Brent, even before liquidity is considered.

In this respect, the INE’s timing is particularly inauspicious, because the US crude oil export boom, which is seeing large volumes go to Asia and China specifically, has more tightly connected WTI prices with Asian prices.

I deliberately say “transformation costs” (rather than just transport costs) above because there can be disparities between international prices and prices in China due to regulations, currency conversion issues, and taxes.  I don’t know the details regarding the relevant tax and regulatory regime for oil specifically, but I do know that for cotton and other ags the tax and quota regime has and does lead to wide and variable differences between China prices and ICE prices, and that periodic changes in this regime create additional basis volatility.

Related to transformation costs, the INE has implemented one bizarre feature that is likely to undermine contract performance.  Specifically, it is setting a high storage rate on delivery warehouses.  The ostensible purpose of this is to restrain speculation and reduce price volatility:

One of its strategies to deter excessive price swings is to set related crude storage costs in China at levels that are at least twice the rate elsewhere. That’s seen discouraging speculators interested in conducting so-called cash and carry trades, which seek to take advantage of differences between the spot price and futures of a commodity.

This will be highly detrimental to the contract’s performance, and will actually contravene the intended purpose.  Discouraging storage will actually increase volatility.  It will also increase the volatility in the basis between the INE price and the prices of other oil in China.  The fact that discouraging storage will make the contract more vulnerable to corners and squeezes will further increase this basis volatility.  This will undermine the utility of the contract as a hedging mechanism.

Where will hedging interest for the contract come from?  Unlike in say the US, there will not be a large group of producers will big long positions that they need to hedge (in part because their banks insist on it).  Similarly, there is unlikely to be a large population of traders with inventory positions, as most of the Chinese crude is purchased by refiners.  The incentives of refiners to hedge crude costs are limited, because they have a natural hedge: although they are short crude, they are long products.  To the extent that refiners can pass on crude costs through products prices, their incentives to hedge are limited: this is why there is a big net short futures exposure (directly and indirectly) by producers, merchants and processors in WTI and Brent: sellers of crude (producers and merchants) have an incentive to hedge by going short futures because they have no natural internal hedge, and the big refiners’ natural hedge mutes their incentive to take long positions of commensurate size.

Ironically, regulation–price controls specifically–may provide the biggest incentive for refiners to hedge.  To the extent they cannot pass on crude cost increases through higher product prices, they have an incentive to hedge because then they have more of a true short exposure in crude.  Moreover, this hedging incentive is option-like: the incentive is greater the closer the price controls are to being binding.  I remember that refined product price restrictions have been a big deal in China in the past, resulting in periodic standoffs between the government and Sinopec in particular, which sometimes involved fuel shortages and protests by truckers.  I don’t know what the situation is now, but that really doesn’t matter: what matters is policy going forward, and Chinese policies are notoriously changeable, and often arbitrary.  So the interest of Chinese refiners in hedging will vary with government pricing policy whims.

If hedging interest does develop in China, it is likely to be the reverse of what you see in WTI and Brent, with hedgers net long instead of net short.  This would tend to lead to a “Keynesian contango” (the Canton Contango? Keynesian Cantongo?), with futures prices above expected future spot prices, although the vagaries of Chinese speculators make it difficult to make strong predictions.

Will the contract develop into an international benchmark? Left to its own devices, this is highly unlikely.  The factors discussed above that create basis risk undermine its utility as an international benchmark, even within Asia.  But we are talking about China here, and the government seldom leaves things to their own devices.  I would not be surprised if the government explicitly requires or strongly pressures domestic firms to buy crude basis Shanghai futures, rather than Brent or WTI.  This contract obviously involves national prestige, and being launched at a time of intense dispute on trade between the US and China I suspect that the government is highly motivated to ensure that it doesn’t flop.

Requiring domestic firms to buy basis Shanghai could also force foreign sellers to do some of their hedging on INE.

Another issue is one I raised in the past, when China peremptorily terminated trading in stock index futures.  The prospect of being forced out of a position at the government’s whim makes it very risky to hold positions, particularly in long-dated contracts.

All in all, I don’t consider the new contract to be transformative–something that will shake up the world oil market.  It will do better than the laughable Russian Urals oil futures contract (in which volume over six months was one-third of the projected daily volume), but I doubt that it will develop into much more than another venue for speculative churn.  But like all things China, government policy will have an outsized influence on its development. Refined product pricing policy will affect hedging demand.  Attempts to force firms to use it as a pricing mechanism in contracts will affect its use as a benchmark, which will also affect hedging demand.

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.

Update. I had a moment to catch up on Chinese price regulations.  The really binding regulations, which resulted in shortages and the periodic battles between Sinopec and the government date from around 2007-8, when (a) oil prices were skyrocketing, and (b) I was in China teaching a course to Sinopec and CNPC execs, and so heard first-hand accounts.   These battles continued, but less intensely post-Crisis because the controls weren’t binding when prices collapsed.  Moreover, the government adopted a policy that effectively implemented a peg between crude and refined prices, but only adjusted the peg every 22 days and only if the crude price had moved 4 percent.  Subsequently, in 2013, Beijing revised the policy, and eliminated the 4 percent trigger and shortened the averaging period to 10 days. Then in 2015, after the collapse in oil prices, China suspended this program.  A few months later, it introduced a revised program that makes no adjustments to the price when crude falls below $40 or rises above $130.

Several takeaways.  First, at present the adjustment mechanism reduces the incentives of refiners to hedge crude prices.  Under the earlier adjustment system, the lags and thresholds would have created some bizarre optionality that would have made hedging decisions vary with prices in a highly non-linear way.  The system in effect from 2015 to 2016 would have created little incentive to hedge because the pricing system imposed hardly any constraints on margins that were allowed to vary with crude prices.

Second, the current system with the $40 floor and $130 ceiling actually increases the incentive to hedge (relative to the previous system) by buying futures when prices start to move up towards $130 (if that ever happens again).  That’s actually a perverse outcome (triggering buying in a rising price environment, and selling in a falling price environment–positive feedback loop).

Third, and most importantly, the policy changes often, in response to changing market conditions, which reinforces my point about the new futures contract being subject to government policy whims.  It also creates a motive for a perverse kind of speculation–speculation on policy, which can affect prices, which results in changes in policy.

One thing I should have mentioned in the post is the heterogeneity of refiners in China.  There are the big guys (Sinopec, CNPC, CNOOC), and there are the independents, often referred to as “teapot refineries.”  Teapots might have more of an incentive to hedge, given that they are in more tenuous financial straits–but those very tenuous straits might make it difficult for them to come up with the cash to pay margins.  And even they still have the natural hedge as long as price controls don’t bite.  It’s worth noting, however, that Chinese firms have a penchant for speculating too. I wouldn’t be surprised if some of the teapots turn plunger on INE.

Government policy towards the independents has been notoriously volatile–I know, right? In 2015, China granted the independents the right to import oil directly.  Then in late-2016 it thought that the independents were dizzy with success, and threatened to suspend their import quotas if they violated tax or environmental rules.  As always, there are competing and ever changing motives for Chinese policy.  They’ve lurched from wanting to protect the big three and drive consolidation of industry to wanting to provide competitive discipline for the big three to wanting to rein in the competition especially when the independents sparked a price war with the big firms.  These policy lurches will almost certainly affect the commercial utilization of the new futures market, even by Chinese firms.

Updated update. The thought that cash-and-carry trades are some dangerous speculative strategy puzzled me–it’s obviously not a directional play, so why would it affect price levels. But perhaps I foolishly took the official explanation at face value.  Chinese firms have been notorious for using various storage stratagems as ways of circumventing capital controls and obtaining shadow financing.  Perhaps the real reason for the high storage rate is to deter use of the futures market to play such games.  Or perhaps there is a tax angle.  Back in the day futures spreads were a favored tax strategy in the US (before the laws were changed and the IRS cracked down), and maybe cash-and-carry could facilitate similar games under the Chinese tax code.  Just spitballing here, but the stated rationale is so flimsy I have to think there is something else going on.

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March 12, 2018

Into the Rosneft Black Hole–And No, I Don’t Mean an Oil Well

Filed under: China,Energy,Russia — The Professor @ 9:36 am

If you didn’t think the Rosneft-Glencore-QIA-Intessa-CEFC deal could get more bizarre–WRONG! Today Reuters reports that during the period of time that Chinese Firm of International Mystery CEFC agreed to buy a 14.6 percent share in Rosneft from whom it was parked initially–Glencore and QIA, funded by Intessa Saopaolo and ???–it was paying loan-shark rates to secure short term financing:

But from at least the second half of last year CEFC was approaching shadow bankers – non-traditional lenders – for costly short-term loans, said six sources with direct knowledge, in a sign of the strained liquidity the company was facing.

In early January, CEFC borrowed 1 billion yuan ($158.00 million) from the Shanghai-based Bida Holding Group, also known as U.Trust Holding Group, for a 15-day loan with a daily interest rate of 0.1 percent, equivalent to an annual interest rate of 36 percent, said one person with direct knowledge of the matter.

And, of course, it was recently revealed that the head of the CFIM–Ye Jianming–is under investigation for “economic crimes.” And an arm of the government of Shanghai has taken control of CEFC Energy–the part of the convoluted group that actually agreed to buy the Rosneft shares. Given the news relating to CEFC’s desperate need for funds in the shadow banking market, this now is quite clearly a shadow bailout.

More puzzles: at the time the deal was announced CEFC made a “huge” initial payment. To whom? Where is the money now? Glencore states that it anticipates the deal will close in the first half of 2018–meaning that they haven’t been paid.  Intessa says “no problema! The deal will-a get-a done!” Meaning it hasn’t been done and they are still on the hook.  The Qataris of course say nothing.

So where’s the money? Show me the money!

Some great due diligence by all involved, no? Sell out to a virtually unknown company with the creditworthiness of a busted racetrack punter. No doubt everyone was too anxious to get out to look too closely at the buyer, and perhaps they took it for granted, or on faith, or something, that CEFC was really a stalking horse for the Chinese government, and so no worries!

The Rosneft “privatization” has been opaque since day one.  And no surprise, as it involves a convergence of the most opaque entities on the planet: Russia, China–specifically a virtually unknown Chinese conglomerate with apparent ties to the Chinese security apparatus–Middle East investors, and a Swiss commodities firm.  Have them walk into a bar, and you have the beginnings of a great joke. Put all these together, and you get a black hole from which no light can possibly emerge.

And I say again: the one entity that should be shedding light because it is a listed public company in the UK–Glencore–provides little more information than the other conspirators involved in this drama.  The FCA should be all over Glencore like flies on cow pies. But it isn’t–although the recent Beaufort Securities scandal suggests its lassitude should be no surprise.

So what happens next? I have no idea. But whatever happens, there’s no guarantee that the world at large will know what actually happens, given this lot of opaque–and unaccountable–participants.

 

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March 3, 2018

Trump Cuts the Hair Suspending the Trade Sword of Damocles

Filed under: China,Economics,Energy,Politics,Regulation — The Professor @ 11:04 am

Overall, I have found the Trump administration’s economic policies to be favorable.  The tax bill was pretty good, even though it was worse than the administration’s original proposal.  The chipping away at the encrustation of regulation has been highly beneficial.

But there was always a sword of Damocles hanging by a thread over our heads: protectionism. Heretofore, that sword has remained dangling, but last week the hair broke (perhaps by Trump’s hair-trigger temper) when he announced plans to impose substantial tariffs on imported steel and aluminum.

This is egregiously bad policy, even on its own terms. Like all tariffs, these will impose far greater costs on consumers than they will generate benefits for producers.  Since steel and aluminum are intermediate goods, the first consumers are manufacturers that use the metals.  The cost will be borne in the form of lower output from these firms, lower employment and wages in the consuming industries, and higher prices for the final goods.

These tariffs are a failure on their own terms, and demonstrate Trump’s economic ignorance. Trump wants to bolster American manufacturing: these tariffs will harm US manufacturing overall, even though they benefit relatively small subsectors thereof.   This is because US manufacturing is a big consumer of these materials.  As an example, Trump touts the American energy revolution and promotes American energy exports.  Well, the energy business is a huge consumer of steel in particular, in everything from pipelines to rigs to drill pipe to storage tanks to oil refineries to LNG liquefaction plants.  By helping one shrunken sector of the US economy, Trump is imposing substantial harm on a growing one–and one that he touts, no less.

A common retort to criticisms like mine is that the trade playing field is unfair, and that countries like China in particular advantage domestic producers at the expense of foreigners.  Well, they do that in many sectors, but even though that is inefficient, it redounds to the benefit of other sectors in the US economy: for example, subsidizing aluminum benefits US auto manufacturers, who increasingly utilize aluminum (in part to achieve compliance with self-inflicted regulatory harms, namely CAFE standards).

What is little understood is that a tax on imports is a tax on trade: it reduces both imports and exports.  Similarly, subsidizing exports increases trade–including exports by the country importing the subsidized good.

This is true over the long run: in the short run capital flows adjust as well as trade flows.  For example, Chinese subsidies can lead to an increased US trade deficit (Chinese trade surplus), which means that the Chinese accumulate US dollar claims–pieces of paper (or, more accurately, electronic book entries).  Then one of two things happens.  Either the dollar claims prove worthless, or the Chinese spend the dollars on US goods.  So we either get goods in exchange for worthless pieces of paper (or electronic records), or we export goods later.

If retaliatory measures like Trump’s tariffs could result in some bargain or accommodation that levels the playing field, then perhaps the benefit would exceed the cost (although ironically much of the overall benefit will redound to those who tip the playing field, because they bear the brunt of the cost of doing so). The track record on this is hardly encouraging, however. I predict that the likelihood is that Trump’s actions will not materially reduce imbalances in the trade playing field, and that as a result they will be highly detrimental to the US economy–including the sectors which Trump claims to champion.

When Trump was a candidate, I was highly critical of his views on trade, e.g.:

Perhaps to give him more intellectual credit than he deserves, Trump is a died-in-the-wool mercantilist who believes trade is a zero sum game, and who favors protectionism and beggar-thy-neighbor currency policies. He talks like it is the late-80s, and Japan is still an economic juggernaut that will overwhelm the US, completely overlooking the fact that Japan’s crypto-mercantilist policies gifted it a 25 year long lost decade, and that neo-mercantilist China is on the brink of the same fate. If it is lucky.

and:

What is bizarre is that the sin of “giving our industrial markets to the Japanese” was somewhat dated by 1999, but Trump pounds on that theme today, when it is well past its sell date. Decades past. Just yesterday, in  Greenville, SC, he said something to the effect that “the Japanese are up here [holding his hand over his head] and we are down here [holding his hand by his knee].” Fact: Japanese per capita GDP is $36K, and US per capital GDP is exactly 50 percent higher, at $54K. But facts don’t matter. The image of Japanese domination (now accompanied by the image of Chinese domination) resonates intensely among Jacksonians.

I was hoping that he would not act on these impulses, or that he would be constrained from doing so. No such luck. Impulsive ignorance has won out.

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September 9, 2017

The Rosneft “Privatization”: The Farce Continues

Filed under: China,Commodities,Energy,Politics,Russia — The Professor @ 3:32 pm

The Rosneft deal involving Qatar and Glencore, announced with such fanfare in December, and commemorated with Putin awarding medals a few months later, has been undone. A Chinese conglomerate, CEFC (not exactly a giant name in the energy business) has agreed to invest $9.1 billion. As a result, Qatar’s stake will fall by more than half to less than five percent. Glencore, which notionally owned half of the nearly 20 percent stake sold in December, but which went to great pains to point out that it was at risk to the tune of a mere $300 million, will retain only .5 percent of Rosneft. The Italian bank which funded the deal, Intesa, will be paid off and exit the transaction. And as Ivan Tkachaev notes in RBC, it also lets the heretofore unknown Russian banks who provided guarantees to Glencore (and perhaps provided some funding too, given the gap between the price of the deal and the contributions by Intesa, QIA, and Glencore) to eliminate their exposure to Rosneft. (Exposure that Rosneft/Sechin/Putin never admitted, and which was allegedly not supposed to exist in this “privatization.”)

Like the original transaction, this one raises many, many questions. And like the original transaction, no doubt few (if any) of these questions will be answered.

The most notable issue is that the transaction clearly was not done at a market price. The amount invested exactly pays off the Intesa loan, plus about $100 million to cover costs and fees: it would be miraculous if a market-price deal exactly paid off existing loans. Thus, the deal was clearly done to save Intesa from its predicament, which was quite dire given that it could not syndicate the loan, and its association with the deal put the banking some sanctions-related binds.

Further, the deal is a boon to Qatar, which is embroiled in a standoff with the Saudis and the rest of the GCC, and which has suffered some economic difficulties as a result. The deal helps its balance sheet, which was under pressure due to the economic conflict. Further, Qatar needs all the friends it can get right now, and being a major investor in Rosneft did not help its relations with the US.

Not only was the deal not at a market price, it is highly likely that the Chinese overpaid. The price was at a 16 percent premium to the average of Rosneft’s stock price over the previous month. It is extremely rare to pay a premium, let alone that big a premium, for a minority passive stake–especially in a country where minority investors are routinely raped. (And Sechin is a multiple offender in this regard.) Indeed, most such deals are done at a discount, not a premium.

Note that the original deal was at a discount, and Putin explicitly acknowledged it was at a 5 percent discount. He claimed it was the “minimum discount,” but it was a discount nonetheless.

The Chinese are not notorious for overpaying. Thus, it is almost certain that there is some side deal that makes the Chinese whole. Or better than whole. The side deals could be in the form of cash payments from Rosneft (or maybe even Qatar), but I consider this the least likely. Instead, CEFC could obtain oil at preferential prices from Rosneft, or provide financial services to the Russian company at above market prices.

Ivan also reminds me that just days before the CEFC purchase, Rosneft and the Chinese company announced a “Strategic Cooperation Agreement and a contract for the supply of Russian crude oil at the 9th BRICS summit.” Rosneft describes the oil contract thus:

Rosneft and CEFC signed a contract for the supply of Russian crude oil, opening up new opportunities for the strategic partnership. This contract will lead to an increase in direct supplies of crude oil to the strategic Chinese market and ensure a guaranteed cost-efficient export channel for the Company’s crude sales.

Price is not mentioned, but this could provide a mechanism that would allow Rosneft to compensate CEFC for any overpayment on the purchase price of the stake. (Recall that Russia obtained funding for an oil pipeline to China by contracting to deliver oil at discounted prices.)

Again, we will likely never know the details, but there has to be more to this deal than meets the eye.

Here is how the investor describes its business:

In recent years, CEFC China has been accelerating its strategic transformation, focusing on building an international investment bank and an investment group specialized in energy industry and financial services, which has helped boost the Company’s sustained rapid development. The Company has under it two group companies at management level, 7 level-one subsidiaries as investment platforms and an A-share listed company, with a workforce of nearly 30,000.

Underpinned by its European oil and gas terminals, CEFC China secures its position by obtaining upstream oil and gas equities and interests, building professional teams of finance and independent traders and providing financial support with a full range of licenses. The profits in the financial and logistics sectors are driven by its energy operations and financial services. In addition, CEFC China has set up its second headquarters in the Czech Republic to conduct international banking businesses and investment, and acquired controlling shares in banks and shares in important financial groups with its investment focusing on airline, aircraft manufacturing, special steel and food, in order to facilitate international cooperation in production capacity.

Hardly a major oil player, and certainly not a strategic investor that brings to Rosneft any technical expertise or access to upstream resources outside Russia. It’s just a supplier of cash. And as such, and as one that is providing cash to help previous Rosneft investors/lenders get out of a sticky wicket, you can be sure that it got a pretty good deal. Thus, like so many Russian transactions, the interesting action is not that which takes place in plain sight, but that which takes place behind many screens and curtains.

Although Sechin now boasts that Chinese investors are always the ones he wanted, that’s not what he–and notably Putin–said in December and January. Then they were saying how the participation of a noted western company–Glencore–put a stamp of legitimacy on the deal, and showed that Russia was an attractive place for western companies to invest.

Well, Glencore never really invested anything substantial in the first place: if there was any doubt back in December and January that this was a Potemkin privatization involving western companies, there should be no doubt now. And of course, Glencore comes out a huge winner in this. The company earned a lot of goodwill from Putin and Sechin for saving them from the embarrassing situation that they faced in 2016, with a privatization deadline looming and no investors in sight. More tangibly, Glencore obtained–and retains after this deal–a lucrative concession to market Rosneft barrels. It took on very little risk in the first place, and has very little risk now. Glasenberg received a seat on the Rosneft board, and apparently retains it, even though Glencore’s equity stake is now trivial. And Ivan gets to keep that totally cool Order of Friendship medal.

But he better not fall in with the “wrong crowd,” like previous recipient Rex Tillerson, whom Putin is now very sore at! But since I doubt Ivan has any prospect or interest in becoming a diplomat, that’s probably not going to happen. Ivan knows a good deal when he sees one. And this deal was very, very good for him and Glencore.

For Rosneft and Russia, I’m guessing not so much.

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July 26, 2017

Europe Has Always Been at War With the Diesel Engine!

Filed under: China,Climate Change,Economics,Energy,Politics,Regulation — The Professor @ 7:26 pm

Europe is at war with the diesel engine. Paris, Madrid, and Athens will ban diesels starting in 2025. Even Stuttgart (home of Daimler and Porsche) and Munich (home of BMW) are following suit. France and Britain have pledged to eliminate internal combustion engine cars by 2040.   The cars–diesel in particular–are too polluting, you see. And so the Euros are intent on replacing them with electric vehicles.

Europe has always been at war with diesel!

Um, not really. Like Oceania and East Asia, Europe and diesel were once fast allies. In its early days of the fight against climate change, Europe figured that since diesel engines burn fuel more efficiently than gasoline ones, they could reduce carbon emissions by forcing or inducing people to switch to diesel. They gave tax breaks and incentives that led to 1/3 of the European car fleet being diesel.

Then reality crept in. Diesels create more particulates, which create nasty pollution, particularly in urban areas. The Euros thought they could address this by strict emissions standards. So strict, that auto companies couldn’t meet them economically. So they lied and cheated. Brace yourself: even morally superior German companies lied and cheated! So Europe bribed people to pollute their cities. Well played!

Further, even by its own objectives the policy was a failure. Even though diesel has lower CO2 emissions, it has higher soot emissions–and soot contributes to warming. Whoops! Further, the CO2 advantage of diesel has been narrowing over the years, due to improvements in gasoline engine technology. So at best the impact of diesel on warming has been a push, and maybe a net bad.

But never fear! The same geniuses who forced diesel down Europe’s throat have a solution to the evils of diesel: they will force electric cars down people’s throats.

What could possibly go wrong?

Well, off the top of my head.

First, in the near term, a good portion of electric cars will be powered by electricity generated by coal. This is especially true if China goes Europe’s way.

Second, the green wet dream is for renewables to replace coal. Don’t even get me started. Renewables are diffuse and intermittent–they don’t scale well. They have caused problems in the power grid wherever (e.g., Europe, California) they have accounted for over 10 percent or so of generation. They consume vast amounts of land: air pollution (if you believe CO2 is a pollutant) is replaced by sight pollution and the destruction of natural habitat and foodstuff producing land. Renewables are a static technology (e.g., the amount of wind generation is limited by physical laws), whereas internal combustion technology has been improving continuously since its introduction in the 19th century. Really economic renewables generation will require a revolution in large-scale storage technology–a revolution that people have been waiting for for decades, but which hasn’t appeared.

Third, disposal of batteries is an environmental nightmare.

Fourth, mining the materials to produce batteries is an environmental nightmare–and is likely to benefit many kleptocrats around the world. Are greens really all that excited about massive mines for rare earths (notoriously polluting) and copper springing up to provide the materials for their dream machines? Will they pass laws against, say, blood cobalt? (And when they do, will they acknowledge–even to themselves–their culpability? Put me down as a “no.”)

Fifth, depending on the fuel mix, carbon emissions over an EV’s lifetime are not that much lower than those of an internal combustion car using existing technology–and that technology (as noted above) will improve.

Like I say, top of my head. But there’s an even bigger reason:

Sixth, unintended consequences, or more prosaically, shit happens. Just like the diesel box of chocolates was full of things the Euro better thans didn’t expect, and didn’t like upon consuming, the EV craze will also present unintended and unexpected effects, and in this type of circumstance, these effects are usually negative.

But they know better! How do we know? Because they keep telling us so! And because they keep telling us what to do!  Despite the fact that their actual record of performance is a litany of failures. (I cleaned that up. My initial draft had a word starting with “cluster.”)

Given such a track record, people with any decency would exercise some restraint and have some humility before embarking on another attempt to dictate technology. But no, that’s not the elite’s way. That’s not the bureaucrats’ way. They have learned nothing and forgotten nothing and will continue to prove that until someone stops them. Sadly, short of revolution it’s hard to see how that can happen.

Almost all attempts by states to dictate technology are utter fiascos. The knowledge problem is bigger here than anywhere, and the feedbacks are devilishly complex and hard to predict. Look at something seemingly as prosaic and well-understood as the production of oil and gas. Ten or twelve years ago, only a few visionaries glimpsed the potential of fracking, and I doubt that even they would admit that they foresaw the transformation that has occurred. Trying to dictate a technology that is dependent on myriad other technologies, and which may be rendered obsolete by technologies not yet developed, is something that only fools do.

But alas, there are many fools in high places.

The Orwellian switch from Europe and Diesel Have Always Been Allies to Europe Has Always Been at War With Diesel is particularly revealing because rather than recognize that the experience of Europe’s pro-diesel policy makes a mockery of policymakers pretenses of foresight, the failure of that policy is spurring them to embark on an even more speculative binge of coercion!

If you think CO2 is an issue, tax CO2 and let the market figure out the optimal way of reducing emissions: there are many margins on which to adjust, including technical innovation, fuel substitution, changes in lifestyle. Yet these madmen (and women) and fools insist on dictating technology right after their past dictates have proved failures. Worse than that: they are issuing new ukases because their old ones were crashing failures.

We are in the best of hands.

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June 2, 2017

Trump Rejects the Climate Gateway Drug: Global Progressives Go All Spanish Inquisition

Filed under: China,Climate Change,Economics,Energy,Politics — The Professor @ 7:00 am

The wailing, gnashing of teeth, and rending of garments that has followed Trump’s widely expected decision to withdraw the US from the Paris Climate Accord is truly amazing to witness. It is virtue signaling taken to a new extreme. Indeed, since so many people want to signal simultaneously, each apparently feels obliged to outdo the other in hysterics in order to attract the attention their precious egos crave. Hence the apocalyptic paroxysms of rage that started the moment Trump spoke.

Truth be told, even if one believes the predictions of standard climate models, and even if one believes there will be compliance with the commitments of the Accord (which is slightly less likely than my becoming Pope), it would have a trivial impact on global temperatures: on the order of .2 degrees. The impact of the US withdrawal alone, given its declining CO2 emissions relatively (especially compared to China and India) and even absolutely (something the pious Europeans have not been able to manage despite their moribund economy and costly—and insane–commitment to renewables), means that Trump’s action by itself will have an immeasurable effect on climate in any time frame.

So despite all of the screeching that Trump has doomed—doomed I say!—life on earth, in reality the accord is not a practical agreement, but a ritual. And like all rituals, its primary purpose is to provide an opportunity to display obeisance to a creed, theology, doctrine, or dogma.

Which explains the overwrought reaction: those rejecting creeds, theologies, doctrines, and dogmas are heretics, and heretics must be attacked, ostracized, ridiculed, and in the dreams of some, burned. Trump is accused of heresy on three counts — heresy by thought, heresy by word, heresy by deed, and heresy by action — four counts! Yet he does not confess, and indeed revels in his heresy, only infuriating his inquisitors all the more.

There is much dispute over the concrete effects of Paris qua Paris. Some claim it is merely symbolic. Others claim that it will lead to real policy changes. Whatever the practical effects, there is no doubt about the ambitions of those pushing Paris, and Trump rejected them all. He rejected the delegation of authority over the United States to an unelected and unaccountable (self-perceived but actually utterly failed) elite. He rejected the exploitation of climate concerns to implement a vast scheme of international wealth redistribution.

And perhaps most importantly, he called out, confronted, and rejected the role of Paris as a gateway drug to even more intrusive supranational elite control and power:

The risks grow as historically these agreements only tend to become more and more ambitious over time.  In other words, the Paris framework is a starting point — as bad as it is — not an end point.  And exiting the agreement protects the United States from future intrusions on the United States’ sovereignty and massive future legal liability.  Believe me, we have massive legal liability if we stay in.

Absolutely. Climate concerns (hysteria, really) have become an engine for rent seeking and power grabbing on a global scale never seen before, and it needs to be throttled in the crib. For it is evident from years of experience how the leftist-statist-dirigiste march through the institutions works. Stake out a modest set of policies to achieve a lofty goal. When the policies fall short, impose more draconian ones. When those policies in turn fail, unleash more bureaucratic dragoons to intrude on every aspect of institutional life. And in this case, the institution at stake is the world. Better to stop it now, then to watch it metastasize later.

The reaction has been predictable. Corporate rent seekers—Goldman Sachs’ Lloyd Blackfein, GE’s Jeffrey Immelt, and our favorite among them Elon Musk—have expressed their rage and dismay. Political power seekers, the Euros most notable among them, are beside themselves.

The Euros are particularly amusing. After Trump spurned them, they are now looking to China’s Xie for climate policy leadership, just as they did on “free trade” at Davos. Daddy didn’t give them what they wanted, so they are throwing themselves into the arms of the leader of a biker gang. That will show that meanie, harrumph!

That won’t end well, and don’t bother come crying to us when it doesn’t! China is a mercantilist environmental disaster that will pump out increasing quantities of CO2 for the foreseeable future. China is in this for China, and will exploit climate policy to advance its economic interests while paying lip service to green pieties. Only the willfully self-deluded refuse to see otherwise.

The economic costs of any actual implementation of Paris promises would have dwarfed any benefits accruing to its effects on climate. Force-feeding of renewables will increase energy costs, thereby impairing growth—which will have a disproportionate effect on the poor. Taxes to fund global wealth transfers will have similar effects: and if you think that money transferred to poor countries is going to go to the poor, rather than sticky-fingered elites, you are truly a fool.

So Donald Trump has said we’ll never have Paris. And that’s a damn good thing. Arguably the best thing he’s done—and the shrieking of global progressives is about the best proof of that I can think of.

 

 

 

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April 9, 2017

Down the Syrian Rabbit Hole

Filed under: China,History,Military,Politics,Russia — The Professor @ 12:15 pm

The Syria story has many threads. I’ll address a few of them here.

First, to follow on Ex-Regulator’s comment: Trump’s initial public justification for the strike–the humanitarian impulse stirred by pictures of dying children–is deeply troubling. Sentimentality is a poor basis for policy. In particular, it has no limiting principle. If you take a tragic view of humanity–if you view mankind as fallen and flawed–you know that there is a virtually unending supply of sad, heartbreaking, stories. So how does a president choose which appeal to answer? And how do people know which appeals he will answer? Truth is, we have no idea. The line will be arbitrary, which leads to unpredictable, inconsistent policy.

Further, as Ex-Reg notes, by emphasizing his susceptibility to sentimentality, Trump makes himself a target for manipulation. These manipulations are likely to include false flags whereby those attempting to get the US to intervene on their side create an outrage to pin on their opponents: it cannot be precluded that this occurred in Syria last week.

Second, in subsequent remarks by others than Trump, the administration has downplayed the humanitarian aspect, and emphasized the signaling motivation. Moreover, it has explicitly stated that the signal was not directed at Assad alone, or even Putin and Assad, but also at Kim Jung Un and the Chinese.

My concern here is the Rolling Thunder problem: the signal that you think you are sending through a limited use of force is not necessarily the signal that your intended audience hears. What happened in Vietnam during the Johnson years was that graduated escalation was interpreted by Ho Chi Minh et al as weakness, and as an unwillingness to take decisive action. Assad or Kim Jung Rolly Poly may conclude that they can easily absorb a strike like the one launched Thursday night, and that Trump may not be willing to go much further. Or, they may conclude that (a) this strike was so modest, (b) Trump is likely to engage in graduated escalation if he escalates at all, and (c) they can absorb much heavier blows. Either way, they could be encouraged, rather than deterred.

Lesson from Vietnam (pun intended): if you want to achieve a decisive outcome, Linebacker trumps Rolling Thunder.

Of course, one reason for Johnson’s reticence in Vietnam was the risk of drawing in the USSR or China. That’s obviously an issue in Syria and North Korea. But if that is the real concern, don’t even start down the road with a limited strike. If you do, eventually you will pull up short and look feckless.

Third, the administration is sending extremely mixed signals. Last week, Tillerson said point blank that regime change was not on the administration’s agenda. This morning, Nikki Haley intimated that it is. Given that no matter how horrid the Assad regime any successor is likely to be as bad or worse, that regime change is even on the table is highly disturbing.

Fourth, assessing whether the chemical attack was a false flag or a regime attack requires an evaluation of the plausibility that Assad would do such a thing. As Dearieme and Ex-Reg note, and as I noted initially, it does not seem rational for Assad to have taken this action. It certainly was not a military necessity. But people like Assad think differently, and there may be some Machiavellian reason for him to take this action.

One is that he, like everyone else, is trying to fathom Trump’s policy, and Trump himself. Therefore, Assad ran a calculated risk to see how Trump would respond to a pretty extreme provocation. As suggested above, he might be pleased with the answer (contrary to DC conventional wisdom).

Another is that he needed to bind Russia and Iran closer to him. Again running a calculated risk that they would stand with him rather than abandon him (for that would call into question their previous policy of support), he launched this attack and forced them to be complicit in a very inflammatory war crime.

Relatedly, one of Assad’s big fears has to be a rapprochement between Russia and the US that would make him expendable. The Russians had guaranteed that he had eliminated chemical weapons. That guarantee is now shown to be inoperative, either due to (as Tillerson said) deliberate deception or incompetence. Regardless, now no deal with the Russians regarding Assad can be considered credible. This reduces the risk that the Russians will be able to cut a deal with Trump that makes Assad expendable.

I have no idea whether these possibilities are realities. I just put them out there to highlight that there can be twisted motives that cause people like Assad to take actions that seem to be against their interest–just as there can be twisted motives for jihadis to kill their own in horrible ways.

Fifth, Occam’s Razor would say that Trump’s attack completely undercuts the narrative that he is Putin’s bitch. But Occam’s Razor is an alien concept in the fever swamps of the left. The certifiably insane (Louise Mensch) and the hyper partisan but supposedly sane (Lawrence O’Donnell, Chris Matthews) certain have never shaved with it. They are claiming that this proves Trump is Putin’s bitch! The “reasoning”? He is doing it because the most likely interpretation is that it shows that Trump isn’t Putin’s bitch, so that means that he is! Or something.

In other words, this lot interprets everything that Trump does as evidence of his collusion with the Russians. This means that the hypothesis that he is in collusion with Putin is unfalsifiable, and hence is junk reasoning. It should therefore be rejected, as should anything that those who espouse this theory say.

Lastly, the attack is a complete embarrassment to the Obama administration, which preened and bragged that it had rid the Assad regime of chemical weapons. All of the administration weasels–Susan Rice, Ben Rhodes, Colin Kahl among them–have been quick to defend the administration. Although Obama remains silent, their voices were joined by the next most authoritative one–John Kerry–who ranted against the airstrike. He claimed that the Obama administration had accomplished MUCH more without firing so much as a shot, and that Trump’s attack will undermine all of the great progress that had been achieved.

But watch the weasels’ weasel words. They all say that the 2013 agreement eliminated all of Assad’s declared chemical weapons. Um, the criticism of the deal all along was that Assad might have undeclared stocks, and hence might retain a chemical capability despite the deal. It is beyond embarrassing that these people would protest so stridently that their deal was great in the face of an event which most likely shows that it was a complete, and completely predictable, sham.

So is Kerry’s outraged response to the Tomahawk Chop delusional? Chutzpah? I’m going with delusional chutzpah.

It’s almost tax time. So I suggest that you implement the following strategy, and cite the authority of John Kerry as justification. Report 50 percent of your actual income on your 2016 1040. When the IRS comes after you, tell them–in high dudgeon: How dare you! I paid all I owed on my DECLARED income! Good luck! I’ll write you in jail!

The alternative explanation for the chemical attack–a false flag–hardly provides any cover for Obama and the Obamaites because that would mean that the chemical attack was launched by opposition forces that the administration supported. So, either the administration entered into a farcical deal, and was played the fool by Assad, or it was played the fool by anti-Assad forces whom it had supported.

People with any decency would don sackcloth and ashes and plead forgiveness. But we are talking about the Obama administration, so  . . .

Perhaps there will be more clarity on all these issues in coming days and weeks. But I kind of doubt it. Any venture into understanding Syria is a trip down the rabbit hole. And given the depravity of all the actors involved, that’s yet further reason to stay as far away from this mess as is humanly possible.

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April 7, 2017

Trump, Putin, and the Tomahawk Chop

Filed under: China,History,Military,Politics,Russia — The Professor @ 9:14 pm

President Trump ordered a cruise missile strike on a Syrian air base that was allegedly the launching point of a sarin attack on a town in the Idlib  Governate. My initial take is like Tim Newman’s: although the inhumanity in Syria beggars description, getting involved there is foolish and will not end well.

The Syrian conflict is terrible, but Syria makes the snake pit in Indiana Jones and the Temple of Doom look hospitable.

Further, the politics of Syria (both internally, and in the region) make the intrigues of Game of Thrones seem like child’s play by comparison. So I agree with Tim:

Every course of action I can think of other than “fuck ’em” has an almost zero chance of succeeding in its aims and a very high chance of making things worse.

. . . .

It’s not through moral principle that I am saying this, it is from practicality based on fourteen years of recent, bloody experience: Assad is a monster, the Russian government is showing the world exactly what they are like by backing him, and the Syrian people are suffering terribly, but there is nothing – nothing – we can do about it. It is a terrible indictment on the state of the world, but a policy of “fuck the lot of ’em” is the only workable one on the table right now. It’s high time our leaders started taking it seriously.

To put it slightly differently. Good intentions mean nothing. Results and consequences do. I am at a loss to think of any policy with results and consequences that accord with good intentions. Indeed, it almost inevitable that any major military intervention would not save Syrian lives but would cost American ones.

Truth be told, given the devastation wreaked on children, women, and men in Syria by bombs, shells, small arms and even throat-slashing blades, chemical weapons do not represent a quantum shift in the horribleness of the Syrian war. Dead is dead, and periodic use of chemical weapons does not materially affect the amount of dying that is going on. Assad–and the Islamists he is fighting–have killed and maimed far more innocent civilians with conventional weapons than with chemical ones.  The use of chemical weapons does not represent a fundamental shift in the nature of the war, which was already a total war waged without restraint against civilians by all sides (would that there were only two sides in Syria).

Insofar as Trump’s action is concerned, it is best characterized as a punitive strike. And as punitive strikes go, it is modest. It bears more similarity to Clinton strikes in Iraq (e.g., Desert Fox) than Reagan’s Operation El Dorado Canyon in 1986, which put the fear of god into Gaddafi: a 2000 pound bomb dropped near one’s tent has a tendency to do that. In contrast, Thursday’s Tomahawk detonations wouldn’t have disturbed Assad’s sleep in the slightest, let alone put him in mortal danger.

The record of such punitive actions in curbing the misbehavior of bad actors like Saddam or even Gaddafi is hardly encouraging, but at least the downside (to the US) of such indulgences of the Jupiter Complex is rather limited. The concern is that the raid turns out to be ineffectual in moderating Assad’s behavior and leads to Trump to escalate, and to make regime change–rather than a change of regime behavior–the objective. The neocons are celebrating and baying for more: that should be a cause for serious concern.

And I don’t think that this was exclusively about Syria, or even primarily so. The Tomahawks might have landed in Syria, but in a very real sense they were aimed at North Korea.  It is significant that Trump launched the attack while Chinese premier Xi was still digesting the steak he had eaten with the president.

Russia is clearly processing the message. The Russians are obviously angered. One would think that this puts paid to the Trump is Putin’s bitch narrative. But that would assume sanity on the part of the left and the Never Trumpers, who are anything but sane.

The prospects for some rapprochement between the US and Russia were already on life support, now they appear to be dead and buried. This reinforces a point I’ve made for months: that if Putin really did think that a Trump presidency would be better for him than a Clinton one, he made a grave miscalculation. This event proves that Trump is predictably unpredictable, and that he is completely capable of a volte face at a moment’s notice. The word I used was “protean”, and the decision to fire off a barrage of cruise missiles after months-years, in fact-of criticizing the idea of American intervention in Syria is about as protean as you get.

This points to a broader message. For all his alleged tactical acumen, Putin has stumbled from one strategic blunder to another. It is highly unlikely that Russian involvement, whatever it was, materially impacted the US election: its impact has been exaggerated for purely partisan and psychological reasons. It is also highly unlikely that any Russian meddling in European elections will sway them in favor of pro-Putin candidates.

But Russia has paid a steep price for these equivocal gains: Russian actions have created political firestorms not just in the US but in Europe that have actually increased Russian isolation. Hysteria in America about Russian meddling in US politics is vastly overblown, and has been ginned up for partisan reasons, but that is irrelevant as a practical matter: it has made the US-Russia relationship more adversarial than it has been since the height of the Cold War, and that works to Russia’s detriment.

His support for Assad in Syria has had similar effects. Yes, Putin achieved his immediate objective: Assad has survived, and looks likely to prevail. But Russia has only cemented its pariah status. The chemical attack makes it even more than a pariah. For what? Syria’s strategic value is minimal.

Indeed, the chemical attack is not just a crime, but a blunder, and puts Putin and Russia in an even worse spot. The action appears so militarily unnecessary and politically counterproductive that like Scott Adams, it raises doubts in my mind as to whether Assad actually ordered it. (The alternative explanations include a rogue general or a false flag carried out by the opposition.) But this is largely irrelevant: Assad is almost universally blamed, and as his stalwart defender, Putin and Russia have been deemed guilty of being accessories to and enablers of what is just as universally considered a war crime. By going all in for Assad, Putin made himself vulnerable to this. (That might provide a Machiavellian motive for Assad’s action: maybe he thought that the chemical attack would bind Putin even more closely to him.)

So by intervening in Syria, and defending Assad even in the aftermath of a widely reviled chemical attack, what has Putin gained? Yes, he had the satisfaction of showing Obama (and in his mind, the US as a whole) to be feckless, all grandiose talk and no action. He could claim to have reversed Russia’s retreat from the Middle East. He could assert that Russia is back and must be reckoned with in world affairs. He apparently experienced great personal satisfaction as a result of these accomplishments.

But viewed more soberly, these gains are more than offset by losses on the other side of the ledger. Russia is isolated, distrusted, feared, and reviled. It’s not entirely fair, but it should have been predictable. Moreover, nothing that Putin has done has improved what the Soviets called the correlation of forces. Indeed, although Russia has rejuvenated its military to some degree, other elements of national power (relative to the US) have slipped since 2008, and a Trump presidency will almost certainly erase the relative change in military power that occurred during Russian rearmament and the American sequester.

The simple fact is that other than in nuclear weapons, Russia cannot compete with the US, let alone the entire west. By achieving limited victories in strategic backwaters like Syria, all Putin has succeeded in doing is goading the US and the west into viewing him as a threat and sparking a competition that he can’t win.

But Putin has staked a great deal on Syria, in terms of both national and personal prestige. He is not the kind of man to back down and lose face after putting down such a stake. For his part, after claiming benign indifference to who rules Syria, the protean Trump has reversed course, and in so doing has put his own reputation on the line over who rules there, or at least how the man who rules there behaves. That is a combustible mix, and I have no idea how it will turn out.

But I am sure of how things will not turn out. Sore election losers’ dystopian fantasy of Trump selling out to Putin will never become reality. In fact, the reverse is more likely. Indeed, this could develop into a reversal of Reagan-Gorbachev. Then, two bitter antagonists found enough common ground to come to an understanding and ratchet down Cold War tensions. Now, two alleged members of a mutual admiration society are likely to find themselves in an increasingly antagonistic relationship, in yet further proof of my axiom that if you want to find the truth, you could do far worse than to invert elite conventional wisdom.

 

 

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March 1, 2017

Ivan Glasenberg: Mistaking Luck for Genius?

Filed under: China,Commodities,Economics,Energy — The Professor @ 8:58 pm

Glencore is back from the brink, posting a $1.4 billion profit for 2016. When I first read about the 2016 results, I wondered aloud to a friend whether Ivan Glasenberg would have learned something from the company’s near death experience, or instead would consider the fall someone else’s fault, and the resurrection the result of his genius. I should have known it would be the latter.

Glasenberg has been gloating about the 2016 results, and flaunting them as some sort of vindication. He is openly musing about paying a $20 billion dividend to the company’s “long suffering shareholders,” and is looking for acquisitions, including in North American grain trading.

The fact is that Glencore and Ivan Glasenberg were (and are) just along for a ride on the commodity price roller coaster, which is located at a Chinese amusement park. When the roller coaster plunged as the Chinese economy shuddered in 2015, Glencore plunged along with it. Now, in large part due to Chinese policy moves that have caused the prices of coal and other raw materials to climb again, Glencore has rebounded. Management genius had nothing to do with it.

Well, that’s not completely true. Glasenberg made the conscious choice to transform Glencore from a trading firm that was basically flat price neutral to a mining firm with a big exposure to the flat prices of coal and copper in particular. So the big drop and the rebound are the result of his choice.

When Glencore was in peril in 2015, I said that its fate was dependent on commodity prices, and hence on Chinese policy, rather than any decision that management can make. I said that Glencore was along for the ride. That turned out to be true. It remains true going forward. That was the fundamental strategic choice that has shaped and will continue to shape its performance. Management can at best optimize performance over the cycle, but the cycle will dominate.

Prior to 2015, Glencore management did not optimize. The firm was over-leveraged: it continued to operate with trading-firm like leverage levels even though it faced bigger commodity price risks. Glasenberg/Glencore have cut down on debt in the past year, and this reduces the likelihood of a repeat of 2015–if they stick to a lower leverage policy going forward. But the fact is that the biggest driver of Glencore’s fate is not decisions made in Baar, but the whims of policymakers in Beijing.

It is interesting to compare Glasenberg’s crowing to the more muted tones of other mining firms which have also profited from the rebound. The managements of these other firms apparently realize that what the cycle giveth, the cycle can taketh away. Is Peabody Coal’s management preening over the company’s rebound? No. They are silently grateful that factors outside of their control have turned their way. Similarly, Noble eked out a profit, but its management isn’t breaking their arms patting themselves on the back.

Traders typically make deals of relatively short duration, and it is possible to evaluate trading decisions and trading acumen based on P/L. But by transforming Glencore into a mining company with a  supersized trading arm, Glasenberg purposefully made a very long term trade with a duration of years (decades, even): quarterly or even annual fluctuations in P/L tell you little about the wisdom of such a trade. It is therefore rather disturbing to watch Glasenberg gloat on the basis of a profitable year driven by a cyclical turn with which he had exactly zero to do with.

And let’s put this in perspective. Glencore lost $5 billion in 2015. 2016 made up less than 30 percent of that loss. There is still a long way to go to determine whether the big, multi-year trade that Glencore made a few years ago was a smart play or not.

Perhaps Glasenberg still has a trader’s mindset, and a trader’s time horizon, suited for a transaction cycle measured in weeks or months, not years or decades. If so, the company might be in for a big future fall, because its guiding light is apt to mistake luck for skill.

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January 24, 2017

Two Contracts With No Future

Filed under: China,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 7:14 pm

Over the past couple of days two major futures exchanges have pulled the plug on contracts. I predicted these outcomes when the contracts were first announced, and the reasons I gave turned out to be the reasons given for the decisions.

First, the CME announced that it is suspending trading in its new cocoa contract, due to lack of volume/liquidity. I analyzed that contract here. This is just another example of failed entry by a futures contract. Not really news.

Second, the Shanghai Futures Exchange has quietly shelved plans to launch a China-based oil contract. When it was first mooted, I expressed extreme skepticism, due mainly to China’s overwhelming tendency to intervene in markets sending the wrong signal–wrong from the government’s perspective that is:

Then the crash happened, and China thrashed around looking for scapegoats, and rounded up the usual suspects: Speculators! And it suspected that the CSI 300 Index and CSI 500 Index futures contracts were the speculators’ weapons of mass destruction of choice. So it labeled trades of bigger than 10 (!) contracts “abnormal”–and we know what happens to people in China who engage in unnatural financial practices! It also increased fees four-fold, and bumped up margin requirements.

The end result? Success! Trading volumes declined 99 percent. You read that right. 99 percent. Speculation problem solved! I’m guessing that the fear of prosecution for financial crimes was by far the biggest contributor to that drop.

. . . .

And the crushing of the CSI300 and CSI500 contracts will impede development of a robust oil futures market. The brutal killing of these contracts will make market participants think twice about entering positions in a new oil futures contract, especially long dated ones (which are an important part of the CME/NYMEX and ICE markets). Who wants to get into a position in a market that may be all but shut down when the market sends the wrong message? This could be the ultimate roach motel: traders can check in, but they can’t check out. Or the Chinese equivalent of Hotel California: traders can check in, but they can never leave. So traders will be reluctant to check in in the first place. Ironically, moreover, this will encourage the in-and-out day trading that the Chinese authorities say that they condemn: you can’t get stuck in a position if you don’t hold a position.

In other words, China has a choice. It can choose to allow markets to operate in fair economic weather or foul, and thereby encourage the growth of robust contracts in oil or equities. Or it can choose to squash markets during economic storms, and impede their development even in good times.

I do not see how, given the absence of the rule of law and the just-demonstrated willingness to intervene ruthlessly, that China can credibly commit to a policy of non-intervention going forward. And because of this, it will stunt the development of its financial markets, and its economic growth. Unfettered power and control have a price. [Emphasis added.]

And that’s exactly what has happened. Per Reuters’ Clyde Russell:

The quiet demise of China’s plans to launch a new crude oil futures contract shows the innate conflict of wanting the financial clout that comes with being the world’s biggest commodity buyer, but also seeking to control the market.

. . . .

The main issues were concerns by international players about trading in yuan, given issues surrounding convertibility back to dollars, and also the risks associated with regulation in China.

The authorities in Beijing have established a track record of clamping down on commodity trading when they feel the market pricing is driven by speculation and has become divorced from supply and demand fundamentals.

On several occasions last year, the authorities took steps to crack down on trading in then hot commodities such as iron ore, steel and coal.

While these measures did have some success in cooling markets, they are generally anathema to international traders, who prefer to accept the risk of rapid reversals in order to enjoy the benefits of strong rallies.

It’s likely that while the INE could design a crude futures contract that would on paper tick all the right boxes, it would battle to overcome the trust deficit that exists between the global financial community and China.

What international banks and trading houses will want to see before they throw their weight behind a new futures contract is evidence that Beijing won’t interfere in the market to achieve outcomes in line with its policy goals.

It will be hard, but not impossible, to guarantee this, with the most plausible solution being the establishment of some sort of free trade zone in which the futures contract could be legally housed.

Don’t hold your breath.

It is also quite interesting to contemplate this after all the slobbering over Xi’s Davos speech. China is protectionist and has an overwhelming predilection to intervene in markets when they don’t give the outcomes desired by the government/Party. It is not going to be a leader in openness and markets. Anybody whose obsession with Trump leads them to ignore this fundamental fact is truly a moron.

 

 

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