Streetwise Professor

FT Alphaville ran a long piece on oil prices, and the forward curve specifically. I guess it’s good that a mainstream outlet delves into such an arcane topic, but it would have been better if they’d done better than a Fractured Fairy Tale treatment.

The piece does a service by pointing out that yes Virginia, there is a forward curve, and as a result there are different prices of oil for different delivery dates (not to mention for different qualities). Furthermore, unlike in say the equity or FX markets, there is no real “spot market” (i.e., market for delivery on the spot/immediately) for oil–or for most commodities for that matter.

The article also rightly recognizes that “the relationship between spot and futures prices in oil, as for most commodities, is actually quite complex.” Where it goes wrong is explaining that relationship.

It starts out by explaining the cash-and-carry (no) arbitrage relationship, and claims that it doesn’t hold in oil markets. Which is correct. But it gets the reason wrong.

It says: “In practice, this is difficult because the institutional structure of oil markets impedes the process where the future price is forced to this equilibrium level through arbitrage.” Further, “[o]ne problem is that physical oil is difficult to short.” And participants in the futures market are diverse: “Another is that the participants in the physical and futures market differ. While they use futures to hedge prices, producers, refiners and consumers need the actual oil. Financial investors use the futures market to simply trade price movements.”

In fact, none of these things explain the departure of the oil forward curve from the cash-and-carry (no) arbitrage model, and in particular the existence of backwardation, which is a facial violation of the model.

My teaching mantra is that futures markets price bottlenecks/constraints in transformation processes. And since the forward curve (and thus calendar spreads) provides intertemporal relative prices, the bottleneck in the forward curve relates to transformations in time. And it is a fundamental one: time travel is impossible.

Backwardation signals that the commodity is expected to be more abundant in the future than it is today. If it were possible, we would like to use a time machine to move the commodity from the future to the present. It’s not possible, however. The best we can do is to NOT move the commodity from the present to the future, which would be like carrying coals to Newcastle. That is, backwardation signals that we should consume the commodity today, not add to storage thereby moving the commodity to the future, and in fact draw down on inventories.

Indeed, it is never optimal for inventories of the deliverable underlying a futures contract to always be positive. Instead, sometimes a “stockout” should occur. That’s essentially what we are observing now in WTI, where Cushing stocks are at “tank bottoms.” (If a stockout never occurred, then there would be stuff that is produced yet never consumed. That is suboptimal).

Formal models describe the mechanism. My book is all about such models.

The book (and books and articles by others, including Wright and Williams, and Scheinkman and Schectman) derives forward curves from dynamic programming models that optimize storage and consumption decisions. And in my models. in particular, forward prices are derived from no-arbitrage principles. Namely, to prevent arbitrage, forward prices are expected future spot prices under an equivalent probability measure. So it’s incorrect to say “actual futures prices for commodities don’t follow arbitrage models.”

They don’t follow cash-and-carry arbitrage models, but such models are applicable only to pure assets–things that are always in positive supply like stocks or bonds–and with zero transactions costs. (Positive transactions costs in stocks and bonds can result in deviations from full carry too). And that’s the key point. Commodities are not pure assets. They are consumables, and as noted above, sometimes it is optimal for the commodity underlying a futures contract (e.g., WTI stored in Cushing, Oklahoma) to be in zero supply. The possibility for a stockout breaks the transactions underlying the cash-and-carry model, which implicitly assumes that inventories are always positive.

So all of the stuff Alphaville says differentiate physical from paper (futures) markets are utterly irrelevant in explaining the forward curve, and deviations from full carry. Instead, it’s all about the fact that commodities are storable consumables, not assets analogous to a stock or a bond.

Alphaville really gets into fairy tale territory when it commits the common error of confusing backwardation as the term is used by traders and market participants, and Keynesian backwardation. Backwardation as the term is used in markets means that a nearby price at time T is above a futures price at time T for delivery after T. For example, when the May 2026 price was above the December 2026 price during April.

Keynesian backwardation is when a futures price is above the expected future spot price at the expiration of the futures contract. This is totally different. An expectation is not a traded price. A futures price is a traded price. So Keynesian backwardation compares a tradable price to a non-tradable one. A backwardation backwardation compares a tradeable price to another tradable price. Moreover, whereas backwardation as used in the markets compares, say, a spot price (or nearby futures price) to a futures price with later expiration, Keynesian backwardation compares prices related to the same point in time–the futures expiration date.

Long story short, a market can be in an actual backwardation and not in a Keynesian backwardation, or in a Keynesian backwardation and not an actual backwardation, or different amounts of backwardations. The concepts are not at all related.

Perhaps the best illustration is that stock index futures can be at full carry (adjusted for dividends), and simultaneously in a Keynesian backwardation. In fact, that’s what you’d expect. Futures prices drift up in a Keynesian backwardation, rewarding the long for taking on risk. If the expected rate of return on the index exceeds the risk free rate (as is definitely true), the index will be in a Keynesian backwardation.

Alphaville does get the gist of Keynes’ argument regarding “normal backwardation” correct:

Keynes’ premise was that the participants in the supply chain have asymmetric risk aversion. Refiners, distributors and some consumers might not hedge, as they can pass on price fluctuations. In contrast, producers incur high upfront capital expenditures and bear greater financial risk from lower prices, encouraging hedging. This gives futures prices a downward bias, with producers willing to sell at a discount to the theoretical futures prices.

That is, there is a short hedging imbalance that puts downward pressure on futures prices (relative to expected future spot) to encourage speculators to go long and absorb the imbalance.

The problem with the “downward bias” conclusion that says that hedging imbalance determines the bias in the futures price is that it is based on an archaic view of asset pricing, and arguably an archaic futures market structure. Keynes implicitly assumed futures markets were not integrated with broader financial markets, and also wrote before modern asset pricing theory showed that the risk premium on a given claim depends on its contribution to the risk of some portfolio (e.g., the market portfolio in CAPM), or its correlation with aggregate consumption, or something of the like. In Keynes’ world, speculators in market X were undiversified, and hence their risk exposure and the compensation they demanded for bearing risk was related to the volatility of the futures price. With much demonized “financialization,” however, the marginal market participant is almost certainly well diversified (e.g., a hedge fund) and hence the risk premium he requires to take a position in market X depends not on price volatility but its covariance with his portfolio, or aggregate consumption, or whatever your asset pricing model of choice tells you.

But again, Keynesian backwardation is about risk premiums, and that’s a different issue from what causes an observable forward curve to deviate from the predications of the cash-and-carry arbitrage model.

Alphaville compounds the confusion by mixing up the concept of convenience yields with Keynesian backwardation: “reflecting the fact that producers are prepared to pay a positive insurance premium (the convenience yield) to protect against unforeseen adverse price movements.” Relatedly, it says: “The level of backwardation can be exacerbated by shortages of stock available for immediate delivery from an adverse supply shock — as in the oil market as during the Iran war — or a positive demand shock. This reflects the ‘possession’ value, as refiners and consumers hoard available stocks as a security measure.” This is basically a convenience yield story: the security provides a flow of implicit benefits.

“Convenience yield” is another of my pet peeves. It was a kludge devised by Kaldor to explain deviations from full carry. He reasoned the future price of stocks is less than the future value of the spot price by the amount of dividends. That is, a cash flow on the underlying asset depresses the futures price. Commodities don’t pay a cash flow, but Kaldor argued perhaps they pay some implicit benefit analogous to a dividend that similarly reduces the futures price relative to the spot price and the future value of the spot price (i.e., the spot price plus financing costs).

Very hand-wavy. And there has never been a coherent model that predicts the existence of such an implicit benefit from the optimization decisions of economic agents in equilibrium. In my book, I show that convenience yield only arises when it is essentially assumed (as a kludge) or in models with magical properties (e.g., inventory lowers production costs even if it is never consumed).

So convenience yield is bad enough, but to mix it together with something unrelated to actual backwardation is really ridiculous.

The article does identify some factors that are associated with backwardation. These are factors that feed into structural, dynamic programming models like those in my book. So Alphaville has identified the correlations, but is clueless on the causal mechanism.

What it comes down to is that the extreme backwardation observed during the hot phase of the Iran War is simply explained using the dynamic programming logic. There was a huge adverse short term supply shock. The supply shock was not expected to last forever. That made oil scarce in the short term relative to what was expected in the longer term, when the supply shock dissipated with the end of the war. Under these circumstances, it was optimal to draw down on stocks. The forward curve moved into an extreme backwardation to incentivize this.

This also relates to another issue that has been discussed lately: why is the 2026 oil shock different than the 1979 oil shock in terms of its economic impact? Because the shocks are different. 1979 represented a structural change in the oil market that was expected to last indefinitely. The 2026 shock was expected to be transitory, and indeed that is apparently the case. Old hotness: shortage of oil. New hotness: impending glut. Persistent shocks have very different effects than temporary ones, again as demonstrated in the book.

One last thing. Alphaville starts the piece with a story about Keynes allegedly having to take delivery on wheat futures, and measuring the King’s College Chapel only to learn that it was not large enough to hold the wheat. Keynes told this story, and it is clearly a joke. Delivery on the futures contracts was in store. That is, Keynes received warehouse receipts giving him ownership of wheat in a warehouse. He could have kept it there, as long as he paid storage. No sacrilege required.

But what is revealing is that Saint John Maynard was a welsher: “Keynes cleverly avoided the problem by objecting to taking delivery on quality grounds.” The problem wasn’t finding a place to store the wheat delivered to him. Keynes just didn’t want to take on the obligations (namely paying storage) that delivery entailed. Not clever: commercially disreputable.

And that wheat was ever delivered to Keynes was either the result of his choice or negligence. He could have avoided this problem by selling his futures prior to the delivery period. Did he choose not to do so, then regret the consequences? Or did he have a brain cramp and forget? Either way, he should have manned up, rather than weaseled.

The interwebs are all ablaze with the news that Chinese oil demand has collapsed, and that this is why the rise oil prices has been moderate as compared to expectations, given the size of the supply shock.

No no no no no no no (repeat ad infinitum).

Chinese quantity demanded has fallen. That’s a movement along a demand curve. “Demand has fallen” is an inward shift in the demand curve. Very, very different.

If this seems pedantic: (a) it isn’t, because it is an important distinction, and (b) whatever–it’s a pet peeve precisely because I see this mistake over and over and it leads people to extremely erroneous conclusions.

The unexpectedly large decline in Chinese oil consumption (not demand) means that Chinese demand has turned out to be far more elastic than anticipated. That is, the demand curve is flatter than had been believed.

Note that a more elastic Chinese demand curve translates into a more elastic world demand curve for oil than previously believed, especially since China represents such a large fraction of world consumption. This, in turn, means that the price effect of the supply shock due to the closure of Hormuz has been far less severe than had been anticipated.

It’s interesting to ponder why Chinese demand is apparently so elastic, and why analysts apparently didn’t realize how elastic it is.

The Slutsky equation breaks down demand elasticity into two parts, a substitution effect and an income effect. The income effect is the product of expenditure share and income elasticity. So goods that account for a large share of consumption expenditure have large elasticities, ceteris paribus. Similarly, more income elastic goods are more price elastic. So high expenditure shares or income elasticity could be part of the story.

Furthermore, the demand for oil is a derived demand–it depends on the demand for final goods produced with oil, and the supply curve for transforming oil into final (or at least further downstream) goods. Meaning that elastic final goods demand and/or more elastic transformation supply curves contribute to elastic oil demand. With respect to China, the overcapacity situation can make supply elastic and contribute to demand elasticity.

With respect to why analysts seemingly underestimated Chinese demand elasticity, I wonder if they really seriously consider it at all. Elasticities are hard to calculate, and that would be especially true in China given the dodginess of its data and the distortions in the pricing system. And the fact that analysts so frequently refer to changes in Chinese consumption as changes in Chinese demand suggests that many of them operate under the all-to-common confusion of the two, and hence don’t even think about elasticity.

There are also the usual econometric difficulties, namely identification problems–which is all about separating the effects of demand shifts from the effects of movement along the demand curve caused by supply shifts.

Sometimes the best way to estimate elasticities is a natural experiment. And that’s exactly what the Iran War has created. A sudden shock to supply with no simultaneous shock to demand allows one to trace movements along the demand curve. And that’s what Hormuz is allowing us to do now.

The elasticity issue might explain the administration’s apparent nonchalance over oil prices. No doubt pre-war within the administration the effects of a supply disruption were modeled. If those doing the modeling had a fairly accurate estimate of Chinese demand elasticity, they would have concluded that the economic fallout would be far less than widely feared. This would have emboldened Trump to proceed, and explain the administration’s what-me-worry attitude and we-can-wait-this-out approach. Relatedly, it means that the impact of the blockade on Iran is a far more pressing issue for it than is the impact of the closure on the US.

The fact that China appears to be the main loser is also a plus from the US perspective.

In order to understand what has transpired, it is necessary to adopt the right analytical framing. Confusing consumption/quantity demanded with demand is the wrong framing, and leads to incorrect conclusions. Elasticity of demand is the right framing. So ignore anyone who writes or says “Chinese oil demand is plunging” or when the supply shock reverses “Chinese oil demand is soaring.” What is really going on is the consumption moves along the demand curve. Meaning that the main analytical challenge is to understand the slope (elasticity) of that demand curve, and why it is the way it is.

When the US Treasury torpedoed Gunvor’s bid to buy Lukoil’s international assets, it was the occasion for “serious self-reflection” within the company. Today, a few weeks later, that “self-reflection” resulted in action: the exit of Torbjörn Törnqvist from the company, and the sale of his 86 percent stake to a “management-led” group of insiders. Tellingly, Törnqvist’s family was also shown the door–most notably his son Fredrik whom he viewed as a successor.

In my earlier post on the implosion of the Lukoil deal, I wrote that the Treasury’s plan was “to put the squeeze on Gunvor, because it views the company as Putin’s cats’s paw as long as Törnqvist is in charge.” Today’s developments are consistent with that, and with a continuing squeeze that led him to self-reflect himself into retirement. The suspected cat’s paw has been amputated.

I wonder what-and/or who-persuaded him.

The company named an American, Gary Pederson, as the new CEO. That is not a coincidence, comrades.

Financial terms have not been disclosed. It would be very interesting to learn the price and the financing. Would the US want Törnqvist even as a creditor of the company? And have no doubt: it is the US that has the whip hand in what is going on here.

From the outside it is impossible to assess the justice of the US’s actions, and the accuracy of its suspicions. But they are what they are, as are the consequences. Namely, that there is no doubt that Gunvor is out of Russia’s orbit, and firmly within that of the US.

The FT has a long article about the aborted Gunvor purchase of Lukoil International. It adds a few interesting details.

For one, the orders to squelch the deal came from the upper levels of the Treasury, most likely Scott Bessent himself: “As Gunvor’s offer inched through a half-functioning bureaucracy [due to the shutdown], the decision to kill it came down from high up in the Treasury, according to two people familiar with what happened.”

No doubt because the structure of the deal made it look for all the world like Gunvor was merely a straw buyer, or a parking spot: “A banker briefed on the Lukoil proposal said Gunvor planned no upfront payment and did not need additional financing. Instead, profits would be placed in escrow until sanctions were lifted.”

Uh-huh. The company would remain intact, managed by another company without the expertise or experience to do so (even “Törnqvist admitted Gunvor might not be the natural owner for such a wide portfolio”), with the profits socked away until the day sanctions disappeared. Totally makes sense!

So what was in it for Gunvor?

And the company could be sold right back to Lukoil when sanctions disappeared. Oh yeah, Törnqvist insisted “there was no path for Lukoil to buy back assets spanning the globe that it had spent decades acquiring.”

Sorry, but “no path, swearsies!” doesn’t cut it. If there was a path to sell it kit-and-kaboodle, and it remained intact kit-and-kaboodle in the Gunvor parking lot, there would be a path to buy it back kit-and-kaboodle.

The US’s action has also cast a taint on Gunvor that will hang over it for the foreseeable future. One bank (Santander) withdrew from participating in a financing facility for Gunvor. Others are sticking, but one told the FT that it would “review new financing in a way we wouldn’t have previously.” I bet they will. In fact, every bank will look at Gunvor with the understanding that Uncle Sanctions is looking over their shoulder.

And no doubt that is part of Treasury’s plan. To put the squeeze on Gunvor, presumably because it views the company as Putin’s cat’s paw as long as Törnqvist is in charge.

The FT says “At Gunvor, the shock of the past week has given way to ‘serious self-reflection’ according to one person with knowledge of the situation.” There’s a lot to reflect on.

Törnqvist had to know the risks he was running. That given the structure of the deal, with all the profits going into escrow, there was little in it for his company, and this would be evident. Yet he did it anyways. Which suggests that he was effectively compelled to do so.

The vibe I get comes from the Godfather, with in the role of the undertaker Bonasera and Putin playing Don Corleone:

Due to the US sanctions on Lukoil, that day came. But Gunvor could not provide that service, because an even more powerful Godfather stood in the way.

I’m baaaccckk. Posting pause due to travel (which I’ll write about in my next post) and a pressing expert report deadline.

The biggest news event of interest to me during the hiatus was the agreement for Gunvor to buy the non-Russian assets of the just sanctioned Lukoil, and the early term abortion thereof, with Treasury Secretary Scott Bessent administering the abortifacient. Sort of a reverse of the Anchor Man meme:

It was surprising, not to say shocking, to read of the announcement of the Gunvor-Lukoil deal. It raised many questions.

For one thing, this was a minnow trying to swallow a whale. With a book value of around $6.5 billion, Gunvor was trying to acquire assets worth between 3 and 4 times as much.

Which meant that Gunvor would have needed to raise substantial financing. When the deal was announced, no mention was made of this.

And seriously, what non-Russian bank would want to touch this? Or was it thought that some Middle Eastern SWF be willing to step up? Even that is a stretch. Nobody wants to attract the attention of a sanctions-happy US.

Strategically it would have created a beast somewhat unique in the energy trading world. Lukoil, with significant upstream and downstream assets as well as a largish trading operation, is more analogous to Shell, BP, Total, and the like than it is to a trading firm. Yes, trading firms (e.g., Vitol, Trafigura) have become asset heavier, but the contemplated acquisition would have turned Gunvor into a privately owned, very asset heavy company very different from its peers. There would have been a serious mismatch between ownership structure, capital structure, and asset structure.

There’s also a serious question about the ability of Gunvor to manage such an enlarged, and much more complicated, organization. Torbjörn Törnqvist has not demonstrated that expertise, and in any event, he is 72 and a management transition is on the horizon. He is trying to groom his son for the role, but he obviously has even less experience.

Given all the very serious questions about the deal, one is led to wonder why it was even attempted. The most benign interpretation is that it matched a desperate seller to an opportunistic buyer wanting to do something unprecedented.

A less benign, and probably more accurate, interpretation is that Törnqvist was acting as the Kremlin’s cat’s paw. That is, Putin wanted to retain control over the assets, and therefore wanted them to go into friendly hands that he could control, at least to some degree.

Gunvor’s Russian roots are well known. The sanctions against Gennady Timchenko, former co-owner of Gunvor, in 2014 created an existential crisis which Törnqvist successfully navigated. (Though the details of how he did so remain obscure). With the exception of the Ust Luga port asset Gunvor had shed its Russian assets. The company claims complete independence.

But there is a history of deep connections. And Törnqvist’s second (current) wife is Russian, and continues to operate an environmental NGO in Russia. Further, given the opacity of the commodity trading world generally, and the Russian commodity trading world specifically, it is always reasonable to suspect that subsurface connections still remain, and that Russia has leverage over Gunvor and Törnqvist.

The US Treasury Department certainly thinks so, and said so bluntly when it torpedoed the deal.

President Trump has been clear that the war must end immediately. As long as Putin continues the senseless killings, the Kremlin’s puppet, Gunvor, will never get a license to operate and profit.

— Treasury Department (@USTreasury) November 6, 2025

“Kremlin’s puppet.” Brutal. And “Never” seems pretty final.

I laughed when I read that. No bureaucratic doublespeak. Just a right cross to the jaw. (Which Bessent is apparently quite capable of throwing. As Elon).

Of course, the US has far more information about Gunvor and its doings than a mere blogger. You can bet its communications are surveilled, and it is likely that the US has human assets working in the company, and in Lukoil too. Meaning that allegations of puppetry are likely grounded in hard intelligence.

So, whither Lukoil? Well, it will be more like wither, Lukoil.

The trading operation has to be totally shtuped. Trading lives on credit and they won’t get it. And any buyer will feel Uncle Sanctions looking over their shoulder.

Bulgaria is planning to nationalize the Lukoil refinery there. Romania is likely to do something the same with the refinery in its country.

The biggest asset is Lukoil’s big stake in an Iraqi oil field. Likely the other partners will continue operations, and the US will probably acquiesce, not wanting to see a hit to world oil supplies. Revenues can be escrowed, and conceivably Iraq could nationalize it.

Moldova is trying to obtain the Lukoil storage assets located there.

Lukoil stations in Finland, the US, and elsewhere are already having problems getting supplied with fuel. Those could be pieces that other entities, including trading firms or NOCs (note that Kuwait Petroleum operates Q8 gas stations) could snap up.

Meaning that the likely outcome is that rather than being bought in one piece, as Gunvor had proposed, pieces of Lukoil will be seized, sold, or shut down.

One issue I haven’t seen addressed is that of Lukoil International’s creditors, and how that will be handled. A subject for another day.

For now, suffice it to say that the Gunvor Gambit–and arguably the Putin Gambit–was shot down in flames by the United States, and there appear to be no survivors.

The severity of the US action, and the in-your-face explanation thereof, have a clear geopolitical subtext. Trump has had it with Putin. He offered Putin all sorts of off ramps, face saving deals, and the like. But an alternately smirking and snarling Putin refused to budge an inch on Ukraine.

So Trump tightened the sanctions screw, not just on Lukoil but on Russian oil sales generally, and these are having an effect. And he wasn’t about to give Putin a workaround on Lukoil via a transaction with a potentially friendly or even controlled buyer.

The cancellation of a mooted meeting in Budapest between Putin and Trump further demonstrates that Putin has exhausted Trump’s patience. (This cancellation sparked a rejuvenation of Kremlinology. The meeting was cancelled after a phone call between Russian Foreign Minister Lavrov and US SecState Marco Rubio. Lavrov was missing from some subsequent Kremlin meetings, leading to speculation that the failure of the call has led to his being disgraced, and to suggestions he stay away from windows).

But maybe Vova doesn’t care. He appears more than willing to spend another million lives to seize shreds of blasted territory in Ukraine rather than make any concessions whatsoever. Sad. And sick.

In my recent post on Don Wilson and GPU trading, I expressed skepticism at the prospects for such trading based primarily on market structure issues. Specifically, a commodity futures market can thrive if the underlying product has a highly intermediated value chain, but that vertical integration or long-term contractual relationships between producers and ultimate buyers is inimical to their success. Further, I surmised that transactions costs considerations would lead to long-term contracts and/or vertical integration dominating the GPU sector.

And indeed, that outcome is becoming clearer by the day. OpenAI (it of ChatGPT) has agreed to a massive chip purchase from AMD and has also bought a 10 percent stake in the chipmaker. OpenAI has also entered into a five-year deal with Oracle to buy “computing power.”

There is also increasing verticality in power supply arrangements. (Apparently the new industry buzzword is “circularity” but we are really talking about vertical relationships here, so I’ll stick with traditional IO speak). Example: AI firms building gas-fired plants in Texas. Musk’s xAI building a gigawatt scale plant in Mississippi to power a data center outside Memphis.

Microsoft has entered a 20 year deal with Constellation Energy to restart–believe it or not–a unit at Three Mile Island. And on and on.

It’s somewhat amusing to me. Years ago Paul Joskow wrote a seminal article about coal mine mouth power plants in which he showed that this co-location led to long term contracts or vertical integration. We are now seeing data center mouth power plants.

The economics are basically the same. It makes sense to locate something that consumes as much (or more) power than a generator can produce to economize on transmission costs and enhance reliability. However, this creates bilateral monopoly driven transactions costs issues that lead to vertical integration and long term contracting.

Going back to GPUs, there is no reason for colocation, but economies of scale on both sides of the market–huge consumers operating data centers, and a small number of GPU producers–create similar bilateral monopoly opportunism risks, which in turn are leading to the implementation of traditional responses to these risks–tight vertical connections between producers and consumers.

This market structure is inimical to the development of a thriving derivatives market. So I wouldn’t be surprised to see the launching of GPU futures contracts, but I fully expect them to sink faster than a Nork destroyer after launch. But unlike the Nork ship, GPU futures would not be refloated.

Odd Lots was in Chicago last week, and after interviewing Don Wilson they interviewed CME CEO Terry Duffy. The interview was posted today.

CME's Terry Duffy touts its partnership with FanDuel. What CME will offer is basically what bucket shops offered back in the day. The irony is that back then bucket shops were the betes noire of exchanges. https://t.co/Z34P89KDJZ

— streetwiseprof (@streetwiseprof) October 2, 2025

I’ll get to the FanDuel tie-up in a bit, but first I want to discuss something else that came up–perpetual futures, which are a hot topic now (even though hot topic is not punk rock). Duffy cast doubt on the feasibility of perpetual futures in most CME products–he mentioned ags specifically. I agree with his conclusion but not his reasoning.

Duffy argues that perpfuts can’t work for commodities because they don’t fit the legal definition of a futures contract, which involves pricing something for delivery at a later date. He also argues that it can’t work for deliverables.

Maybe perfuts check the legal box, maybe they don’t. Twirling my Oliver Wendell Holmes-esque mustache, I could come up with a clever legal argument that based on the way perpfuts work, they are pricing a commodity at the time of the next marking-to-market, say an hour from now. Or a minute from now. Which would be in the future, either way.

And that marking-to-market is the real reason commodity perpfuts won’t work. Take the case of Bitcoin. Bitcoin perpetuals involve periodic (usually hourly) “funding payments” based on the difference between the futures price and the reference spot price taken from an exchange like Coinbase or Bitstamp. Basically cash settlement on an hourly frequency. But the contract remains live after each settlement.

So basically, a perpfut it is a perpetually (automatically) rolling cash-settled one hour futures contract. The advantages of the future over trading the spot are (a) embedded leverage, often 100-to-1, and (b) the ability to short without borrowing the underlying. Perpfuts are like trading spot, but with leverage.

This works for things for which there is a liquid reference spot market. Bitcoin and some other cryptos have that.

You could do this with say the S&P 500 because there is a large, liquid, continuously traded, transparent cash/spot market. You could do it with currencies, and via its FX Spot+ (“Rolling spot”) contract, the CME (via its EBS subsidiary) is doing just that.

You can’t do it with most commodities because there are no liquid, continuously traded, transparent cash/spot markets. Not in grains. Not in oil or other energy products (with the possible exceptions of natural gas and power). Not likely in precious metals–there is RTC trading in gold, but it is bilateral and there is no transparent pricing. Maybe you could do it with LME non-ferrous metals, because of their unique “cash” pricing mechanism.

So it’s not legal obstacles or deliverability that preclude perpetual futures in most (if not all) physical commodities. It’s the lack of a reliable spot pricing mechanism that can tie the futures and cash/spot prices together as perps are intended to do.

This is basically a special case of why I have ridiculed proposals for cash settlement in commodities for over 30 years. It’s only that the problem is even more pronounced for perpfuts because you need to observe spot prices with metronomic regularity every day, not just around contract expirations.

Turning to CME and FanDuel, my X post basically says it all. It is hilarious to me that CME is offering “event contracts” that are indistinguishable from the kinds of bets one could make on bucket shops back in the bad old days. Duffy describes contracts like “will the price of gold be above X an hour from now?” (NB: if that’s a futures contract, as Duffy claims it is, then perpfuts are no different: see above). The contracts would be “digital” (i.e, have a fixed positive payoff if the event happens, zero payoff if it doesn’t).

Well, that’s exactly the kind of thing bucket shops traded back in the day. (0dte options, which are also a thing now on many exchanges, are also very similar to old-school bucket shot bets). Exactly like them.

That’s an 1892 painting of a bucketshop. Note the use of the high tech chalkboard app.

So why hilarious? Because exchanges waged war on bucket shops for decades in the late-19th and early-20th centuries. A journal article provides some color:

On the morning of August 29, 1887, Abner Wright, president of the Chicago Board of Trade, forcibly removed the instruments of the Postal Telegraph and the Baltimore and Ohio Telegraph companies from the floor of the exchange, literally throwing their equipment out of the building. A few months later, on the night of December 15, Wright discovered some mysterious electrical cables leading out of the basement of the exchange building. Thinking that they were telegraph lines, he ordered them cut with an axe. Instead, they were cables connecting the building to the police and fire departments.¹ His desire to sever the Board of Trade’s telegraph connections might seem surprising, since the telegraph network was indispensable to the operations of the major stock and commodity exchanges.

That’s why the CME’s current move is hilarious. If you can’t beat ’em, join ’em.

I’m not censorious of bucket shops per se. People gonna gamble. The CBOT’s (and NYSE’s and other exchanges’) ire reflected not a moral judgment, but a dislike of competition. (Yes you can make arguments like Mulherin, Netter and Overdahl that the shops free rode on the price discovery of exchanges, and that impaired liquidity. But as I’ve shown in my academic work, this “free riding” can actually enhance efficiency if exchanges have market power, which they almost certainly do).

Exchanges today almost certainly realize that they can’t drive bucket shops, excuse me, betting apps, out of business: Terry Duffy can’t forcibly remove their equipment, a la his distant predecessor Abner Wright. So the best alternative is to get in the game with them.

Perfectly reasonable commercial strategy, but a deeply ironic one.

After all this time, you’d think that people would have figured out to take Trump seriously, but not literally. You’d be wrong.

Case in point, Javier Blas’ bloviation about Trump’s proposed mineral deal with Ukraine, which Trump has characterized as a deal for rare earths.

Despite the talk about its huge potential, Ukraine isn’t known to hold any reserves of the main rare earths elements sought after by Trump pic.twitter.com/8Z6pdkKrhp

— Bloomberg Opinion (@opinion) February 19, 2025

Yes, rare earths are what Trump has touted, but that’s not what he’s really after:

Donald Trump’s demand for a $500bn (£400bn) “payback” from Ukraine goes far beyond US control over the country’s critical minerals. It covers everything from ports and infrastructure to oil and gas, and the larger resource base of the country.

The breathtaking expansiveness of Trump’s demands (apparently trimmed back subsequent to that article) is the real story here. Writing that Trump is an idiot because there aren’t ackshually any rare earths in Ukraine totally misses it.

Why does Trump emphasize rare earths? Who knows for sure, but I have some ideas.

One is typical Trump kayfabe, “presenting staged performances as genuine or authentic” (in professional wrestling mainly, but a staple of the Trump method). Rare earths are in the news, primarily because of Chinese dominance thereof. (Not, by the way, because China is uniquely endowed with them, but because the US and the West have outsourced the intensely polluting refining process to China, which has a far higher tolerance for industrial pollution). Although a lot of people know that rare earths aren’t rare, and may know that Ukraine doesn’t have any, that’s not common knowledge. By broadcasting that he’s going to get America’s hands on something commonly perceived to be extremely valuable, Trump can sell his base on continued support for Ukraine despite his early promises to cut it loose.

Another possibility is that this is a head fake. By focusing on a single resource, he obscures his more breathtaking ask (or demand) which stirs concerns among those of his supporters are aware of it. Instead of “Look–squirrel!” he’s saying “Look–rare earths!”

Either way, by taking Trump literally Blas et al are failing to note what they should be taking seriously. Which probably doesn’t bother Trump one bit–and wouldn’t if either of my conjectures that rare earths are a blind or a feint are correct.

For his part, Zelensky reacted with outrage. Never! Colonialism!

At least in public. Marco Rubio–seconded by J.D. Vance–called out Zelensky publicly for duplicity.

What Secretary Rubio is saying here is exactly right. https://t.co/nh2pHzramp

— JD Vance (@JDVance) February 21, 2025

This surprises me not in the least, but it makes me question yet again Zelensky’s intelligence (in the sense of IQ, not information). Arguing with Trump and exchanging insults with him in public on this and other issues (notably the negotiations with Russia) is an incredibly stupid strategy for someone whose fate largely rests in Trump’s hands.

Indeed, the more you think that Trump is an asshole who hates Zelensky, and is looking to sell Ukraine down the river, the more you have to agree that Zelensky should keep his mouth shut, and definitely should not wave a red cape at a raging bull president. Being two-faced with Trump is a recipe for getting both of them ripped off. Or if you are going to be two faced, display the nice one in public and the mean one in private, rather than the reverse as Zelensky is doing.

It would be particularly stupid of Zelensky to pick a fight over non-existent rare earths. Sure Donald, the rare earths are yours! He’d be giving up nothing and potentially gaining something. Picking a fight over nothing is beyond stupid. (That fact alone should have the ackshually crowd questioning whether it’s rare earths that Trump is ackshually after).

It’s really mystifying what Zelensky think he’s accomplishing here. Playing up to the Europeans? Since they are utterly impotent and can’t protect him (not to mention that many including Scholz and Poland have expressed publicly an unwillingness to do so) that would be incredibly foolish. Playing to the anti-Trump element in the US? Equally foolish because at present they are even more impotent than the Europeans.

Maybe it’s just exhaustion or a psychological breakdown, either of which would be understandable given the strain he’s been under for the last three plus years. Or maybe he wants out of a hopeless situation and is creating a pretext for his ouster. Or maybe he’s just an arrogant idiot.

As for the substance of a US-Ukraine deal over Ukrainian resources (other than rare earths), Rubio brings up a point I made several weeks ago on X. Namely, giving the US a major stake in Ukraine would serve as a far more credible bond to secure continued American protection than pie crust promises. Major skin in the Ukrainian game vis a vis Russia aligns American and Ukrainian interests far better than any alternative.

That is not complicated. An American stake produces time consistency. “Commitments”–promises to do things in the future on Ukraine’s behalf–are not time consistent because there would be little cost of reneging on those commitments in the future. You know, sort of like the Budapest Memorandum. You’d think Zelensky would have learned from that experience. Apparently not.

I assert that a major economic stake in Ukraine’s economy would be a far better guarantor of Ukraine’s security than membership in Nato. There is no reason to believe that Nato would not fade Article 5 commitments in the event of a future Russian incursion or subversion.

This is especially true when dealing with a relentlessly transactional man like Trump.

Besides, 50 percent of something is a lot better than 100 percent of nothing. Which is what Ukraine will have if the US walks.

There is considerable room for skepticism about Trump’s approach to Ukraine. But that skepticism should be grounded in something other than snickering about Trump’s supposed rare earth delusions. And for Zelensky turn his comedic talents to insult comedy is suicidal.

Cocoa has been on a wild ride for the past year.

So wild that Bloomberg has a separate category for “The Cocoa Crisis.” Contributing to the recent hysteria is news that Hershey has requested “special permission to buy over 90,000 tons of cocoa.” Evidently the chocolate manufacturer has requested a position limit exemption from the CFTC. (Links to the “Cocoa Crisis” coverage are in the article).

Note that exemptions, specifically for hedging, are explicitly recognized in the relevant regulations, and are granted routinely, so this is not really exceptional. Not knowing the exemptions granted to Hershey in the past it is difficult to know whether the magnitude of the exemption is extraordinary.

The article is confusingly written. In commodities subject to limits, there are different kinds of limits. These include single month and all month limits outside the “spot month” and “spot month” limits. Spot month limits kick in sometime prior to expiration. In cocoa, it is my understanding that the spot month limit kicks in on First Notice Day, which for the next ICE Cocoa contract (“CC”), March 2025 (“CCH5”) is 24 February, 2025.

The article implies that the exemption requested is for the spot month:

The maker of Reese’s Peanut Butter Cups wants to take a position that will allow it to purchase more than 90,000 metric tons of cocoa on ICE Futures US, said the people, who asked not to be identified because the information is private. The request to the Commodity Futures Trading Commission equates to about 5,000 20-foot containers and is more than nine times the amount the exchange currently allows.

The spot month limit is 1,000 lots, so 9,000 contracts would be 9x the spot limit. The single month/all month limit is 4,900 contracts, so the requested exemption would be less than 2x the single/all month limit.

I am somewhat skeptical that the exemption request is related to the spot month given that spot exemption requests can occur closer to FND, and the magnitude is so large relative to ICE cocoa certified stocks (currently only 1,604 lots) that granting such an exemption would be problematic. Particularly problematic would be “purchas[ing] more than 90,000 metric tons of cocoa on ICE Futures US” if that means acquiring that much physical cocoa via the delivery process.

But Hershey did that in 2020, and exchange cocoa is supposedly at a discount to the cash market. The cash market discount begs the question: why? Are apples being compared to apples in terms of quality, location, etc.?

Acquiring 90,000 tons–or 25 percent of that amount– would require bringing in large amounts of cocoa to exchange warehouses. That in turn would require acquiring cocoa on the cash market (at a supposed premium), getting it to ICE warehouses, grading it, etc. So it’s hard to believe that cert cocoa is an economical source of supply for Hershey in the quantities mentioned in the Bloomberg article.

The price movement in 2020 sure as hell looks like a squeeze, but neither ICE nor the CFTC took action, so maybe Hershey figures it can do it again.

Unlike 2020, this time the spread didn’t take off:

The March-May 2025 spread did spike in mid-December, but only narrowed slightly after the publication of the Bloomberg article on 8 January. (Perhaps somewhat confusingly, an increase in the spread is referred to as “narrowing”. “Wider” means a bigger carry: “narrower” means less carry or more backwardation).

Here’s 2020 for comparison:

I certainly believe that big commercials can sometimes bamboozle ICE and the CFTC, especially when it comes to telling just so stories about how its economical to take delivery. So it’s not inconceivable that Hershey is trying to do that here, and that they will succeed.

The are other curious things in the article. For example: “A spokesperson for the Pennsylvania-based company said Hershey has a ‘rigorous’ procurement process and that it is ‘well covered’ on its cocoa needs for 2025.” If “well covered” means that Hershey has supply contracts sufficient to meet its anticipated physical needs, why would it need to take delivery? If “well covered” means that they supply contracts are fixed price, Hershey wouldn’t need to hedge using futures. So the company’s statement obfuscates rather than informs if it is intended to ease fears that the company could be hammered by a high and rising cocoa price in 2025.

As I noted before, the epic price rally has put cocoa in the news frequently. Another example is this Reuters article from last month. In brief, the high and volatile cocoa prices have driven speculators from the market, leading to thinner, less liquid markets.

A couple of comments.

First, the exit of hedgies has not caused prices to decline, which implies that they were not the ones that caused the high prices in the first place as has been frequently claimed (as is usually the case when prices move a lot–“round up the usual suspects”).

Second, the reduction in speculative capital makes the price more sensitive to bigfooting by commercials. Like Hershey. Just sayin’.

Third, this demonstrates clearly the effects of clearing and margining. Volatility and high flat prices increase margins and thereby the cash needed to maintain positions. Since cash liquidity can be costly, this raises the cost of providing both long term and short term market liquidity, which leads to the exit of speculative capital that has occurred in cocoa. This in turn increases volatility all things equal. That is, the margining mechanism creates a positive feedback loop that can be detrimental to market performance.

Not to say that the credit risk mitigation benefits of margining don’t outweigh these market liquidity costs. Just pointing out that mitigating credit risk is not cost free.

Given the decline of liquidity and the possibility that a large commercial may lean on the delivery process, the cocoa market is worth keeping an eye on.

As an aside, some years back there were squeezes in cocoa in March. I used to teach my commodity trading course in Geneva in March, and I joked to my students that I should buy CC calendar spreads before heading to Geneva. (I now teach there in April). This March might be particularly interesting.

And of course there was the big Armajaro corner in cocoa in July 2011.

All in all, cocoa can be a source of material for those interested in how er “technical factors” affect pricing. Including me. So I guess you could say I’m coo coo for cocoa:

(A flashback to my youth).

The structure of financial market regulation has been a source of dissatisfaction since at least the time of the birth of the SEC in the 1930s, and maybe even dating back to the first regulation of futures markets in 1922. Don Wilson of DRW is only the latest of those to express this dissatisfaction.

Since derivatives markets first emerged from their niche in the commodities, and especially agricultural commodities, a lot of the criticism has focused on the bifurcated nature of US regulation, with separate securities and derivatives regulators, the SEC and the CFTC respectively. Why not just have one regulator given the substantial overlaps between securities and derivatives markets? Whereas previous “reform” proposals have been to merge the agencies, Wilson suggests scrapping them both and creating a new unified regulator.

This idea is a hardy perennial and has always struck me as mere org chart shuffling, or furniture rearranging. And that’s the best case. Worse outcomes are very possible.

For one thing, the relevant laws–the Securities and Exchange Acts, and the Commodity Exchange Act–would remain in place, with one commission in charge of implementing both. Many of the conflicts, tensions, and contradictions involving the SEC and the CFTC are rooted in the underlying laws, and would remain post-merger (or replacement with a super agency). The conflicts would become intramural rather than intermural as it were, but would not go away.

For another, I generally favor functional regulation and given the myriad functions of financial markets and institutions subsuming all regulatory oversight to a single agency may well impede functional specialization.

The SEC already represents a good example. In broad strokes the Securities Act relates to securities issuers (e.g., disclosures) and the Exchange Act relates to the trading of securities. Those are two very different functions and only tangentially related. Yet a single regulator oversees both.

The CFTC also has authority over trading per se on some venues.

Both agencies have authority over intermediaries (e.g., broker-dealers, FCMs) and clearing.

Maybe there would be some reasonable rationale for splitting off regulation of issuers from regulation of trading, trading intermediaries, and clearing, and putting these last three in a single silo. But even that is problematic due to path dependence.

We are not starting with a blank slate. The pre-existing statutory division is one historic fact. Another is that derivatives and securities markets have evolved very differently, and that could very much reflect the longstanding regulatory bifurcation.

Is it desirable to move toward uniformity in how derivatives and securities markets are organized and governed, and in essence ignore the historical process that created the current market structures? That’s not immediately obvious given how wrenching and unpredictable the process of achieving uniformity would be–and how rife the unexpected consequences would be.

Moreover, how would the political economy work? There’s no guarantee that the politics of a unified regulator would lead to a more efficient regulatory structure.

Indeed, to me it’s more likely that that rent seeking would rule, and efficiency would be damned. There’s actually a strong argument to be made that competition between regulatory agencies disciplines the rent seeking to some degree. And it can also discipline the ideological fervor of someone like Gary Gensler.

The ongoing drama over crypto regulation is an example. I’m not a crypto evangelist by any means but overall I favor letting market processes determine the outcome. If GiGi was king, or even merely the sole regulator of crypto, that would never happen. Regulatory competition (with the CFTC) constrained Gensler and the SEC, so the market will have the chance to have the final vote.

Indeed, one of Don Wilson’s beefs is very specifically with Gary Gensler. (And oh boy, do I get that!) A regulatory structure with one regulator would make some future GiGi far more dangerous.

Why should regulatory monopoly be looked upon more favorably than private monopoly? Indeed, regulatory monopoly is more dangerous because it cannot be disciplined or undermined by entry. Only the naive who believe in the public interest theory of regulation (and regulators) could believe that a single regulator would act to enhance efficiency rather than exploit its power for often malign reasons.

I have often written that there is a multitude of ways for executing financial transactions that have some common elements because transactors and transactions are heterogeneous. One size does not fit all. (Gensler was something of a one size fits all fanatic at the CFTC). Even though any division will lead to anomalies, conflicts, and regulatory arbitrage, there is enough distinctiveness between say derivatives markets on the one hand and security markets on the other to make separate regulators a better outcome. The division of labor is limited by the extent of the market. The scope of financial markets is so huge that there is considerable division of labor in them, and a division of regulatory labor makes considerable sense too.

Further, although the term “regulatory arbitrage” is typically used as a pejorative, it is not necessarily a bad thing. Indeed, it can be a good thing when market participants use regulatory fragmentation to introduce beneficial innovations that a particular regulator would prevent.

It should also not be forgotten that the SEC and the CFTC are not the only regulatory players in this game. The banking regulators and the Fed are also quite involved, especially on issues relating to intermediaries (who are banks or deeply enmeshed in the banking system) and clearing. Some regulatory fragmentation is inevitable as a result. Just mashing together the SEC and the CFTC will not make the fragmentation disappear.

I say only slightly facetiously that the best effect of regulatory consolidation is that reduced specialization would increase the cost of regulation, leading to less of it. There are no economies of scale, and are in fact diseconomies of scale, at the commissioner level. The bandwidth of the commissioners who are the final arbiters of rules is limited. As a rough estimate, a single commission responsible for double the statutes will have the capacity to produce half the rules as two commissions would. Sounds good to me!

(And no, doubling the number of commissioners would not help. Each commissioner has to weigh in on each proposed rule).

(Less factiously, doubling the workload would empower staff as commissioners would be more reliant on staff to craft rules, and explain them, so rule “output” might not decline that much as the commissioners just end up spending less time on each proposal).

Proposing agency merger or creation of a super agency is almost always a symptom of overall dissatisfaction with regulatory outcomes. But those bad outcomes are usually the result of bad regulators or bad underlying statutes. As noted above, consolidating regulators would increase the power of the bad regulators who will inevitably come along, so be careful what you ask for. And redrawing the regulatory org chart won’t address the statutory problems.

So if you don’t like current regulatory outcomes, don’t focus on the number of agencies and the names on the buildings they occupy: focus on the laws that determine what regulators can do and how they can do it.

Frankendodd was full of bad things, so start with that. Go to a slimmer legal framework that focuses on force and fraud rather than one that attempts to micromanage market macrostructure. Work towards a framework that disempowers would be Gary Genslers rather than the reverse.

Recent Supreme Court decisions, especially Loper, will help by constraining the ability of regulators to go beyond the authority explicitly delegated to regulators by statute. But many of the delegated powers are already too broad, so that needs to be addressed too.

In sum, to fix regulation it is necessary to get to its roots. Its roots are in legislation. Shuffling around who implements the legislative mandates is a superficial response to a deeper problem that originates in the Capitol.

PS. My friend Jeff Carter has a Substack on the same issue. Check it out.