Streetwise Professor

May 24, 2018

Gazprom and Its Connected Contractors: The Credit Mobilier Scheme, With Russian Variations

Filed under: Commodities,Economics,Energy,History,Russia — The Professor @ 6:05 pm

A couple of SWP friends were kind enough to send me a copy of the swan song of one Alex Fak, an erstwhile senior analyst at Sberbank.  Alex lost his job because he committed a mortal sin: telling the truth, in this instance about the monstrosity that I have savaged for years–Gazprom.

Alex said that the oft-heard question “why does Gazprom do such stupid things?” is off base because it presumes that the company is run in the interest of shareholders: if it were, its unmatched record of value destruction would indeed be stupid.  However, Mr. Fax opined that the company’s actions over the decades are definitely not stupid if you evaluate them from the perspective of its contractors, who make massive amounts of money building obscenely negative NPV projects.

Why does this persist, in the Putin era, which allegedly cracked down on oligarchic thievery? Well, one reason is that the biggest contractors happen to be owned by–wait for it–the two biggest friends of Vova: Gennady Timchenko (a hockey buddy) and Arkady Rotenberg (a judo buddy).*  Putin did not eliminate oligarchs, so much as replace them with his cronies.  Calling out such connected men by name is no doubt why Mr. Fax is an ex-Sberbank analyst.  And saying this kind of thing puts him at risk of being an ex-person.

The Gazprom MO described by Mr. Fak  represents a continuation of, and a mega-sizing of, the bizness model of the 1990s, when the “red directors” of state-owned firms tunneled out huge amounts of funds by having their firms buy supplies and services at seriously inflated prices from firms owned by their relatives.

Indeed, in the pre-Cambrian days of this blog–2006(!)–I hypothesized that Gazprom and its contractors were in effect a Russian version of Credit Mobilier, the construction firm that the Union Pacific hired to build the railroad.

The WaPo article also mentions that Gazprom’s pipeline construction costs are two to three times industry norms. To me this suggests a Credit Mobilier-Union Pacific type situation, where inflated prices for materials and equipment flow into the pockets of companies owned by Gazprom managers. Just thinkin’.

Thomas C. Durant was the president of the Union Pacific–and the major shareholder in Credit Mobilier.  The UP paid Credit Mobilier around $94 million, and Credit Mobilier incurred only about $50 million in costs to build the UP.   The Gazprom arrangement is somewhat different given that neither Timchenko nor Rotenberg are executives at the Russian gas giant, but the basic idea is very similar. (I also noted early on that Transneft, the oil pipeline monopoly, operates on the same model.)  Gazprom and its contractors operate on the Credit Mobilier model, with Russian variations.

Once upon a time Gazprom CEO Alexei Miller boasted that he would make Gazprom the world’s first trillion dollar company.  Today it’s market cap is south of $55 billion.  Hey! anybody can be off by two orders of magnitude, right?

This is not surprising, because maximizing value to shareholders is not, nor has it ever been, the objective of Gazprom.  The objective is, and always has been, to divert resources to the politically connected via wasteful capital expenditures (that happen to be the revenues of the likes of Timchenko and Rotenberg).  Alex Fak understood this, and paid the price for shouting that the emperor had no clothes.

Both Gazprom and Rosneft are world leaders in destroying value, rather than creating it.  But this is a feature, not a bug, given the natural state political economy of Russia, which prioritizes rent creation and redistribution to the elite. And this is precisely why Russia’s pretensions to great power status rest on economic quicksand.  That should be blindingly obvious, and I am sure that Putin understands this at some level.  But revealed preference suggests that he values enriching his friends more than implementing the economic changes that would make his nation economically and militarily competitive.

*The sums tunneled from Gazprom to Timchenko make me laugh when I think about the oft-repeated allegation that oil trader Gunvor (half-owned by Timchenko) was a source of massive personal wealth for Putin (via Timchenko).  There was much more money to be made much closer to home, and completely outside the scrutiny of bankers and regulators.

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May 17, 2018

Rosneft: The Farce Continues

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 7:22 pm

Remember when the Russian government said it was going to privatize a piece of Rosneft? Hahahaha. That is so 2016–please try to keep up!  In its announcement of “Rosneft 2022” the company proposes to buy back about $2 billion in shares, which is just about 20 percent of the piece sold off in 2016–no, wait–2017–no, wait–2018.  Adding even more hilarity is that the buyback plan was apparently at the insistence of Qatar, the last buyer standing which agreed to buy most of the shares initially privatized, much to the relief of the banks (Intesa and unnamed Russian ones) who were wearing a big piece of the risk.

I’m guessing that this was one of the terms Qatar laid down to absorb the entire hand-me-down stake for the original 2016 price, even though in Euro terms Rosneft’s shares are substantially lower today (despite a rallying oil price!)

Quite the vote of confidence there, eh?  Well, not that that’s surprising.  The conspicuous failure of any Chinese buyer to step into the shoes of disgraced CEFC tells you just how much confidence Rosneft inspires these days.

I am hard pressed to recall such a farcical series of events involving a major company.  If this one of  Russia’s state champions, just think of the shape the palookas are in!

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May 15, 2018

Contrary to What You Might Have Read, the Oil Market (Flat Prices and Calendar Spreads) Is Not Sending Mixed Signals

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 9:27 pm

In recent weeks, the flat price of crude oil (both WTI and Brent) has moved up smartly, but time spreads have declined pretty sharply.  A common mistake by oil market analysts is to consider this combination of movements anomalous, and an indication of a disconnect between the paper and the physical markets.  This article from Reuters is an example:

Oil futures prices have soared past three-year highs, OPEC’s deal has cut millions of barrels of inventory worldwide and investors are betting in record numbers that prices could rocket past $80 and even hit $90 a barrel this year.

But physical markets for oil shipments tell a different story. Spot crude prices are at their steepest discounts to futures prices in years due to weak demand from refiners in China and a backlog of cargoes in Europe. Sellers are struggling to find buyers for West African, Russian and Kazakh cargoes, while pipeline bottlenecks trap supply in west Texas and Canada.

The divergence is notable because traditionally, physical markets are viewed as a better gauge of short-term fundamentals. Crude traders who peddle cargoes to refineries worldwide say speculators are on shaky ground as they drive futures markets above $70 a barrel, their highest levels for three-and-a-half years, on concerns about tighter supply from Venezuela and the potential impact of U.S. sanctions on supply from Iran.

Investors have piled millions of dollars in record wagers in the options market, betting on a further rally on the back of rising geopolitical tensions, particularly in Iran, Saudi Arabia and Venezuela, and the global decline in supply.

“Guys who are trading futures have a view that draws are coming and big draws are coming,” a U.S.-based crude trader at a global commodity merchant said, adding that demand could ramp up as global refinery maintenance ends.

. . . .

BIG DISCONNECT

Those on the front lines of the physical market are not convinced. Traders say the surge in U.S. exports to more than 2 million bpd has saturated some markets, leaving benchmark prices ripe for a correction.

“There is a huge disconnect between futures and fundamentals,” a trader with a Chinese independent refiner said. “I won’t be surprised if prices correct by $20 a barrel.”

In fact, the alleged “disconnect” is readily explained based on recent developments in the market, notably the prospect for interruption/reduction in Iranian supplies due to the reimposition of sanctions by the US.  The situation in Venezuela is exacerbating this situation.  Two things are particularly important in this regard.

First, the Iranian situation is a threat to future supplies, not current supplies: the potential collapse in Venezuela is also a threat to future supplies (although current supplies are dropping too).  A reduction in expected future supplies increases future scarcity relative to current scarcity.  The economically efficient response to that is to share the pain, that is, to shift some supply from the present to the future by storage.  To reward storage, the futures price rises relative to the spot price–that is, the time spread declines.  However, since the driving shock (the anticipated reduction in future supplies) will result in greater scarcity, the flat price must rise.

A second effect works in the same direction. This is a phenomenon that I worked out in a 2008 paper that later was expanded into a chapter my book on commodity price dynamics.  Both the US actions regarding Iran, and the current tumult in Venezuela increase uncertainty about future supplies.  The efficient way to respond to this increase in fundamental uncertainty is to increase inventories, relative to what they would have been absent the increase.  This requires a decline in current consumption, which requires an increase in flat prices.  But incentivizing greater storage requires a fall in calendar spreads.

An additional complicating factor here is the feedback between inventories or calendar spreads (which are often used as a rough proxy for inventories, given the opacity and relative infrequency of stocks numbers) and OPEC decisions.  To the extent OPEC uses inventories or calendar spreads as a measure of the tightness of the supply-demand balance, and interprets the fall in calendar spreads and the related increase in inventories (or decline in the rate of inventory reductions), it could respond to what is happening now by restricting supplies . . . which would exacerbate the future scarcity. Relatedly, a known unknown is how current spread movements reflect market expectations about how OPEC will respond to spread movements.  The feedback/reflexivity here (that results from a price maker/entity with market power using spreads/inventory as a proxy for supply-demand balance, and market participants forming expectations about how the price maker will behave) greatly complicates things.  Misalignments between OPEC behavior and market expectations (and OPEC expectations about market expectations, and on an on with infinite regress) can lead to big jumps in prices.

Putting to one side this last complication, contrary to what many analysts and market participants claim, the recent movements in flat prices and spreads are not sending mixed signals.  They are a rational response to the evolution in market conditions observed in recent weeks: a decline in expected future supply, and an increase in fundamental risk.  The theory of storable commodities predicts that such conditions will lead to higher flat prices and lower calendar spreads.

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May 4, 2018

Stick a Fork In It: It’s Done

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 10:02 am

Glencore has just announced that the deal to sell Rosneft shares to CEFC has been terminated.  Furthermore, the QIA-Glencore consortium is being wound up, with virtually all of the shares going to QIA:

The members of the Consortium have agreed to dissolve the Consortium originally put in place in December 2016 for the purposes of acquiring a 19.5% stake in Rosneft and will take direct ownership of the underlying Rosneft shares.  In connection with that, the Consortium has today entered into an agreement to transfer a 14.16% stake in Rosneft to a wholly owned subsidiary of QIA (the “Transaction”) the consideration for which will to be used for the settlement of the Consortium’s liabilities. This agreement will become effective on 7 May 2018.

On completion of the Transaction, the Consortium will be wound up and the margin guarantees provided by Glencore will be terminated.  At that point, Glencore will retain an equity stake in Rosneft shares commensurate with its original equity investment announced in January 2017, which amounts to 0.57%, and QIA will hold an equity stake of 18.93%.

Meaning that in reality, as I noted at the outset of the deal, Glencore was basically a straw buyer–a beard–to provide the appearance of western corporate participation in the deal.

The price is also interesting:

The consideration for the Transaction attributable to Glencore’s interest in the Consortium (being 50% of the consideration for the Transaction) is approximately EUR 3.7 billion.

Well, the original December 2016 price was EUR 10.2 billion, meaning that this price is at a 25 percent discount from the original deal.

Who ate this difference?  Glencore?  I doubt it, but if it did, it would raise huge questions about its disclosures (or lack thereof) at the time of the original deal.  Regardless, this is yet another example of Glencore playing with fire.  What comes after trifecta?

I further note that whereas it was rumored that a Chinese state company would step into the shoes of CEFC, this hasn’t happened.  Yet, anyways.

Some state champion, that Rosneft, eh?

Update.  Some arithmetic.  The sums disclosed by today’s announcement basically indicate that Qatar assumed all but Glencore’s sliver at an amount equal to the original amount of the deal agreed to in December, 2016–including the mystery €2.2 billion which pretty much everybody but me and Ivan Tkachaev at RBC missed.  Qatar originally put up €2.5b, Glencore €.3b, and Intesa €5.2b, which adds up to €8b, or €2.2b short of the announced €10.2b.  The difference apparently came from as yet unnamed Russian banks, this in spite of Putin’s claim that Russian banks would not provide financing for a Rosneft “privatization.”

Today Qatar agreed to pony up €7.4b.  Add to that its original €2.5b and Glencore’s €.3b, and voila!, you have . . . €10.2b.  Miraculous, no?  Everybody remains whole!

Here’s the problem though.  Rosneft has been trading pretty much flat in RUB.  On 9 December, 2016, its share price was 370.8 RUB.  Today, it is 386.75 RUB, about 4 percent higher.  However, the RUB has depreciated about 12 percent against the EUR, going from 65.9707 to 75.155RUB/EUR.  So, in EUR terms, Rosneft is worth about 8.5 percent less than in December, 2016, but Qatar is paying the same price today as was agreed to then.

Why would Qatar do this?  Yes (as Ivan T points out to me) ~€1b is pocket change for the QIA, which has a $320b portfolio.  But still, you don’t get rich by gifting ~10 percent of deals.  So is there a side deal?

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May 2, 2018

When You Play With Fire, Eventually You Get Burned–Even if You are Glencore

Filed under: Commodities,Economics,Politics,Regulation,Russia — The Professor @ 6:10 pm

Even by the standards of the commodity business (and the commodity trading business in particular) Glencore is known for its appetite for political and legal risk, and its willingness to deal with sketchy counterparties.  It does so because by taking on these risks, it gets deals at good prices.  But the bigger the appetite, the greater the indigestion when things go wrong.

In the past several weeks, Glencore has hit the going wrong trifecta.

It has a longstanding relationship–including marketing deals and equity investment–with Rusal, entered when the Russian company’s reputation was particularly dubious in the aftermath of the aluminum wars, and its owners were involved serial litigation.

We know what happened to Rusal–it is in dire straits because of US sanctions.  Yes, the Treasury has indicated that it will take Rusal’s case on appeal, but there is no guarantee that it will grant a stay of execution when the appeal process is completed.

Glencore also partnered with very dubious Israeli businessman Daniel Gertler in the Democratic Republic of the Congo (DRC).  Gertler was sanctioned by the US government in December for a history of corrupt dealings in that country.  Glencore bought out Gertler in 2017.  After the sanctions were imposed, Glencore stopped paying Gertler royalties, but now Gertler is suing for $3 billion in royalties that he claims Glencore owes him.

Also in the DRC, Glencore is in a dispute with the government’s mining company, which claims that a Glencore subsidiary operating in the country is undercapitalized.  This is really a battle over rents: in essence, the government claims that foreign miners (including Glencore) overburden operating subsidiaries with debt in order to reduce dividend payments to the government (which is part owner).  The government has moved to dissolve the Glencore subsidiary.

I don’t know enough to comment on the substance of the various legal disputes in Africa.  But I can say that the risks of such disputes are material, and that they can be very costly.

In some respects, the Glencore political/legal risk strategy is like a short vol trade.  It can be a money printing machine when things go well, but when it goes bad, it goes really bad.

In a way Glencore is lucky.  It can withstand these hits now, having clawed its way back from its near death experience in the fall of 2015.  If these hits had occurred back then, well . . .

In sum, when you play with fire, eventually you are going to get burned.  Even if you are Glencore.

PS. The tumult in the Congo could disrupt cobalt supplies.  This would put pressure on one of my fave targets–Tesla–which is already in a parlous state.  Elon gave a crazed performance at today’s Tesla earnings call.  To me it came off as the meltdown of a narcissist who is facing failure and cannot handle being questioned.

I’ve been biding my time on some additional Tesla posts.  The time may be near!

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May 1, 2018

Cuckoo for Cocoa Puffs: Round Up the Usual Suspects

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 10:39 am

Journalism on financial markets generally, and commodity markets in particular, often resorts to rounding up the usual suspects to explain anomalous price movements.  Nowadays, the usual suspect in commodity markets is computerized/algorithmic/high frequency trading.  For example, some time back HFT was blamed for higher volatility in the cattle market, even though such trading represents a smaller fraction of cattle trading than it does for other contracts, and especially since there is precious little in the way of a theoretical argument that would support such a connection.

Another case in point: a flipping of the relationship between London and New York cocoa prices is being blamed on computerized traders.

Computers are dominating the trading of cocoa in New York, sparking a dramatic divergence in the longstanding price relationship with the London market.

Speculative funds have driven the price of the commodity in New York up more than 50 per cent since the start of the year to just under $3,000 a tonne. The New York market, traded in dollars, has traditionally been the preferred market for financial players such as hedge funds.

The London market, historically favoured by traders and commercial players buying and selling physical cocoa, has only risen 34 per cent in the same timeframe.

The big shift triggered by the New York buying is that its benchmark, which normally trades at a discount to London, now sits at a record premium.

So, is the NY premium unjustified by physical market price relationships?  If so, that would be like hundred dollar bills lying on the sidewalk–and someone would pick them up, right?

Not according to this article:

The pronounced shift in price relationships comes as hedge fund managers with physical trading capabilities and merchant traders have exited the cocoa market.

In the past, such a large price difference would have encouraged a trader to buy physical cocoa in London and send it to New York, hence narrowing the relationship. However, current price movements reflected the absence of such players, said brokers.

Fewer does not mean zero.  Cargill, or Olam, or Barry Callebaut or Ecom and a handful of other traders certainly have the ability to execute a simple physical arb if one existed.  Indeed, given the recent trying times in physical commodity trading, such firms would be ravenous to exploit such opportunities.

What’s even more bizarre is that pairs/spread/convergence trading is about the most vanilla (not chocolate!) type of algorithmic trade there is, and indeed, has long been a staple of algorithmic firms that trade only paper.  Meaning that if the spread between this pair of closely related contracts was out of line, if physical traders didn’t bring it back into line, it would be the computerized traders who would.  Yes, there are some complexities here–different delivery locations, different currencies, different deliverable growths with different price differentials, different clearinghouses–but those are exactly the kinds of things that are amenable to systematic–and computerized–analysis.

Weirdly, the article recognizes this

Others use algorithms that exploit the shifts in price relationships between different markets or separate contracts of the same commodity. [Emphasis added.  I should mention that cocoa is one of the few examples of a commodity with separate active contracts for the same commodity.]

It then fails to grasp the implications of this.

One “authority” cited in the article is–get this–Anthony Ward of Armajaro infamy:

Anthony Ward, the commodities trader known in the cocoa market for his large bets, has been among the more well-known fund managers to close his hedge fund, exiting the market at the end of last year. Mr Ward, dubbed “Chocfinger” due to his influence over the cocoa price, blamed the rising power of algorithmic and systems-based trading for making position-taking based on “fundamental” supply and demand factors more difficult.

Methinks that the market isn’t treating Anthony well, and like many losing traders, can’t take the blame himself so he’s looking for a scapegoat. (I note that Ward sold out Armajaro’s cocoa trading business to Ecom for the grand sum of $1 in December, 2013.)

I am skeptical enough that computerized trading can distort flat prices, but those arguments are harder to refute because of the knowledge problem: the whole reason markets exist is that no one knows the “right” price, hence disagreements are inevitable.  But when it comes to something as basic as an intracommodity spread, I find allegations of computer-driven distortions completely implausible.  You can’t arb flat price distortions, but you can arb distorted spreads, and that business is the bread and butter for commodity traders.

So: release the suspect!

PS. For my Geneva students looking for a topic for a class paper, this would be ideal. Perform an analysis to explain the flipping of the spread.

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Rusal: Premature Celebration

Filed under: Commodities,Derivatives,Economics,Politics,Regulation,Russia — The Professor @ 9:31 am

Rusal shares rose sharply and aluminum prices fell sharply on the news that the US Treasury had eased sanctions on the company.  The concrete change was an extension in the time granted for those dealing with Deripaska-linked entities to wind down those dealings.  But the market was more encouraged by the Treasury’s statement that the extension was being granted in order to permit it to evaluate Rusal’s petition to be removed from the SDN list.  It is inclusion on that list that sent the company into a downward spiral.

Methinks that the celebration is premature.  Treasury made clear that a stay of execution for Rusal was contingent upon it cutting ties with Deripaska.  Well, just how is that supposed to happen? This is especially the case if any transaction that removes Deripaska from the company not benefit him financially.  Well, then why would he sell?  He would have no incentive to make certain something–the total loss of his investment in Rusal–that is only a possibility now.

Of course, Putin has ways of making this happen, the most pleasant of which would be nationalization without compensation to Deripaska, perhaps followed by a sale to … somebody (more on this below). (Less pleasant ways would involve, say, Chita, or a fall from a great height.)

But if the US were to say that this was sufficient to bring Rusal in from the cold, the entire sanctions regime would be exposed as an incoherent farce.  For the ultimate target of the sanctions is not Deripaska per se, but the government of Russia, for an explicit foreign policy purpose–a “response to the actions and polices of the Government of the Russian Federation, including the purported annexation of the Crimea region of Ukraine.”

Deripaska didn’t personally annex Crimea or support insurrection in the Donbas.  The Russian government did.  The idea behind sanctions was to put pressure on those the Russian government (allegedly) cares about in order to change Putin’s policies.  They are an indirect assault on Putin/the Russian government, but an assault on them nonetheless.

So removing Rusal from the SDN list because it had been seized by the Russian government would make no sense based on the purported purpose of the sanctions.  Indeed, under the logic of the sanctions, the current discomfiture of the Russian government, facing as it does the potential unemployment of tens of thousands of workers, should be a feature not a bug. The sanctions were levied under an act whose title refers to “America’s adversaries,” which would be the Russian state, and were intended to punish said adversaries.

Mission accomplished!  Which is precisely why the Russian government is completely rational to view the Treasury announcement “cautiously,” and to view the US signals as “contradictory.”  The Russians would be fools to believe that nationalization and kicking Deripaska to the curb would free Rusal from the mortal threat that sanctions pose.

Perhaps Treasury has viewed the market carnage, and is trying to find a face-saving way out.  But it cannot do so without losing all credibility, and appearing rash, and quite frankly stupid, for failing to understand the ramifications of imposing SDN on Deripaska.  Also, doing so would feed the political fire that Trump is soft on Russia.

Further, who would be willing to take the risk buying Rusal from Deripaska either directly, or indirectly after nationalization?  They would only do so if they had iron clad guarantees from the US government that no further sanctions would be forthcoming.  But the US government is unlikely to give such guarantees, and I doubt that they would be all that reliable in any event.  Analogous to sovereign debt, just what could anyone do if the US were to say: “Sorry.  We changed our mind.”?

Indeed, the Treasury’s signaling of a change of heart indicates just how capricious it can be.  Any potential buyer would only buy at a substantial discount, given this massive uncertainty.  A discount so big that Deripaska or the Russian government would be unlikely to accept.

And who would the buyers be anyways?  Glencore already has a stake in Rusal, and a long history of dealings.  But it is probably particularly reluctant to get crosswise with the US, especially given its vulnerabilities arising from, say, its various African dealings.

The Chinese?  Well, since China is already on the verge of a trade war in the US, and a trade war involving aluminum in particular, they would have to be especially chary about buying out Deripaska.  Such a deal would present the US with a twofer–an ability to shaft both Russia and China.  And perhaps a three-fer: providing support to the US aluminum industry in the bargain (although of course harming aluminum consuming industries, but that hasn’t deterred Trump so far.)

So short of the US going full Emily Litella (and thus demolishing its credibility), it’s hard to see a viable path to freeing Rusal from SDN sanctions.  Meaning: Put away the party hats.  The celebration is premature.

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April 18, 2018

CEFC: The Rise and Fall of a Financial House of Cards

Filed under: China,Commodities,Economics,Russia — The Professor @ 12:34 am

This 1 March article from Caixin–which has since disappeared down the memory hole in China–is a stunning exposé about the ostensible purchaser of a 14.1 percent stake in Rosneft.  It portrays the company as a financial shell game that basically kited trade finance credit to grow like Topsy, and accumulate a collection of assets around the world–many of which it is now unloading.   The company also utilized shadow finance to raise funds via a securities affiliate.  It needed to grow rapidly to generate the financial churn that it used to finance itself. Now it is unraveling because the powers that be in China have, for some reason, decided this will happen–presumably because a forced unwind executed in a highly opaque manner is far preferable to an uncontrolled collapse that was impending.

That Glencore, Qatar, Intessa, Rosneft, and Russian and Chinese banks would agree to sell to such an entity, and/or to lend it money to permit it to purchase the Rosneft stake indicates either a shocking lack of due diligence, or more likely, a desperation to exit the deal and the lack of a more reputable buyer.  Given CEFC’s implosion, and the even more fraught circumstances of government-linked Russian companies, I’d be hard pressed to identify any company that can or will step into CEFC’s shoes.

An even more important issue here is why the Chinese authorities have yanked the reins on CEFC, and hard.  This follows the seizure of Anbang Insurance, and the regulatory pressure on HNA.

My suspicion is that the government realized that CEFC was a house of cards, and the financial strains of the Rosneft acquisition would bring the house tumbling down.  Indeed, it seems that the company was having real difficulties securing the funding, and if it had failed that would have been a major embarrassment to China. But this only raises more important questions, such as, what inferences should be drawn from the government’s intervention?  In particular, what inferences should be drawn about the state of the Chinese financial system?

One possible inference is that the CEFCs and Anbangs are the exceptions, and the government will intervene before they threaten the broader system.  That’s the comforting inference.  The more disturbing inference is that there are many houses of cards in China waiting to fall, and that the government can neither crack down on them all or let any fall, so it intervenes on a just-in-time basis.  This kicks the can down the road, and buys time to attempt to get the leverage in the system somewhat under control.

I say attempt, because this strategy is fraught with moral hazard.  A controlled wind-down cushions the blow for creditors, and the expectation that the government will do this in the future provides little disincentive to cut back on the extension of credit today.  Protecting creditors from the consequences of lending to the likes of CEFC ensures that they will continue to lend to similar companies in the future.  But letting companies fail in a way that imposes big losses on creditors threatens a crisis in the financial system.

I paid attention to CEFC initially because of the Rosneft angle.  But I think a far more important angle is what CEFC’s rise and fall say about the Chinese financial system, and the ability of firms to grow rapidly and to a huge size on the basis of the most dodgy financing mechanisms.  If CEFC is at all representative, the implications for the Chinese financial system are dire.  Which could explain the haste with which the government consigned the story to the memory hole.

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April 10, 2018

What SDN Hath Wrought: How Trump Rocked Not Just Rusal, But Most of Russia

Filed under: Commodities,Economics,Politics,Russia — The Professor @ 8:42 pm

I clearly underestimated the impact that the sanctions imposed on Deripaska, Rusal, and others would have.  The initial reaction Monday by many was to puke everything Russian.  Everything.  The ruble. The overall Russian stock market.  Russian debt.  Every major Russian company.  They all crashed. The carnage was widespread and indiscriminate and extended far beyond those directly targeted.

Rusal was the biggest loser, and extended its losses today.  Overall, its stock price is down almost 55 percent.  Ivan Glasenberg resigned from the board, and just now two Russian non-executive directors also resigned.  The company is clearly toxic/radioactive.  I don’t see it surviving without massive state support, and perhaps nationalization.   But even then . . . who outside of Russia and China will buy its aluminum?  (Note China is already suffering an overcapacity problem in the metal, which US trade restrictions would only make worse.)

I thought I might have misjudged seriously that Potanin would gain at Deripaska’s expense: on Monday Norilsk Nickel was down almost 20 percent, and Potanin was the biggest absolute loser.  Norilsk has since bounced back, and recovered much of its loss: it is now down about 7.5 percent from Friday.  But the “shootout” auction will still be between two gunmen who have been grievously wounded by fire from an unexpected direction.

Many other Russian companies that were pounded yesterday have also bounced back.  Severstal is actually trading above the pre-sanctions-news price.  Rosneft and Novatek have also recovered most of their losses.

Sberbank remains down–down more than 16 percent.  The bank disingenuously stated that the selloff was overdone because its exposure to sanctioned companies represented only 2.5 percent of its assets.  Well, since it is leveraged about 12-to-1, that represents 30 percent of its shareholder equity, which would justify a pretty big selloff.

The ruble remains down.  Indeed, it extended its loss today, and actually experienced a greater percentage decline today (almost 5 percent) than it did Monday (around 3 percent).  Perhaps this reflects the central bank’s statement that it would not intervene in support.  But it does indicate that this is perceived as a Russia-wide shock, and not one limited to a few billionaires and their companies.

The broader selloff, somewhat overdone as it was (as reflected by today’s recovery in many names) suggests a widespread estimation that other shoes will drop, and that billionaires that escaped the first round are still at risk for the Oleg treatment.

This raises the question of how the targets were chosen. Leonid Bershidsky argues that Deripaska and Rusal were targeted because taking Rusal’s aluminum off the market (as is happening, with the LME saying it will not warrant Rusal metal not already in warehouses) would be a much more effective way of supporting the US aluminum industry than selective tariffs.  This does have a certain logic, but if that is the logic, it would speak very poorly of the the US government, for it would imply the masking of a protectionist measure behind an allegedly principled reaction to Russian turpitude. It also doesn’t explain the other targets.

Nor does it explain the non-targets.  Novatek and Timchenko are much more tightly connected to Putin than Deripaska and Rusal. And Novatek LNG competes with US LNG, so there would be a protectionist rationale for hitting it.  Yet Novatek was not subject to SDN treatment, and as noted earlier its stock price has largely rebounded.  Perhaps a journalist friend in Moscow is right that Total’s big investment in it and its Yamal project has given it some immunity.

Similarly, Rosneft and Sechin are much more in the inner sanctum than Deripaska/Rusal.  Yet it too has escaped SDN.  Perhaps the risk of creating an oil shock is too great.

The “perhapses” indicate, however, that the rhyme and reason of the administration’s actions is not obvious.  And perhaps (there’s that word again) that’s what really has the market–and many rich Russians–spooked.  Given the capriciousness of the list, everyone is at risk.

Russia’s official reaction was of course negative, but one voice has been missing: Putin’s.  It’s not quite akin to Stalin, 22 June-3 July, 1941 (when he remained out of sight after the shock of Barbarossa), but it does suggest uncertainty as to how to respond.  Not a B’rer Rabbit reaction, at least not yet.

This uncertainty is no doubt fed by the realization of the vulnerability of the Russian economy to US policy.  I’ve written before that the US could crush Russia like an overripe grape by, for instance, cutting it off from SWIFT or the dollar system altogether.  This shows that it can wreak havoc with far more limited measures.

It’s also interesting that Xi made rather conciliatory remarks yesterday.  A coincidence? Perhaps (again). But Friday’s sanction action shows that Trump can act unpredictably and punishingly.  That likely concentrates minds in Beijing as well as in Moscow.

Whatever the logic of Friday’s thunderbolt, it should put paid to the Trump-is-Putin’s-pawn and Putin-has-something-on-Trump theories.  Indeed, a desire to terminate with prejudice those narratives is as good an explanation for the administration’s action as anything.  Not that reality will interfere with the conspiratorial ravings of those in the Democratic Party and the media and the neocon NeverTrumpers.  They are just too invested and obsessed, and nothing short of a preemptive nuclear strike on Moscow is likely to change that–and even then . . . . And with Trump threatening to attack Syria despite Russian warnings against it, maybe we’ll soon put that theory to the test as well.

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April 8, 2018

Caught in the Crossfire: Oleg Deripaska and Ivan Glasenberg

Filed under: Commodities,Politics,Russia — The Professor @ 7:15 pm

On Friday, the US Treasury Department sanctioned several Russian billionaires, commonly but misleadingly referred to as oligarchs. Topping the list was Rusal’s/EN+’s Oleg Deripaska.  Also included were Suleiman Kerimov , Alexey Miller of Gazprom, and Viktor Vekselberg of Renova (which holds a substantial stake in Rusal).

Presumably the intent behind choosing these specific targets, and the sanctions law which led to their selection, is to somehow punish Putin, and to cause him to change his behavior.  The sanctions will probably fail in achieving these objectives, and could actually be a net benefit for Putin.

When it comes to Russian billionaires, there are distinct classes.

There are Putin’s favored billionaires–his buddies like Timchenko and the Rotenbergs (who share St. Petersburg roots with Putin).  To a large extent these figures are billionaires because of Putin–they are beneficiaries of his largesse.  As further evidence of their privileged position, he compensated them through favoritism to offset their losses when they were targeted for sanctions early on.

There are the billionaires Putin hates (or hated).  These are the 90s oligarchs proper, men like Khodorkovsky, Berezovsky, and Gusinsky, who are in exile or dead.

Then there are those billionaires he tolerates, because they steer clear of politics and pony up to pay for Putin pet projects (e.g., the Sochi Olympics).  Deripaska, Vekselberg, and Kerimov are in this category.

Deripaska in particular is hardly a Putin favorite, and at times Oleg has tested Putin’s tolerance–as evidenced by the pen throwing incident at Pikalevo in 2009, where Putin chastised Deripaska publicly, likening him to a cockroach who ran at Putin’s approach.

Punishing this group is unlikely to cause Putin any loss of sleep. And indeed, he may reap some benefits.  The sanctions make these men and their firms more dependent on him and Russian state support–and he can extract a price for this support.  Furthermore, it pays into his narrative of Russia being unfairly targeted by a hostile West (and the US in particular).  Indeed, the peripheral political role of those sanctioned allows Putin to make the colorable claim that the US harbors an animus against Russia and Russians generally: he will therefore be able to claim that this is just another example of American Russophobia.

Perhaps most importantly, Putin has been attempting rather pathetically to get wealthy Russians to repatriate their fortunes: truth be told, the US government is making a more persuasive case for that than anything Putin has done or even could do.  Putin is therefore somewhat in the position of B’rer Rabbit, and the US in the position of B’rer Fox.

All of these factors strongly suggest that the US action is at best symbolic, and perhaps counterproductive.  They certainly are insufficient to induce Putin to ratchet down his confrontation with the US, and may indeed play into his justification for such a confrontation.

Putting motivations and incentives aside, the sanctions will not have much impact–if any–on Russian capabilities to implement Putin’s confrontational strategy.

So again, a flamboyantly symbolic act, with little practical benefit accruing to the US.

This is not to say that the individual targets will not suffer–they will.  It’s just that Putin won’t feel their pain, or will use it to advance his own purposes.

Deripaska’s case is particularly striking.  The sanctions were clearly a surprise: Rusal stock fell 20 percent on the news, which would not have happened had it been anticipated.  [Update: as of Monday morning Central Time, Rusal is down 50 percent, and the company has asked customers to stop payment while it tries to right the business.] Moreover, Rusal/EN+/Deripaska were subjected to the most harsh form of sanctions–Special Designated Nationals (SDN) sanctions.  These are more punishing than those imposed on Rosneft, for instance.  Under SDN, any US person (including corporations) is forbidden to transact with the sanctioned individual or entity.  Moreover, secondary sanctions can be imposed on non-US entities that deal with an SDN target.  US firms can be precluded from dealing with foreign firms subject to secondary sanctions.  This makes it far more risky for non-US firms to cushion the blow against (say) Rusal: such firms may have to make the choice between transacting with US firms (especially banks and other financial institutions) and transacting with Rusal.  Many will likely say: “Lots of luck, Oleg! Been nice doin’ business with ya!”

Topping the list of firms facing this grim choice is Glencore, which has a marketing deal with Rusal through 2018.  This deal was expected to be renewed, except on a smaller scale for 2019 forward.  (On a smaller scale because Rusal has been moving away from selling primary aluminum which Glencore markets to selling value added wire rods, billets, and slabs directly to industrial customers.)  Glencore also owns 8.75 percent of Rusal, which it had announced it will convert into EN+ shares.

Of course one of Glencore’s strategies has always been to go where other companies daren’t.  Its appetite for political risk is clearly much larger than its peers in mining, and even its Swiss commodity trading peers.  But tempting fate with Uncle Sam on sanctions is a different matter, and thus I would consider a renewal of the marketing deal to be unlikely, and Glencore may also be looking to unload its Rusal/EN+ shares, although to whom and at what price are rather difficult questions to answer.  Probably to Russian entities (or a buyback financed by Russian state banks), and perhaps the Chinese, and for a song.

Glencore shares fell modestly on Friday, so the blow is not perceived as being too heavy.  But the company is likely the biggest loser other than Oleg himself.

The grievous blow directed at Deripaska also raises an issue that has not attracted much attention in the US or Europe–the fate of Norilsk Nickel.  Nornickel has been subject of a long running battle for control between Deripaska and Vladamir Potanin.  Roman Abramovich had indicated his intent to sell a block of shares that he had purchased as part of a peace deal between Deripaska and Potanin, and this raised the possibility of a “shootout” auction for the block between the two.

Well, methinks Oleg is plumb out of bullets right now, and so Potanin will prevail.  Which means that even a Russian billionaire can benefit from US sanctions on Russian billionaires.

(Curiously, although Potanin was on the “Forbes List of Potential Sanction Targets” announced earlier this year–as was Deripaska–he was not hammered the way Oleg was.  I have no idea why.)

All in all, there are loser and winners from Friday’s sanctions.  The losers are clearly Deripaska and to a lesser degree a non-Russian (despite the first name!), Ivan Glasenberg. One like winner is a Russian billionaire, and other winners are likely Chinese.

One person who is clearly not a loser, and may even be a winner, is the ostensible target–Vladimir Putin.

So other than throwing a few Russians to the US hounds baying for Russian blood, it’s really hard to see the point of this exercise.  It doesn’t advance American interests in any meaningful way.  Anyone looking for any change in Russian behavior–in Putin’s behavior–in the coming months will almost certainly be disappointed.  This is more another act in the ongoing American political melodrama than a serious policy move.

To alter a saying which Putin is fond of  quoting: the hounds will bay but the caravan–Putin’s caravan–will move on.

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