Streetwise Professor

January 27, 2024

The “Pause” on LNG Permitting: Another Manifestation of “Elite” Hatred of Humanity, and a Monument to Stupidity

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — cpirrong @ 7:25 pm

The Braindead Administration–sorry, sorry, the Brandon–I mean Biden!–Administration (understandable confusion there)–has announced a pause on permitting on new liquified natural gas (LNG) terminals. And how long a pause? How ’bout to a quarter ’til never:

The review will take months and then will be open to public comment which will take further time, Energy Secretary Jennifer Granholm told reporters in a teleconference.

This policy, if one can dignify it with such an appellation, is a sop to the ecoloonies upon whom the administration depends for support:

The growth [in LNG exports] has set off protests from environmentalists, part of Biden’s base. Activists say new LNG projects can harm local communities with pollution, lock in global reliance on fossil fuels for decades, and lead to emissions from burning gas and from leaks of the powerful greenhouse gas methane.

In brief, the administration (regime, really) wants to kneecap the remarkable energy revolution of the past 20 years, which has seen technological innovations that have turned the US from a nation worried about where its next MMBTU would come from to a natural gas production powerhouse, and which have allowed others to share in its bounty with the world.

But you see, to the ecoloonies that’s the bad news. Really bad. Climate change, dontcha know.

But even evaluated on those (dubious) terms, the policy is demented. Because the ecoloonies don’t understand basic economics. They are myopic, linear thinkers who are incapable of analyzing the ultimate impact of their policy.

In their thinking, less LNG exports from the US equals less fossil fuel consumption equals lowers carbon emissions equals saving the polar bears. Even overlooking the (again dubious) last step in the logical chain (hey, I’m a a generous guy) the analysis is flawed. Where it definitely breaks down is the third, and arguably the second, steps.

Yes, reducing US natural gas output (by choking one source of demand) will reduce world natural gas production. But the resulting higher world price will induce higher output by competing producers (e.g., Qatar, Australia, PNG, Africa, etc.), resulting in a net decline in world gas production smaller than the decline in US production–and it is world production that matters when considering “well mixed” GHGs. Further, some production that would have otherwise been exported will be consumed domestically instead, meaning that a given decline in exports does not result in an equal decline in production.

But more importantly, the rise in the price of gas relative to other fuels–notably coal–will induce substitution towards those fuels. Since those fuels are more carbon intensive than natural gas, it is possible, and indeed likely, that the net effect of the policy would be to increase the output of GHGs.

So at the very least, the amount of reduction in GHGs resulting from this policy will be far smaller than the reduction in US LNG exports that it will cause, and plausibly will result in an increase of GHGs.

Well played! All pain, no gain!

But the economic idiocy of ecoloonies is an old story by now. Perhaps you’ve read of the recent finding that the ban on “single use” plastic bags in New Jersey led to a tripling of consumer plastics consumption because of the substitution effects that the ban induced. Again, myopic, linear, one-step ahead thinking led to a policy that produced perverse results.

The foregoing analysis focuses on only one dimension–GHG output. But one also has to consider the cost incurred to achieve any GHG gains (if there are any, that is). But trade-offs (costs vs. benefits) is not something that ecoloonies do. They are monomaniacs, and monomaniacs don’t evaluate trade-offs.

This policy will also shtup European allies, whom in the aftermath of the Russian invasion of Ukraine Biden promised would receive bountiful supplies of US gas.

To paraphrase Animal House: “You fucked up, Europe! You trusted Biden!”

The administration pinky swears that

the pause would not hurt allies, saying the plan will come with exemptions for national security should they need more LNG.

Yeah, because it’s just like turning the faucet on and off, right?

If you believe what they say, you are truly an idiot and probably believe they’ll respect you in the morning.

But none of this should be a surprise. After all, this is an administration that is infested with members of the “elite,” and which counts on the “elite” for its support. According to a recent Rasmussen poll:

An astonishing 77% of the Elites – including nearly 90% of the Elites who graduated from the top universities – favor rationing energy, gas, and meat to combat climate change. Among all Americans, 63% oppose rationing.

Face it. They hate your guts and want you to suffer. This “pause” on LNG exports is just another manifestation of their hatred.

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January 1, 2024

Agency Problems, or, The Progs Lose Control Of Their Bodily Functions in Fear of How the SCOTUS May Rule

Filed under: Commodities,Derivatives,Economics,Politics,Regulation — cpirrong @ 2:43 pm

In the coming year the Supreme Court will rule in two cases that could result in the imposition of substantial constraints on the administrative state. Since federal administrative agencies are progressive pets, the prospect has the left freaking out. And I do mean freaking out.

The first case is Securities and Exchange Commission v. Jarkesy. Here Jarkesy is challenging the legitimacy of the SEC (and by implication other agencies) relying on internal administrative law judges (“ALJs”) to decide enforcement actions brought by the agency. Jarkesy argues that such cases should be tried in Article III courts (i.e., in federal court).

The Constitutional basis for his argument is compelling. Agencies flout the separation of powers: they combine legislative, executive, and judicial functions. In the case of enforcement actions like that against Jarkesy, the SEC brings the charges against the defendant/respondent, prosecutes the case, and if the agency uses an ALJ, tries the case and renders the judgment and assesses the penalty. The case is brought under regulations adopted by the agency in a quasi-legislative role (supposedly under powers delegated by Congress–an issue that is relevant in the other case I will discuss).

Jarkesy argues that being subordinate to, and accountable to, the agency, ALJs are not independent are subjecting him to their judgment violates his Constitutional rights, and in particular his right to due process.

As an empirical matter, Jarkesy has a compelling case. I recall that in an antitrust case, Justice Potter Stewart opined that the “only consistency” in such cases is “that the government always wins.” (That was in the 60s.). And that was before Article III courts. That is even more true in cases before ALJs in agencies like the SEC and FERC. (When is the last time a FERC ALJ decided against the agency in a big matter?)

Jarkesy therefore wants the trier of fact to be an ostensibly independent Article III federal court. He doesn’t want to have his fate decided by an ALJ who is effectively beholden to the commissioners who run the agency who are bringing the charges and prosecuting them.

Reasonable, no? But not to the progs. They are losing their sh!t over the prospect. Case in point, this article in the Atlantic–which is always a reliable barometer of prog opinion.

According to author Noah Rosenblum, this would represent The End of the World as We Know It.

It would “destroy the government”!!!!!!!! (He says this like it’s a bad thing!–JK).

Rosenblum’s argument veers between the hysterical and the dishonest.

This part in particular cracks me up:

Jarkesy’s second claim—that the internal adjudicator who first heard his case held too much independence—is especially galling. These adjudicators should be independent; the alternative would be to put their regulatory powers at the political whim of whichever administration might be in charge. 

The relevant question is “independent from whom?” The very essence of Jarkesy’s argument is exactly that ALJs are creatures of “whichever administration may be in charge.” “The political whim of whichever administration might be in charge” is precisely the problem, not the “alternative.”

Article III courts are about as independent of the current administration (whether it be the presidential administration, or the commissioners of an agency) as is possible–and that’s by the Founders’ design. ALJs are definitely not.

Rosenblum loses control over his bowels at the thought that allowing those accused by federal agencies be judged by, you know, federal judges will gut the ability of agencies like the SEC to prosecute financial crimes:

The SEC was created as an independent agency in 1934, after the financial crash of 1929, to thwart the sort of market manipulation that preceded the Great Depression; Congress has granted it additional powers over the years to continue protecting financial markets. Responding to catastrophes and guarding against market manipulation is exactly the kind of work that Congress should empower the executive branch to do. Requiring Congress to legislate in response to every new fraud some crook might dream up would not be a good use of its time. And there’s no reason to think that delegating authority to police markets runs afoul of the Constitution.

Requiring those who “police markets” to prove their cases beyond the relevant burden of proof (preponderance of the evidence in a civil case) to a truly independent trier of fact does not permit manipulators and fraudsters to run rampant, any more than requiring your local police and prosecutor to prove charges before a judge allows murderers and rapists to run rampant.

Given the stakes in federal securities cases, which can easily run into the tens or hundreds of millions, if not more, requiring prosecuting agencies to clear such a hurdle is eminently reasonable.

What is Rosenblum so afraid of? These people would be prosecuted before Article III courts under the same laws and regulations that they are currently prosecuted before ALJs. A decision adverse to the SEC in Jarkesy would not eliminate the Securities Act, or the Exchange Act, or the SEC regulations adopted pursuant thereto. It would just require the SEC to prove cases brought under those acts and regulations in an Article III court rather than on the agency’s home court.

Rosenblum’s ultimate argument is that Jarkesy is a scumbag:

George R. Jarkesy Jr., a right-wing activist and conservative-radio talk-show host.

Heaven forfend that such a MAGA man should have rights! Oh! The humanity!

The kind of ad hominem chickenshit to which the left routinely resorts to today, and uses to stamp “QED!!!!” on its argument. By doing so, Rosenblum betrays the substantive weakness of his arguments.

I note that many seminal Supreme Court cases involving fundamental Constitutional rights have involved scumbags. And the Supreme Court ruled–rightly–that scumbags have rights too.

It is interesting to note that the CFTC now brings most of its manipulation cases–you know, “exactly the kind of work that Congress should empower to the executive branch to do”–in Article III courts. Now, as it happens, there is a tangled and unrepresentative story behind this, namely that the CFTC ALJs proved to be particularly dysfunctional and inveterately opposed to the agency’s enforcement staff. (I have intimate knowledge and experience regarding this history.). But the why is no matter. The reality is that an agency can bring manipulation cases (and fraud cases, for that matter) in federal court. Requiring the SEC (and other agencies) to do so will not “destroy the government” or allow wrongdoers to run rampant.

Indeed, the CFTC’s experience in federal court–most notably, its loss in the DRW/Wilson case–demonstrates the virtue of forcing agencies to play in the big leagues. It reduces the probability of Type II errors, i.e., false convictions.

I also note that there are rights of private action for certain federal securities, antitrust, and commodities law violations. Here private plaintiffs can bring cases in federal court against alleged malfeasors. I believe that such private rights of action are more reliable deterrents of bad conduct than agency actions, for a variety of reasons. (Again, this observation is based on considerable experience and observation.)

The other case that has the progs’ undies in a bunch is FDA v. Alliance for Hippocratic Medicine. This case threatens to demolish so-called “Chevron deference,” a reference to the case Chevron v. Natural Resources Defense Council in which Justice Scalia (!) on behalf of the court opined that courts should defer to agency judgements in cases in which Congress did not unambiguously delegate authority. That is, when there are “gaps” in a statute pertaining to a regulatory agency, Article III courts should defer to agency decisions regarding on how to fill those gaps.

Alan Blinder (among others) fears the abrogation of Chevron deference. Blinder is less hysterical than Rosenblum in his criticism (a low bar to clear!) but substantively he is no more persuasive.

The gravamen of Blinder’s argument is that agencies are experts, and we should defer to their expertise: we are not worthy to challenge them, nor are federal judges!

This has been the mantra of progressives since, well, the Progressive Era. Blinder is channeling his inner Woodrow Wilson. (Scary thought, that.)

There are two major problems with this. The first–and arguably less important–is that their “expertise” is vastly exaggerated. I mean vastly. Again based on extensive personal experience, I conclude that this is definitely the case when it comes to complicated markets (e.g., electricity, commodity derivatives). And yes, I realize that these complexities challenge federal judges, but the relevant question is who is better to resolve these issues: on that, I come down firmly on the side of the judges.

The second is what economists call “agency problems”–which in the present context can be called Agency problems. That is, the progressive view endorsed by Blinder (and Woodrow Wilson et al) is that agency decision makers are acting in the public interest.

This view has been laughable since the 1960s when Stigler posited “capture theory,” and then others like Sam Peltzman and Gary Becker looked at how the regulatory sausage is really made. The Public Choice literature has also utterly discredited the public interest view.

In a nutshell: regulatory agencies have their own agendas and own incentives that are not aligned with the public interest, for myriad reasons.

As valuable and insightful as they are, even the Peltzman-Becker-type analyses are inadequate. They are best suited to model the regulatory laws legislatures pass. They posit a decision maker looking to maximize political support (“votes”). That makes some sense when modeling legislatures that are somewhat accountable to an electorate. But the problem raised by Chevron deference is that regulatory agencies are incredibly insulated from such electoral feedback. If you view Congress as an agent of the public, agencies are agents of agents of the public. As a result, their incentives are extremely attenuated, and they have considerable scope to implement their own agendas regardless of whether they comport with the public interest or not.

John Cochrane laments that a new theory of regulation is required, because the Stigler-Peltzman-Becker theories, and public interest theory, are inadequate. I agree that these theories are inadequate, but do not believe that there is a vacuum. Certain strands of public choice that treat bureaucracies as independent agents in their own right have much to teach here. I recommend the works of Gordon Tullock and James Q. Wilson in this regard. (Tullock was an amazing scholar whose work deserves close attention–even his work from nearly 60 years ago.)

Here’s my Cliffs Notes theory of regulation: a large unaccountable bureaucracy combined with Hayek’s “why the worst get on top.” Ideologues with agendas are attracted to agencies with power over their agendas. Ensconced in power, they are largely immune from external check. So ensconced, they wreak havoc, the public be damned.

People, I give you–the EPA.

That’s why deferring to these agencies is disastrous. Their “expertise”–really their specialization in subjects of particular interest to the ideologues who infest them–is positively dangerous when given free rein.

I hope that the Supreme Court decides in Jarkesy’s favor, and also hacks away at Chevron deference. That said, I realize that the Supreme Court usually splits the baby, and that ringing decisions that drastically curtail the scope of agencies’ powers are unlikely. Meaning that the war against the agencies–or more accurately, the war of the agencies against us–will continue.

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December 5, 2023

Luddism in the Oil Futures Markets

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — cpirrong @ 1:06 pm

The old, old game of Pin the Tail on the Speculator has been updated. According to Bloomberg, the speculators who now “disrupt” the oil markets are not human: they are bots. Specifically, bots operated by Commodity Trading Advisors (CTAs).

This argument consists of two parts. The first being that the crude oil futures markets have been disrupted. The second being that the CTAs are the cats behind the disruption. Both plinths are defective.

Insofar as disruption is concerned, Bloomberg claims “Trading oil has perhaps never been more of a roller coaster ride than it is today.” Further:

Just in the past two months, prices threatened to reach $100 per barrel, only to whipsaw into the $70s. On one day in October, they swung as much as 6%. And so far in 2023, futures have lurched by more than $2 a day 161 times, a massive jump from previous years.

Bloomberg

Never more of a roller coaster ride? Well, let’s do something crazy. Like look at historical data.

The conventional measure of the wildness of the ride is volatility. The annualized daily volatility of crude oil during the alleged Rule of the Bots (the last two years) is 41.62 percent. The historical volatility (2010-2020) is 41.2 percent. (This omits 4/20/20 and 4/21/20, the day of the negative oil price and the following day.) Excluding the COVID months of 2020 produces a somewhat lower vol of 36 percent, not that much smaller than in the last two years. Further, extended excursions of realized volatility to above 40 percent are not unusual in the historical record. So to say that oil prices have been more volatile recently than has historically the case is categorically false.

With respect to the big daily moves, the Bloomberg analysis is fatally flawed because it looks at dollar price moves: big dollar price moves are more likely when prices are high than they are low, and by historical standards oil prices have been high in the last several years. It is appropriate instead to focus on percentage price changes (which is how vols are calculated, btw).

Rather than count the number of times an arbitrary threshold (like $2/bbl) is breached, it is more rigorous to look at a statistical measure of the frequency of extreme events: the “kurtosis.” Kurtosis bigger than zero means a distribution has fat tails relative to a Gaussian (“normal”) distribution, i.e., extreme moves up or down are more likely than under a normal distribution. The bigger the kurtosis, the more likely extreme moves are, i.e., the fatter the tails of the distribution.

Looking at the kurtosis of daily percentage changes rubbishes the Bloomberg analysis. The kurtosis in the last two years is 4.15, whereas from 2010-2020 it was 27.9! That is, the frequency of extreme daily price moves in years of alleged CTA disruption is far, far smaller than was the case prior to their alleged emergence as the dominant force in the. markets.

Interestingly, the kurtosis of dollar price changes is not that different between eras: 6.9 post-2020 vs. 7.2 2010-2020. So even extreme dollar price moves are less frequent in the alleged CAT era than previously. The difference is smaller, which demonstrates the need to take into account the level of prices in an analysis of “extremes.”

So the predicate for the article–that oil prices have been unusually volatile and unusually susceptible to extreme moves in the past couple of years–is not supported by the data.

As for the alleged causal factors, the dominance of CTAs is not evident in the data. CTAs are included in the “Managed Money” category of the CFTC’s Commitment of Traders Report. Here is a graph of the net position of Managed Money going back to 2006:

There was a peak in 2017-2018–a drilling boom in the US, to which I will return shortly–followed by a decline–a drilling drought–followed by a rebound to levels comparable to the 2017-2018 levels. Indeed, managed money net positions have actually been relatively low in the past year (with the exception of a recent spike) as compared to the post-2015 period as a whole. Certainly no Alice to the moon spike in CTA presence apparent here.

Bloomberg claims that the CTAs have become dominant in large part due to a sharp decline in producer hedging:

That coincided with the collapse of another source of futures and options trading: oil-production hedging. During the heyday of shale expansion about a decade ago, drillers would lock in futures prices to help fund their growth. But in the aftermath of the pandemic-induced price crash, a chastened US oil industry increasingly focused on returning cash to investors and eschewed hedging, which can often limit a company’s exposure to the upside in a rising market. By the first quarter of this year, the volume of oil that US producers were hedging by using derivatives contracts had fallen by more than two-thirds compared with before the pandemic, according to BloombergNEF data.

It should be noted that this claim that CTAs have achieved greater dominance due to an ebbing of hedging is implausible on its face. Futures are in zero net supply. If producers have reduced their net positions, necessarily non-hedgers–including CTAs–must have reduced their net positions.

Hedging has indeed declined. In the oil market, much (if not most) producer hedging is via the swaps market rather than direct producer participation in the futures market. Banks buy swaps from producers, and then hedge their exposure by selling futures. Here is a chart of net Producer and Merchant Plus Swap Dealer exposure from the CFTC COT data:

Note that there was a big increase in hedging activity (by this measure) in 2017-2018 that was reversed, followed by a partial resurgence, but in the last couple of years hedging activity has indeed ebbed, and reverted to its 2016 levels.

But note that this pattern of hedging mirrors closely Managed Money net positions. As is necessarily the case. If there is less hedging, speculators necessarily hold smaller positions. Meaning that this statement is nonsensical:

The recent wave of dealmaking by US oil producers threatens to further accelerate the decline in hedging. And it’s highly likely that CTAs will continue to fill the vacuum left by those traditional market players.

It’s not as if CTAs–or speculators generally–are “fill[ing] a vacuum.” If hedgers reduce positions, speculators do too.

The Bloomberg writers may dimly glimpse the truth, though they don’t realize it.

How did CTAs come to become so dominant? Like many current phenomena, the answer starts in the depths of the pandemic.

As shutdowns engulfed the world in 2020, fuel consumption collapsed by more than a quarter. All hell broke loose in the crude market. The benchmark US oil price briefly dropped to minus $40 a barrel and investors were in wholly new territory. Some funds that took longer-term views based on supply-and-demand fundamentals quickly pulled out.

Such bear markets proved to be “extinction events” for traditional funds, which made way “for algo supremacy,” the bulk of which are CTAs, said Daniel Ghali, senior commodity strategist at TD Securities. Russia’s invasion of Ukraine gave the CTAs another foothold. Spiking volatility in the futures market drove many remaining traditional investors to the exits, and open interest in the main oil contracts tumbled to a six-year low.

So if CTAs have indeed become more prevalent, it is because they have supplanted other speculators who exited the market. Futures are risk transfer markets. If some of those who previously took on the risk from hedgers have exited the market, either hedgers must hedge less or other speculators must step in. It seems that both things have been happening.

That’s not some ominous development–it’s markets at work. And CTAs shouldn’t be damned–they should be praised for stepping into the breach.

And another paragraph in the Bloomberg article suggests at what is actually happening here:

The unpredictability of this year’s market swings haven’t been kind to human traders, many of whom are making less money on oil than they did last year when they raked in record gains, according to market participants.

What is likely driving this story is whinging by the traditional specs, who have been outcompeted by the bots. “No fair! They are making money and I’m not! They must be cheating.”

Reminds me of my epigram from my manipulation book, where riffing on Ambrose Bierce’s Devil’s Dictionary I wrote something to the effect that a market is manipulated when it moves against me.

Again, this is markets at work. The fact that bots are doing well relatively to trad specs means that they are better at predicting market movements, or have lower costs of bearing risk, or both.

It does not mean that they are making the markets move.

So this Terminator Tackles the Oil Market narrative is really nothing more than Luddism. A new technology outcompetes the old. The incumbents complain. End of story.

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September 28, 2023

Come On Down! And Will the Last Business in Chicago Turn Off the Lights? Thanks.

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 4:50 pm

Texas governor Greg Abbot has extended an invitation to the CME Group to relocate from Chicago to Texas. The exchange group may well be moveable because the city’s new mayor, Let’s Go Brandon Johnson, has mooted a $1 or $2 per transaction tax on futures, options, and securities transactions in order to fill the city’s gaping fiscal hole–despite the fact that this is currently illegal under Illinois law.

Now you might not think that a buck is a big deal, given that a T-note or crude oil contract has a nominal value of around $100 grand. But it is a big increment to the cost of executing a contract. For example, the bid-ask on a crude oil futures trade is usually about $10, and the brokerage commission adds on only a few bucks. So the tax would increase transactions costs on the order of 5 or 10 percent.

I note that the industry fought for years at efforts to impose a 15 cent futures transaction tax. What Johnson is proposing is substantially greater than that.

Now, if Johnson’s objective was actually to raise revenue, this would be an incredibly stupid idea. Rule one of taxation: tax what can’t move. Although in the floor days uprooting the exchange and taking it outside the city or the state would have been very difficult, that’s not the case in the electronic era.

Have servers, will travel. Yes, CME Group (and CBOE–which given recent developments might end up in CME) has corporate employees there, but if any city should understand that is no impediment to relocation, Chicago should given the exodus of several major corporate HQs from the Chicago area in recent years–Caterpillar, Boeing, and Tyson Foods being prominent examples.

Moreover, even before the CME says hasta la vista motherfuckers, it faces competition in some of its products from ICE, and a tax would shift business there.

Numerous trading firms (notably Citadel) have fled Chicago for reasons–namely the marked decay of the city. (And I do mean marked: even in the last two years the decline has accelerated dramatically.) The CME has certainly already put those factors on the scale when making its decision, and a sizable transaction tax would almost certainly tip the balance heavily in favor of joining the exodus.

Notice that I framed my analysis as a conditional statement: if Johnson’s objective was actually to raise revenue. One cannot be too sure these days. Mayors of city after city have taken actions, or failed to take actions, that seem designed to drive out all but the underclass and turn the polities they govern (I use the term loosely) into crime-ridden, drug infested wastelands. In fact, it’s hard to name a big city whose elected officials haven’t done that or aren’t doing it.

American Spectator writer Scott McKay calls it “weaponized government failure:” “deliberate refusal to perform the basic tasks of urban governance for a specific political purpose.” The “specific political purpose” being to drive out middle class voters who pose the main political threat to the Brandon Johnsons and their ilk.

Framed as a hypothesis, I’m hard pressed to come up with contrary evidence.

Whether that’s the true purpose behind Johnson’s transaction tax brainwave, if he moves forward with it it’s a near lock that CME will hit the road. An electronic exchange is footloose and fancy free and not beholden to any place. Where once there were “locals” whose physical presence was necessary to operate an exchange, there are now what may be called “globals” who can and do supply liquidity from anywhere.

And if it moves, Texas is a good place. No income tax for one thing. Reasonable housing costs. And as for the weather, as I told my late mom when she fought coming here: “Look, you spent four months a years indoors in Chicago. You’ll spend four months a year indoors in Houston. Just different months.”

So come on down, Terry Duffy. I’ll be here to greet you. With bells on.

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September 3, 2023

Shell Has a Come to Jesus Moment: Will the Politicians? Alas, Probably Not.

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — cpirrong @ 3:22 pm

In 2010, along with my UH colleagues Victor Flatt and Praveen Kumar, I taught what I believe was the first academic carbon trading course in the world. My lectures in the course related to the economic challenges of creating traded commodities, specifically the challenges of merely defining what the commodity is and monitoring adherence to the standards so established.

Now, this may seem trivial, but even something like “wheat” poses challenges due to heterogeneity related to quality (even within a given variety, such as soft red winter wheat) and monitoring whether the wheat traded under a contract adhered to the relevant terms agreed to by the parties. Indeed, as I noted in an early article of mine, the genesis and early development of commodity exchanges like the Chicago Board of Trade and the Liverpool Cotton Exchange was not driven by the desire to trade futures: these were cooperative, private efforts to define property rights and to create a mechanism to standardize commodities and to adjudicate contractual disputes primarily over quality. Only after these challenges were met was it possible to trade futures. Standards (and their enforcement) are obviously a necessary condition for trading standardized instruments like futures.

The major intended takeaway from my lectures in 2010-11 was that the problems of standard definition and especially standard enforcement were even more daunting in carbon than in traditional commodities like wheat or cotton, and that this was especially true with respect to carbon offsets–things like contracts to plant trees to capture carbon.

How do you define what is being bought and sold? How do you monitor whether the offset contracted for performs as agreed? How do you address contract performance failures? The Chicago Board of Trade struggled for years to overcome these issues in wheat and corn and oats in the post-Civil War era, even though the trade was relatively geographically concentrated, the contracts were of relatively short duration (typically for a single consignment), and the commodity was relatively simple.

All of these challenges are far greater for carbon, let alone for offsets. Sources of carbon emissions are numerous and diffuse and costly to monitor. With respect to offsets, they are highly heterogeneous; have very long lives; require continuous investment and upkeep; and have highly unpredictable performance (e.g., the forest that you plant may burn down, or be ravaged by insects). These contracts are far more complex than a deal to buy 10,000 bushels of SRW winter wheat for delivery in Chicago next month. Moreover, many offsets are located in countries with weak–and sometimes close to non-existent–legal systems.

Furthermore, the incentives of the parties to these agreements can be perverse, especially for “voluntary” offsets. A buyer who pumps its ESG score by purchasing offsets that turn out not to perform seldom suffers serious adverse consequences (although there is some backlash against “greenwashing”), and the seller has a strong incentive to collect the cash and not make the necessary expenditures to ensure that the offset performs as promised.

I taught the class in the immediate aftermath of the Global Financial Crisis, and I suggested that there were a lot of similarities between offsets and the kinds of deals that wreaked havoc in the banking system in 2008-2009, where bankers paid their bonuses upfront based on imagined profits predicted by highly speculative models to be realized over several years churned out garbage securities.

In 2010 I was therefore extremely skeptical about the viability of markets for offsets. And the defects that I talked about have been increasingly recognized in the last year or so.

I believe that the actions of Shell during the last week represent an authoritative recognition that these predictable–and predicted–problems have come to pass. Like other (especially European) energy firms. Shell made ambitious carbon reduction pledges that it intended to meet largely through the use of offsets. But reality has reared its ugly head, and Shell is all but abandoning this strategy. Other companies (e.g., Microsoft) say that they are still committed, but if they are even remotely interested in spending their shareholders’ money wisely, they will eventually have the same come to Jesus moment as Shell.

A Shell-funded mangrove restoration project in Senegal (Bloomberg).

This represents another grievous blow to the ambitions of the Net Zero fanatics. Offsets are a major component of Net Zero plans. Renewables are another part–and reality is catching up with that too (as the travails of Danish renewables developer Orsted and German turbine manufacturer Siemens demonstrate).

But will the fanatics be deterred? Alas, it appears not. Indeed, they appear to be doubling down, as illustrated by lunatics like Michael Gove:

Net Zero and the policies intended to bring it about–including extensive reliance on renewables and offsets–are a guaranteed recipe for an impoverished future. This was predictable–and predicted–more than a decade ago. But when will the madness end? I am guessing not before these policies cause economic catastrophe.

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July 14, 2023

The Hydrogen Economy, or The Hindenberg Economy? Or, Gosplan Goes Gassy

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — cpirrong @ 12:32 pm

The Biden administration, courtesy of the delusionally titled Inflation Reduction Act, has made a huge spending commitment on alternative fuels, and in particular “clean” hydrogen, i.e., hydrogen not produced from fossil fuels (such as methane). Most of the “green” hydrogen stimulus involves supply-side subsidies (especially a $3/kg production tax credit, but also loans to be doled out by the administrative state). The Infrastructure Law sets aside funds for hydrogen electrolysis and hydrogen “hubs” (like that just announced for Germany). The administration is also attempting to make “the economic case for demand-side support,” such power purchase agreements (PPAs), contracts-for-differences (CFDs), advanced market commitments (made by whom?), and prizes (funded by whom?).

It’s hard to know where to begin in criticizing this mess. The biggest problem is that it attempts to address the climate issue (which I will take as a given, focusing on means not ends) by picking technologies. This almost never ends well. First, there is the knowledge problem–bureaucratic governments do not possess the information to make these technology choices. Second, there is the rent seeking/corruption problem–which exacerbates the knowledge problem, as interested parties exploit the ignorance of bureaucrats and funders, and their political connections, to induce investments based not on their economic virtues but instead on political influence.

There are also serious doubts about whether hydrogen qua hydrogen is the right alternative fuel given that it poses numerous problems and costs. The first is that using renewable energy to produce green hydrogen is extremely expensive. The second is that, well, hydrogen is highly explosive: I distinctly remember my 8th grade science teacher, Mr. Fisch, using electrolysis to fill a test tube with hydrogen, putting in a piece of chalk, then lighting a match to set off an explosion that sent the chalk flying across the room. You didn’t have Mr. Fisch as a teacher, but perhaps you’ve heard of the Hindenberg:

Explosiveness creates hazards, of course, and mitigation of them is expensive. Hydrogen is also extremely expensive to transport and store and requires a new and distinct transportation and storage system.

We are talking trillions of dollars to create “the hydrogen economy”–something even its boosters admit. Hell, they brag about it.

Hydrogen “carried” with carbon, in the form of ammonia or methanol, pose fewer problems (although ammonia in particular is nasty stuff). They are also costly, and it is clearly uncertain whether “green” forms of these hydrogen carriers are economical ways to reduce carbon emissions from fuels for transportation and power generation.

But the administration (and Europe too) have gone all in on hydrogen. Why? Maybe because their extreme antipathy towards carbon leads them to disdain fuels with any carbon in them.

Having chosen its technology, for better or more likely worse, now the administration is focused on how to force its adoption. The supply-side incentives are clear enough, so now there is a pivot to the demand-side, as expressed in the appallingly shoddy Council of Economic Advisors document linked above.

According to the CEA–and not just the CEA, as will be seen shortly–the problem is that “[r]eal or perceived risks around clean energy projects can raise the cost of accessing capital,  which could slow the rate at which projects like those in the hydrogen hubs program achieve commercialization..”

Well, I should hope so! That is, I should hope that risks are taken into account when allocating capital!

John Kerry flogged the risk issue on MSNBC (h/t Powerline):

“What’s preventing it is, to some degree, fear, uncertainty about the marketplace. People who manage very significant amounts of money have a fiduciary responsibility, an obligation to the people they manage it for not to lose the money, but to produce returns on that investment. Pension funds, many of them, are very careful about those investments in order to make certain they have the money to pay out to the pensioners who work for that money all their lives. So, there are tricky components of making sure that you have taken the risk away from these investments. And energy, which is what the climate crisis is all about, it’s about energy, it’s about how we fuel our homes, how we heat our homes, how we light our factories, how we drive and go from place to place.”

Damn those money managers for taking into account the risks and rewards of the money their investors entrust to them! Don’t they understand that John Effing Kerry knows what is right for humanity????? After all, he flies around the world in a private jet sharing his wisdom (and then dissembles about it before Congress).

I loved this part: “So, there are tricky components of making sure that you have taken the risk away from these investments.” Does John Kerry have a magic box into which he can make the risks disappear? Do tell!

Of course he doesn’t. What he means, clearly, is that the government must somehow absorb the risks inherent in the technology that they have already decided upon–apparently without analyzing those risks fully or carefully, or wondering whether maybe these damned investors might know something they don’t. (Of course they don’t wonder that! They are all knowing, right?)

At least the CEA attempts to put lipstick on the pig and raise some economic arguments to justify the need for demand-side support. There are market failures! Government never fails, but markets do, right?

In my experience the concept of market failure is most likely to be advanced when the market fails to do what someone thinks should be done, or wants to be done, based on their own vision. That is, when the market disagrees with someone, the market has failed! Especially when that someone is a member of what Thomas Sowell calls “The Anointed.”

The CEA basically cites to some theoretical possibilities. At the core of their argument is that learning by doing, including learning-by-doing that “spills over” among companies, can lead to inefficient investment. The CEA advances a couple of reasons.

One is a contracting failure. LBD–moving down the learning curve–reduces costs, meaning that prices are expected to fall. So, according the CEA, potential buyers are unwilling to enter into long term contracts for fear of agreeing to pay a price that will turn out to be too high: “if rapid declines in technology costs are expected, the willingness of private sector end-users to seek out such contracts with clean energy developers will be limited” (emphasis added). Without such contracts, hydrogen project developers can’t secure financing, so plants won’t get built, no learning takes place, and costs don’t fall. The Curly Equilibrium, in other words:

Really? If costs are expected to fall, market participants can enter contracts with de-escalator clauses, i.e., contractual prices that fall over time. Apparently the CEA only envisions contracts at a fixed price that extends through the life of the contract. But even then, given anticipated cost declines, the developer would be willing to sell at a price below the initial cost, basically, at the average cost expected over the life of the contract.

The CEA mentions the risks of of the magnitude of cost declines, but again, that should be a material consideration in any contracting and investment decision. Is the CEA arguing that the risk compensation demanded by borrowers will be excessive? They don’t say so explicitly, but that’s what you would need to argue that the prices in these contracts would be “too low” and thereby stymie investment.

I’d also note that indexed prices, widely used in a variety of commodity off-take agreements, eliminate the risk to buyers of locking in too high a price. They also address the asymmetric information problem that the CEA frets about. If the developer has better information about the likely trajectory of price declines, then yes, buyers looking at fixed price deals or deals with mechanical (non-market based) price de-escalators face a “winners’ curse” problem: the developer will agree to terms that overestimate his (better) forecast of future prices, and reject deals that underestimate.

I think in fact that the issue is that there is considerable uncertainty among all parties, developers and buyers alike, regarding what the future cost trajectory will look like. That is, there is a real risk here, and that risk should be taken into consideration when deciding whether hydrogen investments make sense. And market participants are far better at assessing the risks, and the pricing of those risks, than the government, which is clearly taking a “Damn the risks, full speed ahead!” Approach.

Sorry, but John Kerry et al don’t inspire confidence like Admiral Farragut at Mobile Bay.

One of the proposals under discussion is Contracts for Differences (“CFDs”) in which the government would (perhaps through a non-profit intermediary) provide a guaranteed revenue stream to a developer and absorb the price risk. To work, CFDs require indexing to some market price–and the market price for H2 hasn’t really been created. Further, they require some mechanism to set the guaranteed price, a non-trivial task given the very information asymmetries that the CEA worries about. The government-appointed third party (or the government for that matter) will certainly be the less informed party in any negotiations with developers, and will almost certainly overpay. (Not that they will mind–not their money!) Meaning that the asymmetric information problem the CEA frets about is present in spades in one of their preferred means of addressing it. Further, CFDs have already presented performance issues, with the sellers (those getting the guaranteed revenue stream) treating these contracts like options rather than forwards, and spurning their CFD commitments when market prices rise above the guaranteed price (as has happened with with generators in the UK when power prices spiked).

The CEA also invokes capital market imperfections also driven by asymmetric information that may impede financing if developers know more about the economics of projects than the financiers. This is a hoary old story that has been used to identify alleged market failures since time immemorial. So long ago, in fact, that when Stigler wrote “Imperfections in the Capital Market” (JPE) 56 years ago, he (in typical Stigler fashion) drolly started thus: “The adult economist, once the subject is called to his attention, will recall the frequency and variety of contexts in which he has encountered ‘imperfections-in-the-capital market.'” That is, “capital market imperfections” were an old joke decades ago.

Here’s another one, George! Based on long experience, George was a skeptic. Based on even longer experience, I am too, in this case in particular.

And let’s look at the empirical record. Learning by doing is a ubiquitous phenomenon. Dynamically declining costs in industries with potential information asymmetries abound. Yet industries have developed and thrived nonetheless.

Some examples.

I recently finished a piece describing extensive learning-by-doing in the shale industry, including evidence of learning spillovers and dynamic cost reductions. Yet, the shale sector has not faced problems getting capital or expanding rapidly. Hell, if anything, a common criticism is that shale drillers have obtained too much capital and drilled too much, not that they are starved for capital and drilled too little.

Does the CEA (or John Kerry!) believe the shale sector in the US is too small?

Insofar as spillovers is concerned, the fact that the costs of firm A decline when firm B produces more output is a necessary, but not a sufficient condition for an externality. One plausible outcome in oil (as identified in a paper on LBD in conventional drilling by Kellogg in the QJE) is that service firms are the ones that do the learning, and capture and internalize it.

LBD is well-documented for computer chips, which have seen relentless cost and price declines over the years. Yet computer chip factories have been built, and companies especially in the US and Asia have attracted the capital necessary to build these very expensive facilities and build new chip lines nonetheless. (In this industry too, there have been chronic complaints about overcapacity, rather than undercapacity. I am not commenting on the validity of those complaints, just noting that their existence contradicts the notion that dynamic scale economies and price declines due to LBD starve an industry of capital.)

The LNG industry has many of the characteristics that the CEA attributes to hydrogen. Yet this industry has expanded apace for well over 50 years now.

I viewed a presentation by DOE people today in which LNG was raised several times, and as an example not to be followed. DOE advisor Leslie Biddle (ex-Goldman) mentioned LNG several times (“I keep going back to the LNG analogy”), and in a negative way. LNG took 30 years to move to a traded market, dontcha know. And we don’t have that time! We need to create such a market in a year! (DOE’s Undersecretary for Infrastructure David Crane was more generous, giving us all of 5 years.) (Crane was also hyping the idea of hydrogen for everything, including home heating–apparently oblivious to the fact that even Net Zero fanatical Britain has just recently determined that H2 is too dangerous to heat homes.)

In the context of the discussion of a grand government plan to transform the energy system, I couldn’t help but think of Gosplan, or Stalin’s race to industrialization (e.g., the Magnitogorsk Steel Factory). We will inevitably–inevitably–meet the “Dizzy With Success” phase in hydrogen, mark my words.

I note that LNG production grew substantially before it became a traded market, which actually undercuts Biddle’s argument. Even though there was not a liquid traded market for LNG in the first decades of its growth and development, long term contracts, usually using crude (no pun intended) indexing features (like tying prices to Brent), contracts were agreed to, financing was obtained on the backs of these contracts, and liquefaction plants were built.

Oil refining faced many of the conditions that worries the CEA about hydrogen. Kerosene was a radical product early on, with a lot of uncertainty about market adoption. But Rockefeller dramatically expanded output and reduced costs: the cost of kerosene by 2/3rds in 10 years (1870-1880), in large part due to extensive learning and research on all aspects of the value chain. Standard Oil’s supposedly predatory acquisitions of were actually ways by which SO’s knowledge could be combined with physical assets to improve their efficiency.

The co-evolution of gasoline refining and the adoption of the automobile represents another example of investment and falling prices in a new market in a capital intensive industry.

I note that the early refining examples occurred when capital markets were far less developed than is currently the case. I further note that large energy firms (IOCs and NOCs like Aramco in particular) can potentially finance hydrogen (and other alternative energy projects) with cash flows generated by their legacy fossil fuel investments: this would largely eliminate any asymmetric information problem between developer and financier (because the developer is the financier) and developer and customer (because the developer could finance without securing a long term price commitment).

Another example. Electricity generation. Beginning with its inception in the early-1880s, electricity generation was highly technologically dynamic, with substantially declining costs. Yet in a few short years most urban areas in the US were electrified, with numerous private companies competing with government utilities. This was another industry in which overbuilding, rather than under-building, was widely discussed. The movement to price regulation occurred well after the industry developed, and was a reaction to intense price competition: regulation effectively cartelized electricity generation.

One more. Aircraft. LBD was first identified in the production of airframes. This phenomenon was first documented by Wright in 1936, and was subsequently observed in myriad other industries (e.g., Liberty Ship construction in WWII). LBD and the associated cost declines have continued in aircraft construction ever since. And aircraft have been built and aircraft manufacturers have been able to attract the capital to design and build new aircraft that benefit from these cost declines.

In the face of all these examples, the CEA and others making these market failure arguments should identify an industry that died aborning due to the alleged chicken-or-egg problem that makes demand side support of hydrogen investment necessary.

The CEA document has echoes of some rather common, but unpersuasive, arguments for government support of industry, such as the infant industry argument and the big push development literature. The latter has been demolished by practical experience: the list of its dismal failures is far too long. There are more than echoes of this discredited approach in the CEA document. It links to a paper that credulously recycles the old, bad, discredited theories.

What is amazing about the infant industry argument is how often it is invoked, and how little empirical evidence supports it. One of the few empirical papers, that of Krueger and Tuncer, rejects the argument in the case of Turkey.

A paper by Juhasz is often touted to support the theory. It shows that after the stimulus of the cotton spinning industry in France due to Napoleon’s Continental system, post-1815 the industry was competitive with the British, indicating that it had moved down the learning curve. Again, at most this identifies a necessary condition for protection–learning–but not a sufficient one. Even if LBD occurs, and even if there are spillovers, the cost of protection may exceed the benefits. A simple story demonstrates this. If the protected industry achieves cost parity with the first-mover (e.g., the UK in cotton), the protected firms merely displace firms in the first-mover country, leaving post-parity total costs unchanged. So in equilibrium, protection is costly but generates no benefits.

All in all, the CEA document reminds me of a rather conventional undergraduate econ paper, repeating textbook wisdom about externalities and market failures. It completely ignores the Coasean insight that market contracting methods are far more sophisticated than those in the textbooks, and that market participants have incentives to find clever ways to contract around what would be market failures if market transactions were limited to the forms considered in textbooks. It also ignores the historical record.

In other words, rather than writing off the difficulties of securing “bankable” contracts to secure funding for H2 developments to “market failures” or the excessive risk aversion of market participants, the government should step back and consider whether this alleged hesitation reflects a more sober and informed evaluation of risks than our betters in DC have undertaken.

I crack myself up sometimes.

In sum, the administration’s entire approach to hydrogen is utterly flawed. It attempts to pick technologies based on a pretense of knowledge it does not possess. It views flashing red lights warning of risks as signals to be suppressed rather than considered when making policy and investment choices. It engages in simplistic analyses of how real markets work, and how they have worked historically, to conclude that market failures requiring government intervention to fix abound in hydrogen.

All of these government failures could be eliminated by cutting the Gordion Knot, pricing carbon, and letting markets and private enterprise develop the technologies, products, contracting practices, and market mechanisms to trade off efficiently the benefits of reducing CO2 emissions. Decentralized mechanisms discover and utilize information, including information about new technologies, far more efficiently than governments. Decentralized mechanisms incentivize learning and innovation–including contracting and organizational innovations that can be instrumental in developing and adopting new technologies, products, and techniques.

In the case of hydrogen, pure or “contaminated” with carbon, priced carbon would address the problems that the CEA frets about, in particular the contracting problem. A carbon price would make it straightforward to index prices in contracts. A formula related to NG prices (because blue hydrogen is likely to drive the price of hydrogen at the margin, and because methane is likely to be the substitute at the margin for H2 in many applications) and the cost of carbon would send the appropriate signals and eliminate the need to fix prices in advance.

What the price of carbon should be and how it should be determined is a whole other question. But it would be far more productive, and not just in regards to hydrogen, to focus on that problem rather than leaving it to the John Kerrys of the world to pick technologies and then devise the coercive mechanisms necessary to force the adoption of those technologies.

Alas, we are on the latter path. And it will not take us to a good place. Probably figuratively, and perhaps literally, to the fate of the Hindenberg.

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June 6, 2023

Stop Me If You’ve Heard This Before: Those Damned Speculators Are Screwing Up the Oil Market!

Filed under: China,Commodities,Derivatives,Economics,Energy,Russia — cpirrong @ 1:05 pm

Saudi Arabia is fussed at the low level of oil prices. So true to form with those unsatisfied with price, they are rounding up the usual suspects. Or in this case, suspect–speculators!

I’m sure you never saw that coming, right?

As the world’s biggest oil producers gather here Sunday to decide on a production plan, the spotlight is on the cartel kingpin’s fixation on Wall Street short sellers. Abdulaziz has lashed out repeatedly this year against traders whose bets can cause prices to fall. Last week he warned them to “watch out,” which some analysts saw as an indication that the Organization of the Petroleum Exporting Countries and its allies may reduce output at their June 4 meeting. A production cut of up to 1 million barrels a day is on the table, delegates said Saturday. 

Claude Rains is beaming, somewhere.

I’m so old that I remember when oil prices were beginning their upward spiral in 2007-8 (peaking in early-July), in an attempt to deflect attention from OPEC and Saudi Arabia, one of Abdulaziz’s predecessors blamed the price rise on speculators too.

Is there anything they can’t do?

Not that I’m conceding that speculators systematically or routinely cause the price of anything to be “too high” or “too low,” but if you do think that they influence price, they should be Abdulaziz’s best buddies. After all, they are net long now and almost always are. (Cf. CFTC Commitment of Traders Reports.)

If the Saudis (and other OPEC+ members) have a beef with anybody, it is with their supposed ally, Russia. Russia had supposedly agreed to cut output in order to maintain prices, but strangely enough, there is no evidence of reductions in Russian supplies reaching the world market, even despite price caps on Russian oil and the fact that they are selling it at a steep discount to non-Russian oil. Perhaps Russia has really cut output, but (a) that doesn’t really boost the world oil price if Russian exports haven’t been cut, and (b) it would mean that Russian domestic consumption is down, which would contradict Moscow’s narrative that the economy is hunky-dory, and relatively unscathed by sanctions.

But I think that the more likely story is that Russia is playing Lucy and the football with OPEC.

Which would be a return to form: see my posts from years ago. And I mean years ago. Apparently Won’t Get Fooled Again isn’t on Abdulaziz’s play list.

The other culprit behind lower oil prices is China: its tepid recovery is weighing on all commodity prices–not just oil. A fact that Abdulaziz should be able to understand.

But it’s much easier to shoot the messenger, and that’s what speculators are now–and almost always are. Venting at them probably makes Abdulaziz feel better, but even if he were to get his way that wouldn’t change the fundamental situation a whit.

Bashing speculators is what people who don’t like the price do. And since there’s always someone who doesn’t like the price (consumers when it’s high, producers when it’s low) bashing speculators has been and will continue to be the longest running show in finance and markets.

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May 9, 2023

Oh No Not This BS Again: The EU Looks to Regulate Commodity Trading Firms Like Banks

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Politics,Regulation — cpirrong @ 1:09 pm

In response to the liquidity crunch in the commodity trading sector (especially in energy trading) last year, the European Union is looking to regulate commodity traders more like banks:

For decades, Europe’s commodity traders have avoided being regulated on par with other financial firms. A new proposal currently working its way through the European Union legislative system could change that.

To close “loopholes,” dontcha know:

The loophole allows industrial companies like utilities and food processors — but also commodity trading houses — to take derivative positions without the scrutiny facing investment firms. Designed to reduce the burden of managing price risk, it also means that traders aren’t subject to rules on setting aside capital or limiting positions the same way banks and hedge funds are. 

2022 certainly saw unprecedented liquidity pressures in the commodity trading sector, as firms that had sold derivatives (especially on gas and power) to hedge their exposures from supplying the European market saw huge margin calls that greatly strained credit lines and led a coalition of traders to request ECB support (which the ECB declined).

The crucial part of the previous paragraph is “to hedge.” The danger of restricting or increasing the cost of such activities through regulation of the type that is apparently under consideration is that it will constrain hedging activities, thereby (a) making these firms more vulnerable to solvency, as opposed to liquidity problems, and (b) raising the costs of commodity intermediation.

Note that the companies that received state support that are mentioned in the article are not commodity traders qua commodity traders, e.g., Vitol or Trafigura or Gunvor. They are energy suppliers who were structurally short gas and did not hedge, and hence were facing serious solvency issues when gas prices exploded in late-2021 (before the Russian invasion) and winter and spring 2022 (when the invasion occurred). That is, firms that didn’t hedge were the ones that faced insolvency and received state support. (Curiously, Uniper is missing from the list of companies in the Bloomberg article, although Fortum Oyj was collateral damage from Uniper’s collapse.)

The relevant issue in determining whether commodity trading firms should be regulated like banks or hedge funds is not whether the traders can go bust: they can. It is whether (a) they are financially fragile like banks, and (b) whether they are systemically important.

These are exactly the same issue I addressed in my Trafigura white papers in 2013 and especially 2014. To summarize, commodity trading firms engage in completely different transformations than banks and many hedge funds. Commodity traders transform commodities in space, time, and form: banks engage in liquidity and maturity transformations. The difference is crucial.

Liquidity and maturity transformations are inherently fragile–they are the reasons that bank runs occur, as the recent failures of SVB, First Republic, and Signature Bank remind us. That is, the balance sheets of banks are fragile because they finance long term, illiquid assets with liquid short term liabilities.

Commodity traders’ balance sheets are completely different. The “pure” asset light traders especially: they fund short term (“self-liquidating”) relatively liquid assets (commodity inventories) with short term relatively liquid liabilities. Further, hedging is a crucial ingredient in this structure: banks are willing to finance the inventories because the price risks can be hedged.

This is not to say that commodity traders cannot fail–they can. But they do not face the same kinds of fragility (vulnerability to runs) that entities that engage in maturity and liquidity transformations do. It is this fragility that provides the rationale for bank capital requirements and limitations on the scope of their activities. This rationale is lacking for commodity trading firms. They are intermediaries, but not all intermediaries are alike.

Further, as I also pointed out almost a decade ago, major financial firms dwarf even the largest commodity trading firms. Even a Trafigura, say, is not remotely as large or systemically important as, say, Credit Suisse. Yes, a bankruptcy of a big trader would inflict losses on its lenders, but these losses would tend to be spread widely throughout the global banking sector given that most loans and credit lines to commodity traders are widely syndicated. And the potential for these kinds of losses are exactly reason that banks hold capital and that it is prudent to impose capital requirements on banks.

As I noted in the 2014 study, virtually the entire merchant energy sector in the United States imploded in 2002-3. Lenders ate losses, but the broader economic effect was minimal, the assets of the failed firms continued to operate, and the lights stayed on.

In sum, analogizing commodity traders to banks is seriously intellectually flawed, and what’s good or justified for one is not necessarily for the other because of the huge differences between them.

Pace Bloomberg, the events of 2021-2022 did not “expose” some new, unknown risk. The liquidity risk inherent in hedging has long been known, and I analyzed it in the white papers. Indeed, it’s been a focus of my research for years, and is the underlying reason for my criticism of clearing and collateral mandates–including those embraced enthusiastically by the EU.

Thus, a more constructive approach for Europe would be not to apply mindlessly regulatory restrictions found in banking to commodity firms, but to investigate ways to facilitate liquidity supply to commodity traders under extreme situations. Direct access of commodity traders to central bank funding is inadvisable, but central bank facilitation of bank supply of margin funding to commodity traders during such extraordinary circumstances worthy of investigation.

Recall that the Federal Reserve’s response to a funding crisis originating in the Treasury futures markets was instrumental in containing the systemic risks arising from COVID in March 2020 (as described in my Journal of Applied Corporate Finance article, “Apocalypse Averted“). The Fed’s actions were extemporized (just as they were during the 1987 Crash). The EU and ECB would do well to use that experience, and that of 2021-2022, to devise contingency arrangements in advance of future shocks. That would be a more constructive approach to the risks inherent in commodity risk management than to impose regulations that could impede risk management.

It is important to note that making hedging costlier instead of making it cheaper increases the risk of extreme price disruptions. Constraining risk management means that commodity traders will supply less intermediation especially during high risk periods. This will swell margins and make commodity supply less elastic, both of which will tend to exaggerate price movements during periods of stress.

I always wonder about the political economy of such regulatory proposals. Yes, no doubt regulatory reflex is a driver: “We have to do something. Let’s take something off the shelf and make it fit!” But my experience in 2012-2014 also motivates a more cynical take.

The genesis of the Trafigura white papers was an abortive white paper I wrote for the Global Financial Markets Association, a banking industry group. The GFMA approached me to investigate the systemic riskiness of commodity trading firms, and I came up with the wrong answer, so they spiked the study. Somehow or another Trafigura got wind of this, and that was the genesis of the influential (if I do say so myself) papers I wrote for the firm.

The point being that in 2012 the banks were pushing to regulate commodity trading firms with capital requirements and the like in order to raise the costs of competitors, and were looking for intellectual cover for that endeavor–cover I did not provide after a deep dive into the commodity trading sector.

Hence, I wonder if this reprise of the ideas that were largely shelved in the mid-2010s is an example of “let no crisis go to waste,” i.e., whether there are interests in Europe pressing to regulate commodity firms for shall we say less than public spirited reasons.

The proposals are apparently very protean at this stage. But it will be interesting to see where they progress from here. And I’ll weigh in accordingly.

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April 18, 2023

Wither Shale? Don’t Count on It. It Has Been a Technological Progress Story, Not a Diminishing Returns Story

Filed under: Commodities,Economics,Energy — cpirrong @ 2:00 pm

Recently there have been quite a few articles declaring the death, or at least the senescence, of the shale boom. This from today’s Bloomberg, about the Permian specifically, is one of the more optimistic takes.

The gravamen of the argument of those digging shale’s grave is that the most promising prospects have been drilled already. This is no doubt true–and I’ll present some evidence of that shortly–but it’s hardly the entire story. When one looks more comprehensively at the shale boom, it becomes clear that it was driven by technological progress that has overwhelmed the traditional sources of declining productivity in natural resource extraction.

I recently completed a paper on the shale boom. It examines the sources of productivity growth in both oil and gas unconventional wells. In particular, it quantifies the impact of learning-by-doing on productivity growth on a well-by-well basis in all of the major production basins.

The empirical framework captures three potential sources of productivity growth. Firm specific learning, basin-wide learning, and exogenous technological change. As is conventional, I measure the former effect by the cumulative number of unconventional wells drilled in a basin by a given firm prior to drilling a particular well. The second effect is measured by the cumulative number of unconventional wells drilled by all firms in a basin prior to the drilling of a particular well. The last effect is captured by a time trend (again conventional in the learning-by-doing literature dating back decades).

I examine a variety of productivity measures. In what I consider the most novel and potentially interesting part I also look for evidence of cost-reducing innovation and learning effects.

Productivity measures include things like initial production, maximum production, production over the first 12 months, and decline rates. I find strong evidence of firm-specific learning effects in the first three variables, but not so much in decline rates. (Interestingly, learning does not appear to improve drilling speed, contrary to empirical findings in conventional wells.) I do not find strong evidence of industry-wide learning effects.

The last finding sheds light on the exploitation of most promising prospects first. The cumulative basin-wide experience variable is also impacted by this effect. More wells drilled means more industry experience, but it also means more of the good prospects have been drilled. Those two things offset, leading to coefficients that are small positives or actually negative.

The crucial thing to note is that productivity increased from 2011-2020 (in oil) despite the impact of going to progressively less promising sites. This demonstrates the importance of learning and exogenous technological change.

The cost results are the most fascinating to me. I regress the number of wells drilled in a given month in a given basin against the learning variables, input cost variables, a time trend, and price (instrumented for gas to take into account endogeneity–the oil price is reasonably exogenous). I find strong industry-wide cost reducing effects of learning. Specifically, holding price and input costs constant, the number of wells drilled in a given month increases strongly with cumulative industry experience in a basin. That is, cumulative experience shifts out the supply curve. This is evidence of declining cost, and in particular declining fixed cost.

Here again you would expect that the exploitation of the low hanging fruit first should lead to higher costs as cumulative experience grows. But if that effect is there, it is overwhelmed by learning-driven cost reductions.

Based on this research, I am more bullish about the prospects for unconventional production growth in the United States than the conventional wisdom is. The conventional wisdom focuses on a single margin: the stock of potential drilling locations. That totally overlooks the real shale story: massive technological improvement, largely driven by learning effects. Those learning effects work on a variety of margins, including getting more out of a given well, and reducing the cost of drilling a well.

In essence the conventional wisdom is like neoclassical growth theory, in which diminishing returns are the depressing fact of life. But as modern growth theory emphasizes, technological progress has overcome diminishing returns. That’s why we are so rich–far richer than neoclassical growth theory can explain.

My interest in learning-by-doing dates back decades, to my amazing experience of taking bob Lucas’ undergraduate economic growth course at Chicago: Bob decided to teach the course as a way to master the growth literature, and so those fortunate few of us in the class were witnesses to the genesis of his research on growth, which is more important than his (still important) macro/money research for which he won the Nobel.

I wrote a few papers in grad school on LBD, for example showing how learning effects drove productivity growth in US gun manufacturing (at Springfield and Harpers Ferry Armories) in the 19th century. Researching learning in shale gave me an opportunity to dust off and update that previous research interest.

I would also note that shale pessimism is focused on oil. Gas has continued to go great guns–despite the fact that the same diminishing returns effect should be operating there as well. US gas production has continued to grow, especially in Marcellus and Permian. The latter is largely associated gas, but the former is not. This is a productivity story, and it’s not like diminishing returns don’t operate in Marcellus.

Indeed, gas supply growth has been so robust that prices are hovering around $2/MMBTU–back to the level prior to the spike in 2021-2.

Of course one cannot count on the rate of technological improvement continuing at the rate observed in 2010-2020 (for oil) and 2006-2020 (for gas). But one should certainly not discount it, and one should definitely not ignore it altogether and focus only on a source of diminishing returns.

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March 5, 2023

If You Say “Convenience Yield” I Will Not Take You (or Your Research) Seriously

Filed under: Commodities,Economics — cpirrong @ 4:57 pm

I have a relatively simple way to filter out serious research on commodity prices from the not-so-serious. If you rely on “convenience yield” I will not take you seriously. Alas, based on this filter, the bulk of commodities research is unserious.

For the uninitiated (consider yourself lucky!), convenience yield is an attempt to explain that commodity futures prices are typically at less than “full carry”, i.e., that futures prices are below the spot price plus the cost of carrying inventory (financing plus physical storage costs). Furthermore, convenience yield is invoked to explain the fact that departures from full carry vary systematically with (some measure of) inventories, with big departures associated with small inventories.

These are empirical regularities, and convenience yield is invoked to explain them. The idea dates from Kaldor (1939), who was attempting to explain Working’s earlier (1934) empirical findings from the CBOT wheat market.

The intuition is simple. With true assets (e.g., bonds, stock, currencies), the futures price is depressed by the income (“yield”) on the asset (e.g, the dividend on a stock). So, to explain the depression in commodity futures prices below full-carry values, Kaldor said: stocks “have a yield, qua stocks, by enabling the producer to lay hands on them the moment they are wanted and thus saving the cost and trouble of ordering frequent deliveries, of waiting for deliveries.”

Problem solved!

The problem is not solved, because there are no real microfoundations here. Kaldor merely waved his hands, and analogized a departure from full carry in commodity markets to the depression in the prices of futures on assets caused by the income on these assets.

The problem is that, as Stephen Ross pointed out around 30 years ago in a paper on the Metallgesellschaft episode, commodities are not true assets. True assets are always in positive net supply. Commodities–and in particular commodities at the delivery point of a futures contract–are not always in positive net supply: sometimes there are “stockouts” when all inventories at a particular location are consumed. As Bob Lucas taught me years ago, commodity inventories in positive supply at all times is inefficient, as this would imply that a commodity is produced but never consumed. So stockouts are inevitable in competitive commodity markets.

Thus, the real cause of below-full-carry futures prices is that the zero inventory constraint is periodically binding.

So how to explain positive inventories and less-than-full-carry futures prices? There are two basic explanations: aggregation in space, and aggregation in time.

The best exposition of the former is Brennan, Wright, and Williams, (1997). Working off of earlier theoretical research by Wright and Williams, this article shows that including inventories held outside a delivery point (where spreads are used to measure carry) is misleading. When a delivery point is at an inverse/backwardation/less than full carry while inventories are positive at other locations, it is because the inverse (which measures the benefit of immediate delivery and consumption in the market where the inverse is measured) is smaller than the cost of moving inventories from where they are held to the delivery point.

With respect to the latter, the rigorous theory of storage based on optimal intertemporal allocation subject to a non-negative inventory constraint implies that if inventories at the delivery point are positive, the futures price for delivery on the next day will be at full carry. However, most departures from full carry are typically measured using futures prices for many delivery days if not months into the future. (For example, Working analyzed the May-July and July-September spreads.) These deferred delivery contracts can be below full carry when the one-day price is at full carry if there is a positive probability of a stockout prior to the expiration of the futures contract used to measure the spread.

This explains the Working Supply of Storage relationship even when one uses stocks in the delivery market as the independent variable. The smaller the inventory, the more likely a stockout prior to expiration of the futures contract used to calculate the spread, and hence the bigger the inverse.

This was all discussed thoroughly in my book.

In sum, convenience yield is a fudge factor, justified with hand waving. The attempts to provide microfoundations, such as invoking inventories as a factor of production, as in Ramey (1989), have farcical implications (which I ridicule in my book).

The Working supply of storage curve is an empirical regularity. Convenience yield is not the explanation for this regularity. The real theory of storage, which is based on the non-negative inventory constraint, is.

I plead guilty to using convenience yield in some of my earlier research, in particular my fairly widely cited paper with Victor Ng on industrial metals. By way of justification, I would say that (a) I was a young academic that needed to present our research in a way that conformed with the conventional wisdom (which alas did, as it still does, rely on convenience yield, as illustrated by a slightly earlier paper by Fama and French) (ah the price of publish or perish) , and (b) we also invoked the more rigorous theory of storage.

But I have seen the light: indeed, I saw the light years ago. Academics working in commodities now should also have a Come to Jesus moment, and swear off the concept of convenience yield. At least if you want to be a serious researcher committed to analysis grounded in firm microfoundations–which “convenience yield” is decidedly not.

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