Streetwise Professor

The oil collapse continues apace, after a one day breather on Monday. As I write, WTI and Brent are off almost 8 percent. Equity indices around the world are going in the same direction.

This recent co-movement between crude (and other commodities, especially non-precious metals) has unleashed torrents of twaddle. One of the most egregious pieces thereof was a recent Krugman column:

When oil prices began their big plunge, it was widely assumed that the economic effects would be positive. Some of us were a bit skeptical. But maybe not skeptical enough: taking a global view, there’s a pretty good case that the oil plunge is having a distinctly negative impact. Why?

Well, think about why we used to believe that oil price declines were expansionary. Part of the answer was that they reduced inflation, freeing central banks to loosen monetary policy — not a relevant issue at a time when inflation is below target almost everywhere.

Beyond that, however, the usual view was that falling oil prices tended to redistribute income away from agents with low marginal propensities to spend toward agents with high marginal propensities to spend. Oil-rich Middle Eastern nations and Texas billionaires, so the story went, were sitting on huge piles of wealth, were therefore unlikely to face liquidity constraints, and could and would smooth out fluctuations in their income. Meanwhile, the benefits of lower oil prices would be spread widely, including to many consumers living paycheck to paycheck who would probably spend the windfall.

Now, part of the reason this logic doesn’t work the way it used to is that the rise of fracking means that there is a lot of investment spending closely tied to oil prices — investment spending that has relatively short lead times and will therefore fall quickly.

Where to begin? I guess the place to start is to note that Krugman commits a cardinal economic error (you’re shocked, I’m sure): he argues from a price change. What is frightening is that if you believe his characterization of the received wisdom in macroeconomics, this is the standard way of thinking about these things in macro.

Prices do not move exogenously. Prices can go down because of supply shocks. They can go down because of demand shocks. The price movement is the same direction, but the implications are very different. In particular, the implications for co-movements between oil prices and asset prices are very different. You cannot analyze based on the fact of the price change alone: your analysis must be predicated on what is driving that change.

A price decline because of a favorable supply shock is generally positive for the broader world economy. Yes it is bad for oil producers, but especially for advanced and most emerging economies who are oil/commodity shorts, a supply-driven price decline is beneficial and should be associated with higher stock prices, economic growth, etc. The production possibility frontier shifts out, leading to higher incomes overall although in a world with incomplete risk sharing there are distributive effects. But the adverse consequences for producers are almost always swamped by consumer gains.  In this scenario, growth and asset prices on the one hand, and commodity prices on the other, move in opposite directions.

Things are very different for demand shocks-driven price changes. A price decline because of an adverse demand shock is generally negative for the broader world economy, because it is a weakening world economy that is the major source of the demand decline. This is a matter of correlation, not causation. Causation runs from a weakening economy to lower demand for oil (and other commodities) to lower commodity prices and lower asset prices.  Oil price (and asset price) changes are an effect not a cause.

The current situation is much closer to the latter case than the former. Yes, there have been oil production increases in the last couple of years, but if world economic growth had continued on its pre-mid-2014 pace, demand would have grown sufficiently to absorb this increase. In fact, the decline in oil and other commodity prices starting around June 2014 occurred right about the time that world growth forecasts declined appreciably. Subsequent months have seen a litany of bad growth news from the main sources of commodity demand growth in the boom years, most notably, of course, China. And the news from China keeps getting worse. This is reflected in cratering stock prices there, and other indicia of economic activity. (Notably all of these indicia are pretty much non-official. Official Chinese statistics should be nominated for the next Nobel Prize in Fiction.)

But rather than go back to basics, Krugman assembles a Rube Goldberg contraption to explain what is going on. And of course, austerity and the liquidity trap play a starring role:

But there is, I believe, something else going on: there’s an important nonlinearity in the effects of oil fluctuations. A 10 or 20 percent decline in the price might work in the conventional way. But a 70 percent decline has really drastic effects on producers; they become more, not less, likely to be liquidity-constrained than consumers. Saudi Arabia is forced into drastic austerity policies; highly indebted fracking companies find themselves facing balance-sheet crises.

Or to put it differently: small oil price declines may be expansionary through usual channels, but really big declines set in motion a process of forced deleveraging among producers that can be a significant drag on the world economy, especially with the whole advanced world still in or near a liquidity trap.

Since because of his cardinal error Krugman does not identify what caused the price decline that begins his chain of “reasoning,” it’s hard to understand fully what he means. The most charitable interpretation is that there was a favorable supply shock that was so big that it caused such a large price decline in oil that this caused world “aggregate demand” to decline because of the severe adverse consequences on indebted and liquidity constrained producing countries and companies.

Inane. For one thing, these economies and sectors are very small in comparison to the world economy. Commodity producing countries have historically suffered major financial crises with little, if any, effect on growth world-wide, or on asset prices world-wide. The US oil and gas sector has also undergone some severe crises (e.g., 1986-1987) with limited fallout on US and world growth: the impacts tended to be concentrated regionally in the producing states, such as Texas. Not much fun there, but the rest of the country and the world didn’t much notice. In fact, they benefited from the favorable oil supply shock.

For another, even if there is some asymmetry between the “liquidity constraints” of producers and consumers, Krugman has been arguing strenuously that US and European consumers are liquidity constrained, hence his constant attacks on austerity. In Krugman’s argue-from-a-price-change story, that liquidity constraint has eased, and therefore one would expect to see improvement in consumption growth in places like the US, but the reverse is in fact true. The US economy is slowing rather noticeably.

No. The back-to-basics-trace-the-cause-of-the-price-change story is much more plausible. And here’s the irony. The epicenter of the commodity demand and world growth shock is China, which has binged on credit stimulus since 2009 in a way that Krugman should approve. But that cannot go on forever, and indeed, the main source of problems in China is the recognition that it can’t go on forever. China faces colossal balance-sheet issues that make deleveraging inevitable. When that happens, the commodity crisis will enter a new phase. How bad it is depends on how well the Chinese handle it. Given their mania for central control, I do not believe they will handle it well.

Macro panjandrums, like Oliver Blanchard, are puzzled, because official data do not yet reflect any large decline in growth. But that’s because official data are backward looking, and markets look forward relentlessly. They are signaling current and future problems, which official data will eventually validate. (And that’s when the data aren’t made up, as is notoriously the case in China.)

Commodity prices are particularly important, because commodities are consumed in the here and now. When demand declines, consumption declines, and prices decline contemporaneously. For all the talk about financialization, that can’t overcome the decisions of billions of commodity consumers around the world. Thus, at present, the high positive correlation between commodity prices and asset prices, like in 2008-2009, is a symptom and harbinger of broader economic problems. You don’t need Rube Krugman contraptions to explain that.

The decline in oil prices is producing a predictable political outcome: attempts to prop up the domestic US industry. Some initiatives would make sense regardless of the financial distress of the US upstream sector: the Clinton and Obama administrations in particular have imposed a variety of inefficient regulations and restrictions on US hydrocarbon production, and it would be desirable to roll these back, as is being proposed:

Among the proposals under discussion: Expediting the process for exporting liquefied natural gas, and upgrading infrastructure to move energy to market more quickly and cheaply.

Another top priority for the two Republicans is loosening environmental and other regulations.

But then there’s just the plain stupid:

Some lawmakers are floating the possibility of taking retaliatory trade measures against Saudi Arabia, which has flooded the market with cheap oil in what some analysts see as a bid to drive America’s growing shale oil industry out of business.

. . . .

North Dakota Rep. Kevin Cramer (R) said lawmakers could begin to mull retaliatory tariffs against Saudi Arabia in the future but emphasized he is not advocating for that yet.

“I’m very hesitant to go down that path at this time but clearly that would be a possible option should the Saudis not play fair. Because as much as I advocate for free and open markets, I also advocate for fair markets,” he said.

Saudi Arabia, taking advantage of its low extraction costs, has refused to curb oil production in a bid to expand market share and undercut competitors. This has raised the prospect of the U.S. government taking action to level the playing field for domestic companies.

“I’m not prone to a lot of government intervention in terms of propping industry up, per se. What would be the most helpful is to roll back regulations that get in the way of further development and profitability,” said Cramer, who cited the Endangered Species Act as one burdensome regulation.

“Obviously they have access to our market and I suppose to some degree there is a role that can be played there. I’m not at the point where I’m ready to advocate tariffs or restricting their access necessarily,” he added.

Any tariff on Saudi imports would be special interest protectionism pure and simple, tarted up in the usual rhetoric (and whining) used to justify protectionist measures. “Fair markets” is a sure tell. Anyone who says “I’m for free markets but they should be fair markets” is a liar, and should drop the pretense. Any such person is all about protecting a favored industry or firm. When someone, regardless of party, says “fair markets”, I strongly advise you to check your wallet, because they are trying to rob you.

And why should Saudi Arabia “refuse to curb oil production”? Indeed, “curbing oil production” is the exercise of market power, for which the US (rightly) criticized OPEC and the Saudis in the past. What’s more, low cost producers are the ones who should sustain output in the face of a demand decline: high cost producers are the ones who should cut back.

Furthermore, although North Dakota is an oil long, the US as whole is an oil short, still producing only about 1/2 of its consumption, despite the spurt in oil production in the past 5-6 years. So low oil prices are still in the interests of the US.

It should also be noted that the “flooding the market with cheap oil” meme is vastly overstated. Saudi output in June, 2014, right before the price collapse began, was about 10mm bpd. It is now about 10.5 mm bpd. That difference represents a whopping .5 percent of world output. Even given an elasticity of 10 (which is probably too high) that could cause at most at 5 percent decline in prices. As I write, Brent just went below $33/bbl, and hence is down almost exactly 70 percent off its pre-collapse levels. So this collapse is not the result of the Saudis flooding the market.

Nor are the Saudis engaged in some predatory pricing strategy. At least I doubt that they are, because such a strategy would be irrational.

The price decline is the result of increased output in a variety of places (including the US), but mainly due to a steep decline in demand growth, especially from China.

Yes, the upstream sector in the US is suffering severe financial distress. So be it. That’s the nature of the business, and the nature of a market system generally. Resources should exit sectors that suffer demand declines. They should not be propped up through trade restrictions, especially trade restrictions that will impose far greater costs on the US economy as a whole than they will benefit one sector in that economy.

It is also perversely ironic that the very same Republicans (I am speaking of the individual legislators, like Murkowski and Cramer, not the party as a whole) who pushed for ending the idiotic export ban are now mooting an equally idiotic restriction in imports. This makes it plain that it’s not about principle, in the least. It’s all special interest politics. That’s not surprising, but it’s not admirable. And it’s not any better when Republicans push it than when Democrats and Obama do.

So yes, eliminate or cut back inefficient restrictions that a relentlessly anti-hydrocarbon administration has imposed, in order to eliminate unnecessary burdens on US oil and gas production that hurt both US producers and consumers in the US and around the world. But don’t impose large costs on American consumers of oil in order to prop up the US upstream sector. The sector should shrink if the demand for its product declines due to increased production elsewhere, or reduced demand. So be it.

I’ve often written that HFT firms are the best able to detect spoofers, and to take preventative measures (which reduce the profitability of spoofing, and hence its prevalence). The whole business of HFT is extracting signals from orders and order flow, and trading accordingly. Spoofing is based on manipulating the order flow–in essence, injecting noise into it. HFT firms evaluate their executions, and attempt to identify patterns that predict both winning and losing trades. If spoofers systematically impose losses on HFT firms, eventually the latter will figure it out.

This is the first article that I’ve read that supports this contention:

Inside Ken Griffin’s $25 billion empire, Citadel’s cyber investigators had isolated a new enemy: spoofers.

It was late 2013, and at the firm’s Chicago headquarters, a team of researchers discovered that a rival company’s algorithm was outmaneuvering their automated trader. The algo was placing futures orders it had no intention of filling to entice firms like Citadel into the transactions, then canceling them, leaving Citadel with money-losing trades. Citadel’s plan: to pit its computers against the spoofer in a high-stakes duel over market manipulation.

. . . .

Vertex Analytics may have devised a way to make high-frequency trading more transparent and spoofing easier to detect. The Chicago-based technology firm can represent graphically every order and transaction on CME’s markets, obviating the need to go through pounds of paper searching for a telltale sequence of

Vertex’s approach was a revelation for Robert Korajczyk, a finance professor for more than 30 years at Northwestern University, where he’s studied asset pricing and liquidity.

“My first reaction to seeing the graphics capabilities was ‘This can’t be done,’” Korajczyk said. “However, Vertex can do it.”

. . . .

Citadel isn’t the only firm that took measures against spoofers without regulators’ help.

In 2012, Chicago-based HTG Capital Partners detected a pattern of large canceled orders followed by aggressive trades in the opposite direction that left them with losing positions, according to an affidavit released last month. The firm created tools to help identify when spoofing was taking place, the affidavit said.

Transmarket Group has created an “anti-manipulation guide” that tells traders how to spot spoofing, according to a copy seen by Bloomberg News. The Chicago-based firm lists specific examples of spoofing in the natural gas market on CME as part of the guide.

The article spends a lot of time discussing enforcement actions against spoofers, and the difficulties of making a case. Even ignoring my doubts (expressed in earlier posts) whether the social costs of spoofing really warrant expensive enforcement efforts, the fact that sophisticated and knowledgeable players have the incentive to detect this kind of conduct, and take defensive measures (and perhaps offensive–at least that’s what the description of Citadel “pit[ting] its computers” against spoofers suggests) means that the frequency and scale of spoofing activity is likely to decline significantly. It is a pathogen that found a niche, but the hosts’ immune systems are adapting, and it will become less dangerous in short order.

This isn’t true of all forms of manipulation, but the very nature of spoofing–which involves doing things that are intended to be detected–makes it vulnerable to detection and countermeasures. This means that the system tends to be self-correcting, and this mitigates the need for enforcement. Unfortunately, it appears that enforcement officials (both civil and criminal) think otherwise, and have prioritized the prosecution of spoofing. Combined with the outrageous overcharging and over-penalizing that I’ve mentioned before, this is a disturbing development.

I’ve been spending something of a busman’s holiday, reading this and that about commodity market corners in days long past. I started out looking into some of the big cotton corners at the beginning of the last century, namely the Brown-Hayne corner of 1903 and the Patten corner of 1910. These are the subject of a new book, The Cotton Kings: Capitalism and Corruption in Turn-of-the-Century New York and New Orleans. The book is entertaining history, but could use some more economics. It is journalistic in style, rather than analytical.

Reading about Patten’s cotton corner led me to read about his wheat corner of 1909, his corn corner of 1908, and his oats corner of 1902. Mr. Patten was a busy man.

And a reviled one. He was known as “The Wheat King,” whom the The Literary Review accused of  “The Crime of Making Bread Dear.” He was the model for the villain in the very influential D. W. Griffith short film, “A Corner in Wheat.”

This early short was one of the first films, if not the first, to address a serious social subject. Its theme would be very familiar today: the two Americas, rich and poor. Sergei Eisenstein admired Griffith, and employed his “parallel editing” technique (which he referred to as Griffith’s “montage of collision”): some film historians consider Griffith’s technique more subtle and less heavy-handed than Eisenstein’s.

(Unbeknownst to me when I was growing up in Evanston, Illinois, Patten was a longtime resident of the city, and its former mayor. He built a mansion there, and funded the Patten Gymnasium, where I swam in the summers.)

Patten was a nationally known figure. The Justice Department indicted him under the Sherman Act for his cotton corner, and the case attracted front page attention in national newspapers, including the New York Times, when it went to the Supreme Court. (Patten was fined $4000, or less than .1 percent of what he allegedly made in his corner. Not much deterrence effect there, eh?)

Patten was not alone in being a figure of national renown–and infamy. Commodity speculators were the banksters of their day. The Matt Taibbi of the 1880s, Henry Demarest Lloyd, wrote about cornerers at the Chicago Board of Trade in a famous essay. Frank Norris wrote a famous roman à clef, The Pit, based on the Leiter wheat corner of 1898.

In sum, in the last third of the 19th century and the first quarter of the 20th, commodity markets generally, and commodity market corners in particular, were the subject of intense interest. In some respects, it is not surprising that commodity corners were the subject of close journalistic coverage, serious fiction, social critical literature, and film during this era. Agricultural commodities were much more central to Americans as both consumers and producers. In 1900, 41 percent of the American workforce was employed in agriculture: now it is under 2 percent, and agriculture represents less than .7 of GDP. Half of American consumption spending went to food and textiles in 1900: a century later, that figure was down to 20 percent. Relatively speaking, the commodity derivatives markets (the Chicago Board of Trade, the Minneapolis Chamber of Commerce, Kansas City Board of Trade, the New York and New Orleans cotton exchanges, etc.) were more important and more developed that the capital markets, including the New York Stock Exchange, than is the case today: by the 1990s, when I was researching commodity exchanges and doing work with some, the commodity traders lamented that the explosion of financial futures had led the managements of exchanges to lose touch with the realities of commodities.

That said, one can see many echoes of the distant debates about and social criticism of commodity trading and corners in current controversies over financial markets. Just as outrage over the alleged excesses of the 2000s gave birth to the spate of post-Crisis financial regulation, fury over the Leiters and Pattens and Browns led to the first major regulations of financial markets in the United States: the Cotton Futures Act of 1914, and the Grain Futures Act of 1922 (which morphed into the Commodity Exchange Act, which is still with us, and which was amended by Frankendodd). Both Acts followed major government studies, the Commissioner of Corporations’ Report on Cotton Exchanges, and the Federal Trade Commission’s Report on the Grain Trade. Both of these are very well done, and provide very detailed descriptions of both the cash and futures markets. They are priceless resources. In some respects, because of them, we know more about the operation of commodity markets in the first decades of the 20th century than we do of their operation in the first decades of the 21st.

Maybe someday I’ll write a book about all of this, one that integrates the economics, history, and political economy. It’s of great personal interest, but not highly valued in the economics or finance professions today. I was amused when I came upon the link to an AER article about the Cotton Futures Act: it is beyond imagining that something similar would appear there today. But as I hope the foregoing shows, plus ça change, plus c’est la même chose. Issues of the relationship between financial markets and the real economy, the political economy of financial markets, and the influence of financial titans on political and judicial institutions, are still with us. In 1909, a film like A Corner in Wheat grappled with the social impact of finance in a very provocative and arguably simplistic way: in 2009-2015 movies like Too Big to Fail, Margin Call, and The Big Short do the same.

Don’t hold your breath, but maybe someday you’ll read about this in depth in print, rather than superficially in pixels.

Satyajit Das writes some smart things. He also writes some silly things. This article in the FT is definitely in the silly category. Embarrassing is more like it.

Das claims that “increased financialisation” has “exacerbated” the downturn in commodities. What does he mean exactly?

Let’s start with the what Das means by financialization. (I’m ‘Merican and I’ll spell it like a ‘Merican, dammit!) This has become a term of art to mean traditional financial investors (pension funds, hedge funds, retail investors etc.) taking on direct exposure to commodity price risks, usually via derivatives (including ETFs). But Das treats anything touching finance as financialization. His use of the word is so broad as to be meaningless.

Cash flows from future sales were monetised to raise large amounts of debt to finance expansion. The collateral value of commodities secured expansion in borrowing and trading.

Uhm, when has this not been true in commodities? Commodity production tends to be highly capital intensive, which requires, you know, capital, which requires tapping the capital markets to, you know, fund. Since the dawn of capital markets, lenders and equity investors have mobilized savings to supply capital to miners, drillers, etc., to fund the digging of mines and the drilling of wells, based on the expectation of being paid back from cash flows from future sales. That’s exactly what finance is. If that is “financialization,” pretty much everything is “financialized” and the term is so general as to lack all meaning and analytical bite.  Modern markets have always been financialized in this way.

Natural resource firms have long been major users of the capital markets. Indeed, many of the earliest stock and bond markets developed to finance commodity investments, and mining and E&P firms have long been leading names in major stock and bond markets. In that respect, commodities have been financialized a lot more for a lot longer than most sectors of the economy.

In fact, it is the very capital intensity of extractive industries (which made natural resource firms reliant on capital markets from the first) that  explains the boom-bust cycle. Most of the costs of natural resource extraction industries are sunk costs. Literally sunk: very expensive, very long-lived holes in the ground that can’t be undug and used for something else. If demand turns down after these investments are made, it usually makes economic sense to continue operating , because the variable costs of operation tend to be relatively low and can be covered even when prices are low. Since the capacity is long-lived, exit does not occur, meaning that low prices can persist for long periods. But that’s economically efficient when investment is largely irreversible.

Which brings me to Das’s next groaner:

The need to maintain cash flow to service debt requires production levels to be maintained, even if it is below cost. This delays the withdrawal of supply and correction of prices. It also destroys the value of equity, making it difficult for firms to raise new capital to reduce debt.

Producing “below cost” (by which I assume he means continuing to produce when prices are below cost) destroys cash flow, rather than maintains it, if cost is measured properly. It is optimal to operate as long as prices cover avoidable costs (e.g., variable costs, and fixed costs that must be incurred as long as output is positive), even if prices are below some measure of accounting cost which typically embeds sunk costs: you can’t judge economic operation by looking at income statements, which have sunk costs baked in.

This kind of continued operation doesn’t “destroy the value of equity.” To the contrary, it is shutting down when price more than covers avoidable cost that destroys the value of equity. The fact that avoidable costs in natural resource extraction tend to be low relative to total costs means that not exiting even when prices are low is economically efficient.  (Another implication of the cost structure of natural resource production is that it is typically efficient to produce either at capacity or shut down altogether.)

Debt costs reflect the sunk costs of investment. Sometimes–like now–cash flows are insufficient to cover the costs of servicing this debt for many firms. That’s what bankruptcy laws are for. If they work well, the continued operation (or not) of insolvent firms will depend on current and expected future margins between price and avoidable costs, not the Ghost of Sunk Costs Past.

Then there’s this:

For industries like shale gas and oil which were cash flow negative even at high oil prices because of the need to invest in new wells to maintain production, reduction in the supply of capital affects the ability of firms to operate.

Again, Das is apparently utterly confused about the proper cash flow concept to apply. If “maintain production at all costs” was truly the mantra of the E&P industry, the problem would not be financialization, but management retardation. Finance would be implicated only to the extent that financiers are similarly retarded and gladly shovel good money to them to permit continued value destruction. If anything, it is the need to access the capital markets that prevents retarded managements from wreaking havoc: few things are more destructive of value than CEOs with bountiful free cash flows that relieve them of capital market discipline. Cutting off capital from negative NPV projects is a boon, not a burden.

Finally we get to derivatives!:

Hedging ameliorated the effect of declining prices. Derivative gains contributed in excess of 30 per cent of revenues in the US shale industry in 2015

And this is a problem why? This is exactly the way “financialization” is supposed to work. It transfers price risks to those (namely, well-diversified financial investors) who can bear them at a lower cost. Yes, investment probably would have been lower, and prices higher, had this risk transfer mechanism not existed. But this doesn’t mean that the level of investment with an efficient risk transfer mechanism is too high: it means that the level of investment without one is too low.

More bad derivatives stuff:

Margin calls further complicate matters. An airline that has hedged future oil purchases at high prices may face margin calls that make unexpected claims on its cash flow.

Yes, cash flow mismatches on hedges can be a problem. Which is exactly why corporate end users strongly preferred (and prefer) OTC hedges which embedded credit to mitigate these problems.

More financialization evils, according to Das:

Financialisation altered fundamental industrial structures. Traditionally high barriers to entry, such as technology, expertise and access to capital, led to domination by large producers who planned and controlled production.

Now specialised resources service firms provide access to technology and the willingness of capital markets and non-traditional lenders to provide finance allows easier entry resulting in a more fragmented industry.

These are features, not bugs! These are benefits of financialization! Breaking down oligopolistic and monopolistic market structures is good, not bad!

At the same time, trading in financial claims on future commodity cash flows has encouraged institutional investment in the sector as part of diversification into new asset classes. Hedge funds and trading firms now act as quasi banks financing and facilitating risk management by commodity market participants.

So facilitating the flow of capital from savers to investors is a bad thing? Facilitating risk management is bad too? Who knew?

This is just bizarre:

This activity is marked-to-market daily or secured by the value of the commodity. Any change in value can trigger calls for additional collateral complicating cash flow management or force liquidation of holdings. Capital market investors may lack the ability to ride out prolonged corrections. It complicates dealing with financial distress and the necessary restructuring.

Tapping into a deeper pool of capital, which financialization (as defined by Das) allows, spreads the risks and makes it easier to ride out prolonged correction (which, again, are an inherent consequence of the cost structures/operational leverage of natural resource extraction), not harder. And the statement about complicating dealing with financial distress and restructuring is completely conclusory, with no supporting argument or evidence.

Yes, in a world with poorly developed financial markets, large scale investments in industries characterized by irreversibility and large scale (like natural resource extraction) are expensive to fund. “Financialization”–which in Das’s expansive usage, apparently just means lower cost access to bigger pools of investment and risk capital–indeed leads to a bigger natural resources sector. Yes, by its very nature this sector will inevitably go through protracted periods of low prices, which will impose losses on investors. But that’s a risk that they willingly choose to bear, in exchange for an expected return that they consider compensatory.

Das appears to be afflicted with Bastiat Disease, i.e., the inability to distinguish between the seen and the unseen. Das sees the financial carnage that the current natural resources depression has created, but hasn’t considered what would happen if the world was less financialized. What are the unseen consequences of that?

I can tell you: a poorer world.

There are some forms of finance that are wealth-destroying rent seeking. The financing and risk management of the production of minerals and energy are not among them.

The myth that global warming caused a drought which caused the civil war in Syria has been flogged repeatedly by the left, especially in the lead-up to the Paris farce: another example of the “elites” letting no good crisis go to (political) waste. As I discussed in March, there was indeed a drought in Syria, but no credible scientific evidence links the drought to climate change.

Droughts happen. What turned the drought into catastrophe in Syria was the depletion of groundwater by previous government-driven efforts to spur production:

Syria was such a successful producer that it became a net exporter of wheat for the better part of two decades — almost unheard-of in a region where most governments imported cheap wheat from abroad. According to ICARDA Director General Mahmoud Solh, the increased productivity netted the Syrian government more than $350 million a year . The country also kept a strategic reserve of wheat — usually about 3 million metric tons, enough to get it through a lean year or a price spike. In this most stable of dictatorships, nobody dreamed of a war.

But all that productivity came at a price. To produce these remarkable gains, Syria’s agricultural sector “mined” groundwater to irrigate farms. Experts predicted that this would lead to severe water Shortages. When a four-year drought struck in 2006, devastating 60 percent of Syria’s agricultural lands, the country’s groundwater was already depleted.

(This sounds a lot like Soviet agricultural malpractice.)

This brings to mind Adam Smith’s argument that bad government policy turns “dearths” caused by nature into famines:

The seasons most unfavourable to the crop are those of excessive drought or excessive rain. But as corn grows equally upon high and low lands, upon grounds that are disposed to be too wet, and upon those that are disposed to be too dry, either the drought or the rain which is hurtful to one part of the country is favourable to another; and though both in the wet and in the dry season the crop is a good deal less than in one more properly tempered, yet in both what is lost in one part of the country is in some measure compensated by what is gained in the other. In rice countries, where the crop not only requires a very moist soil, but where in a certain period of its growing it must be laid under water, the effects of a drought are much more dismal. Even in such countries, however, the drought is, perhaps, scarce ever so universal as necessarily to occasion a famine, if the government would allow a free trade.

It as not just the  Syrian government that contributed to spiraling food prices which created popular unrest in the Middle East that culminated in 2010-2011 (which the Muslim Brotherhood exploited in Egypt and Syria in particularly): US government policy contributed to the problem. In particular, US biofuels mandates that stimulated the production of ethanol drove up the price of corn by an estimated 30 percent, and as Brian Wright has shown, drove up all other grain prices as well (because corn is a substitute for other grains in both consumption and production). (I strongly recommend reading at least the introduction of the Wright paper: I’d quote in detail, but the online versions embed some devious feature that makes it impossible to copy-and-paste.)

It is sickly ironic that policies intended to reduce global warming pushed by the same crowd that falsely blame the Syrian drought and subsequent civil war on global warming (a) do nothing to reduce global warming, and (b) have done far more to exacerbate poverty and create social unrest  in the Middle East than global warming ever has or ever will.  Ethanol is an unmitigated disaster environmentally, economically, and socially. Yet the people Thomas Sowell trenchantly calls “the anointed” colluded with agricultural lobbies in the United States (encompassing both growers and processors) to inflict this monstrosity on the world.

How dare they–how fucking dare they–presume to lecture anyone on their obligations to “save the planet” and help the poor? Through biofuels policies alone they have inflicted huge misery and privation, and yet they have the audacity to try to exploit one of the consequences of these policies in order to ram more of their brilliant ideas down our throats.

Haven’t they done enough? Can they please now just go away?

Alas, we won’t be so lucky. These are our elites, after all, and we are stuck with them, like a case of malaria. And they are actually proud of stupid policies like biofuel mandates. There is no stupid that can equal the stupid of not just not learning from mistakes, but reveling in them.

Do you still wonder why the Trump phenomenon exists? The global reaction against the elites, of which Trump is just the most prominent example, is yet another baleful consequence of the failure of these so called elites. The reaction may be as bad as the disease, but let the blame fall where it should: squarely on the shoulders of those condescending fools whose allegedly good intentions have paved a superhighway to hell.

Well, ding dong the wicked export ban is dead. The repeal was included in the wretched omnibus deal passed in the dead of the night last week.

As a matter of economic principle, banning the ban is a good thing. Trade restrictions are almost always inefficient, and the oil export ban was no exception to that rule. In the near term, however, the practical impact of the sunsetting of the ban will be limited. At present, Louisiana Light Sweet is trading about par with Brent on a spot basis, and at only a few cents discount on a forward basis. Even given the quality premium for LLS, the differential is too narrow to make it economical to transport oil to Europe. This situation differs dramatically from the conditions that sparked the move to eliminate the ban, namely, a double digit discount of US oil prices from Brent.

The narrowing of the spread was due to many factors, but probably the most important of these was the fact that although oil exports were banned, exports of refined products were not. The low domestic oil prices made refining, including refining for export, to be very profitable. This encouraged investment in refining capacity that increased the demand for US crude, which narrowed the spread.

The repeal of the ban essentially creates an option, and this option is valuable. Although exporting crude is not economic now, it will be in response to some economic shocks. For instance, a disruption of European supplies, a spike in US production, or a big refinery outage in the US would all tend to depress the US price relative to the price in Europe, and if the shock is big enough, this could open the arb.

As for those who think that the lifting of the ban will help US producers in their hour of need, get ready for disappointment. The price difference between the export and no-export worlds is capped by the no-export-world spread: if absent the ban the price difference is greater than transportation costs, lifting the ban raises the domestic price and lowers the foreign price until the spread equals the cost of transport. When the arb channel is closed (as is currently the case), lifting the ban has no effect. Any price effect from lifting in the ban will occur in the future, and will be contingent on future supply and demand conditions. My guess is that the elimination of the ban will periodically give a couple of bucks boost to the US oil price. Not a huge deal.

The lifting of the ban will help traders, to the extent that arbs periodically come into play. It will also periodically benefit infrastructure owners (e.g., pipelines, terminals, and ports) that hand exports. Refiners  will lose when the arbitrage opens: this is why the compromise included a modest tax break for refiners, to secure their support.

Perhaps the biggest losers are those who bet on the continuation of the ban by building condensate splitters: minimally processed crude and condensate could be exported, so the splitters were a way to circumvent the ban. They are now white elephants, as the crude can be exported directly.

All in all, the lifting of the ban is not a big deal. Perhaps the main effect of this development, at least in the short term, is to show that 239 years after the publication of the Wealth of Nations, bad arguments about trade survive and even thrive. But even this didactic effect is overshadowed by circumstances, because the continued success of Trump shows the same thing, and much more forcefully.

In sum, I’m glad to see the ban go, but am underwhelmed by the near-term effects of its demise.

Elizabeth Warren’s panties were in a bunch the other night because of an ad that portrayed her as a “Commie dictator” (her description). (Liz’s panties always seem to be in a bunch, but they were bunchier than usual on Tuesday.) The ad, which blasts Warren’s anti-Constitutional monstrosity, the Consumer Financial Protection Bureau is actually somewhat amusing. Warren’s image appears in the background on a Big Brother-ish–or would that be Big Sister-ish?–banner.

I agree with Warren. She is not a  Commie dictator. She is a wannabe Commie dictator.

Her anti-market efforts are not limited to birthing and defending the CFPB. She is also a virulent critic of derivatives, especially when banks trade them. Pre-commercial, her ire this week was focused on the repeal of the swaps pushout rule, the brainchild (and I use that term very loosely) of fortunately ex-Senator Blanch Lincoln (D-for-dim, Arkansas). Warren fulminated that as a result of the repeal, banks were able to keep $10 trillion notional in particularly risky swaps in their deposit-taking units, rather than spinning them off into separately capitalized subsidiaries that cannot benefit from deposit insurance.

This rule was targeted at swaps that were deemed especially risky, including most notably, commodity swaps. But commodity swaps, and many equity derivatives, are not especially risky. Risk depends on whether the positions are hedged or hedgeable, the creditworthiness of the counterparty, and the credit support (e.g., collateral) in the transactions. And notional principle is certainly not a measure of how much risk is in a derivatives book. Therefore, putting commodity swaps, equity swaps, etc., in a ghetto does not make economic sense. There is no reliable mapping between the underlying of a derivative and the risk it creates.

Furthermore, risk has to be evaluated on a portfolio basis. Segmenting derivatives books can reduce diversification benefits, and crucially, breaks netting sets. Breaking netting sets tends to increase counterparty risk, or require more costly collateral to keep counterparty risk the same. (As I’ve written many times, the systemic effects of netting and collateral are ambiguous because of their main effect is redistributive. But if you are concerned about the counterparty risks that banks face, you should prefer more netting to less.)

Frankendodd is chock-full o’ stupid and dangerous, but the swaps push out was in the running for the title of dumbest and most dangerous. It makes no economic sense as a way of achieving the purported purpose of reducing the risks that banks pose to taxpayers. But Warren and other progressives have made it a litmus test for determining which side you are on, that of the angels, or the banksters? This is a false choice.

But expect Big Sister Liz to remain on the warpath against derivatives. Which is exactly why the 1984-esque portrayal of her in that commercial is spot on.

Yesterday in a federal court in Chicago, Michael Coscia of Panther Energy Trading was convicted of six counts each of commodity manipulation and fraud for “spoofing.” Coscia faces decades in prison.

I haven’t seen the evidence, so I cannot judge whether Coscia did manipulate. For the purposes of this post I will stipulate that he did. But even given that stipulation, this entire exercise was judicial overkill and a travesty that can do serious damage to the markets.

What is spoofing? A trader puts in a large order (an offer, say) several ticks away from the best price in the market. He also places a small limit order on the other side of the market (a bid, in this example). If the market moves towards the large order, the spoofer cancels and replaces the order several ticks away from the new inside market. It is this cancellation that attracts all the attention. Much of the coverage says that the spoofer submits orders with the intent of canceling them.

That’s not the whole story though. The point of spoofing is to increase the odds that the small order is executed. After all, what would be the point of submitting orders that are never executed?

In the example, the large sell order is intended to convince others that the current price is too high. This may induce some bidders to cancel their bids, and others to cross the market and hit the bid. Both of these actions increase the odds that the spoofer’s small order will be executed.

So how does he make money? It can’t be by driving down the price persistently. The spoofer has bought: to profit, prices must rise subsequently. So, often the spoofer will reverse direction, putting in a big bid away from the market, and a small offer.

If spoofing works, the spoofer will repeatedly buy at the bid and sell at the offer, making the dealer’s turn. This will not cause the price to diverge persistently from where it would be, absent this conduct.

That’s apparently what happened with Coscia. He made a whopping $1K on the six episodes for which he was charged and convicted. He was just making a tick here and a tick there. And crucially, unlike the kinds of manipulation that cause real damage-corners, in particularly-he is not causing the price to be persistently inflated or depressed.

So who is hurt? Some people may be induced to trade when they wouldn’t have absent the spoofing. Their losses are approximately equal to the spoofers gains, on the order of a tick. And since some might have hit the spoofer’s bid even absent the spoofing, only a fraction of those with whom the spoofer trades are damaged.

Others who might be damaged are those who are fooled into canceling orders, and see the spoofer execute a trade they would have liked to if they hadn’t been fooled. The spoofer takes some of the profit they would have earned.

I find it hard to believe that these damages are are all that large. (They would also be hard to estimate because it is virtually impossible to identify who traded because of the spoofing, and who pulled a quote because of the spoofing, and gave up the opportunity to trade.) And regardless, this is exactly the kind of conduct that can be deterred using monetary fines.

This brings me to another bizarre aspect of these spoofing cases. Many of those who scream loudest about spoofing, like Eric Hunsader of Nanex, say: “SPOOFING IS SO OBVIOUS!!!! JUST LOOK AT THE DATA!”

As another case in point, I saw a Tweet embedding a .gif of someone’s TT trading screen, in which the quoted depth a couple of ticks above the inside market would rise and fall by 800 contracts or so. The Tweeter (I can’t find the Tweet) said something to the effect “look at this obvious spoofing.”

Well, I agree with the obviousness of it, but the implication of that is exactly the opposite of what Hunsader, the Tweeter, and presumably the DOJ and CFTC believe: If it so obvious, nobody is fooled. If nobody is fooled, it can’t affect trading behavior or prices. If it doesn’t affect trading behavior or prices, there is no economic harm. If there is no economic harm, it shouldn’t be prosecuted.

There is a law and economics take on this too. Classic Gary Becker analysis shows that draconian penalties-like 25 years per fraud charge and 10 years per manipulation charge-are justifiable if the probability of detection of a harm/crime is small. This is necessary to make the expected cost paid by the offender equal to the cost of the harm. But if the conduct is obvious, even only ex post, the probability of detection should be high, so penalties far greater than any harm are excessive. In this case, grotesquely excessive. (Furthermore, again pace Gary Becker, incarceration of a defendant who can pay the monetary value of the harm caused is a social waste, in the form of the cost of imprisonment, and the lost output of the convict.)

But it gets worse. The Coscia prosecution-and the popular condemnation of spoofing-focuses obsessively on the large rate of order cancellation. But perfectly legitimate market making strategies involve large rates of order cancellation, especially in volatile markets. They also involve buying frequently at the bid and selling at the offer. Given the Javert-like zeal of prosecutors, their dim understanding of trading, and the difficulty of explaining market making to a jury create the very real risk that a market maker could be charged, and convicted, and be punished severely, because he cancelled a lot of orders, and made the dealer’s turn all day long. This huge and very real risk will no doubt lead to less aggressive quoting (a market maker is less willing to quote aggressively if he is reluctant to cancel too often for fear of being accused of spoofing).

And who pays for that? Market users, including both institutional and retail traders, who take the liquidity market makers supply. Thus, you and me are harmed by overzealous prosecution of spoofing that threatens to demoralize legitimate, efficiency-enhancing trading.

This raises the very real possibility that the prosecution of actions that produce little economic harm will inflict a far larger harm. That is perverse.

What is particularly infuriating is that enforcement authorities are apparently incapable of prosecuting much truly damaging market conduct. Federal prosecutors are crowing over getting Coscia’s scalp, and the Chairman of the CFTC is using the verdict to intimidate would-be spoofers, but 6 years ago Federal prosecutors in Houston utterly botched the BP propane corner case (US v. Radley). That was a real manipulation that caused real damage. But the prosecutors totally flubbed the case, and the perps walked. Then there are those obvious manipulations that the Feds haven’t even bothered to prosecute (perhaps to spare themselves the embarrassment of flubbing another one.)

It reminds me of the old joke about the lawyer who said: “I lost the cases I should have won, and won the cases I should have lost. Therefore, on average, justice was done.”

No, actually, Mr. Lawyer: justice is never done if the guilty walk free and the innocent are punished. And sad to say, US manipulation law is perilously close to embodying that cynical joke.

In September of last year, I gave the dinner speech at the CWC LNG Asia Pacific Summit conference in Singapore. The dinner was held at the Singapore Aquarium, and I spoke in front of the Aquarium’s giant shark tank. I couldn’t help but think of the scene with Kim Jung Il and Hans “Brix” Blix from Team America. Especially after the way my remarks were received, which ranged between cool and rather hostile.

I predicted the demise of oil-based pricing, and increased reliance on the spot market or long-term contracts indexed to spot prices. There were three basic parts to my argument. The first was that the large increase in supplies coming online in 2015-2017 combined with the even-then apparent slowdown in demand in China, and the likely decline from Japan due to the restarting of its nuclear plants, would lead to a large overhang of cargoes that would need to find a home. The trading of these cargoes would lead to increased spot market activity.

The second part of my argument was that the dynamics of liquidity would then take over. Liquidity creates liquidity. More spot market activity reduces the transactions costs of trading spot, which leads to more spot trading. There is a virtuous cycle in liquidity, and the increase in spot trading to dispose of contracted of but now unneeded cargoes would start the cycle.

The third part of my argument was that a robust spot market would support gas indexing, as opposed to oil indexing, in term contracts. Oil indexing is akin to the drunk looking for his wallet under the lamppost, because the light is best there, not because he lost it there. LNG buyers and sellers looking for a price benchmark looked to oil in the early days because in the 70s oil was a substitute for gas in power generation, so there was some connection between the markets, but mainly because oil was the only lamppost around. But especially now, with gas and oil having little fundamental connection in either consumption or production, oil prices are not closely correlated with the marginal value of a ton of LNG. The development of a liquid LNG spot market would-will, in my view-allow contracts to be indexed to a price that reflects gas values. This would also permit the development of a paper hedging market.

My unpopular prediction is now looking much better, though not all are persuaded. There is a huge LNG overhang, with Australian and US supplies about to come on stream. This supply increase is occurring simultaneously with a protracted decline in demand growth. Much of this overhang will find its way to the spot market. That, in turn, will start the virtuous cycle.

The supply overhang will have other consequences. It will force down prices world-wide, and lead to a redirection of supplies from Asia to Europe. One of the biggest losers from this will be Russia, which will face more intense price competition in its biggest export market in Europe, and a reduced Chinese appetite for the gas it had hoped to send east. Another will be Qatar, at present the world’s largest supplier.

Making things even more interesting is that Russia and Qatar are adversaries in Syria. (And by the way, those conspiracy theorists who think that the Syrian civil war was started by Qatar because Assad would not allow the construction of a pipeline to bring Qatari gas to Europe-spare me. Qatar’s big LNG investment dramatically reduced its need for a pipeline, and it anticipated being able to sell all it could to a growing Asian market.)

The next few years will be interesting in LNG. I am even more convinced that in 3 to 5 years the market will look nothing like it does today. It will look more like the oil, iron ore, and coal markets. Furthermore, in the near-to-medium term it will be more of a buyer’s market, and indeed, these things are connected. The surfeit of supply that makes it a buyer’s market will catalyze the development of a spot market.