Streetwise Professor

The USDOJ has filed criminal charges against a trader named Michael Coscia for “spoofing” CME and ICE futures markets. Frankendodd made spoofing a crime.

What is spoofing? It’s the futures market equivalent of Lucy and the football. A trader submits buy (sell) orders above (below) the inside market in the hope that this convinces other market participants that there is strong demand (supply) for (of) the futures contract. If others are so fooled, they will raise their bids (lower their offers). Right before they do this, the spoofer pulls his orders just like Lucy pulls the football away from Charlie Brown, and then hits (lifts) the higher (lower) bids (offers). If the pre-spoof prices are “right”, the post-spoof bids (offers) are too high (too low), which means the spoofer sells high and buys low.

Is this inefficient? Yeah, I guess. Is it a big deal? Color me skeptical, especially since the activity is self-correcting. The strategy works if those at the inside market, who these days are likely to be HFT firms, consider the away from the market spoofing orders to be informative. But they aren’t. The HFT firms at the inside market who respond to the spoof will lose money. They will soon figure this out, and won’t respond to the spoofs any more: they will deem away-from-the-market orders as uninformative. Problem solved.

But the CFTC (and now DOJ, apparently) are obsessed with this, and other games for ticks. They pursue these activities with Javert-like mania.

What makes this maddening to me is that while obsessing over ticks gained by spoofs or other HFT strategies, regulators have totally overlooked corners that have distorted prices by many, many ticks.

I know of two market operations in the last ten years plausibly involving major corners that have arguably imposed mid-nine figure losses on futures market participants, and in one of the case, possibly ten-figure losses. Yes, we are talking hundreds of millions and perhaps more than a billion. To put things in context, Coscia is alleged to have made a whopping $1.6 million. That is, two or three orders of magnitude less than the losses involved in these corners.

And what have CFTC and DOJ done in these cases? Exactly bupkus. Zip. Nada. Squat.

Why is that? Part of the explanation is that previous CFTC decisions in the 1980s were economically incoherent, and have posed substantial obstacles to winning a verdict: I wrote about this almost 20 years ago, in a Washington & Lee Law Review article. But I doubt that is the entire story, especially since one of the cases is post-Frankendodd, and hence the one of the legal obstacles that the CFTC complains about (relating to proving intent) has been eliminated.

The other part of the story is too big to jail. Both of the entities involved are very major players in their respective markets. Very major. One has been very much in the news lately.

In other words, the CFTC is likely intimidated by-and arguably captured by-those it is intended to police because they are very major players.

The only recent exception I can think of-and by recent, I mean within the last 10 years-is the DOJ’s prosecution of BP for manipulating the propane market. But BP was already in the DOJ’s sights because of the Texas City explosion. Somebody dropped the dime on BP for propane, and DOJ used that to turn up the heat on BP. BP eventually agreed to a deferred prosecution agreement, in which it paid a $100 million fine to the government, and paid $53 million into a restitution fund to compensate any private litigants.

The Commodity Exchange Act specifically proscribes corners. Corners occur. But the CFTC never goes after corners, even if they cost market participants hundreds of millions of dollars. Probably because corners that cost market participants nine or ten figures can only be carried out by firms that can hire very expensive lawyers and who have multiple congressmen and senators on speed dial.

Instead, the regulators go after much smaller fry so they can crow about how tough they are on wrongdoers. They go after shoplifters, and let axe murderers walk free. Going for the capillaries, ignoring the jugular.

All this said, I am not a fan of criminalizing manipulation. Monetary fines-or damages in private litigation-commensurate to the harm imposed will have the appropriate deterrent effect.

The timidity of regulators in going after manipulators is precisely why a private right of action in manipulation cases is extremely important. (Full disclosure: I have served as an expert in such cases.)

One last comment about criminal charges in manipulation cases. The DOJ prosecuted the individual traders in the propane corner. Judge Miller in the Houston Division of the  Southern District of Texas threw out the cases, on the grounds that the Commodity Exchange Act’s anti-manipulation provisions are unconstitutionally vague. Now this is only a district court decision, and the anti-spoofing case will be brought under new provisions of the CEA adopted as the result of Dodd-Frank. Nonetheless, I think it is highly likely that Coscia will raise the same defense (as well as some others). It will be interesting to see how this plays out.

But regardless of how it plays out, regulators’ obsession with HFT games stands in stark contrast with their conspicuous silence on major corner cases. Given that corners can cause major dislocations in markets, and completely undermine the purposes of futures markets-risk transfer and price discovery-this imbalance speaks very ill of the priorities-and the gumption (I cleaned that up)-of those charged with policing US futures markets.

Silly me, I thought the “gaz” in Gazprom was methane. But reading this article in Platts, I’m thinking it’s nitrous oxide.  I had to read it several times before I could catch a glimpse of what Sergei Komlev, head of Gazprom Export’s contract structuring and price formation department, was getting at. I now see the basic problem is that he thinks the price of gas in Europe is too low. And the culprit? Speculators! Paper traders! “Virtual gas”!

Come on Sergei, you can’t get originality points for that one. Round up the usual suspects and all that.

Anyways, FWIW, here are Sergei’s deep, N20 inspired thoughts on the subject:

“Paradoxically, gas price erosion is taking place at a time when physical supplies are tight,” Komlev said, adding that some European market analysts had acknowledged that hubs were overflowing with largely “paper” gas.

This became possible with the development of the spot gas market as hubs developed a new class of customer such as banks and commodity traders, Komlev said.

But “as no one is in a position to predict the weather, traded volumes of ‘paper’ gas significantly surpassed real world demand for gas because of the abnormally warm winter in 2014,” he said.

This artificial oversupply had put significant pressure on the market, resulting in a collapse in spot prices, he said.

“As a result, our European customers are facing negative margins as they have to supply gas to end-consumers at lower prices than they pay for physical deliveries under long-term contracts,” he said.

“When some time ago our clients sold our contract volumes on a forward curve for many months ahead they targeted this new class of customers first,” he said.

I’m doubled over in convulsions here, and I haven’t even taken a hit. Is there such a thing as second hand N20?

Let me translate what really happened. Speculators went long. Weather was unusually warm. Prices fell, and speculators took a bath. Simple story. As for “tight physical supplies”, later on Sergei lets on that gas demand in Europe fell 20 percent in the 1st half of 2014.

Sorry, but “paper gas” doesn’t heat a single home or turn a single turbine. It doesn’t oversupply. It doesn’t overdemand. It just transfers price risk. As contracts go prompt, the price of paper gas converges to the price of physical gas, which is driven by supply and demand fundamentals-most notably the weather. What frosts (or is it burns?) Sergei is that the price converged to a low price which is out of line with the oil-linked prices in Gazprom contracts. This has imposed pain on Gazprom’s customers, who are clamoring to renegotiate their contracts, which Sergei and Gazprom no likey.

Like the proverbial blind hog and the acorn, Sergei did root up a bit of the truth:

Long-term contracts were shaped at a time when spot gas markets in Europe were not developed, and the gas price — linked to oil prices — “was practically independent of supply/demand dynamics,” Komlev said.

I repeat: The oil linked price was/is “practically independent of supply/demand dynamics.”

Exactly! That’s the problem! That’s why a move to hub-based pricing, where gas prices can reflect gas values, is so necessary: it ensures that contract prices reflect supply/demand dynamics. Prices that don’t reflect values lead to distortions in output and consumption and investment, and to conflicts between buyers and sellers that inflate transactions costs.

Komlev went on to say that since price in the contracts was not flexible, and was out of line with gas values, it was necessary to permit quantity flexibility in Gazprom contracts. If the company is dragged kicking and screaming into the 21st century, and must index its contractual gas prices to-wait for it-gas prices, it will eliminate the quantity optionality.

Throw the customers into that b’rer patch, Sergei. Truth be told, fixed quantity forward supply contracts are quite the thing in the US, and have been since the dysfunctional price controls on gas were discarded in the 1980s. Companies can buy and sell base load volumes using fixed quantity long term contracts (perhaps at indexed prices); respond to near term fundamental conditions with short-term (e.g., month ahead) forward contracts entered into during something analogous to “bid week” and respond to intra-month/daily supply and demand swings with spot transactions. They can also get various customized contracts that are seasonally shaped, or have some optionality that permits efficient responses to supply and demand shocks (though the CFTC’s proposed Seven Prong-Prong, not Pirrong-test for determining whether supply contracts with quantity optionality are swaps subject to Frankendodd could wreak havoc with that).

A liberated gas market offers a variety of contract terms, including contracts that embed various sorts of quantity optionality. But the point is that heterogeneous suppliers and demanders can utilize a variety of contracts tailored to meet their idiosyncratic needs, as opposed to Gazprom contracts, which remind me of nothing so much as an ill-fitting Soviet suit.

I do have to thank Sergei. I haven’t had such a good laugh in a long time, with or without chemical assistance. But I doubt he-and Gazprom-will be laughing for long. The disconnect between oil and gas prices has become too large and too persistent for their beloved oil linkage to survive much longer.

Speaking of oil-linked prices, this is an issue in LNG markets too. I recently authored a white paper on the subject. I’ll provide a link and write a post on that subject in the next few days.

Igor Sechin has made a breathless announcement of a discovery of oil in the Kara Sea:

Exxon Mobil Corp. and Russia’s OAO Rosneft have found major amounts of oil and natural gas at their first well in the Arctic, Rosneft said Saturday, offering a glimpse of the potential buried beneath the ice-studded waters north of Siberia.

. . . .

“This is an outstanding result of the first exploratory drilling on a completely new offshore field,” Igor Sechin, Rosneft’s chief executive, said in a statement. Rosneft praised other western partners including Schlumberger Ltd., Halliburton Co. and Weatherford International PLC.

Sechin said the field would become the Arctic equivalent of Saudi Arabia, in terms of reserves.

To which I say: not so fast. First, this is the first well and the full analysis of the results has barely begun, let alone been completed. Second, the area is huge, and a single well cannot provide more than a rough estimate of the productivity of the entire field. Third, ExxonMobil was far more circumspect:

“We have encountered hydrocarbons but it is premature to speculate on any potential outcome regarding the University-1 exploration well,” Alan Jeffers, an Exxon spokesman, said Saturday

Fifth, even if the size of the reserves is similar to those in Saudi, the cost of getting at them, and the technological and logistical challenges of exploiting them, are far greater: even with such assistance, Arctic drilling is a fraught enterprise (just as Shell). Development and production will require the assistance of the “western partners” that Sechin praised, and that assistance is on hold for who knows how long as a result of sanctions. No doubt Perfidious Exxon will be pulling out all the stops to get the sanctions lifted, but betting on that is even more dicey than Arctic oil exploration, at the present political juncture.

But most importantly, one must heavily discount Sechin’s happy talk due to these very same political circumstances. He needs to put on a bold front to counter negative news about the company and its prospects in the aftermath of sanctions. Further, to the extent that he can convince the west that a bonanza awaits only if sanctions are eased he can increase the odds of a lifting of the sanctions. He thus has an even greater incentive to exaggerate than would normally be the case, and note that he is not operating under the same legal restrictions on making forward looking statements as a US CEO would (which could explain Exxon’s reticence, despite the fact it also would like to advance arguments that would undermine the sanctions regime).  Exaggerations therefore are basically costless, and could have a big positive payoff to the extent they are believed. All the more reason not to believe him.

Exxon’s complicity here is disturbing. Understandable, but disturbing. It is dealing with the devil, and although the deal benefits shareholders, these benefits pale with the costs resulting from bolstering a revisionist, revanchist, and expansionist gangster state, and the capos who benefit directly from it. This is a case where state action is warranted on public goods grounds.

Indeed, the more Rex Tillerson squeals, the stronger my conviction that the sanctions are a good idea. Exxon will reap only a fraction of the benefits of cooperation with Rosneft: the larger fraction will accrue to Rosneft and the Russian state, and thereby fuel its predations, and those in the power structure that are the residual claimants. In this case, what’s good for Exxon is good for Putinistan, which given the malign consequences of the latter is precisely why the former should have to suck it up.

Russia is mounting a full-spectrum offensive to grind Ukraine into the dust. Military, paramilitary, diplomatic, political, and economic.

The centerpiece of the economic campaign is, of course, gas. Today Russia’s energy minister threatened a gas cutoff to any country that resold gas to Ukraine, in violation of Gazprom’s sales contracts. Hungary immediately knuckled under.

Energy Minister Alexander Novak asserted that the re-export to Ukraine of gas Europe buys from Russia was illegal and could see some of its nations go without fuel shipments from state energy giant Gazprom for the first time since 2009.

“We hope that our European partners will stick to the agreements. That is the only way to ensure there are no interruptions in gas deliveries to European consumers,” Novak told Friday’s edition of Germany’s Handelsblatt business daily.

Novak’s comments were published only hours after Ukraine’s state energy firm Naftogaz reported an interruption of gas supplies it receives through Hungary.

Naftogaz noted that the apparent cut “came only a few days after a visit to Hungary by representatives from (Russian state gas firm) Gazprom”.

Hungarian Prime Minister Viktor Orban conceded that his country could not risk losing access to Russian gas — responsible for about 60 percent of the country’s supplies — over Ukraine.

“Hungary can not get into a situation in which, due to the Russian-Ukrainian conflict, it cannot access its required supply of energy,” Orban said on state radio.

For its part, the EU disputes Russia’s interpretation of contracts:

The European Union rapped Hungary over the supply interruption.

“There is nothing preventing EU companies to dispose freely of gas they have purchased from Gazprom, and this includes selling this gas to customers both within the EU as well as to third countries such as Ukraine,” Commission spokeswoman Helene Banner said in Brussels.

Any such contractual terms would be, literally, agreements in restraint of trade. They restrain trade between first buyers of Russian gas and others.

Sometimes  restraints enhance efficiency. That is definitely not the case here. The restrictions have one purpose, and one purpose only. To facilitate price discrimination (and hence the exercise of market power) by Gazprom and Russia. This map provides a fascinating visual demonstration of how Gazprom discriminates by price. Adjacent countries can pay dramatically different prices. More distant countries pay lower prices than ones nearer to Russia.

Much of the discrimination is purely economic. Countries with access to few alternative suppliers or few alternative energy sources pay higher prices. But much of the discrimination is political. Note that Belarus and Armenia, reliable Russian clients, pay very low prices, but Ukraine and Lithuania, which bracket Belarus, pay very high ones.

Destination clauses are necessary to maintain these big price differentials. Hence eliminating them would reduce Gazprom’s market power and profitability (though the welfare effects of 3d degree price discrimination are ambiguous) and also reduce Russia’s political leverage. With the ability to resell, those buying at a favored price could resell to those whom Gazprom wants to charge a high price. Gazprom would have to charge pretty much the same price to everyone (though since diversions are not costless it would retain some ability to discriminate, but not nearly as much, especially in the longer run as new infrastructure could be created).

Which makes it all the more bizarre that Europe, and Germany in particular, hyperventilate over far more dubious and abstract theories of market abuse by Google and Microsoft, but meekly let Gazprom run roughshod with textbook monopolist tactics. The lack of a unified energy policy, and unified energy purchasing (Europe could act as a monopsonist) allows Gazprom to play its usual divide and conquer games, of which price discrimination is one obvious result. Expediting the antitrust action against Gazprom would be another way of combating Gazprom’s malign influence.

In the current dispute the stakes are both economic and political/geopolitical. Despite the high stakes, Europe will doubtless limit its response to theoretical objections like those delivered by Helene Banner.

One (bitterly) amusing sidelight to this is despite its market power (the result of Russian law which gives it a monopoly over gas exports and of European acquiescence) Gazprom is still a horrible performer by all conventional metrics. It’s price-earnings ratio is about 3. Contrast that to Shell, Chevron, and Exxon, which have ratios of 10, 11, and 12, respectively. Performance metrics, such as value added per employee or earnings as related to reserves, are horrible.

This is a testament in large part to appalling corporate governance and the insecurity of profits and property in Russia. Speaking of which, there were several developments in the Yevtushenkov/Sistema/Bashneft story today. Yevtushenkov’s house arrest was confirmed and extended, and the Russian government seized Sistema’s Bashneft shares.

I’m never going to run out of material. Never.

Some months ago, Morgan Stanley agreed to sell its oil trading business to Rosneft. Now the deal is at risk of unraveling, due to the effect of sanctions on the Russian company:

Rosneft has enough cash to buy the Morgan Stanley unit, which sources said carries a price tag of between $300 million to $400 million. But to operate day-to-day, the business requires billions of dollars of bank lines of credit, funding that is difficult to secure given the sanctions.

Reuters could not learn the precise size of these credit lines, but trading houses that compete with Morgan Stanley such as Vitol, [VITOLV.UL] Mercuria and Trafigura [TRAFGF.UL] each have $30 billion to $40 billion worth of credit lines with dozens of banks.

“This deal just cannot go through. It is not an issue of finding $300 million to buy the business. Rosneft has the money. But it won’t be able to operate it,” one Russian-based source with direct knowledge of the matter said.

Trading is an extremely working capital intensive business. Depending on its size, a supertanker can carry oil worth $50 million-$300 million, and this has to be financed during the period of the voyage. A decent-sized trading operation can have several tankers on the water, plus additional oil in storage, all of which needs to be financed. A major trading operation needs access to billions in funding on a continuous basis.

Typically, traders finance this with bank credit, with the bigger ones using open lines with banks (which offer considerable flexibility). (I discuss commodity trade financing in my white paper, The Economics of Commodity Trading Firms-bonus video!) You cannot compete efficiently in this business without access to such credit/credit lines. Loss of access to credit is a death sentence to a trading firm, and one that can’t get access in the first place will never be born. That’s where Rosneft finds itself now.

This is another blow to Sechin’s (and Putin’s) aspirations to make Rosneft into a peer super major like BP or Shell or Total that have  robust trading operations. The firm’s longer term ambitions have been seriously dented by the withdrawal of western firms from deepwater and unconventional onshore drilling projects in response to sanctions.

This is also a pain for Morgan Stanley, which is under government pressure to exit the physical trading business: it’s not clear that there’s anyone with enough appetite to pay what Rosneft agreed to. But its pain is nothing compared to Rosneft’s, which will remain dependent on traders to market its oil for the foreseeable future.

Breaks me all up.

Larry Summers has called for an end to the crude oil export ban in the US. This is pretty much a no-brainer for even a pedestrian economist, let alone one of Summers’s intelligence, not to say one as intelligent as Summers thinks he is.

No-brainer or not, eliminating the ban (which isn’t a total ban, in any event) will have only modest effects. This is because although crude cannot be exported freely, refined products can be. Lifting the ban will mainly entail a substitution of crude exports for product exports, which will result in modest impacts on final product prices.

Here’s a crude outline of how opening up exports will play out (pun intended).

1. The price of crude in the US will rise, and the price in Europe (notably Brent) will fall, until the price differential is approximately equal to transport costs of a buck or two, in contrast to the current differential of approximately $6.50. This isn’t immaterial, but it’s not a huge change either, given current prices in the $90s.
2. The amount of crude refined in the US will decline, and the amount of crude refined overseas will rise. Refining margins in Europe will rise and those in the US will fall. The differentials in product prices will remain about the same, because products will be exported after the ban is lifted just as they are now, though export volumes will decline. Prices will differ by transportation costs post-lifting, just as they do now.
3. The effect on product prices in the US (e.g., the price of gasoline) is a priori impossible to sign, because there are offsetting effects. US refiner input prices will rise, but margins will fall. The net price effect of higher costs and lower margins can’t be determined a priori.
4. One factor will definitely lead to lower product prices. Post-free trade in crude, there will be a better match between crude slates and refineries. US refineries are more complex, and optimized to process heavier crudes from Mexico and Venezuela. Most are not optimized to process the large quantities of very light crudes that are flowing from Eagle Ford and the Bakken. In contrast, European refineries are better able to process lighter crudes. This better match of refineries to crude will reduce costs and increase productivity, which tends to reduce product prices.
5. The main factor that will determine whether product prices rise or fall will be the effect of the lifting of the ban on the total output of crude: if more crude is produced, more products will be produced, and prices will decline. The lifting of the ban will reduce Brent prices, which will reduce North Sea output (and Nigerian output too). The lifting of the ban will increase US prices, which will cause US output to rise. The net effect on total crude output depends on the relative elasticities of supply. If, for instance, Brent supply is very elastic and US supply is very inelastic, total crude output could well fall, which would tend to increase gasoline and distillate prices in the US. If the elasticities are reversed, total supply would likely rise leading to lower product prices.
6. If I had to guess, I would say that given that the product price changes will be negative but small, and hard to detect in the normal fluctuations of prices. The combined price effect shared between the US and non-US markets for light crudes is relatively small (on the order of 5 percent of price) and the offsetting effect on foreign and domestic output leaves a net effect on output (and hence prices) that will be relatively small.
7. Tom Friedman supports lifting the ban, which makes me think twice. Friedman also says that lifting the ban will cause crude prices to drop by $25/bbl and thereby crush Putin and Iran and ISIS, thereby saving Ukraine and the MIddle East. Tom Friedman is an idiot. Pay no attention.

There will be one major effect, which Summers alludes to, and which I have emphasized when I teach about the export restriction in my Energy Policy course for EMBAs: the main effect of the change in policy will be to redistribute rents within the domestic oil industry. It will reduce the profitability of US refiners, especially some independents who are feasting on the abundant supply of light crude. It will increase the profitability of domestic crude producers.

In other words, contrary to a lot of the rhetoric, this isn’t about “big oil” vs. main street. It’s about Downstream Medium Oil vs. Upstream  Medium Oil. The big integrated majors basically see money shifted from one pocket to the other: since the lifting of the ban will increase total surplus in the energy market, the integrated majors will benefit, but the benefit will be smallish. The independent refiners will be losers, and pure upstream companies will be winners.

This is, in other words, a sort of family feud. A battle between different branches of the US energy sector family. But as any cop called to the scene of a domestic dispute will tell you, these can be pretty intense.

In sum, ending the ban would make the pizza slightly bigger, but you won’t notice it much at the pump, if you notice it at all. The main effect would be to change the size of the slices. But since conflicts over how the pizza is divided drive politics, the export ban will generate  political battles of an intensity out of proportion to its modest effects  on overall wealth and welfare.

The European Commission’s competition commissioner has scuppered a proposed settlement with Google. The Commission has already taken many pounds of flesh from Microsoft and Intel over the past year, so now it is looking to add some Google cuts to the meat locker.

What about the EU’s case against Gazprom, you ask? <Crickets.>

I’m not a big Google or Microsoft fan, but the accusations leveled against them (and Intel) are highly speculative. Gazprom’s exercise of market power, and its protection of that market power, is almost textbook. The egregious price discrimination, and its use of contractual terms (no re-sale) to support that discrimination, is a blatant example. So on the merits, the Gazprom case should proceed and the Google case should be settled, and on anything but onerous terms.

But the craven Euros quake before Gazprom. Indeed, they seem to be even less willing to confront the company now that Putin is on the war path.

They have a better case against Gazprom, and that case could be a political lever in what is an existential battle over European security: Putin and the Russians have ranted and raved about the case when the Euros did press it some, which indicates that it hits the company, and hence Russia, where it hurts.  But rather than hitting this pressure point, the Euros bury the case and go kick Google instead.

Don’t think that Putin doesn’t notice. And know that it is exactly this kind of cowardice that emboldens him.

It looks like Igor may get his money:

Allocation of over $40 billion from Russia’s National Welfare Foundation for Rosneft oil giantcould be reasonable, as the investment will be repaid, Russian Prime Minister Dmitry Medvedev said in an interview to the Vedomosti newspaper, released Monday.

“This number only seems so impressive, but this is not [supposed to be repaid] within a year,” Medvedev said, answering a reporter’s question on whether Rosneft’s request for $40 billion is feasible.

“The company needs to keep up production, since Rosneft is a major contributor to the budget. In this regard, we have to help them by maintaining the investment level,” Medvedev explained, adding that the government is considering specific ways of aiding Rosneft.

Now, this is Medvedev speaking, so take it for what it’s worth. But it’s my impression that lately Dmitri’s designated role is ventriloquist’s dummy, and if you looked closely you can probably see Putin’s lips moving. This is at least a trial balloon, and perhaps it is laying the groundwork for an official announcement. It is sufficiently controversial within the Russian government that Putin probably does not want to act precipitously and is putting Medvedev out there to see if the proposal attracts too much fire.

This statement likely reflects a couple of realities. First, Sechin’s influence with Putin. The second is the effect of sanctions. Although the EU and US sanctions have not been as draconian as they might be, the FUD factor has worked. Western capital markets and banks are largely shut to Russian companies, especially those subject to sanctions (like Rosneft). Rosneft has maturing debt to refinance, and as Medvedev says, it needs to invest to maintain production.

Output dropped 1.3 percent in August, as the productivity of western Siberian fields continues to drop as they age.

In another indication of the stress that it is facing, Rosneft (and thus Putin/Russia) actually agreed to let China invest in Russian oil fields on terms never extended to a western firm. The Chinese can bring capital, but not the expertise and technology that Rosneft needs to develop the challenging resources on which has staked its future. And the Chinese usually drive a hard bargain. So even with state money, Rosneft will struggle to achieve anything like the lofty ambitions that Sechin has laid out.

The state money will buy some time for Rosneft. Presumably Putin and Sechin are hoping that the state money will get them through the sanctions, which they likely anticipate will fade away in the near-to-medium term. But the FUD factor will continue to limit Rosneft’s access to western capital and western technology. Yes, energy firms and banks will come back if and when sanctions go away, but on terms that will be far less favorable than had been available pre-Ukraine. Putin’s unpredictability has dramatically raised the political risks of investing in Russia, especially in the energy sector.  Future capital will come with strings, and will be reluctant to invest in long term projects that could fall victim to Putin’s next adventure.

In other words, if Putin indeed permits Rosneft to dip deeply into the National Welfare Fund, it will be an acknowledgement that Russia has burned its bridges with western finance and technology.

A lot of CFTC news lately. Much of it involves the agency, under new chairman Timothy Massad, dealing with the consequences of Frankendodd and the overzealous efforts of his predecessor Gary Gensler to implement it.

One of Massad’s priorities relates to clearinghouses (CCPs):

CFTC Chairman Timothy Massad said in a Sept. 5 interview that his agency will bolster examinations of clearinghouses, which process trillions of dollars in transactions and are potentially vulnerable to market shocks or cyber attacks. The agency is working with the Federal Reserve on the effort, he said.

New rules requiring banks and other firms to use clearinghouses owned by LCH.Clearnet Group Ltd., CME Group Inc. (CME) and Intercontinental Exchange Inc. (ICE) have been “a great thing” and have helped regulators “monitor and mitigate risks, but it doesn’t eliminate risk,” according to Massad.

“We’ve got to be very focused on the health of clearinghouses,” he said.

It’s nice to see that the CFTC, as well as prudential regulators, recognize that CCPs are of vital systemic importance. But as I’ve said many times, on four continents: In a complex, interconnected financial system, making CCPs less likely to default  does not necessarily increase the safety of the financial system. Making one part of the system safer does not make the system safer. It can prevent one Armageddon scenario, but increase the likelihood of others.

Gensler babbled repeatedly about the clearing mandate reducing the interconnectedness of the financial system. In fact, it just reconfigures the interconnections. The very measures that are intended to ensure CCPs get paid what they are owed even in periods of crisis can redirect crushing stresses to other vulnerable parts of the financial system. CCPs may end up standing, surrounded by the rubble of the rest of the financial system.

CCPs are deeply enmeshed in a complex web of credit and payment relationships. Mechanisms intended to reduce CCP credit exposure-multilateral netting, high initial margins, rigorous variation margining-feed back into other parts of that web.

There are so many interconnected parts. Today Risk ran an article about how LCH relies heavily on two settlement banks, JPM and Citi. Although LCH will not confirm it, it appears that these two banks process  about 85 percent of the payments between clearing members and LCH. This process involves the extension of intraday credit. This creates exposures for these two big SIFIs, and makes the LCH’s viability dependent on the health of these two banks: if one of them went down, this could cause extreme difficulties for LCH and for the clearing members. That is, OTC derivatives clearing adds a new way in which the financial system’s health and stability depend on the health of big banks, and creates new risks that can jeopardize the health of the big banks.

So much for eliminating interconnectedness, Gary. It’s just been moved around, and not necessarily in a good way.

Again, mitigating systemic risk requires taking a systemic perspective. The fallacy of composition is a major danger, and a very alluring one. The idea that the system gets safer when you make a major part of it safer is just plain wrong. The system is more than just the sum of its parts. Moreover, it can actually be the case that making one part of the system stronger, but more rigid, as clearing arguably does, makes the system more vulnerable to catastrophic failure. Or at least creates new ways that it can fail.

Another issue on Massad’s plate is addressing the conflict between his agency and Europe on giving regulatory approval to each other’s CCPs. It looks like this issue will not get resolved by the drop dead date in December. This will result in substantially higher costs (primarily in the form of higher capital requirements and higher margins), the fragmentation of OTC derivatives markets, and greater counterparty concentration (as US firms avoid European CCPs and vice versa).

The CFTC is also trying to fix its fundamentally flawed position limit proposal, and particularly the defective, overly restrictive, and at times clueless hedging exemptions. Mencken defined Puritanism as “The haunting fear that someone, somewhere, may be happy.” The CFTC’s hedging exemption, as currently constituted, reflects a sort of financial Puritanism: “The haunting fear that someone, somewhere, may be speculating.” To avoid this dread possibility, the exemptions are so narrow that they eliminate some very reasonable risk management strategies, such as using gas forwards to hedge electricity price exposures.

This has caused an uproar among end users, including firms like Cargill that have been hedging since the end of the freaking Civil War. Perhaps their survival suggests they might know something about the subject.

In the “be careful what you ask for” category, the CFTC is wrestling with a very predictable consequence of one of its decisions. In an attempt to wall off the US from major shocks originating overseas, the Gensler CFTC adopted rules that would have subjected foreign firms dealing with foreign affiliates of US banks to US regulations if the parents provided guarantees for those affiliates. Foreign firms definitely didn’t want to be subjected to the tender mercies of the CFTC and Frankendodd regs. So to maintain this business, the parents stripped away the guarantees.

Problem solved, right? The elimination of the guarantee would eliminate a major potential channel of contagion between the dodgy furriners and the US financial system, right? That was the point, right?

Apparently not. The CFTC has major agida over this:

Timothy Massad, the new CFTC chairman, said in an interview he is concerned aboutrecent moves by several large Wall Street firms to sidestep CFTC oversight by changing the terms of some swap agreements made by foreign affiliates.

“The concern has always been that activity that takes place abroad can result in the importation of risk into the U.S.,” Mr. Massad said. He said there is a concern that a U.S. bank’s foreign losses would ultimately find their way to U.S. shores, infecting the parent company in possibly destabilizing ways.

. . . .

The moves mean any liability for those swaps lies solely with the offshore operation, which the banks have said will protect the U.S. parent from contagion. Yet without that tie to the U.S. parent, the contracts won’t fall under U.S. jurisdiction and so won’t be subject to strict rules set by the 2010 Dodd-Frank financial-overhaul law, including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms [i.e., the SEF mandate].

By de-guaranteeing, the US banks have eliminated the most direct channel of contagion from over there to over here. But apparently the CFTC is worried that unless its regulations are followed overseas, there will be other, albeit more indirect, backdoors into the US.

In essence, then, the CFTC believes its regulations are by far superior to those in Europe and elsewhere, and that unless its regulations are implemented everywhere, the US is at risk.

Not too arrogant, eh?

A few observations should make you question this arrogance, and in a  big way.

First, note that the most likely effect of the CFTC getting its way of exporting its regulations into any transaction and any entity involving any affiliate of a US financial institution is that foreign entities will just avoid dealing with any such affiliate. This will balkanize the global derivatives market: ‘mericans will deal with ‘mericans, and Euros with Euros, and never the twain shall meet. This will likely result in greater counterparty concentration. Such developments would create systemic vulnerabilities, and even though the direct counterparty credit channel could not bring that risk back to US banks, the myriad other connections between foreign banks and American ones would.

Second, note the last sentence of the quoted paragraph: “including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms.” So apparently attempts to avoid the SEF mandate infuriate the CFTC. But the SEF mandate has nothing to do with systemic risk. For this reason, and others, I named this mandate “The Worst of Frankendodd.” But so intent is the CFTC on pursuing this systemically irrelevant unicorn that it is questioning moves by US banks that actually reduce their exposure to problems in foreign markets.

Timothy Massad has the unwelcome task of cleaning up after the elephant parade at the Dodd, Frank & Gensler Circus. Clearing mandates, coordinating with overseas regulators, position limits, and the elimination of affiliate guarantees are only some of the things that he has to clean up. I hope he’s got a big shovel and a lot of patience.

The decline in the price of oil-Brent is down almost to $100/bbl, and Urals-Med is below that level-puts pressure on an already stressed Russian economy. And it especially puts pressure on a stressed Russian government budget, which balances at about $110+. What’s more, Russia is looking to replace private western funding with state support for its banks, and some corporations: recall my post yesterday which described how Sechin is panting after tens of billions of government money to replace western creditors. Further, Putin has made all sorts of promises, including lavish spending on the military and on infrastructure (e.g., a hugely expensive bridge over the Kerch Strait to Crimea). All of these add to the strains on the Russian budget.

Some of this is due to a weakening of the Russian economy for independent factors. Some of it is due to the sanctions.

The effectiveness of the sanctions could be enhanced by putting even further pressures on the Russian government. The most direct means of doing so would be through the price of oil, and short of persuading the Saudis to do a reprise of their 1986 act of flooding the market with oil, the best way to do that would be to release oil from the Strategic Petroleum Reserve.

Especially given the burst in US domestic oil production, the already weak case for maintaining a large reserve is even weaker. Moreover, since much of the oil in the SPR is Brent, and thus could presumably be exported, this would be a way of mitigating the distortions associated with the existing crude export ban.

The number of barrels that would actually flow to the market would presumably be somewhat lower than the amount released from the SPR, because some of the public storage would be replaced by private storage. (As I argued in 2011, this effect depends on market expectations regarding how the SPR would be used.) But the direction of the price effect is clear, and the price impact would not be trivial.

Putin is waging asymmetric war in Ukraine. (Though it is becoming less asymmetric, and more conventional, by the day.) Sanctions are an asymmetric form of warfare. A release of the SPR would be another asymmetric move that would impact Russia directly, and indirectly by enhancing the financial strains produced by the sanctions. There’s no substantive economic case for retaining the SPR at its current levels. Seems like an obvious move. Will Obama make it?