Streetwise Professor

Apropos my Russia-as-a-high-beta-economy theme, consider this Russophobic jeremiad:

Vladimir Putin faces the risk of Russia’s political stability being shaken if Greece leaves the euro area, triggering a global crisis and sinking the price of oil, according to the Center for Strategic Studies in Moscow.

There’s a more than 50 percent chance of a Greek exit, which would lead to more countries pulling out of the currency union, Mikhail Dmitriev [what a clever disguise!], the research institute’s head, said in an interview yesterday. Russia’s main risks are a worsening economy, which would swell anti-Putin sentiment, and increased political repression, according to a study published today by the institute, which advises the government.

“If these trends continue, we will see the escalation of political violence and repression on one hand, and the worst economic crisis on the other,” said Dmitriev, a deputy economy minister from 2000 to 2004. “This may lead to Putin losing control and a chaotic political transformation.”

The article goes on in a familiar vein, linking Russia’s economic fortunes to the price of oil, and the price of oil to the impending train wreck in Europe.  Nothing you haven’t read here, if you’ve been reading here.

Moreover, Dmitriev echoes another long-standing SWP theme.  Namely, that in the present political environment, a sufficiently severed adverse economic shock could threaten Putin’s brittle political system:

“The political crisis could quickly become acute if it’s aggravated by a fresh economic crisis,” it said. “This is highly likely to provoke a rapid loss of political control and an accelerated change in the political system.”

Dmitriev predicts that in the event, Putin will respond with repressive measures.   Indeed, one can see the new law imposing huge fines on demonstrators as a preparation for such an eventuality.

No, pointing out that  (a) Russia is hostage to international economic conditions, and (b) Russia’s brittle polity is in turn vulnerable to economic shocks is not Russophobic.  It is a very reasonable appraisal of reality, and many Russians viewing the situation objectively, like Mikhail Dmitriev and the Center for Strategic Studies, arrive at the same conclusion.

I have often noted that Russia is a high beta economy.  This reflects, primarily, its extreme dependence on raw materials generally, and energy particularly.  Economic contraction reduces the demand for, and prices of, these commodities, and this hits Russia hard.

Witness the events of recent days.  Europe is re-entering crisis mode, with Greece teetering again, and Spain-a much bigger problem-also in extremis.  China is exhibiting serious signs of weakness.  As a result, commodity prices are down, about 7 percent this month (as measured by the DJ commodity index).

And Russia is down along with commodity prices:

While most countries’ stock markets have been hammered amid Greece’s sovereign-debt woes and its possible exit from the euro, the plunge in Russian stocks—which have dropped from their 2012 highs by nearly twice as much in percentage terms as the MSCI Emerging Markets Index—has been particularly fierce.

“Such is the level of risk-phobia in the world right now, and Russia, despite the generally positive domestic backdrop and very cheap asset base, is viewed as being the most at-risk economy in the world,” said Chris Weafer, chief strategist at Troika Dialog, an investment bank in Moscow.

Moreover, capital outflows are continuing:

Activists who clashed with police before Putin’s May 7 inauguration are protesting non-stop in Moscow, using the Occupy Wall Street movement’s tactics. As the benchmark RTS equity index entered a bear market, Russia-focused equity funds recorded $251 million of outflows in the seven days to May 9, the most this year, while China lost $127 million, India $148 million and Brazil $167 million, EPFR Global data show.

Further:

Russia’s top central banker warned on Wednesday that capital flight is a “serious problem,” as newly released figures showed $42 billion has left the country in the first four months of the year.

“Capital outflow continues to be a serious problem for the Russian economy,” the central bank’s chairman, Sergei Ignatyev, told Russia’s lower house of Parliament.

The ruble is weakening too, down about 5 percent this month.

This follows a first quarter in which Russian growth exceeded expectations.  But that was also a quarter in which oil and commodity prices spiked.

One thing that complicates interpretation of these figures is that multiple things are going on. The first is the economic problems in Europe and Asia.  The second is the ongoing political uncertainty in Russia.  Both are pushing money in the same direction-out of Russia.  The difficulty is trying to determine how much of the outflow is attributable to each of these factors.  It is quite remarkable, however, that the election and the ebbing of the protest movement has quite evidently not staunched the outflow.

With respect to the outflows, Russian officialdom is whistling past the graveyard-and blowing smoke up everybody’s collective rear. Yeah, they say, we’ve had problems-but Happy Days Are Around the Corner!  The flows will reverse manana.

I howled when I read this:

Russian financial officials have assured that Russia would start seeing capital inflows in the second half of the year after the new government is formed. Prime Minister Dmitry Medvedev has submitted candidates for the cabinet to President Vladimir Putin for him to sign on the list of new ministers by the end of the month.

Yeah.  It’s all that uncertainty about the cabinet that is driving money away.

To the extent that the outflows are politically driven, rather than a manifestation of the high beta effect, the exact opposite is true.  It is the realization that the Putin Purgatory, with all its legal nihilism, is here to stay that is the problem.  Investors-including, it should be noted, many rich Russians-have seen the future, and know it won’t work.

When a strong world economy or supply shocks keep commodity and energy prices high, the high beta effect covers a multitude of sins in Russia.  When these factors reverse, things get double ugly.  There is the ugliness of the natural state, Putin’s Purgatory. That is, sadly, arguably a constant.  Then there is the ugliness that comes with a commodity price-crushing world economic contraction.

The thing to watch going forward is how these things interact.  Economic weakness resulting from the high beta effect will impact politics in Russia-and Putin will react to that in ways that will likely exacerbate Russia’s politically-grounded economic difficulties. The populism and promises of government largesse that Putin used to campaign for re-election will not be sustainable.  What will the popular backlash? How will Putin hit back?

Meaning that if the world economic situation continues to deteriorate, the brittleness of the Russian natural state will be tested.

Much has been written about Putin’s resumption of the Russian presidency. Much of it relates to economics. Much of it is silly.

This article from the FT’s Beyond Brics blog summarizes a lot of the silliness that is spun by those making the “bullish” case for a Putin return:

The bulls can put together a persuasive story: Putin 2.0 cannot run the economy as he did in his first two presidential terms in 2000-8 or as prime minister in 2008-12 because he can no longer rely on rapidly rising oil prices.

. . . .

Therefore, so the bull argument goes, Putin must pursue economic reform, including market liberalisation, privatisation, reducing red tape and fighting corruption. Otherwise Russia cannot generate the economic growth needed to transform itself into a fully-functioning modern society. Finance minister Anton Siluanov said on Monday Russia required growth of 5.6 per cent annually, (not the 3.4 per cent forecast by the government for 2012).

. . . .

So, say the bulls, Putin will change because he must. At the age of 59, he will be thinking of his legacy, and he won’t want to be remembered as the man who created a historic opportunity to modernise his country – only to waste it.

Most of that is nonsense on stilts.  Or, more accurately it is projection on stilts: it accurately summarizes what Putin should do if his objective was to create a modern Russian economy with self-sustaining growth, which is what the bulls think a “normal” country and a “normal” leader would do.

But that totally misses the way the Russian system works, and what Putinism is about.  It misses that Russia is a natural state, and that the system is structured to benefit the elites and uses control of resources to keep a balance among the elites in order to maintain political stability.  Creating a dynamic system, a modern system, would fatally undermine this equilibrium.  Moreover, in this system, corruption is a feature, not a bug.

As I noted yesterday, Putin is already signaling clearly that he will brook no opposition, and will bring down the batons on anyone with the audacity to raise his head.  This is one aspect of maintaining political control.  Maintaining control of the economic levers is another.   Putin may talk modernism, but he walks traditionalism, meaning a traditional, natural, authoritarian state where economic policy is all about distributing rents and maintaining control of economic resources in order to protect the elite and their property.

And although Putin may talk about moving beyond oil and gas, he’s not walking away from it.  To the contrary.  He is avidly pursuing energy deals with western companies (h/t R), and touting these deals to anyone who will listen.  Steve LeVine argues Putin is “good for business” but the businesses LeVine mentions are notably the big western energy companies.

Some (including LeVine, it appears) rationalize this as a means of funding and pivoting to a more modern economy.  Such beliefs are truly a triumph of hope over experience.  Sergei Guriev has written often and powerfully about this.

Further note that although Putin announced privatizations, energy was clearly off the table:

In the decrees, Putin said he wanted the government to sell its stakes in firms which do not belong to natural resources or defence sectors and are not natural monopolies. That would require a change to the state’s privatisation programme when he wanted in place by Nov. 1, he added.

This strongly suggests that Sechin has prevailed, and that what is old is new again.

Other aspects of Putin’s newly announced programs are purely aspirational, decrees to achieve wonderful economic outcomes, but with no concrete policies that could actually achieve them:

Putin ordered the government to take measures to raise capital investment to no less than 25 percent of GDP in 2015, from the current level of 20 percent, and to create 25 million high productivity jobs by 2020.

He also called for a 50 percent increase in labour productivity by 2018 and a 30 percent increase in the share of high tech products in GDP in order to lessen Russia’s dependency on natural resources.

Uhm, just how, exactly?  This is redolent of Soviet planning, with the center setting ambitious targets.  The difference being that it’s easier to do that with something like steel production, especially when you can shoot people who don’t perform, and dragoon peasants from the farms to the factories and dragoon the peasants who stay behind into feeding those who left.  Not so easy to do in a modern economy.

Putin seems to recognize this (h/t R again):

In characteristically colorful language, Putin struck back by blaming the economic difficulties on the Communists who ruled the Soviet Union until 1991. The Soviet economy was based on heavy industry and produced shoddy consumer goods.

“Yes, my dears, there’s no need to discuss this,” Putin said. “The point is that what we produced — and no need to wave your arms — no one needed. No one bought our galoshes except for Africans who had to walk on hot sand.”

That’s great that he recognizes the obvious, but it’s a long way from that to understanding how to create a system that generates 25 million high productivity jobs and increases the role of high tech in the country.  It’s further still from such an understanding to a willingness to take the measures necessary-measures that would undermine his power, his wealth, the wealth of the elite, and the stability of the political system.

And he’s all about stability.  When analyzing the actual policies he pursues, rather than the pie-in-the-sky rhetoric, you have to start from that fact, rather than projecting western political “it’s the economy stupid” attitudes onto him.  Putin understands Soviet failures, and will not repeat them.  But he also understands the mortal dangers that a rule based, competitive system would pose to him and the elites.  He will steer a middle course, a natural state course.  He will continue on, pretty much as before.

Another “bull” point (with “bull” being accurate in more ways than one) in the Beyond Brics article is that Putin will change to ensure his legacy.   I think that’s farcical for the reasons just discussed, but it is completely unrealistic for other reasons as well.  First, although it is not historically unprecedented, it is extremely rare for aging leaders to change dramatically.  Hell, it’s extremely rare for aging people period to change dramatically.  Indeed, habits and tendencies tend to become progressively more defined and rigid as one ages.   For someone as arrogant as Putin, in particular, it is delusional to think he will conclude that he has to change dramatically.  Second, change requires receiving realistic feedback.  Authoritarian systems generally, and Putin’s in particular, have disconnected most of the feedback mechanisms: elections, a free media.  The crackdown on the opposition (including today’s lovely threats to smear their livers on the sidewalk) may succeed in its object, but in so doing will short circuit another source of feedback.  The natural authoritarian tendency for leaders to surround themselves with sycophants, and for sycophants to rise to the top because sycophancy is the primary fitness trait in such regimes, further isolates the leader from reality.

Some of Putin’s other decrees are particularly idiotic:

Putin bound the government to reduce mortgage loan rates to 2.2 percent by 2018.

He also pushed for state measures to increase real wages 1.4-1.5-fold by 2018. The average lifespan in Russia must reach at least 74 year Putin said in a decree.

2.2 percent? Really? What’s he doing? Trying to create a real estate bubble? That always ends so well!

And just what state measures can increase wages 50 percent in 6 years?  Why hasn’t any other state figured out how to do that?  And how is lifespan to be increased by decree? He might as well order the tides to stop: Canute knew better than this, but pace the sycophancy point, who in Russia is going to tell him so?  And would Putin play Canute to chide the sycophants around him? Please.

No.  There will be no modernization to speak of.  Putin’s Purgatory will continue, and become more stagnant and corrupt.  The hamster wheel from hell will keep on spinning, until it falls apart or is knocked over by some shock that turns off the tap of resource rents that is essential to its operation.

Very interesting of juxtaposition of stories involving Norway and Russia (h/t R).

Story one-Norway’s Statoil and Russia’s Rosneft agree to exploration joint ventures in the Russian Arctic:

Statoil (OSE:STL, NYSE:STO) and Rosneft today signed a cooperation agreement. The companies have agreed to jointly explore offshore frontier areas of Russia and Norway and to conduct joint technical studies on two onshore Russian assets.

The agreement also envisages Rosneft’s acquisition of participating interests in selected Statoil projects.

. . . .

Under the agreement, Statoil and Rosneft will set up joint ventures, with Statoil holding 33,33% in each. The partners will jointly explore the Perseevsky licence in in the Russian part of the Central Barents Sea and three licences – the Kashevarovsky, Lisyansky and Magadan-1 – north of Sakhalin island in the Sea of Okhotsk. The four offshore licences cover an area of more than 100,000 square kilometres, equalling approximately 200 blocks on the Norwegian continental shelf.

Are the Norwegians setting themselves up to be the next victims of expropriation? A couple of things to note.

First, this an exploration deal.  Although this involves irreversible investments, the real risk of expropriation spikes when production begins.  This is particularly true inasmuch as even if the exploration identifies commercially attractive opportunities.  Rosneft would be in no position to try to freeze out Statoil after it had paid to discover the prospects because the Russian company seriously lacks the expertise to develop these resources itself: this is why it is so assiduously pursuing agreements with all the major western majors.

Second, it appears that Statoil is following the hostage model pioneered by ExxonMobil:

The cooperation agreement also provides Rosneft with an opportunity to acquire interests in selected Statoil exploration licences and assets in the North Sea as well as in the Norwegian sector of the Barents Sea.

This article, and all the others I’ve tracked down about the deal, are maddeningly short of details on this crucial aspect of the transaction.  But it is evident that the deal is structured so that Rosneft has a valuable asset at risk if it (or the Russian government) tries its old tricks.

Note to reporters: please get a clue and get more detail on this aspect of the agreement.  This is the crucial term in the agreement.

The hostage mechanism is an oft-used way of enforcing good behavior in transactions involving long-lived investments in specific assets.  Williamson wrote about this mechanism in detail in The Economic Institutions of  Capitalism and elsewhere.

The devil is truly in the details, though.  XOM is apparently confident that it can provide incentives for good behavior from the Russians, and apparently Statoil has taken XOM’s confidence to heart.  But how it works in practice remains to be seen.  Don’t underestimate the ability of the Russians to behave opportunistically.

A particular risk is that the values of the investment opportunities in Russia and in Norway (or in the US Gulf, in the XOM deal) diverge.  Let’s say that the Russian resource turns out to be extremely valuable, but the Norwegian (or Gulf) resource comes a cropper.  Then the hostage has no value, and the risk of expropriation rises dramatically.

That risk seems to be particularly acute in this context, given the extreme uncertainty about the commercial value of the different projects.  Much information will be developed over time about the value of the various resources.  Moreover, technologies will change, affecting the commercial prospects of each.  There is an appreciable risk of a divergence in hostage values.  Given the asymmetric risk of opportunism, that divergence is particularly hazardous for Statoil and Exxon.

This probably explains why all of the deals involve bundles of several exploration prospects.  This diversification reduces the risk of the loss of hostage value.  Only if all of the Norwegian prospects turn out badly do the hostages die, leaving Rosneft free to screw the Norwegians out of any attractive opportunities in Russia.  Note in this regard that the Norwegian prospects are in two different regions-the North Sea and the Barents Sea.  This increases the diversification.

Clever.  I hope it works out for them.

Hey, Tim Newman-your insights would be greatly appreciated.

To emphasize why such measures are particularly important in dealing with Russia, consider the second story, about Russia banning Norwegian salmon imports:

Russia temporarily halted chilled salmon imports from 13 Norwegian firms, the animal and plant health watchdog in Moscow said.

The ban followed repeated instances of microbe pollution, a spokesman for the regulator said on Saturday.

Norway’s food Safety Authority said on April 30 it had received advance notice of the ban, which does not include frozen salmon, and was working with the firms to resolve the “very serious” issue.

Russia is Norway’s biggest salmon market.

Shares in fish and seafood products company Russian Sea . rose 7 percent in Moscow on Saturday.

. . . .

The global salmon market is experiencing a glut, and many firms are struggling to shift their stocks.

There are no “microbes” in salmon caught in Russian nets?  Sure there aren’t.

No.  The last two sentences tell the real story.  A supply glut is weighing on prices, hurting Russian fishers.  So the Russians gin up (or would that be vodka up?) the “health and safety” issue to justify an import ban.  Lo and behold, Russian fishing companies (or at least one, anyways, but there is no reason to believe it is exceptional) realize a windfall.

I’ve written in the past about how Russia routinely manipulates health and safety concerns as a protectionist instrument. (Search the site for “swine flu” and a couple of posts will come up.) (And yes, I recognize and condemn the fact that Russia is not the only sinner in this regard.  The US also engages in various forms of legerdemain to protect US firms.)  That this continues even as Russia joins the WTO indicates that it is still not too keen on rules and agreements that constrain its ability to take from foreigners to benefit domestic interests.

So, this fish story should focus Norwegian minds on the risks that they assume when trawling for other riches in cold waters.  Maybe the hostages will keep the Russians in line.  But the point is that you need hostages in dealing with them, for reputation and contracts alone aren’t enough.  You just need to hope that your hostages don’t die before you need them.

For years Russia and Gazprom have pooh-poohed the shale gas revolution.  No longer.  Putin has raised the alarm:

Russian President-elect Vladimir Putin urged energy producers from the world’s biggest natural- gas exporter to “rise to the challenge” of a changing market as the U.S. increases output of shale gas.

U.S. shale gas production may “seriously” restructure supply and demand in the global hydrocarbons market, Putin said today in an address to the Russian lower house of parliament.

The impact of shale is being felt immediately in pricing, with customers demanding concessions on Gazprom’s oil-linked pricing mechanism.  The divergence between oil and gas prices has exploded, and now tops 52 (WTI to Henry Hub) and 60 (Brent to Henry Hub): historically, the ratio has been around 10.  Although the disparity is not nearly so large in Europe, oil-linked gas prices have diverged substantially from spot prices there as well.

In defense of the oil peg, Gazprom’s Alexander Medvedev keeps blowing the same gas:

Mr Medvedev insists that the oil link is here to stay. “[Because] the liquidity of the gas market is so low, spot pricing can’t give the right price signals, to suppliers or customers,” he says. “We want predictable prices for the consumer.”

To repeat: liquidity is endogenous, and liquidity feeds to liquidity.  A move to a market-based pricing mechanism would lead to a spiral of liquidity, just as occurred in the US following deregulation in the early-1990s.

And please, oil prices that diverge radically from gas prices are giving better price signals? Really?

Finally, since when are oil prices predictable?  Yes, historically they are less volatile than gas prices, but that’s irrelevant.  Volatility per se is neither good nor bad. Prices that don’t adjust to reflect supply and demand conditions for the particular commodity are sending bad signals. If supply and demand are volatile, or there are rigidities and bottlenecks that make it difficult to adjust output in respond to shocks, then prices have to be volatile to send the right signals.  A price that is perfectly predictable is likely sending the wrong signal at all times but on a set of measure zero.

No, if prices are volatile, than customers who don’t like the risk should have the opportunity to hedge that risk via derivatives markets.  That’s exactly what happened in the US markets.  But that would involve speculators who take on that risk, and we can’t have THAT now, can we?

The pricing mechanism is really just a means to an end, from Gazprom’s perspective, the end being high prices.  You can bet the company would jettison the link in a second if the divergence was working the other way.  But the availability of low cost supplies will undermine that end, as Putin publicly recognizes.  The biggest potential obstacle to those supplies hitting the market is environmental restrictions on tracking.  Hence the widespread suspicions that Gazprom bankrolls anti-fracking campaigns and organizations, particularly in Europe.  (Good luck with that in China!)

Gazprom is one of the world’s least efficient companies. It can survive due to a relative lack of competition.  Vigorous competition from new supplies will dramatically erode its profitability-and with that comes damage to the budget of the Russian state, not to mention the personal budgets of all those myriad officials who feed at the Gazprom trough.

The day can’t come soon enough.

Yesterday Obama delivered another of his it-must-have-been-some-other-body-it-wasn’t-me (h/t Chuck Berry) speeches on energy.  And, true to form, he delivered another clarion call to round up the usual suspects: evil speculators, whom he confabulates with manipulators .  (And I am being generous, because confabulation is inadvertent, whereas I Obama’s slander is almost certainly deliberate):

That’s what’s happening right now.  It’s those global trends that are affecting gas prices.  So even as we’re tackling issues of supply and demand, even as we’re looking at the long-term in terms of how we can structurally make ourselves less reliant on foreign oil, we still need to work extra hard to protect consumers from factors that should not affect the price of a barrel of oil.

That includes doing everything we can to ensure that an irresponsible few aren’t able to hurt consumers by illegally manipulating or rigging the energy markets for their own gain.  We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher — only to flip the oil for a quick profit.  We can’t afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick.  That’s not the way the market should work.  And for anyone who thinks this cannot happen, just think back to how Enron traders manipulated the price of electricity to reap huge profits at everybody else’s expense.

. . . .

That includes doing everything we can to ensure that an irresponsible few aren’t able to hurt consumers by illegally manipulating or rigging the energy markets for their own gain.  We can’t afford a situation where speculators artificially manipulate markets by buying up oil, creating the perception of a shortage, and driving prices higher — only to flip the oil for a quick profit.  We can’t afford a situation where some speculators can reap millions, while millions of American families get the short end of the stick.  That’s not the way the market should work.  And for anyone who thinks this cannot happen, just think back to how Enron traders manipulated the price of electricity to reap huge profits at everybody else’s expense.

He used the word “manipulate” or “manipulation” 11 times in his relatively brief remarks.  In typically dishonest fashion, he isn’t responding to specific, credible evidence of manipulation; he provides no evidence that manipulation is rampant or is at all responsible for current price levels.  Hell, he can’t even come up with a current example, having to reach back more than a decade to Enron (itself a dubious example).  He merely insinuates and implies.  But the average listener or reader will conclude from his remarks that manipulation is causing their pain at the pump.  Rather than encouraging a sober and realistic appraisal of the role of speculative trading in energy, he is feeding suspicions and encouraging a witch hunt.

Moreover, note the repeated and casual identification of manipulation and speculation.  This is itself a manipulative use of language.  Manipulation is not even a proper subset of speculation: hedgers can be some of the most dangerous manipulators.  It further encourages the popular suspicion that financial trading in commodity markets is inherently dishonest and crooked.

Insofar as concrete steps are concerned, he is demanding substantial increases in resources for the CFTC to oversee the energy markets and a substantial hike in the criminal and civil penalties for manipulation.  With respect to oversight, I’ve said more times that I should have to that the undetected manipulation is the unsuccessful manipulation.  If manipulation distorts prices, that distortion will be manifest.  Moreover, those harmed by the manipulation have every incentive to bring the manipulation to the attention of the regulators.  The idea that manipulation is rife and is having huge impacts on prices, but it is necessary to surveil the markets intrusively using “modern tools” to find it is an oxymoron.  Which means that greater penalties imposed ex post are defensible.

It doesn’t inspire confidence that Obama justifies the greater CFTC resources by quoting another of GiGi’s inane metaphors.

The other major concrete step is to give the CFTC authority over margins for energy derivatives.  This is another hardy perennial: similar proposals were made with respect to stock index futures in the aftermath of the 1987 Crash.

Obama’s justification for this is risible: “Congress should give the agency responsible for overseeing oil markets new authority to protect against volatility and excess speculation by making sure that traders can post appropriate margins, which simply means that they actually have the money to make good on their trades.”  So which is it? Are margins to ensure contract performance, or are they to reduce volatility and excess speculation?  If the former, there is zero evidence that CME Group or ICE or OTC market participants aren’t charging margins that are sufficiently high to control efficiently counterparty risk.  If the latter, there is (a) no evidence that there is excess speculation in energy, or that it is elevating volatility, and (b) no evidence that tweaking margins will have any impact on volatility.  Indeed, hiking margins can raise volatility by reducing the amount of speculative capital available to absorb fluctuations in hedging demand.

In sum, the parts of Obama’s markets aimed at speculator-manipulators are intellectually confused, empirically baseless, and deeply irresponsible because they encourage a witch hunt atmosphere by slandering (by slimy insinuations) legitimate market actors as criminal manipulators.

Well played.  Because of all the practice, no doubt.

A few other things stand out.  First, he repeats the “we use more than 20 percent of the world’s oil and we only have 2 percent of the world’s proven oil reserves” mantra.  Hell, even he admits he says this repeatedly: “But as I’ve said repeatedly.”  Repetition of a dubious factoid does not make the conclusion it is intended to support true. Indeed, that’s a staple of the Big Lie.

Second, he continues to take credit for increased US oil output when in fact he and his administration don’t have a damn thing to do with it, except that it could have been higher yet without some of their counterproductive policies.

Third, take a look at this remark: “We’ve added enough new oil and gas pipeline to circle the Earth and then some.”  To which my first response is:  What do you mean “we” kimosabe? Again, a guy who has never done anything that would risk getting a callous taking credit for the actions of those that actually put hands to shovel and made some truly shovel ready projects realities.  Moreover, it raises the question: if building so much pipeline capacity is such a great thing, why is he doing everything in his power to stall or stop Keystone?  Is that uniquely damaging? (To the environment, I mean, not to the fortunes of Buffett’s BNSF.)

A rule of thumb to keep in mind.  Whenever Obama talks about energy generally, and speculation specifically, it is safe to conclude you are being manipulated: that’s not at all speculative.

* Title suggested by R.

University of Maryland law professor Michael Greenberger is quoted often in the financial press on derivatives related matters. I have no idea why. He is a complete buffoon on these issues.

Perhaps it is his stint at the CFTC makes reporters think he’s credible. All the worse for the CFTC.

Personal anecdote. He and I were on the same panel when I testified on oil speculation before the House Ag Committee in July, 2008. He said something typically inane; I think it was about increases in Saudi oil output not driving prices down. I jumped on him, saying that he had overlooked the fact that Saudi crude was heavy and sour, and the market was short light, sweet crude. He was flustered, and responded by stammering “I’m not an economist” to which I responded: “That’s the first thing you’ve ever said that I agree with.”

And the last.

But Greenberger has crossed the line from buffoonery to mendacity with this interview:

Greenberger makes very serious allegations: criminal conspiracy to manipulate the prices of multiple commodities.

He says speculators are “working together.” “There is doubtless criminal conduct here.” He compares speculators to bank robbers and burglars. He asserts that the (alleged) huge profits of commodity speculators are due to their criminal conduct, and would not exist if prosecutors did their jobs; instead, they have “blindfolded themselves, stuffed their ears, held their noses” and let criminal conduct proceed uninvestigated, and of course unpunished.

He even gives this a political spin, saying that since higher gas prices are the only thing that can result in Obama’s defeat, the conspiracy could lead to the Republicans taking the White House, and racking up big gains in the House and the Senate.

Which obviously begs the question: then why wouldn’t an Obama DOJ be falling all over itself to investigate? An Obama CFTC? An Obama SEC? I mean, this part of the interview alone marks Greenberger as completely unhinged, as it makes no sense that a hyper-politicized administration would refuse to investigate rampant criminality that threatens its re-election.

Greenberger’s evidence for his lurid claims about a criminal conspiracy to manipulate prices?-zip. Really. Zip. His claim that speculators are driving up prices by trading futures is without solid empirical foundation, but is common enough. But to allege criminal conduct, and a vast conspiracy among major financial institutions, goes far beyond the pale. He says he won’t name names. Why not? If he has the evidence, why shouldn’t he? Truth is an absolute defense in libel and slander.

And recall what Judge Easterbrook wrote over 25 years ago: an undetected manipulation is an unsuccessful manipulation. If there is such a vast and successful effort to manipulate prices, the evidence would be there for all to see.

If Greenberger can back up what he says about criminal conduct, and a criminal conspiracy, he should do so. Now. Stat. If he can’t, he shouldn’t be making such lurid claims. It is beyond irresponsible. It is mendacious.

Recognition is dawning that clearing mandates-the supposed silver bullet for making the derivatives market safe-are not the panacea that their advocates claimed.  Recently, major regulators in the US and the UK have warned about the dangers of concentrating so much risk in CCPs.  The recognition is spreading to the press too, as illustrated by this article in The Economist:

The source of all this angst is the clearing-house, a mundane bit of financial-market plumbing that sits between buyers and sellers in transactions. And the reason why people are fretting is that G20 policymakers have seized upon clearing as the solution to some big problems in the over-the-counter derivatives market.

. . . .

That feeds worries about the other effect of lots more clearing: a new concentration of risk. Moving derivatives trades to clearing-houses mitigates the effect of a default of a clearing member (Lehman Brothers’ cleared trades were handled smoothly in 2008, for example). But it makes the impact of a clearing-house itself going down much worse. They may lack the heft of big banks, but few financial institutions are more interconnected. Failures are rare but they do happen: Hong Kong’s futures clearing-house ran out of resources in 1987, for example, and it took a government bail-out and the closure of the main stockmarket for things to get back to normal.

This should not be a surprise-after all, it’s not like what happened in Hong Kong-or in Chicago-in 1987 was a big secret.  And it’s not as if nobody, ahem, has been raising this point for going on four years now.

And that italicized part is just too rich.  Didn’t Timmy! and GiGi constantly-and I mean constantly-tell us that clearing eliminated interconnections in the financial system? Yes they did! I guess that explanation is now seen to be the BS it always was.  I’ve been calling BS on that for about three years.  I’m waiting for the dynamic duo to admit they were either ignorant, or liars.  There is no third alternative.

The aforementioned regulators are demanding that CCPs be made immune from failure.  The Economist agrees:

The more systemic they become, the more tightly clearing-houses should be regulated. That means more clarity over their collateral and margining policies. It means agreeing on plans for recapitalising a failing entity without tapping the taxpayer. And it means getting clearing-houses to hold more equity: LCH.Clearnet had just €333m ($463m) of capital in 2011, compared with collateral and cash under management that averaged €73 billion. Clearing can achieve many things. Solving the too-big-to-fail problem is not one of them.

Sigh. On the one hand, it is good to see growing awareness of the systemic vulnerabilities that CCPs create.  On the other, it is distressing that regulators and commentators seem to have target fixation and can focus on only one thing at a time.  Put differently, they fail to consider how the financial system will adjust to attempts to make one part of the system safer.

I’ve also written about this ad nauseum.  The point is that raising margins, or increasing the size of default funds, or changing margin calculations, or tightening up restrictions on eligible collateral, or other measures to improve the safety of CCPs will induce reactions and adjustments elsewhere in the financial system, and these adjustments have systemic implications.

For instance, requiring more collateral is likely to lead to the growth of systemically-fragile collateral transformation services and other shadow banking mechanisms to secure collateral to post for CCP margins.  Expanding CCP member commitments to default funds increases their exposure to wrong way risks, and is an important source of interconnection in the financial markets.

I return to the 1987 Chicago experience.  Yes, the big exchange CCPs were under stress, but a major source of stress in the financial system as a whole was due to the extraordinary need for liquidity to meet margin calls-the very mechanism that is put in place to protect CCPs against default.  Sometimes “safety” equipment can be downright dangerous.

I return to a metaphor I’ve used before: that of flood controls.  Building up levees to protect one location can increase the risk of a catastrophic flood elsewhere in a river system.  It is good that more regulators and market observers recognize that CCPs are a source of systemic risk, but the levee-building reflex is worrisome in the extreme.  It suggests an inability to think about the financial system as a whole, a system that reacts to changes imposed on one part of it.  These responses are not necessarily salutary, and can be downright frightening.

The responses need to be anticipated, to the extent possible.  But it is often difficult to do that with accuracy.  Which means that it is necessary to proceed cautiously when making the levee around CCPs higher and higher.  There will be responses to this process, and it is likely best to proceed cautiously and incrementally, seeing what the responses are to the gradual changes, and then adjusting accordingly.  Wholesale changes made in a hurry focused monomaniacally on one part of the system are a recipe for an major disaster elsewhere in the system.

I say again: to understand how policy changes affect systemic risk you need to think of the financial system as an organic whole, a system that responds often unpredictably to changes imposed on one part of it.  Although it is encouraging to see that the magical thinking about clearinghouses is being replaced by sober concern, it is far less encouraging that the concern is leading to policies focused on individual institutions that do not pay adequate attention to how the system will respond.

In other words: Don’t build financial levees without giving very deep study how other financial currents will react to the levees during flood times.

This post on Information Dissemination is going viral (h/t R & LL).  I follow ID on my RSS feed, and it has good stuff about Navy inside baseball, but when it gets to economics, I suggest you take a pass.

Galrahn’s post attempts to pull together disparate strands of information to suggest that an attack on Iran is forthcoming: hence the virulence of the post among the conspiracy minded.  The first strand is information about deployments of US Navy assets to the Persian Gulf (when will they start calling it the Arab Gulf again?).  OK.  That could be legit.

Then he attempts to weave in strands relating to energy.  Starting with China:

So maybe this other relevant activity is just a coincidence, but even as a coincidence it is very interesting. Lets start with China.

The government on Tuesday raised retail prices for gasoline and diesel fuel for the second time in less than six weeks in an attempt to keep pace with soaring crude oil prices.

Chinese motorists are now paying $4.43 a gallon for 90-octane fuel — nearly equal to the $4.45-a-gallon average for mid-grade fuel in California, according to AAA.

The reason provided is found later in the article.

The increase should ease pressure on China’s two main refiners, the state-owned China Petroleum & Chemical Corp. and PetroChina Co., which are not allowed to pass costs on to consumers. The two have reported losing billions of dollars already because of soaring crude prices.

In other words, China is not having a supply or a demand problem right now, what they are having is a ‘losing money’ problem because of the current high costs – and because China price fixes their fuel, they must price fix it relative to the global market.

This is mainly gibberish.  The Sinopec/CNPC battles over pricing with the Chinese government are well-known and have been raging for years.  I’ve written about them on the blog.  This is hardly a new development, and certainly tangentially related at best to what is going on in the PG.

Galrahn then turns to Saudi Arabia increasing output and shipping it to the US.  He discounts the possibility that this is a political favor for Obama intended to keep prices down.  The basis for the discount is an alleged shortage of refinery capacity in the US.  Per Galrahn, the increased oil shipments will not depress gasoline prices in the US because we have a shortage of refinery capacity.  Thus, he concludes that the only reason for the shipments is to add to US stockpiles, which he interprets as a preparation for war.

The sole basis for Galrahn’s claim of a shortage of refining capacity is a Reuters article.  Uhm, data is our friend.

The EIA posts data on refinery capacity utilization.  The most recent data (from December) show that US PADD I (East Coast) refineries are operating at very low levels of capacity utilization.  Very low.  No lack of capacity there.  Indeed, the refinery closure mentioned in the article (Sunoco’s Philly refinery) is due to a lack of buyers.  If refining capacity were the bottleneck, the buyers would be lining up-if Sunoco even wanted to sell.

Refineries in ND, SD, and MN are operating above capacity.  But that’s no surprise.  It’s a manifestation of the Cushing bottleneck.  Refineries in OK and KS are operating at relatively high rates: another manifestation of the buildup of crude in the Midcon.  Gulf Coast refineries are operating at normal rates.

So: no evidence that capacity is the bottleneck in the EIA data.

Price data tell the same story.  Adjusting the Gulf Gasoline Crack for the LLS-WTI differential implies refining margins of about $7-$10/bbl.  The diesel crack is also about $10/bbl. The RBOB-Brent crack is around $15/bbl. These spreads are pretty weak, and hardly symptomatic of a shortage of refining capacity.

So the data completely undermine the basis for Galrahn’s theory.  Crude prices depressing refining margins are the problem, not a lack of refining capacity.  Which means that increasing crude supply available to East Coast and Gulf Coast refineries would reduce gasoline prices.

The fact that the US is exporting some refined products is also inconsistent with a shortage of refining capacity here in the US.

Without that, Galrahn’s big theory goes up in smoke.

That said, the Saudi’s dispatching of a “wall” of VLCCs is curious.  The natural destination of increased Saudi oil output would be Asia, to replace lost Iranian crude.  This does suggest some deal between the US and the Saudis, and one could weave a theory around that, given the Saudi fear and hatred of Iran.

But one cannot, as Galrahn does, bolster this case by claiming that there is no available capacity to refine the additional Saudi oil.

The Li(e)for investigation is metastasizing at an incredible place.  Both Bloomberg and FT have run long pieces on the problems with the rate-setting mechanism, and how to fix them.  Investigations (10, according to FT) are proceeding around the world, in the US, UK, Europe, Japan, Canada, and Singapore.  There is a criminal investigation in the US.  Numerous banks are scurrying to cooperate in the hopes of receiving leniency-the prisoner’s dilemma in action.

Some of the reporting is confusing.  There are at least two different motives for the alleged misstatements, one likely being more legally fraught for the banks.  The first motive is that during the throes of the crisis, banks had an incentive to misreport the rates at which they could borrow unsecured in order to avoid the perception that they were on the brink.  The other motive is that traders wanted to influence LIBOR in order to advantage derivatives positions tied to LIBOR-the latter likely presents the banks and individual traders  with far more acute legal problems.

Then there remains the issue of what to do about it.  The most obvious remedy is to base LIBOR on actually borrowing transactions, in the same way as is done with EONIA and SONIA overnight (hence the “ON”) borrowings.  This is a reprise of the data hub idea I advocated for energy trades back in 2003(!).

There is pushback against this idea, however.  One argument is that particularly during times of stress only a few banks are actually able to borrow unsecured for 3, 6, or 12 months, so the rate would be based on transactions from a small set of institutions.

I don’t get this objection, frankly.  So it’s better to base the most important reference rates in the world on what banks that cannot borrow unsecured say they could borrow at, than to base it on the rates that banks that actually do borrow unsecured pay?  Really? The first alternative is an oxymoron.  The second might result in rates from only a few banks being used, but far, far better to base an index that is supposed to reflect the actual cost of unsecured borrowing (by those able to do it) as represented by real transactions then to use the oxymoronic fantasy rates of those who can’t do it.

And if nobody can borrow unsecured in any volume-that’s important information in and of itself.  That raises the question of the advisability of basing so many derivatives contracts on something that has an appreciable probability of not existing from time to time. Better to recognize reality than MSU and pretend it’s real.

Here’s a thought: BBA could continue to report a LIBOR based on the traditional methodology, but just modify its name to LIBORGIGO. Truth in advertising, dontcha know.

This raises a broader point.  Cash settlement is often raised as a panacea for contract design.  Delivery-settled contracts have problems-so go to cash settlement! But as I’ve argued since 1990, in many markets cash settlement is problematic due to the opacity of cash markets, and/or the absence of cash market transactions.  Cash settlement works where there is a liquid and vibrant and transparent cash market (e.g., S&P500 stock index futures) or centralized collection of cash transactions prices (e.g., live hogs).  Everywhere else, problematic indeed.

LIBOR is the most pronounced example of that today.  Natural gas was so in the late-90s and early-00s.  Right now, the Platts’ methods for oil price assessments are under considerable scrutiny.  Market participants have always been skeptical (though they often mute their criticism given Platts’s heft), but IOSCO has issued a very critical and questioning appraisal, and raises the question of whether further regulation is necessary.

It’s deja vu all over again, folks.  Been there, done that.  Went through all these issues with the energy data hub in ’03.  I can show you the scars.  I can tell you some stories (e.g., the trade group guy who asked me what it would take to get me to back off with my proposal.)

The fundamental problems are that cash settlement is hard if there aren’t, well, a lot of cash transactions going on.  Even if there are a decent number of cash trades, that doesn’t help if people don’t report.  Given the public good nature of more informative price indices, there are under-incentives to report.  Indeed, it can be worse than that: reporting can be a private bad.

This raises a justification for mandatory reporting, and that is actually one of the defensible parts of Frankendodd.  That can’t fix the problem of a lack of transactions, but it can make the most of the transactions that are there.

But this also points out the value of delivery-settled derivatives.  The ability to make delivery  gives market participants the opportunity to put their money where their mouths are in a way that is impossible with cash settlement, especially cash settlement based on self-reported prices and assessments. Even if delivery doesn’t occur all that much, the ability to make delivery keeps prices honest (noting, of course, that the delivery mechanism can be abused, but further noting that’s a problem that can be addressed by appropriate anti-corner measures.)