Streetwise Professor

Gazprom is having difficulty making inroads into Asia generally, and into the LNG market particularly.  Its problem?  Apparently so used to dealing with Europeans who have few outside options (yet), the company is incapable of operating in a competitive environment.  It is fixated on maintaining its traditional oil-linked pricing formula, despite the facts that (a) in the US natural gas prices on an energy equivalent basis have fallen to an all time record low vis-a-vis oil, and (b) US firms, notably the Cheniere Energy* mentioned in the Bloomberg piece, are gearing up to export LNG, particularly to Asia, making the US the likely supplier of the marginal mmbtu of gas, and hence making it the world price setter:

OAO Gazprom (GAZP), the world’s largest natural-gas exporter, is struggling to get a foothold in the Asian markets leading global economic growth.

The Russian company’s plan to supply liquefied natural gas to India from 2016, the year the U.S. is set to start gas exports, is faltering after buyers said they’re looking for cheaper fuel from North America. Last year, decade-long talks to supply pipeline gas to China foundered over price disagreements.

“Gazprom has a major problem of having a fixed view on what the price of gas should be, irrespective of market conditions,”Jonathan Stern, chairman and senior research fellow at the Oxford Institute for Energy Studies, said by e- mail. “If this continues, it will create increasing problems for Russian gas exports.”

“Irrespective of market conditions.”  Yup.  That’s the Gazprom way, and that way doesn’t work when it’s not the market.   In contrast, Cheniere is linking LNG prices to US natty gas prices:

GAIL India Ltd. (GAIL), the country’s largest gas supplier, became the first Asian buyer of U.S. natural gas in December when it signed a 20-year deal with Cheniere Energy Partners LP (CQP), which is planning the first U.S. export terminal. The contract, targeting 3.5 million tons a year starting in 2017, is linked to the day- to-day U.S. benchmark gas prices, which fell to a 10-year low of $2.21 a million British thermal units in January. It will also include a fixed component.

Note that this also permits companies like GAIL to lock in a fixed price fairly easily, given its ability to use derivatives to swap floating prices into fixed ones.  (The fixed component in the formula mentioned above covers liquification and transportation costs.)

Gazprom is a hidebound organization, grotesquely inefficient, notoriously corrupt, and unused to and arguably incapable of operating in truly competitive conditions.  It has a guaranteed monopsony at the upstream end (being the only company permitted to export Russian gas) and has traditionally sold in markets downstream where there is little, and often no, competition from other sellers.

Its disconnect from commercial reality grows with every widening of the difference between gas and oil prices.  It can insist on its self-serving formula, but as the US becomes a major exporter of gas-as fundamentals imply that it should be-its insistence will make it an also ran in the LNG market.

Right now, Gazprom’s biggest hope is that political resistance to gas exports in the US lead to bans or limitations on those exports, or the approvals and permitting for export terminals getting bogged down in the American bureaucracy.  Usual Suspect Ed Markey (D-MA) has introduced a bill to ban gas exports.  This will not go anywhere, but it does give edgy Asian buyers pause.  In the aftermath of Keystone XL, moreover, it is clear that failure to secure regulatory approvals can delay or derail altogether extremely beneficial energy initiatives.

Ironic, isn’t it, that Gazprom’s biggest hopes may be in DC: The White House, Capitol Hill, and FERC (which is responsible for permitting LNG export facilities)?

* Full disclosure: #1 daughter works for Cheniere. Any reader of this blog knows, however, that my criticism (ridicule, really) of Gazprom and my commitment to free trade long pre-date her employment there.

Bart Chilton has been fairly quiet recently, but today he made news twice, with two completely contradictory statements.

First, he bemoaned the lawsuits challenging the CFTC’s ability to quantify the costs and benefits of its regulations-as required by Congress:

“Some regulators live in constant fear and are virtually paralyzed by the threat” that they will face “spuriously” filed suits alleging that the costs and benefits of their rules weren’t adequately considered, Chilton said in a speech prepared for the Trade Tech 2012 conference today in New York. “It is a bastardization of the conduct and use of cost-benefit analyses in regulatory rulemaking.”

. . . .

Chilton, a supporter of the speculation limits, said banks and others should be required to provide cost analyses to rebut regulators’ conclusions.

“We put out a proposal, ask for comments and ask what the costs might be,” Chilton said. “Then we either aren’t provided with costs of the regulation, or what we get from the commenters isn’t very helpful.”

Well, if the CFTC could accurately quantify costs and benefits, (a) it wouldn’t need help from the banks to provide cost/benefit analyses, and (b) it wouldn’t have to fear lawsuits claiming it hadn’t performed an adequate analysis.  Eliding over the issue of burden of proof-which Congress has clearly placed on the agency by statute, not on those subject to the rules as Chilton would like it-this is a clear confession that the CFTC is incapable of performing a rigorous analysis that would persuade a court: if it was confident in its ability to do so, why the paralysis.

But on the same day (and I think the same event) Chilton quantified the effects of “excessive speculation” on energy prices to the penny.  Seriously:

Today, Chilton is expected to tell the traders that the “speculative premium” on oil adds 56 cents to every gallon of gas, which he calls “an enormous drain” on businesses. Chilton has previously said oil speculation costs every consumer up to $757 extra a year.

Not 55 cents.  Not 54 cents.  56.  Not $756 dollars/year.  Not $758.  $757.

And Bart can give very precise industry breakdowns of the impact:

Runaway oil speculation is costing the airline and trucking industries $39 billion a year in added expenses, according to new data to be released today.

The airline sector alone could save as much as $9.8 billion annually if Wall Street speculation is curbed, Commissioner Bart Chilton of the Commodity Futures Trading Commission is expected to announce today.

The trucking industry stands to save even more, as much as $29.1 billion a year, according to Chilton, who will reveal the data in a speech before a group of traders at the Javits Center.

I have no clue how Bart calculated these numbers.  (I suspect he has no clue either.  A little more than “suspect”, actually.)  But apparently he believes he can calculate the impacts of speculation with considerable precision, and since there is no way the costs of complying with the regulation could run into the mid-11 figure per year range, it follows immediately that Bart should have no problem convincing any court in the land that the benefits of the regulation exceed the cost.

So why doesn’t he?  So why are he and his fellow commissioners “paralyzed” by the prospect of providing the cost benefit analysis?

The easy answer is that Chilton is almost certainly MSU (making stuff up–trying to keep it clean tonight, folks) regarding the impact of speculation.  I am very familiar with the literature, and the available methods.  Such accurate quantification is impossible, and no reputable method has produced such numbers.

So when is Bart BS-ing? When he says it is impossible to quantify the benefits and costs of the position limit rule?  Or when he says he can–to the penny?

The answer cannot be “neither.” It’s one or the other.  Smart money answer: he can’t really quantify, which is why he doesn’t want the CFTC to be forced to do so.

Which raises another point.  The CFTC position limit rule’s cost benefit analysis, such as it is, repeatedly says that Congress has decided that position limits are necessary, and that as a result the benefits of the rule are presumed to exist.  But Congress has also decided that cost-benefit analysis is required.  The commission doesn’t really have the ability to choose which Congressional directives it must follow, does it? And wouldn’t the cost-benefit analysis requirement be superfluous if Congress had already decided that the benefits exceeded the costs, as the position limit rule repeatedly argues?  So doesn’t that undermine the commission’s argument?

Full disclosure: I filed a declaration on behalf of ISDA  and SIFMA in what Chilton believes to be the “spurious” lawsuit challenging the position limit rule. But as anyone who has read this blog knows, or who has read some of my other writing knows, I have long been critical of claims that speculation distorts prices, and of position limits.

The material from Book IV, Chapter 5 of Wealth of Nations is quite interesting, and applicable to today’s debate over speculation.  In this regard it is useful to distinguish between financial speculation and what is sometimes referred to as “speculative storage.”  Financial speculation is what often gets people’s jockeys in a bunch, but unless these financial speculators are somehow affecting quantities produced or consumed–by distorting prices in ways that induce distortions in storage, for instance–this activity will not affect the prices that consumers pay or producers receive.  Financial speculators deal in price risk, and affect the price of that risk first and foremost. (These statements are a little overbroad: I refine the analysis a bit below.)

What Smith discusses in IV.5 is speculative storage.  People holding inventories of commodities in anticipation of future market conditions.

Such storage decisions are inherently speculative, in the sense that they are based on expectations about future market conditions.  That’s what storage is all about-and what my book on structural models of commodity prices is all about.  Based on noisy signals, market participants try to determine whether the commodity is going to be more scarce in the future than it is at the present.  If so, it is optimal to add to inventories because the commodity is going to be more valuable in the future.  If not, it is optimal to draw down on inventories.

Since these decisions are necessarily based on conjectures about future fundamental conditions, there is a natural role for speculation: taking risky positions in the expectation of earning a profit, based on current information.

If a speculator is correct, he can make large profits.  A speculator who anticipates that the next crop will be small will add to inventory, and if he is right, can sell that inventory at a high price when the crop is harvested and the shortage revealed.  And note that his actions are beneficial: yes, he sells at a high price, but the price would have been higher still had he not added to the speculative inventory in anticipation of the future shortage.  Further note that his actions do raise prices at the time he adds to inventory: if he doesn’t those bushels would be sold and consumed, and the price today (prior to the harvest) would be lower than they are when he holds them off the market (in Smith’s terms, “forestalls” or “engrosses’.)

Of course the speculators are not always right.  They are working on limited information, and things can change over time-think of how decisions made in June of 2008 looked in October of that year.  But this means that speculators have an incentive to collect information to allow them to make better decisions.  Moreover, purely financial speculators that collect information and trade on it (such as by trading calendar spreads) can contribute to price discovery that leads to better inventory decisions.  And as I’ve shown in some of my academic work (some currently in progress) financial speculators can reduce the cost of inventory by absorbing price risk from inventory holders, leading to an efficient unbundling of the functions of making inventory decisions and holding inventory on the one hand, and bearing the price risk of inventory on the other.  (Smith makes a similar point, related to the allocation of capital rather than risk, at IV.5.55-56.)

Smith recognizes the benefits of this intertemporal trade, undertaken by speculators:

Secondly, it supposes that there is a certain price at which corn is likely to be forestalled, that is, bought up in order to be sold again soon after in the same market, so as to hurt the people. But if a merchant ever buys up corn, either going to a particular market or in a particular market, in order to sell it again soon after in the same market, it must be because he judges that the market cannot be so liberally supplied through the whole season as upon that particular occasion, and that the price, therefore, must soon rise. If he judges wrong in this, and if the price does not rise, he not only loses the whole profit of the stock which he employs in this manner, but a part of the stock itself, by the expence and loss which necessarily attend*79 the storing and keeping of corn. He hurts himself, therefore, much more essentially than he can hurt even the particular people whom he may hinder from supplying themselves upon that particular market day, because they may afterwards supply themselves just as cheap upon any other market day. If he judges right, instead of hurting the great body of the people, he renders them a most important service. By making them feel the inconveniencies of a dearth somewhat earlier than they otherwise might do, he prevents their feeling them afterwards so severely as they certainly would do, if the cheapness of price encouraged them to consume faster than suited the real scarcity of the season. When the scarcity is real, the best thing that can be done for the people is to divide the inconveniencies of it as equally as possible through all the different months, and weeks, and days of the year. The interest of the corn merchant makes him study to do this as exactly as he can: and as no other person can have either the same interest, or the same knowledge, or the same abilities to do it so exactly as he, this most important operation of commerce ought to be trusted entirely to him; or, in other words, the corn trade, so far at least as concerns the supply of the home market, ought to be left perfectly free.

Let me emphasize this part:

When the scarcity is real, the best thing that can be done for the people is to divide the inconveniencies of it as equally as possible through all the different months, and weeks, and days of the year. The interest of the corn merchant makes him study to do this as exactly as he can: and as no other person can have either the same interest, or the same knowledge, or the same abilities to do it so exactly as he, this most important operation of commerce ought to be trusted entirely to him; or, in other words, the corn trade, so far at least as concerns the supply of the home market, ought to be left perfectly free.

Exactly. (See also IV.5.42.)

Smith also understood that attempts to control this type of speculation, in particular by limiting price increases during times of dearth, were extremely counterproductive:

When the government, in order to remedy the inconveniences of a dearth, orders all the dealers to sell their corn at what it supposes a reasonable price, it either hinders them from bringing it to market, which may sometimes produce a famine even in the beginning of the season; or if they bring it thither, it enables the people, and thereby encourages them to consume it so fast as must necessarily produce a famine before the end of the season. The unlimited, unrestrained freedom of the corn trade, as it is the only effectual preventative of the miseries of a famine, so it is the best palliative of the inconveniences of a dearth; for the inconveniences of a real scarcity cannot be remedied, they can only be palliated. No trade deserves more the full protection of the law, and no trade requires it so much, because no trade is so much exposed to popular odium.

But Smith also understood the political economy of the situation:

In years of scarcity the inferior ranks of people impute their distress to the avarice of the corn merchant, who becomes the object of their hatred and indignation. Instead of making profit upon such occasions, therefore, he is often in danger of being utterly ruined, and of having his magazines plundered and destroyed by their violence. It is in years of scarcity, however, when prices are high, that the corn merchant expects to make his principal profit. He is generally in contract with some farmers to furnish him for a certain number of years with a certain quantity of corn at a certain price. This contract price is settled according to what is supposed to be the moderate and reasonable, that is, the ordinary or average price, which before the late years of scarcity was commonly about eight-and-twenty shillings for the quarter of wheat, and for that of other grain in proportion. In years of scarcity, therefore, the corn merchant buys a great part of his corn for the ordinary price, and sells it for a much higher. That this extraordinary profit, however, is no more than sufficient to put his trade upon a fair level with other trades, and to compensate the many losses which he sustains upon other occasions, both from the perishable nature of the commodity itself, and from the frequent and unforeseen fluctuations of its price, seems evident enough, from this single circumstance, that great fortunes are as seldom made in this as in any other trade. The popular odium, however, which attends it in years of scarcity, the only years in which it can be very profitable, renders people of character and fortune averse to enter into it. It is abandoned to an inferior set of dealers; and millers, bakers, mealmen, and meal factors, together with a number of wretched hucksters, are almost the only middle people that, in the home market, come between the grower and the consumer.

The ancient policy of Europe, instead of discountenancing this popular odium against a trade so beneficial to the public, seems, on the contrary, to have authorized and encouraged it.

And as we see over and over again, it is not just the ancient policy of Europe, but the modern policy of the US-or at least it would be if many politicians were to get their way.

This discussion is useful in making a valuable distinction.  It is wrong to say that speculators don’t affect prices: competitive, efficient speculation does affect prices by ensuring that information about future and current fundamental conditions is reflected in inventory decisions, and hence consumption and production decisions: this necessarily affects prices.  But as Smith notes, these price effects lead to a more efficient utilization of the commodity over time, in a way that actually alleviates the most acute shortages-shortages that would be even worse if speculative storage were constrained in some way.

That’s different from saying that speculation distorts prices: affecting prices and distorting them are two very different things.

Moreover, these price effects can be different from those of purely financial speculation, e.g., spread trading by hedge funds, although this trading can (as noted above) affect in a beneficial way inventory decisions through both an information channel and a risk allocation channel.

Finally, since speculative storage requires financing of inventory, it is often efficient for banks or other financial institutions to engage in it as they are often incur the lowest cost of financing: witness the large speculative storage of oil by big banks (e.g., Morgan Stanley) at the depths of the financial crisis.  Financial/capital markets and financial institutions are all about the movement of resources over time: storage is just the movement of resources over time too, so there can be a natural complementarity between finance and storage. This last issue is evidently a source of policy controversy involving the Federal Reserve and large banks that it regulates.  More on this soon.  It is fascinating on many levels.

One other policy issue.  Smith’s concern  about the perverse effects of price ceilings during periods of shortage is the most defensible rationale of government storage programs, like the SPR.  If the government cannot precommit to let prices clear the market during periods of shortage, there will be an insufficient incentive for private, speculative storage, especially since as Smith notes it is selling into these spikes that is most remunerative to inventory holders.  Government storage programs can be a second best response to its inability to precommit not to screw things up.  This raises questions about how the government storage program should operate: again, I hope to post on that soon.  Hint: SPR doesn’t appear to be operated in the efficient way.

In a post earlier this evening, I said that anti-speculation frenzies dated from the 19th century.  But they in fact date back much further. In Book IV, Ch. 5 of Wealth of Nations, Adam Smith analyzed the irrational attacks on commodity speculation:

The popular fear of engrossing and forestalling [types of speculative activity outlawed in England] may be compared to the popular terrors and suspicions of witchcraft. The unfortunate wretches accused of this latter crime were not more innocent of the misfortunes imputed to them than those who have been accused of the former. The law which put an end to all prosecutions against witchcraft, which put it out of any man’s power to gratify his own malice by accusing his neighbour of that imaginary crime, seems effectually to have put an end to those fears and suspicions by taking away the great cause which encouraged and supported them. The law which should restore entire freedom to the inland trade of corn would probably prove as effectual to put an end to the popular fears of engrossing and forestalling.

Sadly, I think that Smith’s belief that legalizing speculation would end attacks against it is quaint, but wrong.  Indeed, it appears that the reverse is true: popular terrors and fears-stoked by opportunistic politicians eager to divert blame for high prices to others-lead to attempts to restrict speculation.

But Smith’s analysis of the counterproductive effects of these restrictions does stand the test of time.  It is worth a read.

Reprising his role as Captain Renault, Obama has order Attorney General Holder to “reconstitute” the oil and gas task force in order to round up the usual suspects: oil speculators.  You know, the one he constituted (I guess) last April.  Yeah. That one.  The one that found so much evidence that speculation had distorted prices.  Just like the numerous other FTC investigations that had turned up zero, zip, nada during previous gasoline price spikes.

In other stunning news, 70 nitwit senators and representatives (but I repeat myself) sent off a letter demanding the CFTC “immediately enact strong position limits to eliminate excessive oil speculation.” Apparently they don’t have newspapers, TV, or internet in DC, because these Einsteins and their myriad staffers overlook the fact that the CFTC passed a position limit rule almost 5 months ago–18 October, 2011, to be exact.  But never let the facts get in the way of an opportunity to strike an indignant pose. (I won’t even bother to ask these geniuses to present a coherent explanation of how speculation distorts prices, or how position limits will eliminate these putative distortions. To them, limits are some sort of talisman.)

As I’ve said repeatedly, these anti-speculator frenzies are a hardy perennial, dating well back into the 19th century.  Prices go up, prices go down-blame it on the speculators. They are a convenient whipping boy for poseur politicians (again, apologies for the redundancy).

And as I’ve also said before: no theory, and no evidence. (And no, Bernie, quoting the Saudis doesn’t count as “evidence”.) But I’ve long since given up any expectation of seriousness about energy.  Demonizing speculators is all to easy, and all to successful, and hence appeals to the lazy demagogues who infest DC.

Well, at least Claude Rains was acting.  I sometimes wonder whether Obama, Sanders, Levin, Pelosi, and on and on are. And I honestly don’t know whether it would be worse if they were, or if they weren’t.

The first post I wrote on SWP related to the pricing of message traffic on electronic trading systems. This has become a major issue in the debate over HFT, with (as I noted last week), the SEC musing about impose by regulatory fiat pricing schemes that would penalize cancellations.

But as Jeremy Grant notes in a couple of articles in the FT, exchanges are already implementing pricing schemes to deal with “stupid algos”-and I would argue, “evil algos” too. There is a process of market experimentation going on, with some disagreement among exchanges. Deutsche Borse is considering a pricing scheme similar to that the SEC is considering-imposing a tax on all cancellations above some level. ICE has criticized this idea, arguing that such a scheme does not discriminate between “good” cancellations and “bad” ones: that was my objection to the SEC idea. Instead, ICE assess charges for cancellations based on how far the orders are away from the inside market. Orders close to the inside bid-ask are more likely to be liquidity enhancing, and less likely to be opportunistic efforts to clog the exchange systems. This is far more discriminating approach.

But there is a bigger point here: who should be making these decisions, exchanges or regulators? A strong case can be made for the former.  Exchanges internalize many, and arguably most, of the costs and benefits.  Opportunistic algos reduce the derived demand for exchange services, costing the exchange money.  Good algos that contribute to liquidity increase the derived demand for exchange services, making the exchange money.  Exchanges have an incentive to get the pricing right to encourage the good and discourage the bad, and moreover are likely to have better information, and to be less susceptible to rent seeking influence activities, than government regulators.

Different exchanges engage in different experiments on pricing.  This contributes to a discovery process that is likely to reach an efficient outcome than the process that legislatures and regulators use to set prices and procedures.  Exchanges that develop effective pricing policies gain imitators: those that don’t, lose business.

Yes, it is possible that there are externalities that exchanges don’t take into consideration.  But only fools believe that regulators can understand, quantify, and correct these externalities.  Indeed, the process by which regulators internalize such effects is often highly distorted and inefficient, due to constraints on information and public choice problems.

Exchanges are clearly aware of the relevant issues, are highly motivated to address them in a discriminating and effective way, and are in fact trying to do just that.

For years I have been saying and writing that every spike in energy prices results in a replay of the final scene from Casablanca: “Round up the usual suspects,” with speculators being at the front of the line.   No exception now. With rising gas prices being the main threat to his reelection prospects, Obama and other Democrats are doing their best Captain Renault imitation.  Obama:

Obama sought to deflect growing Republican attacks over rising prices at the pump, blaming recent increases on a mix of factors beyond his control, including tensions with Iran, hot demand from China, India and other emerging economies, and Wall Street speculators taking advantage of the uncertainty.

Noted energy expert, Nancy-natural-gas-is-not-a-fossil-fuel-Pelosi also chimed in:

“Wall Street profiteering, not oil shortages, is the cause of the price spike,” Pelosi said in a statement. “Unfortunately, Republicans have chosen to protect the interests of Wall Street speculators and oil companies instead of the interests of working Americans by obstructing the agencies with the responsibility of enforcing consumer protection laws.”

And, again at the risk of sounding like a broken record (responding to a vast collection of broken records): no theory, no evidence.

With respect to evidence, a heads up: The opponents of the “financialization” of commodity markets have flogged the Singleton paper on oil index trading for all it is worth. I am putting the finishing touches on a far more extensive study, the conclusion of which is quite simple: the Singleton results do not stand up in a broad sample of commodities, or even in oil for a longer sample period.  Watch this space.

In other words: try again, guys.  But that would actually presume, I guess, that evidence matters to these people, anyways.

One thing struck me about the Obama and Pelosi statements: the deliberate inclusion of “Wall Street” in their formulation, as in “Wall Street speculators.”  What, London, Geneva, and Singapore don’t rate?

Which brings another movie image to mind: the scene in Frankenstein in which the villagers storm the castle.  Obama and Pelosi are just following the #OWS-themed, Valerie Jarret-inspired class warfare campaign script. Be prepared to be bombarded with similar rhetoric for the next eight months.  And the shrillness of the attacks will vary directly and exponentially with the price of gasoline.

I don’t have a lot more to say on the subject, primarily because there’s not a lot new to say.  Obama and Pelosi are being good greens, and recycling well-used rhetoric.

I was interviewed on the subject Tuesday for an NPR piece.  It does a pretty good job of summarizing what I said in a 20 minute interview.  A few brief comments:

1. The CFTC claims that it has brought numerous energy enforcement actions and collected large fines.  This is highly disingenuous.  Highly.  These have not been in the oil market (except for the Arcadia case which I criticize in the piece, echoing what I’ve written on SWP).  They have not shown any connection between speculation and manipulation and high oil prices. Virtually all of these cases relate to price reporting fraud and wash trading in the natural gas markets during the merchant energy boom, prior to the demise of Enron and the merchant energy meltdown in 2002.  I was highly involved in efforts designed to prevent these abuses from recurring.  Efforts that did not come to fruition, but which focused on a solution (the creation of transaction data hubs with mandatory reporting) that has now been adopted for the derivatives markets worldwide-not just natural gas in the US.  That is arguably one of the only sensible things in Frankendodd.
2. The piece mentions John Arnold making a billion in speculating.  Yes, he did.  In gas.  The price of natural gas is at near-historic lows, demonstrating that speculative activity does not inevitably cause prices to be high.  Indeed, the disconnect between natural gas prices and oil prices is a huge embarrassment to the anti-speculation mob, especially those who claim that index investing (which results in highly correlated trades in oil and gas) is a dominant force in driving commodity prices.
3. It drives me to distraction that “speculation” and “manipulation” are used interchangeably.  No. No. No.
4. Manipulation definitely occurs in commodity markets, including the energy markets: for instance, manipulations were common in the Brent market in the late-90s and early-00s, and may become more common again as BFOE production continues to diminish.   These manipulations lead to highly temporary and localized price distortions.   Most of the Brent squeezes resulted in elevations in Brent prices for days, or a few weeks, and didn’t push up prices of other types of oil: indeed, the main symptom of these squeezes was the rise in Brent relative to other grades and locations.  As another example, the BP propane squeeze (a case I was involved in) resulted in a spike in TET propane prices for about two weeks.  They don’t explain persistent, global prices spikes.

Hopefully I will have the results on the expanded Singleton analysis available within a few weeks.  Until then, get prepared for a continued onslaught against “Wall Street profiteers and speculators.”  La plus ca change . . .

Last March I noted that in my two previous trips to teach in Geneva, there had been squeezes in the coffee market, and I said I was going to buy coffee spreads before my next trip.  Well, that trip is coming up in about 3 weeks, but somebody in the market (perhaps the Noble Group, according to the FT) beat me to the punch: there is a good squeeze underway in the robusta market, with spreads going from contango to a $182/ton backwardation.  That ain’t a hill of beans.

Note to self: put on the trade earlier next year.

When I was in Geneva last year the Li(e)bor story came to life after having faded from view for several years.  That story has now exploded into prominence, with numerous disclosures over the past several weeks.

Indeed, the story has taken a major turn.  Whereas suspicions as to motive originally focused on the idea that banks were attempting to make themselves look sounder than they were by exaggerating their ability to borrow unsecured, the new stories claim that there is evidence that some traders were manipulating rates specifically to influence the value of derivatives positions tied to Libor.  This is a major development because specific intent to manipulate the price of a derivative is a necessary element of a manipulation case under the Commodity Exchange Act.  If confirmed, these allegations regarding motive dramatically increase the legal stakes for the banks.

Eric Posner and E. Glen Weyl have attracted a lot of attention for their proposal to create an agency that would approve trading of new financial products, in the same way the FDA must approve new drug entities before they can be sold to the public.  Their initiative is fundamentally flawed, both in its diagnosis and its prescription.

There are a variety of problems.  The most basic is their false dichotomy between contracts that are used for speculative purposes, and those that are used for hedging.  In fact, speculation and hedging are highly complementary functions.  The most important function of derivatives markets is to facilitate risk transfer.  This risk transfer often involves a hedger on one side of a transaction, and a speculator on the other.  The speculator may be, as Posner and Weyl claim, trading on the basis of incorrect beliefs.  So be it.  His existence allows the hedger to reduce risk, and makes both parties subjectively better off, although Posner and Weyl seem to suggest that it would be possible to determine objectively that the speculator is acting irrationally.

In other words, much speculation in financial markets facilitates hedging.  To suggest that these activities are antithetical, or unrelated, as Posner-Weyl do, is highly misleading.

Posner and Weyl use mutual funds as an example of a salutary financial innovation.  No disagreement here.  But these can be used for activities that are commonly and properly considered “speculative.”  Moreover, equity and bond futures are widely used to speculate on broad movements in stock and interest rate changes.  But they are also used by pension funds and institutional investors to achieve the same type of objectives as mutual fund investments. So what, really, is the difference between mutual funds and derivatives?

There are indeed well-known problems with speculation.  Much of it (including excessive acquisition of costly information, the development of faster ways to trade) is properly understood as rent seeking.  But these problems are not uniquely associated with particular kinds of instruments, as Posner-Weyl insinuate.  There can be inefficient acquisition of information for speculative purposes in derivatives that are widely used for hedging–including the agricultural futures that Posner-Weyl consider to be salutary. (Although it does not speak highly of their understanding of these markets that they use farmer hedging as their justification of ag futures, though that is hardly the primary hedging use of these instruments.)

Other possible problems highlighted by Posner-Weyl include the use of derivatives for tax avoidance or regulatory arbitrage.  I say “possible problems” because the real problem can be with inefficient regulations or taxes, not the means that are used to mitigate these inefficiencies.  But even abstracting from this difficulty, there is also a fundamental problem distinguishing “bad” derivatives that are used for tax or regulatory avoidance, and “good” derivatives that are used to hedge.

Back in the 1970s and 1980s, simple plain vanilla futures contracts were widely used in a tax reduction strategy called “tax straddles” involving a spread trade (buying one future, selling another with a different delivery day).  The trader would liquidate the losing leg of the trade to generate losses to offset against other gains, or to convert ordinary income into capital gains.  This strategy was eventually disallowed in 1981: the instruments themselves were not banned because they could be used to avoid taxes.

In sum, hedging and speculation are complementary; speculation is not always inefficient;  and inefficient forms of speculation are not confined to specific instruments.  Therefore, regulations designed to impede speculation by requiring the approval of specific products are misguided because impeding speculation interferes with efficient transfer of risk, and because the inefficient uses of derivatives cannot be reduced reliably by preventing the marketing of particular instruments.

This means that charging some financial FDA with the responsibility of choosing which innovations to permit and which to proscribe, based on the goal of eliminating speculation, is basically hopeless.  Such an agency’s choices will be plagued by Type I and Type II errors.

Not to mention that whereas the effects of a drug can be determined with some (though incomplete) precision in clinical trials, there is no comparable way of determining how financial innovations will be used, the volume of their use, or their economic effects (in part because these effects depend on the scale of adoption, and the interaction of these products with other products in the market).  All of these things depend on the choices of myriad individuals, and these choices can change over time: who would have envisioned, in the 19th century when wheat and corn futures were first traded in Chicago, that they would one day be used by index funds to offer diversification opportunities to pension funds?

Drugs are taken by individuals and their effects can be understood by studying individuals who take them: the systemic effects are just the sum of individual effects. Things are very different in financial markets.  The introduction of financial products can lead to very complex responses in the entire system that cannot be understood or quantified in any clinical trial.

When I originally heard of the Posner-Weyl paper, I thought they would focus on how particular instruments can be systemically risky.  They in fact pay very little attention to this issue.  In this regard, it should be noted that the FDA/clinical trial model is completely inapposite.  You cannot study the systemic effect of a financial innovation in an isolated trial: you have to see how it interacts with, and affects, the entire system.

And to try to understand these effects a priori is certainly futile.  The system is too complex, and there is no way to understand how a particular innovation will fare in the market, and how it will affect the entire system.  As a concrete example, no one truly understood the consequences of CDOs on subprime ex ante, just based on the characteristics of the instrument themselves.  The risks embedded in the instruments were not well understood when they were first created, and these risks depended on the scale of their use, which was impossible to predict at the time they were first created.  In the end, there were risks that were not widely understood at the time of introduction, and these risks had systemic import only because these instruments proved very popular and grew to massive proportions completely unanticipated when they were first introduced.

We actually have historical experience with ex ante entry regulations on financial innovation.  Until the 1990s, no exchange could introduce a futures contract unless the CFTC approved it.  The approval was contingent on a CFTC finding that the proposed contract passed an “economic purpose” test, and was designed in a way that would permit it to achieve this purpose.  In some ways, the economic purpose test was analogous to what Posner and Weyl propose today.

This system was costly and reduced competition.  Like many entry barriers, it was exploited by incumbents to hamstring competitors. I am not familiar with any dangerous product that was kept off the market through this procedure, and the introduction of good products was delayed.  All pain, no gain.  Why would we want to repeat that experience.

Maybe Posner and Weyl would disagree with my appraisal of the CFTC precedent.  They don’t seem to be aware of it, in fact.  Before making such sweeping proposals perhaps they should have performed an analysis of a similar system that operated for decades.

Being a Sam Peltzman student, I was never all that impressed with the FDA model in the first place, even in pharmaceuticals.  I am even less impressed with the FDA as a model for the regulation of products that are fundamentally different from drugs.  Especially when those advocating this model make basic errors about the instruments that they believe should be regulated, and the uses to which they are put.

Walter Russell Mead’s excellent blog recently discussed the conflicts over massive natural gas deposits in the eastern Mediterranean:

Naturally, the race to get the gas has reinvigorated old arguments (Cyprus-Turkey) and added fuel to newer disagreements (Israel-Turkey). Israel and Cyprus have been fastest off the blocks, agreeing their common maritime border in 2010 and contracting exploration work to Noble Energy. Turkey, on the other hand, has been slow to react and increasingly confrontational, holding naval exercises and trying to prevent Cyprus from accessing gas that Turkey says belong to Northern Cyprus, which only Ankara recognizes as a country. The confrontation also threatens to further destabilize Israeli relations with Turkey, which appeared to be on the uptick this week when an Israeli delegation arrived in Turkey’s quake-hit Van Province with aid supplies; “You are our true friends” said Van’s vice governor.

The gas reserves in the Levant Basin may be large enough to make Cyprus self-sufficient in energy and turn Israel into a major gas exporter for the next several decades. That, and Israel’s new tilt toward Greece as a way of countering the cold wind in its relations with Turkey, is opening a new era in Israel-Cyprus relations. Netanyahu is on his way to Nicosia this week (the first ever visit of an Israeli PM to the island), and Israel is expected to formally ask to station fighter jets at a southern Cypriot airbase.

Oh joy. Another reason for conflict in a region of the world that counts conflict and strife as its most important export.

Unmentioned in Mead’s post is Russia, the country which has a huge economic stake in the development of a major gas resource right next to its major western European customers.  Eastern Med supplies would far closer to Europe–especially big consumers like Italy–than Russia, and these supplies wouldn’t be subject to the Russian-Ukrainian Punch and Judy routine every winter, or the vicissitudes of Russian domestic considerations.  Meaning that if these resources were developed to their full potential, Gazprom (and Russia) would suffer substantially.  Very substantially.

Which gives Russia a tremendous incentive to foment instability in the region.  Not like that is very hard, either.

It has two major levers in this endeavor.  The first is Cyprus, which is deeply enmeshed with Russia financially and politically.  Russia has been Greek Cyprus’s financial savior, extending it substantial amounts of credit to keep the country from plunging into Greece-like catastrophe.  Even more importantly, Cyprus is the destination or conduit of dirty Russian money, and the location of choice for Russians setting up dodgy shell companies.  (Oh, how entertaining it would be if Cyprus were the target of an invasion by an army of forensic accountants!) (Also recall that the SVR agent who was the money man for the Anna Chapman spy ring miraculously disappeared in Cyprus after being arrested there.)

The second is . . . Syria.  I do not suggest that this is the only for Russian intransigence in that country: that behavior is overdetermined.  But stoking conflict–or standing in the way of resolution of conflict–in Syria does promote Russian interests in the gas business.  Indeed, the economic stakes here are far greater than the oft-cited Russian commercial interests in Syria: some rather shambolic business and infrastructure projects, and arms sales (which appear never to be paid for, at least fully).

Just saying.