Streetwise Professor

James Hamilton and Jing Wu have a new paper on speculation and oil futures pricing (h/t Brian Goff).  The paper is very carefully done and very impressive econometrically.  It presents some provocative results, but IMO the radical simplifying assumptions James and Jing used in order to come up with something that they could estimate cast serious doubts on the results.  I am also sure that the results will be overinterpreted and misinterpreted to advance political agendas, and regret that the authors provide the hook in a few careless statements that should have been heavily qualified, but weren’t.

Here are my initial detailed comments:

1. The paper focuses on risk premia.  Hallelujah!  The price of risk is what speculators are most likely to affect, because most speculative transactions involve a transfer of risk, rather than the commodity.  A very basic point, but one which is all too frequently overlooked.
2. The most provocative result in the paper is a huge discontinuity of their estimate of the risk premium in oil futures  between the pre-2005 period and 2005-2011 (see Fig. 5).  This discontinuity is an artifact of HW’s splitting of the sample.  They motivate the choice of splitting date by observing that the growth in crude oil futures open interest increased dramatically beginning in 2004.  It would be preferable to do some testing for structural breaks and estimate accordingly.
3. More generally, I am very suspicious of such a sharp discontinuity.  I think it is highly likely that it is symptomatic of other changes going on in the market, and the limitations of their model.  (More on the latter below).
4. The model is not complete, even on its own terms.  Although it discusses the role of speculators (“arbitrageurs” in HW) in absorbing risk from hedgers, hedgers are not formally modeled.  This is a huge hole.  Moreover, “investors”–such as those who trade via index funds–are modeled extremely mechanically.  Yes, once they are in the market, index traders tend to trade mechanically, but the allocation of speculative capital between index funds and other investment opportunities is not as mechanical a process as the paper assumes.  Indeed, in the model the index-fund investors’ trading does not depend at all on risk-return tradeoffs.  They are just automatons that flow in and out of the market based on some autoregressive process. This is extremely problematic: index investor capital allocation decisions are presumably the result of an optimization process that reflects their investment opportunity set and the pricing of risk across these opportunities.  (Again, more on this below).
5. Relatedly, since hedgers are not in the model, there is no effect of index investors shocks on hedger behavior.
6. The model of fundamentals is extremely cramped and limiting.  I am no big fan of affine models generally, but even overlooking that, it is definitely the case that more than one (latent) fundamental factor drives spot oil prices.  Thus, the model becomes a two-factor model, with one (fundamental) factor driving the spot price and the “risk neutral” forward curve and the other (index-investor buying) affecting the shape of the forward curve.
7. One cannot generate interesting forward curve dynamics using a one-factor fundamental model.  One cannot generate interesting and realistic inventory-price relations using a one factor model.  As I show in my forthcoming book, at least two fundamental factors are needed to generate reasonable dynamics.  Furthermore, as I also show in the book, the homoskedastic error structure for the fundamentals variable assumed in the HW paper cannot generate price and inventory behavior observed in the real world.
8. Thus, the fundamentals model is almost certainly seriously mis-specified.  I can understand the modeling choice, but it has consequences.  It is my sense that this mis-specification is so severe that it casts serious doubts on the results.
9. In a frictionless world, risk premia for a particular factor are determined by the covariation between that factor and the pricing kernel.  In markets with frictions (as in the Hirshleifer models of the late-80s, early-90s), idiosyncratic risk of the factor may impact risk premia, in addition to the effect of systematic risk (driven by the covariation).  HW is a single market model: the oil market is all there is, and only factors within the oil market affect risk premia.  This is in essence an old-school Keynesian model of the risk premium.  Again, this is highly problematic.  In particular, since the whole movement of financial investors into commodities strengthens the linkage between broader financial markets and commodity markets, ignoring systematic risk (and hence inter-market covariation) is a serious deficiency.
10. It is a stylized fact that correlations between commodity returns and returns on broad equity indices and FX have changed substantially in recent years.  Although some have asserted a connection between index trading and this change in correlation structures, you can tell fundamentals-based stories as well.  For instance, if supply shocks were dominant in pre-2005, but demand shocks (e.g., the growth of China, the financial crisis) were dominant since, one would tend to observe the oil-S&P correlation to change from negative to positive.  As long as you are not in a Keynesian world with each commodity and investment an island with risk borne only by those living on that island, this change in correlations would lead to a change in risk premia.  The change in sign in the risk premium at the end of the sample corresponds to the financial crisis and associated major recession.  During this time demand shocks were clearly driving oil prices, and the correlation between the S&P and crude prices was very high and positive.  Thus, there was more systematic risk 2007 and later, and this would be expected to affect risk premia, but the model precludes this.
11. The omission of systematic risk in a model of risk premia is a serious, and IMO disabling, limitation.  It is particularly odd to ignore this in a paper that examines “financialization” of a commodity market, since financialization involves financial investors adding commodities to broadly diversified portfolios in order to optimize some risk-return trade-off.
12. These issues all affect how one interprets the HW findings.  What if risk premia did in fact change?  This could well reflect more accurate risk pricing due to the integration of commodities into investor opportunity sets.  Risks are going to be priced differently–and more efficiently–if there is more trade between islands.  A reduction in frictions, and an increase in the connections between markets, should lead to better risk pricing.  So finding a change in risk pricing could represent a very salutary development.
13. Indeed, tying some of these threads together, doesn’t “financialization” reflect a normal economic process of equilibrating prices between segmented markets?  Here, the prices are the prices of risk, and the movement of resources (risk) is more abstract than the movement of physical oil between Cushing and the Gulf.  In the latter example, profit seeking traders will drive the difference in prices in the two markets to the cost of transportation between them.  In the case of risk premia, any innovations (which could well include index investing) that reduces the costs of moving resources (risk bearing capacity) between prices will affect the prices in those markets, and tend to equalize them.  Since in the broader financial markets, oil and other commodities are small relative to the broader capital markets, it should be expected that the risk prices of commodities should account for the bulk of the change toward equalization.  It should also be welcomed.
14. To summarize a bit, the crucial questions include: what risks are priced?  Who participates in the market that determines these prices?  and, What are the investment opportunities available to these participants?  I think on every question, the HW paper is on very, very shaky ground.  The one-dimension model of fundamentals is far too restrictive, and the dynamics are far too simplistic.  Crucial players–hedgers–are left out, and others are treated mechanically.  In a paper that attempts to determine the effect of the movement of well-diversified financial investors into commodities, the Keynesian islands approach is inadequate: these investors have extensive investment opportunities that affect their behavior–and the pricing of risk that is the whole subject of the paper.  Mechanical treatment of one group of agents can make sense in some models, as in noise trader microstructure models.  Mechanical treatment of investors actively and aggressively looking for superior risk-return performance is a serious shortcoming in a model of the pricing of this trade-off.
15. I sympathize with James and Jing.   The impressive empirical cleverness required to estimate even this radically simplified model demonstrates just how challenging is the task of understanding the pricing of commodity risk.  I could readily believe that it could be impossible to estimate a richer model that includes fundamentals subject multiple, potentially heteroskedastic shocks, and three classes of optimizing investors with diverse investment opportunities. But the very complexity of the problem should make people very reluctant to make strong statements about the effects of “financialization” on price behavior.
16. In summary, I believe Hamilton-Wu are eminently correct to focus on risk premia as the variable that could be affected by the entry of a new class of market participant, but the daunting nature of that task is evident.  The radical simplification (again, understandable as a practical matter) needed to permit estimation, which involves abstraction from virtually all of the important economic issues makes their conclusions and results highly dubious as a basis for policy.  But there are plenty of fools out there (and let’s be clear, I do not include the authors in that category) who will no doubt rush in where prudent and thoughtful angels fear to tread.
17. For this reason, I wish they would have abstained from statements likely the valediction in their paper: “We suggest that increased participation by financial investors in oil futures markets may have been a factor in changing the nature of risk premia in crude oil futures contracts.”  This kind of suggestion only encourages the fools.  Every link of the chain of reasoning supporting this suggestion is flimsy.  Most importantly, the suggestion rests on a structural break which corresponds roughly with a period of time during which more financial investors participated in commodity markets.  But many other things changed during the same period.  Indeed, Hamilton himself has repeatedly pointed out that this period was one in which there was a virtual cessation in the growth of oil output.  That’s a pretty important fundamental.  Moreover, this was a period in which emerging markets, notably China, began to impact commodity markets dramatically.  Furthermore, most of the period (say 2007-2011), was one of financial an economic upheaval not observed since the 1930s.  That’s a pretty big change too.  Why put all the focus on index investing?  The model certainly doesn’t support that, because (a) all of these other factors are omitted altogether, and (b) even the model of index investing is crude and mechanical.
18. That is, to attribute the change in risk premia estimated from a clearly mis-specified model to a single change among many that occurred during the period of change is highly, yes, speculative, and an extremely tenuous piece of post hoc ergo propter hoc reasoning.

I do not want to close on a negative note.  I admire that Hamilton and Wu have focused on the right issue and have brought impressive econometric skills to the problem.  Improving our understanding of these issues would best be achieved by following the direction James and Jing have pioneered, by incorporating some of the features discussed above.  It will be a hard road, but worth taking.  Hamilton-Wu is a helpful first step along that road, and I hope that people understand it is only that, and that much hard slogging remains.

******

A few technical asides:

1. The use of NYMEX data in which time to expiration changes presents some complications to the estimation and interpretation.  It would be worthwhile to look at LME metals data (e.g., copper) because (a) it has also been claimed that financial investors have affected metals pricing, and (b) LME trades constant-maturity contracts that are easier to handle empirically.
2. If the focus is on index investors, who by definition trade in multiple commodities in a mechanical way, it seems that cross-sectional evidence would be quite informative.  For instance, did risk premia change in a way similar to that claimed for oil in other markets that are also part of commodity indices?

Javier Blas at FT was a standup guy about the sentence in his article on the Singleton that made it sound like I had criticized the CFTC for not inviting those taking contrary views to the August confab about speculation and the Singleton paper.  In response to my venting (who? me?), the sentence has been corrected in the online version to make it clear that I did not make any such claim, and the version online now contains this text:

“This article has been corrected since original publication to reflect that only Philip K.Verleger has criticised the CFTC’s move to invite academics, mainly with one point of view.”

I appreciate the rapid and gracious response.

Interesting to note that Ken Singleton and I are commonly being used to personify contending sides in the commodity speculation debate.  One example is this piece from the FT on Wednesday.

Before going into substance, I need to set the record straight.  Javier Blas is flatly incorrect to say that I criticized “the CFTC’s decision to invite academics who mainly defended only one point of view.”  Flatly incorrect.  I have never said that either publicly or privately, and I defy Mr. Blas to prove otherwise.

Indeed, I was invited, so I know the statement to be untrue and I would not make it becuase (a) I just wouldn’t, and (b) I’m not so foolish as to make a statement that could easily be proven wrong.   I decided not to attend the event for a variety of reasons, most of them personal.

So, a retraction and correction is warranted (though I’m not holding my breath).

Now that’s out of the way, let me revisit one more time why the Singleton paper is being grossly misinterpreted, though not by Ken (at least in ear/eyeshot of me).

To recapitulate, Singleton finds that a measure of index fund participation helps predict future returns on oil futures positions.   This measure has serious, serious problems, as Scott Irwin and Dwight Sanders have shown.  Singleton has acknowledged some of the problems.  But that still leaves a puzzle, as why would a very noisy measure of speculative participation have predictive power?  But I’ll leave that puzzle aside and take as given that speculation leads prices.

The question is: why?  Does this mean that speculation has distorted prices?

In a rather stinging response to Singleton, the IEA does a nice job of summarizing my views as to why it does not necessarily support this conclusion, and could support the exact opposite one:

Finally, as suggested by the University of Houston’s Craig Pirrong in his blog, suppose that Professor Singleton’s findings do indicate that excess returns on crude oil futures are predictable, conditional on measures of speculative activity. Nonetheless, such a predictability of returns would not imply that speculation has distorted prices. Rather, predictability is the result of market frictions that might create hedging demand, leading to an increase in the risk premium. Professor Pirrong suggests that, in such circumstances, speculative positions can predict changes in futures prices. To prevent the predictability  of returns, it might be advisable to reduce constraints on the flow of speculative investment to  commodity markets, rather than limiting them.

(The entire IEA piece is worth reading.)

Singleton advances another argument–and it is only that, because his evidence cannot distinguish his explanation from that just advanced–based on various behavioral finance/learning stories.  There are indeed asset pricing models in which investor learning can lead to self-reinforcing price movements.  The key phrase here is “asset pricing models.”  The key question is whether such asset pricing models are applicable to commodities.

I am highly, highly skeptical.  Assume for sake of argument that speculative activity in a commodity derivatives market has distorted the price of the commodity; convergence implies that if nearby futures prices are indeed distorted, physical prices have to be distorted too.

Millions–and in some cases billions–of individual consumers, and myriad producers, face these prices.  If these producers and consumers are not playing the same learning game that is going on in the futures market, the price distortion will affect their production and consumption decisions.  All else equal, if speculators cause the price to be too high, consumption will be depressed, and production will increased.  This will lead to an accumulation of inventories.  If the price distortion is large, the inventory accumulation is likely to be large.

Now, there are circumstances in which it may be difficult to detect empirically the inventory accumulation.  If supply and demand are extremely–extremely–inelastic, large price moves may result in small inventory changes that are hard to detect in the noisy stock data that are available for some commodities.  Moreover, all else may not be equal.  As Singleton (perhaps cleverly) notes, my research shows that a decline in fundamental uncertainty could lead to a decline in inventory that masks the speculation-induced change.  (Although more plausibly, higher fundamental volatility leads to greater speculation, which would lead to an increase in inventory that could be blamed on speculative price distortions.)

But there are historical episodes–like the Hunts in silver and government price-support programs–in which price distortions have been associated with huge accumulations of inventory.  Those claiming speculative distortion need to provide a credible explanation whenever an alleged price bubble is not accompanied by a rise in inventories.  It can happen, but it’s unlikely–so show me how.

So, for the Singleton story to work, it has to be the case that consumers and producers–or at least a big chunk of them–are playing the same learning game as the investors.  I find this wildly implausible, particularly for consumers.  Would consumers really buy more gasoline today–gasoline which they are going to consume, not store in anticipation of profiting from price appreciation–for speculative reasons because prices have been trending up?  Really? (Perhaps you could argue that they would engage in intertemporal substitution, but this also stretches credulity.)  It might be somewhat more plausible that suppliers would not produce more today in response to a speculative price bubble in anticipation that they can sell at a higher price in the future.

These stories–and they are just that–are not logically impossible, but they are just implausible, to me anyways.  The consumer side is particularly implausible.  To emphasize: most consumers of gasoline or copper or corn or whatever cannot store the commodity, and hence cannot earn a speculative profit.  Thus, they should respond parametrically to prices, and respond to higher prices by reducing consumption.  The decline in consumption in markets (like the US) where consumers are subject to price changes (because there are no price controls or subsidies) during the oil price spike of 2008 supports this view.  So price distortions should lead to inventory accumulation.

This is an excellent illustration of why commodities are a good place to test theories of speculative distortion.  The speculators may play their games in the financial markets, but if they affect prices, consumers and producers who don’t play the game alter their behavior.  Looking for evidence of behavioral changes–consumption and production changes–is a great way to detect price distortions.  That is not possible in asset markets.  Consumers and producers are canaries in the coal mine.

Which all means that to persuade, Singleton, and those who are using his paper to say Eureka!, need to provide a plausible explanation of how learning/behavioral finance effects change the behavior of producers and consumers in ways that what would mean that price distortions do not lead to noticeable changes in quantities like inventory.  That is, he points to models of asset markets in which there are no consumers; to make a realistic and testable model, you would need to include producers and consumers as well–not just demand for a stock of assets, but flow demand and supply.

One last thing.   The Singleton paper has “boom and bust” in the title, and many behavioral finance/learning models predict boom and bust patterns in speculative prices.  There was a boom and bust in oil prices and other commodity prices–but the bust in 2008 was not plausibly the kind of speculative bubble bursting that occurs in the models.  It was definitely driven by a huge collapse in demand resulting from the financial crisis.  Thus the “bust” part of the price movements should not be used as evidence in favor of the theory.  Instead, it fits far better a fundamentals-based story.  As I told many reporters as prices peaked in summer 2008, when they asked what would bring down prices: be careful what you ask for.  A major recession would be the most likely cause of a big price decline.  That’s what happened–not the bursting of a speculative bubble.

Relatedly.  Prices that positively cannot be driven by asset pricing bubbles–because they are are definitively not assets–boom and bust.  During the same period that oil prices were booming and then busting, shipping rates were doing the same thing.  Space on a ship is not an asset.  It is not storable; you use it or lose it.  You can speculate on the price of the ship, but the price of the services of the ship cannot be subject to asset pricing bubbles–because these services are not an asset.  The spike and thudding collapse of shipping rates in 2007-early 2009 is indicative of a rise and fall in the demand for commodities (which are transported by ship), and cannot be explained by speculative distortion induced by learning, etc. Put differently, booms and busts occur in markets in which asset price bubbles are impossible.

To summarize.  1. Singleton’s results are perfectly consistent with rational pricing, no speculative distortions, and financial market frictions.  2.  The conditions that would reconcile the kind of learning/behavioral finance model that would be necessary to explain the lack of inventory accumulation are highly implausible.  If somebody wants to tell a more convincing story about commodity price bubbles, it is necessary to do more than just genuflect to models devised to explain things like the dot-com bubble.   You have to create a model that includes flow demand and supply, and derive testable implications of investor/speculator learning or irrationality for quantities produced, consumed, and stored.   Only then will it even be remotely possible to determine the real implications of these learning models for commodities.

This week marks the beginning of a whirlwind couple of months in which I give talks or participate in conferences on either clearing or Frank-n-Dodd (there of course being a big overlap there).  Tuesday I moderated a panel at the ISDA Annual New York Conference, and yesterday I participated in a panel on Frank-n-Dodd at a Futures Industry Association event in New York.

First, the FIA event.  What came through loud and clear was the widespread belief that the SEF mandate in Frank-n-Dodd is wholly wrongheaded.  The consensus is that it is an attempt to jam a one-size-fits-all model on an inherently heterogeneous and non-standardized business–the business of executing OTC derivatives transactions.  That heterogeneity reflects the inherent heterogeneity of particular transactions, and the firms that want to execute them.  The market has evolved to accommodate heterogeneity, and the SEF mandate will impose uniformity.  Everybody better fit a 42-regular sportcoat, because that is what Frank-n-Dodd is going to force everybody to wear.

Of course there are dissidents from the consensus: most prominently those who do, or want to, operate SEFs.  Big surprise.  The NYT recently ran an article describing the efforts of these firms to influence policy.  The point you should take away from that article is that the idea of SEFS is not new, that SEFs have tried to gain traction in the market for some time (they are not “Johnny-come-latelys” in the words of one exec quoted in the article), but they have not made a big dent in the marketplace.

The failure to this point of SEFs to transform execution in the swap market, the way electronic trading did for listed derivatives, is a crucial fact.  It is not dispositive proof that the SEF mandate is misguided, but it does raise serious questions about it.  Before remaking the world, it is a pretty good idea to understand why the world is the way it is and why it isn’t the way you want to remake it.  Competition is never perfect, but competitive forces usually work inexorably towards the adoption of more efficient practices.  The rebuttable presumption should be that competition has pretty much gotten it right, and that policy prescriptions that are wildly at odds with existing practice are likely based on ignorance.  Those advocating a wholesale re-engineering of the results of market processes should be required to advance a coherent justification, based on rigorous logic and empirical evidence.

This the SEFocrats have not done.  Not even close.  And no, invoking the magic word “transparency” or advancing theories that presume that half the market is suffering from something akin to battered spouse syndrome don’t cut it.

The SEF rules are a particularly prominent example of the deficiency in cost-benefit analysis in CFTC rulemaking.  I have it on good authority that some analysis will soon be forthcoming that demonstrates that the cost of these rules will be immense.  As for benefits, the six members of the FIA panel couldn’t name one–even when pressed to do so.  We, collectively, couldn’t even come up with a “well you don’t sweat too much for a fat girl” compliment.  (If you don’t like that remark, direct your complaints to Ty Cobb:  I stole it from him.)  So, insofar as cost-benefit analysis is concerned–you should be able to do the math pretty easily.

The title for the post, by the way, is a joint product.  Tom LaSalla of CME Group coined “SEFdom” to describe what Frank-n-Dodd will soon bring on us.  I added the Hayekian allusion.  (Go figure.) I think the comparison is apt.

Insofar as the ISDA panel on clearing is concerned, I walked away from it thinking what I do after hearing any informed discussions of this subject: that it is the most devilishly complex issue you can possibly imagine.  It is one of the world’s biggest onions, and neither I nor anyone who has spent considerable time and effort thinking about it or actually doing it has gotten through even a small fraction of its layers.  The number of serious issues, their complexity, and their interconnectedness, is hard to exaggerate.

Which further demonstrates the frivolity of legislators and regulators around the world,who seized upon it as a panacea and imposed it without due consideration of these complexities.  The idea was hatched out of superficial understanding by panicked people who then proceeded to let others deal with the brain-twisting realities.

One hopes (though I do not expect) that regulators will be sufficiently patient and flexible to permit people who actually know something accommodate these complexities, and make the hard trade-offs that are necessarily involved.  New ideas on ways to perform the same functions as CCPs are still being developed: ISDA chief Conrad Volstad mooted a promising approach that would achieve the purposes of the clearing mandate, but at far lower cost.  These approaches deserve analysis and development before another one-size-fits-all approach is locked in.

I don’t like clearing mandates, but think that clearing has its virtues if it is done right, and in a way that reflects its comparative benefits and costs.  In this way it differs from the SEF mandate, which is why I gave the latter my Worst of Frank-n-Dodd Anniversary Award.  But rigid and superficial conceptions about how the mandate should work (and you know whom I am talking about) raise the very serious possibility that the potential benefits of clearing will be swamped by the unintended costs of imposing it where it is inappropriate, or in a way that is not adapted to its strengths and weaknesses.

In this week’s edition of Energy Metro Desk, John Sodergreen wrote: “Normally, Pirrong is a ‘take no prisoners’
sort of economist.”  He was referring to my apparently serene response to the Singleton paper on energy speculation.

Rest assured, all, that I am not mellowing in my old age.  My response to Singleton qua Singleton was serene primarily because the results are capable of many interpretations, many of which are quite compatible to my views.  Further rest assured that I am my scathing self when it comes to the efforts to misinterpret and overinterpret Singleton’s results.  It is being waved about as the smoking gun proving that speculation distorts prices.  This is completely wrong, and reflects either the ignorance or agenda–or more likely, both–of anyone making the claim.

Remember what Puddin’ Head Wilson said: “We should be careful to get out of an experience only the wisdom that is in it — and stop there.”  People are getting far too much “wisdom” out of Singleton than there is in it. Singleton’s results are perfectly consistent with a favorable or benign effect of speculation.

But there is nothing more likely to get me to break out the black flag than an epistle from Bart Chilton, and yesterday he did not disappoint.  The NY Times’ Dealbook had this gem from our ol’ buddy Bart:

It’s a familiar cry from Wall Street executives and Congressional Republicans: New regulations will dampen profits and crimp an already-feeble job market.

But some federal regulators, now charged with writing dozens of new rules for Wall Street, beg to differ. Bart Chilton, a Democratic member of the Commodity Futures Trading Commission, argues that a regulatory shake-up would actually spawn a wave of hiring on Wall Street and in Washington.

“The possibilities for economic growth and competition here are mind-boggling,” Mr. Chilton said on Friday during a speech at the University of Maryland.

The debate centers on the controversial Dodd-Frank Act, which overhauled financial regulations after Wall Street nearly collapsed during the financial crisis. The law, among other things, transformed the $600 trillion derivatives markets, a lightly regulated industry at the center of the mess.

. . . .

“I have no doubt that these new regulations, instituting new types of clearing, trading and reporting platforms, will foster a landslide of hiring in the financial sector,” Mr. Chilton said.

In particular, Mr. Chilton forecast growing demand for technology experts. “All of this new trading activity, with new regulatory oversight requirements, will mean the development of new technologies, both in the private and public sectors,” he said.

The mind boggles.  Chilton, like all too many regulators and legislators, confuses costs and benefits.  This is the broken window fallacy on crack.  Said regulators and legislators should be required to have Bastiat’s discussion of the seen and the unseen flashed before their eyes repeatedly, Clockwork Orange-like, until the idea sinks in.  Short of that, I am at a loss at how to educate them on this profound–yet simple–concept.

Yes, we can see all the accountants and lawyers beavering away on Sarbanes-Oxley-related work.  But what about all the other–and actually productive–things those people could be doing if Congress in its infinite wisdom and overweening arrogance hadn’t seen fit to create an artificial demand for their services, that distracted them from doing something that is actually socially productive?  What about the companies that are smaller, and the companies that don’t exist, because of the burdens of this and other counterproductive regulation?

Frank-n-Dodd is Sarbanes-Oxley raised to a power far greater than one.  Yes, there will be lawyers and compliance people working in their tens of thousands to ensure adherence to its mind-numbing dictates.  Yes, the idiotic SEF requirement will result in a splurge in spending on technology, and there will be much rejoicing among programmers and IT people.  To the bean counting regulator or legislator this is good.  To the more perceptive, it is a crime.

Riddle me this, Bart: If this technology were actually valuable, why do you and your ilk have to force its creation?  You, in particular have been critical of the dizzying pace of technological development in the trading space.  So you know this is obviously a technologically dynamic industry where there is intense competition to create new products and services and methods of delivering them, not some tradition-bound backwater.  If the kind of technology Frank-n-Dodd is going to bring into existence were actually delivering value to market participants, you can be damned sure that somebody would have figured that out.  Many somebodies, in fact, who would be competing like hell to bring it to market faster and better than anyone else.

And further: please tell me what actually beneficial inventions will not be created, or will be delayed, because their would-be inventors are instead (rationally) responding to some inane government mandate?  You can’t, and I can’t.  But they exist.  Just because you can’t see them, doesn’t mean they aren’t there

And please: tell me how you distinguish a cost from a benefit.

Sadly, the inability to tell cost from benefit is rife in the 202 area code.  The disease is probably most acute at EPA, which blessed us with this gem of economic analysis:

In fact, the EPA has even suggested that new regulations can have a positive impact on job growth. “In periods of high unemployment, an increase in labor demand due to regulation may have a stimulative effect that results in a net increase in overall employment,” the agency wrote in February.

This is the kind of moronism we are dealing with, people.  And the rot is spreading.  Including to the CFTC, apparently.

When you read or hear this or that macroeconomic theory about why the recovery–such as it is–has been so weak, and why the economy totters on the brink of another recession, put it in its proper perspective.  Yes, macro factors are important.  But so too is the massive regulatory millstone hanging around our collective necks.  People who think costs are benefits are running amok.  And sad to say, they are just getting warmed up.

We need to fight these people.

* The Degüello was a bugle call dating from the Moorish Wars of the Reconquista in Spain. Literally, it means “throat slashing” and was played to signal “no quarter–take no prisoners.” Santa Ana’s army played it before the final charge at the Alamo.

Gillian Tett has apparently discovered (via JP Morgan) that commodity production costs are a fundamental.  Who knew?

There are news reports providing some glimpses into draft regulations regarding the regulation of derivatives and securities markets in Europe.  It looks like it is taking some of the worst of Frank-n-Dodd, and adding some dumb flourishes of its own.

Insofar as the worst of Frank-n-Dodd is concerned, despite initial indications to the contrary, it looks like the proposal is going to incorporate something like a SEF requirement.  You might recall that on The Monster’s first birthday, I named the SEF requirement as its worst feature.  Well, the Euros (don’t they have bigger problems right now? Just asking.) don’t look to be avoiding the US’s mistake:

Widely traded derivatives would have to be transacted on an electronic platform to improve transparency and safety, draft European Union rules showed on Monday.

The bloc is overhauling its markets in financial instruments directive (MiFID) to catch up with technological advances, apply lessons from the financial crisis and deal with problems such as price fragmentation raised by the original rules.

“The main aim of the proposal is to ensure that all organised trading is conducted on regulated venues and is fully transparent,” the draft, seen by Reuters, said.

More specifically, world leaders agreed in 2009 that derivatives, largely traded bilaterally between banks in an opaque $600 trillion sector, should be traded electronically.

This will give supervisors the full picture of who is affected when a counterparty gets into trouble, which they lacked when Lehman Brothers bank collapsed three years ago.

“The proposed revision will shift trading of the suitably developed derivatives to such platforms,” a draft of the MiFID reform, now circulating widely in Brussels, said.

“This obligation will be imposed on both financial and non financial counterparties,” the draft added.

Another unfortunate imitation is the adoption of restrictions on commodity speculation, including position limits:

The European Securities and Markets Authority should have the power to impose position limits on traders in crisis situations when “the stability of the whole or part of the financial system” is threatened or “delivery arrangements for physical commodities” could break down, the document says.

The Euro flourishes are clearing-related, although here I have to say that the reporting is not too clear.  As I’ve written in the past, European regulators are obsessed with the vertical integration of execution and clearing–the silo issue.  Various reports (including the two linked above) and this one suggest that the regulators will force CCPs to be open access.  The reporting also states that integrated exchanges will have to share data streams, including calculations of indexes that are the basis for traded products.

Insofar as open access is concerned, the FT article quotes language stating that CCPs will be required to accept trades for clearing “on a non-discriminatory and transparent basis, regardless of the trading venue on which the transaction is executed.”

The idea here is to facilitate competition between CCPs, apparently.  But it is fraught with difficulties.

For one, there is the question of why a dominant CCP, including one that is integrated with an execution venue, would turn away business.  Even if it is a monopoly, it could sell clearing services at the monopoly price.  If, as the anti-silo crowd commonly argues, the execution of transactions is potentially highly competitive, absent some cost, the monopoly CCP would maximize profits by selling its services at the monopoly price.  It wouldn’t be necessary to mandate open access.  The CCP would gladly offer access–for a price.

It is therefore necessary to understand why an integrated CCP wouldn’t sell clearing services to others on an open access basis.

One possible reason is that the dominant CCP believes that open access rules will eventually result in the regulation of the prices it can charge for its services.

I think a more important reason relates to a fundamental misunderstanding  among the Europeans of the way competition is likely to work.  There are two possibilities.

One possibility is that there remains a single clearer–given the cost conditions in clearing, that’s not unlikely, although it seems that the Europeans think that they are constructing rules that will reduce the likelihood of this outcome.  Note that particularly now, financial trading is highly technological.  There will thus be the necessity of coordinating technologies and changes in systems between the execution venues and the clearer.  This can be very difficult to achieve across firm boundaries; this is one of the factors that I identified as justifying integration well over 5 years ago.  It should also be noted that this is precisely the reason given for many recent exchange decisions to integrate into clearing; the LSE is the most recent and prominent example of this.

The other possibility is that there are multiple CCPs offering to clear a particular instrument.  There are myriad challenges to this, but I’ll focus on just one.  In particular, assume a transaction in a particular instrument is cleared at CCP A and CCP B.  A trade is executed on venue X.  If the parties to the trade can choose independently where to clear, the buyer may submit the trade to A and the seller to B.  In this case, A and B must be interoperable.  Interoperability is extremely challenging.  It is likely to increase collateral costs (as A and B are going to require collateral from each other).  Moreover, A and B may find it difficult to negotiate an interoperability arrangement because of (a) competitive pressures (the model the Europeans seem to have in mind involves a unique balance of competition and cooperation), and (b) distrust of each other’s risk management, arising from the difficulties of monitoring.  Moreover, the technology/system coordination issues are now multiplied, as X has to coordinate with both A and B.  And if there are multiple execution venues (Y and Z, say) as the Euros presumably hope and expect, these difficulties are multiplied accordingly.

Having an exclusive arrangement with an execution venue avoids this problem.  Those trading on X could be required to clear on A, for instance.  But that just raises the same kinds of problems as if there is only a single clearer.

In brief, it is hard to see how robust competition between CCPs is possible.  Once that is admitted, the whole basis of the regulation collapses.

The whole evolution of the exchange space–most notably in Europe–in the past 5 years is exactly contrary to the thrust of the proposed regulation.  And maybe that’s the point: the Euroregulators are clearly bugged by this trend.  But maybe they should try to understand it first; it’s pretty evident that they don’t now.

Case in point: LCH.Clearnet’s difficulties–its loss of exchange clearing business (EuronextLIFFE, ICE, and almost certainly LSE)–suggests that integration is not primarily driven by anticompetitive impulses.  Instead, in my view it reflects the difficulties of coordinating complementary activities across firm boundaries in a highly technologically dynamic industry.*  At the very least, the Euros should consider that possibility, and take it seriously, before attempting to micromanage the structure of a dynamic industry with strong network characteristics.

Instead, it seems that the regulations are based on an intellectual framework that would be suspect in any industry (as I’ve written about before), and which does not seem to take into account that unique characteristics of financial trading: network effects, scale  and scope economies, technological dynamism, and information asymmetries with respect to performance risk.

So, if the European endeavor is truly the son of Frank-n-Dodd, it may well be the ugly bastard child.  It has the defects of F-n-D, and adds some more–as if more were needed.

Perhaps this is Brussels’ negotiating position.  There is considerable opposition (particularly in Germany–go figure) to some of these initiatives, and maybe the EU is proposing a more radical change in the knowledge that it will have to be watered down.   One can only hope that it drowns.

* I spoke at an FIA panel that touched on this issue in March, 2007.  I made the coordination point.  Charlie Carey, then head of the CBT (which had already agreed to sell out to the CME–this was the day before ICE made its surprise offer) was sitting next to me.  After I made this point, he handed me a note that said that was an extremely important, but insufficiently appreciated, fact.

Izabella Kaminska writes very interesting posts at FTAlphaville.  She finds unusual things in the markets, including the commodity markets, and writes about them intelligently and provocatively.  I have to take issue, however, with one of her more recent efforts.

She takes as her inspiration an article by the improbably named (to an American ear, anyways) Hilda Ochoa-Billembourg.  Izabella’s takeaway from HOB (you didn’t think I was going to type that again, did you?) is that the Achilles heel of QE2–which, remember, was specifically designed to produce some inflation–was that it did not produce the right kind of inflation (something which Bernanke adamantly, and not too plausibly, denies):

If you work with the premise that QE2 led to what has been described as ‘bad inflation’ — inflation being exported into commodity and emerging market securities rather than domestic ones — you could argue the Fed has always had an interest in sterilising that inflation effect.

What to do then?  Have the Fed intervene in the commodities markets by selling longer-dated futures, of course!  Kaminska suggests that the Fed–or some Government Body To Be Named Later–did this, although her argument here is highly circumstantial and, uhm, speculative.  Now that deflation fears are reviving given the European tumult and the palpably slowing US economy, she suggests that it could be just the right time for the Fed or GBTBNL to buy commodity futures.

Or not.  I have problems with the argument from start to finish.  It is predicated on the view that speculators are driving the curve (although Kaminska admits that it doesn’t affect spot prices)–a highly dubious proposition.  It presumes a sort of disconnect between the Treasury market and the energy (and other commodity) futures markets (“One might even say that the market has shifted from expressing inflationary views via the Treasury market to the oil market.”  If so, there’s money to be made!) Although she recognizes–blessedly–that speculators affect the risk premium embedded in futures prices, she confounds a risk premium with an inflation expectation effect (which should be impounded in the interest rate terms structure in any event).  Most notably, she makes the all-too-common mistake of confusing Keynesian contango/backwardation–which is a difference between a spot price and an unobserved expected future spot price–and contango/backwardation of the observed curve, which is the difference between traded prices.  (An expected spot price is not traded.)    The risk premium can change without having any impact on the shape of the futures curve; the effect of the risk premium–and hence hedging/speculative balance–on the futures curve is indirect, operating through the effect of the risk premium on inventory decisions: roughly speaking, more Keynesian backwardation (hedgers pay speculators a greater risk premium) leads to less inventory which tends to reduce the contango/increase the backwardation in the curve.  But detecting this effect is hard even in a simulated market, let alone in a real one.  Her story also depends on an implausible relation between speculation and the Brent-WTI spread.

But put all that aside.  Assume it’s all correct.  Do we really want the Fed, or any other GBTBNL, monkeying around with still more relative prices?  Really?

Several times I’ve recounted the story of the great economist Sherwin Rosen, who in 1982 startled an 830 AM section of his Econ301 class at Chicago by shouting: “And that’s the problem with inflation.  It FUCKS UP RELATIVE PRICES.”  Well, of late the Fed apparently thinks that effing up relative prices is its job.  Heretofore, its efforts (unless Izabella is right that the Fed has been active in commodity markets as well) have focused on the yield curve and inflation expectations: twisting this rate relative to that–or is it torquing?

How is that working out for us?  Trivial growth in the H1 2011.  And how about that last jobs report!  Or should I say, that no jobs report?

We really don’t need it attempting to affect–to f*ck up–the relative prices of commodities or anything else.  Indeed, the now common diagnosis of the failure of QE2 (which you might have read here first, well before its end) is that the Fed’s intervention screwed up relative prices: forcing down the dollar, which induced other countries to intervene to prevent undue appreciation of their currencies, thereby sparking inflation in emerging markets, which has led to yet further policy responses; forcing up commodity prices, which put a drag on developed economies.  So we should now believe that there will not be any unintended consequences on other relative prices from an attempt to intervene into the commodity markets?  Really?

The probability that the Fed could somehow tweak relative prices just right this time based on a theory that would do Professor Irwin Corey proud, and which could use a good trip to the barber for a shave with Occam’s razor, is vanishingly small.  The probability that it would wreak yet additional havoc through such an intervention approaches one.

The problems are almost beyond numbering.  There is the knowledge problem: how could the Fed possibly know what the “right” relative prices are?  There is the implementation problem: how could the Fed actually achieve the relative prices it wants to, if by some miracle it could divine what they should be?  There is the strategic/expectations problem: how could the Fed succeed given that it would not be acting on automotons, but on live, thinking, reactive, strategic actors who respond to the Fed in ways that are hard to predict?

No, as Sherwin might say if he were still alive: the Fed has f*cked up relative prices enough, thank you.

So Ben, et al: Stop before you do even more damage, and inject more uncertainty into an economy that is already reeling from it.  We need no more Sorcerer’s Apprentice interventions.  Don’t just do something, stand there.  Become what you were intended to be–a lender of last resort to address liquidity problems and banking crises–and stop trying to be some grandiose central planner that manipulates price signals to achieve some “aggregate” outcome.  It hasn’t worked up to now, and it won’t work any better if you double down.  Do more by doing less.  Go away and leave us alone.

In brief, we may need to revise Reagan’s statement of the ten scariest words in the English language: now, it should be “I’m from the Fed, and I’m here to help you.”  With help like this . . .

A couple of wonderful stories today about contractual fidelity, Chinese style.

First, in 2008, when dry bulk shipping prices skyrocketed, Chinese national champion shipping company Cosco chartered large numbers of ships under long term deals at sky-high prices.  Today, prices are far lower, and Cosco has reneged on numerous contracts–thereby setting up ugly legal battles.  Fortunately, the shipowners believe they have a very strong case, and are threatening to take Cosco to court.  Cosco is counting that the prospect of the loss of future business will lead the shipowners to swallow their pride and cut the charter rates.  But who wants to do business with someone who views a forward contract as a free option?

At the same time, there is a risk that Cosco’s reputation, built up over 40 years, could suffer serious damage. Shipowners are unlikely to feel the same eagerness in future to let Cosco charter their ships to Australia.

Funny thing, reputation.  40 years to make.  40 seconds to break.

And here’s a doozy.  Back in 2009 I predicted that no sooner would the Russia-China oil pipeline get built, than there would be a contractual battle.

Sho’ nuff.

According to the 2009 Russian-Chinese intergovernmental agreement, oil deliveries to China through the Eastern Siberia-Pacific Ocean pipeline are made under contracts among Russian oil company Rosneft, Russian state-owned pipeline monopoly Transneft, and the China National Petroleum Corporation (CNPC) for 15 million tons a year over two decades. In exchange for guarantees of long-term oil deliveries China provided Transneft and Rosneft with loans of $10 billion and $15 billion respectively.

But at the beginning of 2011 the CNPC started underpaying for Russian oil, as China demanded a revision of the price formula. It currently includes the price of transporting oil along ESPO’s entire route to the port terminal in Kozmino. But as the branch to China begins at the point of Skovorodino, 1,271 miles from Kozmino, China is insisting that the pricing formula must be revised and that the cost of transportation from Skovorodino to Kozmino must be subtracted from it, with Beijing originally estimating the difference at $12 a barrel, underpaying accordingly.

Accordingly, China’s debt as calculated by Moscow is now approximately $85 million. In a telling comment on the validity of both Russia and China’s court systems, Rosneft and Transneft have begun consulting with lawyers about the possibility of initiating a lawsuit against the CNPC at the London Court of Arbitration. Earlier this month Transneft sniffed that if the case goes to court, it is prepared to return to China the $10 billion received in 2009 and to stop transporting Russian oil to China, unilaterally abrogating the 20-year contract.

Switching gears, China is upping the stakes to begin discussions at the governmental level to resolve the impasse. Chinese negotiators have invited Russian Energy Minister Sergei Shmatko to participate in the next round of talks, which is to take place in Beijing starting at the end of August, when it was originally assumed that only Rosneft and Transneft representatives would be participating in the discussions.

Konstantin Simonov, general director of the National Energy Security Foundation, is convinced that China is indulging in a bit of good old fashioned “provokatsiia,” to use a Soviet word, telling reporters, “The statement by the Chinese customs is of a provocative nature: The Chinese are endeavoring to show that Russia is not fulfilling its contract obligations and is casting doubt on the development of energy relations with China as a whole.”

Two-sided opportunism, writ large.

The original pricing in the deal was very opaque (and still is), but given Russia’s palpable desperation in early-2009, my surmise was–and is–that the pricing terms were very generous to the Chinese.  I figured that Russia would try to find any pretext to break the deal, so this doesn’t surprise me: “Earlier this month Transneft sniffed that if the case goes to court, it is prepared to return to China the $10 billion received in 2009 and to stop transporting Russian oil to China, unilaterally abrogating the 20-year contract.” But the Chinese are feeling their oats too, and no doubt they are trying to squeeze even more out of a specific asset.

Thus, given the two parties involved, no doubt each is attempting to hold-up the other.  So the Arbitrage Court should have loads of fun dealing with this one. Is “a pox on both” an allowable verdict in an arbitration?

Keep these kinds of things in mind whenever anybody talks about “capitalist” China.  Only fools would have any such illusions about Russia, and it is just as foolish to harbor such thoughts about China.  It is capitalist/rule of law when capitalism suits it, and statist/above the law when it doesn’t.  The country still has many miles to go before it is a truly reliable and law-based trading and contracting party.  When the stakes are big enough–as is apparently the case with Cosco and the ESPO pipeline–it will treat contracts like toilet paper.  (Which they need in a lot of places in China.)

In other words: seller (and investor) beware.

One of the leading crude oil futures contracts–CME Group’s WTI–has been the subject of a drumbeat of criticism for months due to the divergence of WTI prices in Cushing from prices at the Gulf, and from the price of the other main oil benchmark–Brent.  But whereas WTI’s problem is one of logistics that is in the process of being addressed, Brent’s issues are more fundamental ones related to adequate supply, and less amenable to correction.

Indeed, WTI’s “problem” is actually the kind an exchange would like to have.  The divergence between WTI prices in the Midcontinent and waterborne crude prices reflects a surge of production in Canada and North Dakota.  Pipelines are currently lacking to ship this crude to the Gulf of Mexico, and Midcon refineries are running close to full capacity, meaning that the additional supply is backing up in Cushing and depressing prices.

But the yawning gap between the Cushing price at prices at the Gulf is sending a signal that more transportation capacity is needed, and the market is responding with alacrity.  If only the regulators were similarly speedy.

Three companies are at various stages of planning new capacity to ship oil from the Midcontinent to the Gulf.  A fourth is looking to redirect flows from Cushing to Houston.  The addition to capacity would total 1.4 mm bbl/day if all were completed.  Since that’s more capacity than is needed, not all the projects will go to completion.  But regardless, over the medium term it is likely that new pipelines will break the bottleneck and crush the differentials between WTI and LLS, MARS, and Brent.

The main obstacles that the WTI contracts face are enviros and Coasean challenges.  Environmentalists have been trying to put every regulatory roadblock possible in the way of one of the pipeline projects–TransCanada’s Keystone XL. This would bring oil produced from oilsands from Alberta through Oklahoma and on to Texas.  The project cleared one roadblock last week, when the State Department (which has to approve due to the international nature of the pipeline) released an eight volume (!) study finding that the pipeline poses no significant environmental impacts.  The pipeline’s opponents are vowing to redouble their efforts, and the issue is now wrapped up in presidential election year politics.

The Coasean challenge is that reversal of the Seaway pipeline currently flowing from the Gulf to the Midcontinent would cost one of the owners–ConocoPhillips–money by raising input costs for its Midcontinent refineries.  Even though there are more than enough gains on the table to compensate CP for any losses arising from a rise in the price of Midcon crude, so far no one has been able to craft a deal whereby the winners (primarily Canadian and US producers) can make it worth CP’s while to agree to the reversal.

But these problems are all surmountable.  WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

Brent’s problems are more fundamental, because they arise from declining supply.  Even as paper volumes continue to rise, physical volumes available for delivery are falling inexorably.  The Brent complex had faced this problem before, and confronted it by adding Forties, Oseberg, and Ekofisk to the eligible stream.  But BFOE production has declined from 1.6 mm bbl/d in 2006 to barely more than half that today.  And the decline continues apace.  This makes the contract vulnerable to squeezes of a kind that were chronic in the 1990s and early 2000s, and which spurred Platts to add the three other grades to the benchmark.

There are, moreover, few additional North Sea oil stream that can be added to the benchmark this time.  So over the medium term Platts is considering adding other low sulphur crudes produced outside the North Sea to the contract.

The Brent problem is analogous to that faced by the Chicago Board of Trade grain and soybean contracts in the early-1990s.  Volumes of corn, wheat, and soybeans shipped into Chicago and Toledo–the delivery points–were falling, though not due to declining production, but due to changing trade patterns.  Deliverable supplies in Chicago and Toledo were not reliably sufficient to ensure the pricing integrity of the contract.  The Ferruzzi soybean squeeze in July, 1989 brought matters to a head and forced a reluctant CBT to act.

The CBT’s initial response was to tinker with the contract, adding St. Louis as a delivery point at a modest premium to Chicago.  Within a few short years, however, all delivery warehouses in Chicago proper had closed, and the exchange had to adopt a substantially different delivery mechanism (which I helped design–more on this below).

One approach available to Platts would be to create what I called an “economic par” contract in a report (subsequently a book–such a deal!) on the CBT contracts that I wrote in the aftermath of the Ferruzzi episode.  In an economic par contract, differentials for delivery of different grades (or at different locations) are set approximately equal to the cash market differentials.  For instance, if Brent was made the par grade, and another type of crude that typically sells for a $2 discount to Brent were made eligible for delivery against the contract, the deliverer would receive $2 less for delivering that grade than delivering Brent.

The advantages of this type of system are (a) it allows a dramatic expansion of deliverable supply, thereby easing technical/squeeze pressures on the contract, and (b) it can improve hedging effectiveness/reduce basis risk.  In essence (as pointed out in the book), options pricing theory implies that with economic par terms the futures price becomes like a weighted average of the prices of the deliverable grades.  This reduces the idiosyncratic component of futures price fluctuations, making the contract a better hedge for a variety of users.  (Cash settlement based on a variety of crude streams would produce a similar outcome.)  In the present instance, an economic par contract would be a poorer hedge for Brent cargoes, but a better hedge for other kinds of oil (e.g., Urals).

Since cash market differentials can vary over time, it is advisable to adjust the contract premia and discounts periodically.  (The failure to do so with Treasury Bond futures in the 1990s caused some problems with the contract that were eventually fixed by the change from an 8 percent par coupon to a 6 percent.)  Such changes can actually make the contract a better hedge by keeping the weights in the average more stable over time, thereby reducing the likelihood that the idiosyncratic risk of a particular deliverable grade exerts disproportionate influence on contract pricing.

Accomplishing such a substantial remake of a contract is, however, a difficult thing.  Contract changes have different effects on different players, and each will try to lobby for changes that suit its interests.  The case of Chicago grains is illustrative.  As the decline in Chicago and Toledo continued apace, and the tinkering that followed the Ferruzzi squeeze proved inadequate, the CBT formed a committee to come up with a new contract design.  The committee had representatives from virtually every affected party.  Since the interests of these parties were so divergent, the process became rancorous and political, and the committee could not come to agreement on the kinds of changes that would have been necessary to fix the problem.  Eventually, in late-1996 the CFTC said enough, and ordered the exchange to change the contract stat.

Realizing that the traditional committee method that gave everybody a voice would not meet the demands of an impatient CFTC, the exchange created a small task force (0f which I was an outside member) of more independent participants, and which pointedly excluded the big incumbent players (mainly Cargill, Continental, ADM, and The Andersons).  This Grain Delivery Task Force came up with a radical new design (based on delivery via shipping receipts into barges on the Illinois River) in less than 6 months.  The new design was approved by the membership and the CFTC over the following months.

Suffice it to say that the kind of consultative process that Platts envisions in revising the Brent contract will almost certainly bog down in the kind of rent seeking self-interested behavior that stymied fundamental changes in the CBT grain contracts.  (In one of the early go ’rounds on this, in 199o–which spawned my report/book–one of the members of the committee set up to revise the contract was so outraged by my recommendations for bigger changes that we almost came to blows.  The representatives from ADM and Cargill took him outside to cool down.  I had similar experience, though more civil, during discussions of revising the canola contract in Winnipeg a few years later.  Considering that the Brent market is so much bigger and the dollars at play in 2011 are so much bigger than two decades ago, the potential for pyrotechnics is all the greater now. )

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

So Brent boosters, enjoy your laugh while it lasts.  It won’t last long, and remember, he who laughs last laughs best.