Streetwise Professor

I wonder if these stories may have some connection.  First, Rosneft and BP are apparently working to structure a deal to buy out AAR from TNK-BP.  Second, the Russian government has revoked a tax holiday on TNK-BP’s Verknechonskoye field, as well as another field held by Surgutneftgaz.

This will apparently cost TNK-BP $450 million.  Nice way to put some downward pressure on the value of TNK-BP–and hence the price AAR can demand for their piece of it.

Of course there are other reasons to remove the tax breaks, notably the Russian government’s need for money.

But there’s a bigger issue here too.  A constantly changing, unpredictable, and ultimately arbitrary tax regime subject to the short-term political currents in Russia (e.g., Putin promises more bennies as part of his political campaign, and the money has to come from somewhere) as well as the vicissitudes of natural state rent reshuffling, is hardly conducive to robust investment.  Russia is notorious for its low rate of investment, especially compared to its alleged peers.  Foreign direct investment is moribund, and Russians are shifting capital out of the country.  This is another short term measure that undermines the long-term prospects for Russian development.

Not that short-termism is a solely Russian phenomenon.  I hope to post soon on how it is becoming a serious problem in the US too.

Today’s FT carried an interesting article about a Glencore trade in wheat and corn.  FT is a royal PITA to quote from, so I’ll just recapitulate.  In brief, as the Russian drought was beginning, Glencore received early reports from “Russian farm assets” of rapidly deteriorating growing conditions in Russia.  It bought wheat and corn, and profited handsomely from the trade.  It claims that such proprietary trades are exceptional for the firm.

More controversially, on 3 August, 2010 Yury Oganev, Glencore’s Russian grain division chief, publicly advocated a ban on Russian exports (a position not endorsed by Glencore).  Two days later Russia indeed banned exports.  Glencore claims that its export business wasn’t helped by the ban, but note the dog that isn’t barking:  the company does not make any statements about whether profits from the wheat and corn trade more than offset the loss to the export business.

Several things bear noting here.

First, this is a classic example of how information is generated and used in commodity markets.  Market participants with physical assets collect information on supply and demand fundamentals, and use that information in their trading.  It is trading on private information, and it tends to contribute to price discovery–as well as generate profits for those with the information advantage.  Such private information tends to reduce market liquidity and impose costs on the (relatively) uninformed, but that’s part of the inherent trade-off between price informativeness and liquidity.

Second, this shows why trading firms with physical assets can have advantages.  Ownership of these assets helps produce valuable information on fundamentals.

Third, this is “speculation,” but it illustrates how such speculation can actually improve the allocation of resources.  Glencore had an early warning of an impending shortage.  It traded on that information, thereby causing prices to reflect it.  This provided a signal that other market participants could use  to take actions to mitigate the effects of the drought.  In particular, market participants who base their consumption and storage decisions on market prices would tend to adjust those decisions in response to the price changes.  The magnitude, or value, of those adjustments is impossible to quantify, but are conceivably large.  In particular, delayed reaction to the drought information would likely have resulted in greater consumption prior to the information becoming public, which in turn would have led to a bigger price spike when it became widely known.

Fourth, the actions of Oganev are far less admirable, in particular if he made the public call for an export ban after the trade was put on.  I believe that the Russian government had reasons of its own–not “good” reasons from an economic efficiency perspective, but political reasons–to impose an export ban.  Hence, I think that Oganev’s plea probably didn’t affect the Russian government in any way.  But it is unethical for a firm with a position to advocate wasteful policies that would tend to favor that position, and an export ban would have done just that.  Advocating wealth-destroying policies is hardly laudable either, position or no.

Commodity trading and processing firms are notoriously opaque–precisely because they make money on the information they generate in their operations, and have every incentive to hold that information very tightly.  This story provides a very revealing glimpse at what goes on in those firms.  It is a particularly interesting example of the synergy between the operation of physical assets and trading operations.

It is becoming clear that Obama’s criticism of speculators was not a one-off. Instead, it is part of a broader campaign to demonize them. Today’s installment of the Two Minutes’ Hate came courtesy of the Justice Department (so tempted to use quotes around that). Eric Holder announced the formation of an Oil and Gas Price Fraud Working Group consisting of Department of Justice, the National Association of Attorneys General, the Commodity Futures Trading Commission, the Federal Trade Commission, the Department of the Treasury, the Federal Reserve Board, the Securities and Exchange Commission, as well as the Departments of Agriculture and Energy.  The Group’s charge is:

In March 2011, President Obama asked the Attorney General to work with federal and state agencies to monitor oil and gas markets for potential wrongdoing.   In response to the President’s call for action, Department of Justice leadership consulted with federal agencies and state attorneys general and discussed pending inquiries in some states, the most effective legal tools and areas that require additional exploration.   As a result of this examination and to further the central mission of the Financial Fraud Enforcement Task Force, the Attorney General formed the Oil and Gas Price Fraud Working Group.

The Oil and Gas Price Fraud Working Group will explore whether there is any evidence of manipulation of oil and gas prices, collusion, fraud, or misrepresentations at the retail or wholesale levels that violates state or federal laws and harms consumers or the federal government as a purchaser of oil and gas.   The Working Group will also evaluate developments in commodities markets and examine investor practices, supply and demand factors and the role of speculators and index traders in oil futures markets.

Here’s the Reuters feed on Obama’s announcement:

* ( RTR ) 04/21 02:30PM OBAMA SAYS HAS ASKED ATTORNEY GENERAL TO CREATE TEAM TO “ROOT OUT” FRAUD, MANIPULATION IN OIL MARKETS THAT COULD HIT GAS PRICES
* ( RTR ) 04/21 02:31PM OBAMA, IN PREPARED REMARKS, SAYS TEAM’S FOCUS WILL INCLUDE OIL MARKET TRADERS AND SPECULATORS
* ( RTR ) 04/21 02:31PM OBAMA SAYS WILL MAKE SURE THAT NO ONE IN OIL MARKET IS TAKING ADVANTAGE OF THE AMERICAN PEOPLE FOR THEIR OWN SHORT-TERM GAIN

Here’s some additional reporting on Obama’s remarks today:

“The attorney general’s putting together a team whose job it will be to root out any cases of fraud or manipulation in the oil markets that might affect gas prices – and that includes the role of traders and speculators,” President Obama said at a town hall meeting in Nevada on Thursday. “We are going to make sure that no one is taking advantage of American consumers for their own short-term gain.”

That same article quotes Northwestern polisci professor Laurel Harbridge, giving the enabling professoriate’s take on this gambit:

Laurel Harbridge says the formation of the investigative group is a way for the president to take control of the situation without taking more extreme steps.

“Doing something that suggests that there’s at least the possibility that gas prices are high because of manipulation or something like that kind of turns the high gas prices into something that he’s combating and he’s against rather than either a problem that can’t be dealt with or something that’s due to domestic policy decisions,” Harbridge said.

In other words, it’s an opportunistic effort to scapegoat others on the basis of zero evidence in order to distract attention from the real issues–but that’s cool!

Here’s a non-enabling professor’s take:

Craig Pirrong, a finance professor at the University of Houston who specializes in commodity prices, says the task force is hardly needed, since the agencies already have the tools to monitor for fraud and take action. [Yeah.  It’s like their day job.]

“This is a transparently political fishing expedition that insinuates that fraud or manipulation is distorting oil prices without providing even the flimsiest factual basis for such a suspicion,” Pirrong said. “This is part of a broad effort by the administration to deflect criticism with regard to gasoline prices.”

Actually, the “fishing expedition” characterization is probably optimistic.  Especially given Obama’s assertion of ownership of the issue, and his personal identification with the claim that speculators are distorting prices, there is a high likelihood that fishing expedition will give way to witch hunt.  Remember when Obama told bankers “[m]y administration is the only thing standing between you and the pitchforks”?   It is becoming increasingly clear that Obama won’t be standing between oil “speculators” and the pitchforks this time.  Indeed, he’s taking leadership of the mob.

What determines commodity prices is a complex issue.  Injecting superheated political rhetoric won’t improve our understanding, and in fact will inevitably have the exact opposite consequence.  This, combined with the implicit threat of legal investigations and perhaps legal action (“nice little market you have here–wouldn’t want anything to happen do it”) will have no positive consequences, and likely many negative ones.

It’s already ugly out there.  But it just got a whole lot uglier.

It would be nice if this witch hunt was as funny as this one:

I wouldn’t speculate on it, though.

Obama has inserted himself into the oil speculation debate, adding his voice to the baying mob demanding that the usual suspects be rounded up for causing excessively high oil prices:

President Barack Obama on Tuesday blamed speculators for driving gasoline prices higher and straining American consumers, saying there was enough oil in world markets to meet demand.

. . . .

Obama said that global oil supply is adequate and that speculators are driving up prices significantly.

“It is true that a lot of what’s driving oil prices up right now is not the lack of supply. There’s enough supply. There’s enough oil out there for world demand,” Obama said.

“The problem is … speculators and people make various bets, and they say, you know what, we think that maybe there’s a 20 percent chance that something might happen in the Middle East that might disrupt oil supply, so we’re going to bet that oil is going to go up real high. And that spikes up prices significantly.”

Glad that The All Knowing All Seeing Obama is able to assure us that “There’s enough oil out there for world demand.”  Was that before Libya, after, or both?

But let’s consider that last paragraph, about “speculators and people mak[ing] various bets.”  (Are speculators not people?  Or are some people who bet not speculators?  I’m confused.  Not least by the fact that we’ve been told repeatedly that Obama is so0000 articulate.  Or at least his teleprompter is.)

I say: don’t damn these people, but thank the Lord for them.  They are looking  to the future, and evaluating factors that could impact supply and demand in the future.  They are collecting and evaluating information to attempt to determine the likelihood that oil (and other commodities) will become more or less scarce.  This is essential because expectations about the future are crucial for our decision making today: how much oil to store, how many wells to drill, what kind of cars and machinery to build and buy.  You can’t do things right today unless you evaluate future risks carefully.

Yes, sometimes speculators arrive at pessimistic conclusions that cause prices to go up today.  But here’s the thing: without this “speculative” price impact, there will be no adjustments today to the risk of potential future shocks, meaning that the impact of these shocks will be even more severe in the future.

For instance, a rational response to a real risk of a future supply disruption in the Middle East–and does any sentient being believe that the risk of such a disruption has not increased?–is to store (and produce) more oil today.  That increased storage does tend to drive up current prices.

But let’s say that there is no informed speculation, and as a result no additional oil is stored or produced.  If a supply disruption indeed occurs, that oil that isn’t stored isn’t available to cushion the price impact the disruption causes, meaning that prices will spike more without the speculation than with it.  This speculation has made the present a little less pleasant, but only in order to reduce the likelihood of much greater unpleasantness in the future.

Indeed, if there is a criticism to be made of speculation, it is that too much information is collected and prices are too accurate.  Individuals collect information to earn a profit at the expense of the uninformed.  The expenditure of real resources to obtain a transfer is welfare reducing, all else equal.

Even if you buy that critique, though, you can’t criticize speculation on the grounds that Obama chooses.  By collecting information related to future supply and demand conditions, speculators acting as Obama describes ensure the more efficient allocation of resources over time.  Sometimes that indeed causes prices to be higher today–but that’s not a bad thing because it reduces the likelihood of even greater price spikes in the future.

Obama’s resort to populist anti-speculative boob bait is a piece with what we’ve seen in the last days.  I thought Obama and his people had figured out that he was overexposed and had limited his appearances.  But then he gave two speeches–one on Libya, the other on the budget–that went over like lead balloons.  Obviously acting presidential didn’t work, so Obama went back to the one thing he thinks he can do: campaign.

So in April of 2011, we’re seeing appearances and rhetoric that you’d expect to see in October, 2012.  Indeed, apparently the Ryan plan has stung him deeply, and he is responding in full Alinskyite “Pick the Target, Freeze It, Personalize It, and Polarize It” mode.  The level of mendacity is astounding, and in a perverse way, Ryan should be flattered.

How long did that era of new civility last?  Just asking.

This is distressing and revealing.  It is distressing because the nation faces a truly existential fiscal crisis.  It is revealing because it is now painfully obvious that the only thing Obama knows how to do is to fall back on political demagoguery and dishonest personal attacks, delivered in campaign settings long, long before the campaign should begin.

The fact that Obama has joined the anti-speculation know nothings reveals that he’s not the least bit interested in doing anything serious about energy either.  It’s so much easier to blame speculators who are actually providing the signal service of (a) ensuring that market prices reflect information about future supply and demand, and (b) thereby encouraging immediate responses in consumption, production, and storage that will mitigate the adverse impact of those future supply and demand risks.  That’s because it’s so much easier to shoot the messenger than to do something constructive about the message.

CFTC Commissioner Bart Chilton has been touting research that he claims supports his view that speculation has distorted prices, thereby necessitating position limits.   I’ve read each one.  My conclusion: if this is the best he can come up with, the case for position limits is weaker than I thought.  And that’s saying something.

The citations fall into a couple of categories: superficial quasi-academic studies, and quotations from various figures, including some well-known economists, who have done absolutely no serious research on the subject.

Here are my quick takes on each one.

Since Chilton has had three years to trawl the earth to find work that would support his idee fixe, it is rather amazing that this is the best he can come up with. It’s rather sad, actually, that he believes that he is looking at the problem in a “more sophisticated way.” Although Chilton says that based on his literature review, “[i]t’s simply not the case that ‘there is no evidence that financial investors affect commodity prices,'” that’s not true. What I wrote in Regulation last summer, and what I’ve repeated numerous times on this blog remains true. As yet there is no serious theory, and certainly no serious evidence that speculators have distorted commodity prices.

And now on two fronts, as it were.

The battle over the “vertical silo” (i.e., vertically integrated in econspeak as opposed to bizspeak) approach to execution and clearing remains under assault in Europe:

European Union states want to extend a draft law curbing risk in privately negotiated derivatives to the whole sector, which could ultimately dent profitability of the world’s first mega bourse merger.

. . . .

But banks say the merged group should be opened up to clearing competition. Extending the law’s scope to regulating listed as well as OTC derivatives would achieve this goal.

It would make it easier for users to clear listed contracts transacted on Deutsche Boerse or Euronext’s LIFFE derivatives platform elsewhere and not be locked into the group’s clearers.

“The inclination among OTC derivatives fans like us is ‘why differentiate between one derivative and another?’,” said David Clark, chairman of the Wholesale Markets Brokers’ Association.

“The big deal in all this is the competition element with Deutsche Boerse. This move to extend the scope of the draft law has got politics written all over it,” Clark said.  [Politics?  Whoda thunk?]

. . . .

Exchanges sense integrated business models are under threat.

“Some are trying to weaken vertical structures by creating clearing links with other structures. That creates systemic risk and shifts focus away from the real issue of dealing with OTC derivatives,” an exchanges industry official said on condition of anonymity due to the sensitivity of the issue.

The battle between the “verticalists” and “horizontalists” in clearing is a decade old and has never resolved, with the same two countries pitted against each other today as back then.

“Verticalists” and “horizontalists”?  Sounds like something out of Swift.  Count me as a verticalist–or more accurately, a marketalist.  That is, that this is something best left to market processes rather than legislation and regulation.

Now a battle on vertical integration is evidently brewing in the US too.  At least in the eyes of some market analysts, ICE’s CEO Jeffrey Sprecher is worried that a horizontalist, non-marketalist US Department of Justice may condition acceptance of a NASDAQ-ICE-NYSE-EuronextLIFFE merger on opening up of the derivatives clearinghouse (from Bloomberg: no link yet):

IntercontinentalExchange Inc. may drop out of its joint bid for  NYSE Euronext if the U.S. Department of Justice raises concerns about the deal’s combined futures business, Sanford C. Bernstein & Co.’s Brad Hintz said.  ICE, the second-largest U.S. futures market, and Nasdaq OMX Group Inc. made an unsolicited offer for NYSE Euronext last week, valued at $11.3 billion, countering Deutsche Boerse AG’s February offer for $9.53 billion. In the proposal, Atlanta-based ICE would take NYSE’s Liffe futures-trading markets, expanding in Europe. New York-based Nasdaq OMX would take NYSE Euronext’s listings, equity and options units.

ICE and CME Group Inc., the world’s largest futures market, own their own clearinghouses, which may create barriers to entry and be anti-competitive, the U.S. Department of Justice said in 2008. Equity and options exchanges –such as those owned by NYSE Euronext and Nasdaq OMX–use centralized  clearinghouses like OCC that aren’t owned by any one market.

“The most important issue facing these competing offers is the possibility that the ICE/NYSE Liffe merger will resurrect DOJ concerns with vertical integration of futures execution and clearing,” Hintz, an analyst at Sanford C. Bernstein in New York, wrote in a e-mailed note today. “If this issue arises ICE will likely drop out of the bidding and the Deutsche Boerse deal moves  forward.”

Yes, be afraid.  Be very afraid.  I have the sense that the DOJ’s Antitrust Division is itching to attack vertical integration in derivatives, the economics be damned.

* This perhaps corny (perhaps?) title was inspired by my recollection that today is the 149th anniversary of the first day of the Battle of Shiloh.  Two of my great-grandmother’s brothers fought in the battle: Eli and John, who served in the 46th Ohio Volunteer Infantry.

Eli was something of what is called a “Jonah” in the Navy–a hardluck guy.  He was captured at Shiloh, and held in a prison camp in Montgomery, AL for a couple of months.  Exchanged, he returned to Ohio.  He claimed he was unable to return to his regiment because of dysentery contracted during his imprisonment.  His military record includes a note from his family doctor, believe it or not.

His efforts to stay home were unavailing, and he was ordered to report to his unit.  He returned to the 46th shortly before the Battle of Chattanooga.  He proceeded to lose his belt and cartridge box, for which he was dunned $10 pay.  He was then assigned duty as a wagon driver–probably not an endorsement of his soldierly qualities.

Maybe he straightened out, or the need for infantrymen was pressing, for he was in the ranks again for the Atlanta Campaign.  Unfortunately for him.  He was shot in the left arm close to the shoulder joint at the Battle of Dallas, GA, 28 May, 1864.  The surgical record indicates that the regimental doctor performed a resection of his left arm, removing the bone from the shoulder to the elbow.  This surgery was required because the ball struck too close to the joint to amputate.

My great-grandmother told my grandfather that “Uncle Eli had a dead arm.”  His arm dangled uselessly at his side, and my great-grandmother remembers him using his right hand to lift up his left to rest it on the dinner table.

John, on the other hand, served without incident or injury from October, 1861 to the muster out of the regiment in July, 1865.  Pretty amazing, given that the regiment fought at Shiloh, the Siege of Vicksburg, Chattanooga (the storming of Tunnel Hill, the bloodiest part of the battle), the Atlanta Campaign (including the Battle of Atlanta on 22 July, 1864), the March to the Sea, and the Battle of Bentonville.  One lucky brother, one unlucky.

Back when position limits were first being debated at the CFTC in the summer of 2008, here on SWP I questioned whether the Commission had the statutory authority to impose limits in the absence of a finding that “excessive speculation” had caused unwarranted fluctuations in commodity prices.  According to John Kemp of Reuters and Commodities Today, that argument has been raised by numerous commentors on the CFTC position limit NOPR:

The last day of the two-month consultation on Monday witnessed a volley of carefully coordinated submissions from Goldman Sachs, Barclays Capital, Morgan Stanley, the International Swaps and Derivatives Association (ISDA) and a host of others, all urging the CFTC to withdraw the proposed rulemaking.

Many of the objections build upon the criticisms set out at length by the Futures Industry Association (FIA) at the end of last week. The responses help lay the legal paper trail that will be cited when the rule is eventually challenged in the courts.

The gulf between the commission and the industry is so broad it is unbridgeable. A legal challenge to the CFTC’s authority to impose position limits appears inevitable. The only question now is who will bring it. None of the big banks, oil companies or institutional investors is likely to want to court controversy by acting as plaintiff.

But the rule could be challenged by an industry association on behalf of its members (there is safety in numbers) or by any individual firm willing to stand up and accuse the CFTC of over-reaching.

. . . .

But more fundamentally, most objectors argue the CFTC has no rationale and no legal authority to impose position limits at all, notwithstanding passage of the Dodd Frank Act in July 2010 (PL 111-203).

The FIA continues to argue the commission has no authority to impose limits unless it can come up with objective evidence that speculation has actually burdened interstate commerce and position limits are necessary to cure the problem.

BTW, I wasn’t coordinating with anybody.  I think I was the first, and certainly among the first, to raise this issue.

I’m not a lawyer, and especially not an expert on statutory interpretation.  Regardless of whether the law requires the CFTC to act only after making a credible finding that speculation has in fact distorted markets, however, I believe that would be the prudent course.  Given the real potential for harm inherent in the regulation, it should be adopted only if that harm is balanced by some benefit.  Insofar as harm is concerned, if the regulations are binding, that means definitively that they impose costs on market users.  So what is the benefit?  Is it too much to ask the Commission to demonstrate that they are intervening to fix a real problem?

As I noted in my comment to the Commission, it gave a very limited justification for its limits.  What’s more, the limits as proposed were far more expansive than required to fix the problem that the Commission identified.  Thus, in my opinion, the proposed limits are unduly burdensome.  There are far more efficient ways to mitigate the specific problem that the Commission has identified.

On a related note, Kemp omits any discussion of another mandate in Dodd-Frank, namely, that the Commission determine the costs and benefits of its proposed regulations.  Gensler has attempted to stonewall implementation of this black-and-white statutory language.  Although he hides behind statutory language when he does not want to defend substantively his actions (“Don’t look at me!  Congress made me do it!”) he blithely ignores that which he finds inconvenient.  (Yet another soul looking for free options–politicians and regulators are particularly prone to this sort of opportunism.)

This suggests another legal and substantive attack on any position limit rule: even if a finding of “excessive speculation” is not required, the Commission should provide a cost-benefit justification for position limits.  It has not done so.

With good reason.  For if it even tries, the results will be laughable.  The argument I raised in my comment letter would imply that the NOPR would not pass the cost-benefit test, and that it wouldn’t even be close.

But Gensler seems intent on pushing forward.  If he succeeds (which is not assured, as indicated by the Commission’s cancellation of today’s meeting) the (bad) joke will be on the markets–and the millions who depend on them.

So, I presume the industry will see Gensler and the agency in court.  I hope the plaintiffs (whoever they are) make both the statutory authority and cost-benefit analysis arguments.  That would be very interesting.

Steve Landsburg is a marvelous economist.  He has written several things on the Strategic Petroleum Reserve.  Today he invokes the Hotelling Rule to argue that the government should not tap SPR:

If the government starts depleting the oil reserve now (with, presumably, the intent to replenish it in the future), they bid down current prices and bid up expected future prices — creating an incentive for all the other suppliers to sell less now and more in the future — pushing current prices right back up again. For a non-exhaustible resource, this would partially offset the government’s action, but for an exhaustible resource (like, for example, oil) there should be a 100% offset, at least on a naive application of Hotelling’s Rule.

Here (roughly) is the reasoning behind Hotelling’s Rule: The price of oil, in expectation, has to rise at the rate of interest. That’s because leaving oil in the ground is a form of investment, and therefore has to pay the same amount as any other investment (after adjustments for risk, etc.) That pretty much nails down the price path. If a current supplier (like the government) tries to change that price path by increasing current output and lowering the current price, then the expected growth rate (briefly) exceeds the interest rate, inducing everyone else to leave more oil in the ground. They increase this investment until it’s not a good investment anymore, which is to say until they’ve completely offset the effects of the government’s action.

If that’s wrong, it must be because Hotelling’s Rule doesn’t apply, in which case it must not apply for some reason. Has anyone even tried to offer a candidate for that reason?

Let me give that a try, Steve.  Hotelling essentially abstracts from short run rigidities/constraints and stochastic demand and supply.  The only economic decision in the Hotelling world is the rate of extraction.  This was–is–a reasonable abstraction to make in order to understand some crucial issues.  But it is an abstraction.

The more complex reality is that in the short run productive capacity is essentially fixed by the stock of capital–the number of wells, the capacity of the wells, the fields they are in, and so on.  Moreover, output is somewhat inflexible downwards: wells tend to produce at a given rate, unless they are capped.  Capping and uncapping involve fixed costs.  Thus, it is typically inefficient to cap wells in response to a demand decline, especially if that decline is anticipated to be transitory.

Furthermore, both supply and demand are subject to random shocks, and due to the fixed capacity (which limits the ability to expand output, especially in the very short run) and the downward rigidity in output, these shocks cannot be accommodated by adjusting output.  Under these circumstances, it is efficient to hold inventories of oil “above ground” (i.e., oil that has been produced from a well and then stored, as opposed to oil that is “stored” in the oil-bearing formation*).  Like other commodity inventories, these oil inventories can be used to dampen the price impacts of demand and supply shocks.  It is optimal to add to these inventories in response to short run declines in demand or increases in supply, and to draw down on these inventories when the reverse is true.

This is done with commercial inventories of oil.  During the financial crisis and recession, for instance, stocks of oil rose dramatically.  Much of it was stored on ships.  That inventory has been tapped into as demand has risen.  Similarly, the recent oil supply shocks in the Middle East have led commercial inventory holders to draw on those supplies.

There are price implications of these competing stories.  In a Hotelling world, oil futures prices (and the prices of other commodities) are always in full carry, i.e., forward prices exceed spot prices by the rate of interest.  In contrast, the alternative model that I sketch exhibits “backwardations”–situations where forward prices are below spot prices, let alone below spot prices plus interest.

We observe backwardations in the real world.  We observe above ground inventories.  Thus, the Hotelling world is not a precise description of the way the oil market works.

Roughly speaking, Hotelling presents a model of the long run which abstracts from short run rigidities.  The alternative model I discuss focuses on the short run and pays close attention to the implications of these rigidities and the stochastic nature of demand and supply.

It would be nice to have a model that integrates both of these features.  That is very challenging, as it is a high dimensional stochastic dynamic programming problem, with indivisibilities (e.g., fixed costs of exploration, capping and uncapping) and irreversability (there are multiple decision options in oil exploration and production, but investments made when these options are exercised are typically sunk).  Existing models focus on a subset of the relevant features (e.g., including irreversibility while abstracting from above ground storage, including storage but abstracting from adjustments in capacity).

When it comes to SPR, Steve is right to point out the potential interaction between the operation of the SPR and the operations of private storers.  My early posts on this focused on that, focusing on the issue of how commercial storers were affected by the inherently political, and thus difficult to predict, nature of the operation of the SPR.

There is a broader question: Why do we need an SPR in the first place?  Why must the government store?  Why is private storage insufficient?  To determine whether it is optimal to tap SPR today, you need to know why SPR exists in the first place.

One answer is along the lines suggested by the late Earl Thompson (an Alchian student, back in the day) in his analysis of the national defense argument for protectionism.  Thompson argued that one could justify protectionism as a second best response to another market failure.  In particular, government wartime price controls reduce the returns to investing in the production of strategically important materials.  In order to offset the resulting underinvestment, a second best strategy can be to use tariffs and quotas to protect strategic industries.  Protection raises the private rate  of return that is depressed by the possibility of wartime price controls.  This leads to higher investment that offsets the underinvestment resulting from price controls.  Thus, some sort of policy that would otherwise be inefficient (such as protectionism) can be justified on second best grounds for strategic materials that are likely to be subject to wartime price controls or other policies (e.g., taxes) that essentially expropriate from those who have invested in the capacity to produce such materials.

I think you have to make a similar argument for SPR.  It is plausible that in the event of a war the US government would impose price controls on oil.  The anticipation of this would reduce the private returns to investing in oil production capacity.  Filling SPR increases the demand for oil, thereby lifting prices.  This tends to offset the effects of price controls anticipated during wartime.

Moreover, SPR provides a stock of oil that can be utilized for military purposes in the event of a war.  For instance, private storers may hold too little oil in inventory if they anticipate that during a war the government will require them to sell it at below market prices.  SPR can be a second best response to this problem.

Maybe this isn’t exactly the right story, but to justify government provision of storage you need to identify a market failure–or, as in the case of the Thompsonesque story, a government failure–that leads to underprovision of storage and/or investment by private actors.   Once you have this story, you can identify what the appropriate strategy for SPR should be, and can then evaluate whether it is optimal to draw down on this inventory under current conditions.

If it were operated on commercial principles, it would make sense to draw down on SPR inventories: the lack of full carry in the oil market is signaling that there is a short term shortage that can be mitigated by drawing down on inventories, and that’s what commercial storers are doing.  If operated on commercial lines, SPR could generate profits under current conditions by following a similar policy.  But if SPR is instead intended to address a government failure (or a market failure) in which there is a divergence between private incentives and the social optimum, it should not be operated according to the same principles as commercial storage (which only takes into account private benefits and costs).

That’s the direction you need to take to evaluate the prudence of drawing down on SPR.  Hotelling’s Rule doesn’t really help you because it abstracts from crucial aspects of the economics of above ground inventories.  Moreover, even the storage models abstract from the potential for market and government failure.

* This terminology is confusing because some “above ground” inventories are held below ground.  SPR, for instance, is held in subterranean salt caverns.  The relevant distinction is that “above ground” oil has been extracted from its original formation, and moved to some other storage location.

When I taught a course in the Masters of Arts in International Trading, Commodity Finance, and Shipping program at Universite de Geneve last summer there was a corner in coffee.  This year, right when I am teaching in Geneva, there is another coffee corner.  So, before I come next time, I think I’ll put on some coffee spreads.  I’ll announce my travel dates after I put on the trade.

The spread between Gulf Coast oil prices (such as Louisiana Light Sweet) and West Texas Intermediate (at Cushing, OK) remains wide.  The March LLS-WTI spread is $14.42/bbl, and is above $10/bbl through October, 2011.

The key to restoring spreads to more typical levels is breaking the logistical bottleneck south of Cushing, thereby permitting Canadian oil that is weighing on prices in the Midcontinent to flow to the Gulf.  The extension of the Keystone pipeline will help do that, but not for a couple of years.  Another way to ease the logjam is to reverse the Seaway Pipeline, now flowing from the Gulf to Cushing, to carry crude in the opposite direction.

This can have large social payoffs.  Here are some back of the envelope calculations.  Assume the marginal cost of moving oil on Seaway is $1/bbl, and a LLS-WTI spread of around $12/bbl when no oil flows south.  Also assume that the relevant derived demand curve for oil in the Gulf and the supply of oil to Cushing are linear.  The capacity of Seaway is 350,000 bbl/day.  The standard welfare triangle analysis implies that the opening of the pipeline would increase the sum of consumer and producer surplus by at least $1.925 million per day.*

I have been digging for estimates of the cost of reversal, and haven’t found any.  I did find that the reversal of the smaller but longer Spearhead pipeline cost $20 million.  The reversal of Line 9 in Canada cost $100 million.

At a reversal cost of $20 million, the investment would pay for itself in 10 days.  Even at $100 million, it would pay for itself in less than two months.  From a social perspective, this is a no brainer.

But the half-owner of Seaway, Conoco Phillips, says it is not interested in reversal:

ConocoPhillips isn’t interested in reversing the Seaway pipeline that brings crude from the U.S. Gulf Coast to the fuel hub in Cushing, Oklahoma, where inventories of crude oil reached a record high last month.

“We don’t really think that’s in our interest because we need more crude in the area” to supply the company’s refineries in the Midcontinent, Jim Mulva, ConocoPhillips’s chief executive officer, said during a conference call hosted by ISI Group today.

“We don’t think that’s in our interest.”  Which points out that the opening of the pipeline would have distributive effects.  Those are fairly straightforward to figure out.  Opening Seaway would raise crude prices in the Midcontinent, and reduce them in the Gulf, although probably only slightly (as the marginal barrels will be imported).  Gulf refineries are suppliers of the marginal refined barrels in most markets in the Midwest, South, and East, so product prices would probably fall slightly too.

These changes would benefit Gulf refiners (probably slightly), and harm Midcontinent refiners.  Due to the crude price differential, Midcon refiners are operating at higher rates of utilization than Gulf refiners; through February PADD II refiners were working at mid-90s utilization, PADD III in the low 80s, although that differential narrowed in the last couple of weeks with Midcon utilization falling into the mid-80s, probably due to the rise in crude costs resulting from the Mideast turmoil.  Opening Seaway would raise Midcon crude prices, harming refiners there (which would be reflected in reduced utilization).

The main beneficiaries of the rising Midcon prices resulting from a Seaway opening would be Canadian and Bakken crude suppliers.  So the opening of Seaway would transfer wealth from Midcontinent refiners to firms supplying crude to the Midcontinent.

Although the opening would redistribute wealth, the calculations above show that the pie would get bigger.  This means that there is the potential for a Coasean bargain** that could make refiners (including Conoco) and crude suppliers better off.  Roughly speaking, the deal would involve crude suppliers buying Conoco’s 50 percent of Seaway.

Easier said than done, of course.  There are costs of assembling the coalition of buyers (because there are multiple suppliers of crude), and costs of negotiating a deal with Conoco.  The negotiating costs exist in part because there are information asymmetries: Conoco, for instance, knows more about how the profitability of the refinery varies with the price of crude than would the purchasers of Seaway.

But the potential for the expansion of the pie is an enticement for doing an deal.  Perhaps Conoco’s expressed indifference is just a bargaining pose.  Perhaps somebody will make a bid that will make it worth Conoco’s while.  The money is there–on the order of $2 million per day.  Who will structure the deal to make it happen?

* .5 x 350,000 bbl/day * ($12/bbl-$1/bbl)=$1.925 mm.  Note this assumes that  when Seaway operates at full capacity, the LLS-WTI spread equals the marginal cost of shipment.  This means that the shadow price of capacity is zero.  If at full utilization the difference between LLS and WTI exceeds the marginal cost of shipment, the shadow price of capacity is positive and the welfare gain from opening Seaway is greater: there is a welfare trapezoid that contains the welfare triangle whose area I just calculated.  If in equilibrium Seaway operates below capacity, the welfare gain is smaller that I calculated.

** A phrase Coase dislikes, but which is widely used.