Streetwise Professor

I’ve often written that every big move in commodity prices leads to a reprise of Casablanca: “Round up the usual suspects!”

The usual suspects, of course, being speculators.

And here we have a case of the usual suspects calling for a roundup of the usual suspects. People like Michael Greenberger and Tyler Slocum. I would be more than glad to move on. Them apparently not so much.

Now they feel especially energized because they can blame speculators not just for a rise in the price of this or the price of that, but the price of everything. Yes, boys and girls, speculators cause INFLATION!!!!! THEY ARE DRIVING UP THE PRICE OF EVERYTHING!!!!

A handful of congressional Democrats are turning their attention to an arcane loophole that, as TYT previously reported, is driving high prices for gas and food. Rep. Ro Khanna, D-Calif., told TYT that he wants the Biden administration to close the loophole, which lets Wall Street speculators gamble on commodity prices, driving inflation.

I’ll get back to “Ruh Ro” Khanna in a moment.

What Greenberger and others are serving up is the same-old, same-old that was discredited long ago. It’s too tedious to reprise the arguments: go back and look at my posts from 2006-2009 or so. The BS hasn’t changed, so the response to the BS hasn’t changed.

The quickest counterpoint: If–and even Paul Krugman and I agree on this, people, so the apocalypse must be nigh–speculators are driving prices above the competitive level determined by supply and demand fundamentals, (a) inventories increase, and (b) speculators hold the inventories.

Well, inventories are dropping to rock bottom levels in everything from oil, to diesel, to industrial metals. So (a) isn’t happening. And if (a) isn’t happening, (b) can’t happen.

QED.

But this would require Greenberger et al to have a modicum of understanding of economics. In fact, I once forced him to admit he has no such understanding.

We were witnesses at a House Ag Committee hearing on speculation and oil prices in July, 2008. Right about the time WTI hit its all time high. (I published a WSJ oped about the same time.). Greenberger and I were on a panel. He tried to make an argument that prices were irrational because they hadn’t gone down when the Saudis announced an increase in output. I pointed out that the real shortage was in low-sulfur crude (like WTI), driven in large part by Europe’s new low sulfur diesel rules. The Saudi oil was high in sulfur and didn’t address this issue at all, so it didn’t impact the prices of WTI and Brent (which are low sulfur).

In reply, Greenberger stuttered: “Well, I’m not an economist . . .” I interrupted: “That’s the first thing you’ve ever said that I agree with.” (Yeah. I know I’m bad. I can never pass up an easy shot.)

That still holds true. He ain’t an economist. He knows no economics. And anybody who listens to him bloviate about economics is wasting time and killing brain cells. (Though looking at his audience–Salon AKA Daily Dipshit readers, congressional Democrats–that latter is pretty much impossible.)

These geniuses think they’ve uncovered some damning new evidence. In footnotes:

But thanks to an obscure CFTC passage — Footnote 563, in regulatory guidance — buyers and sellers of oil and other commodities are outnumbered something like 10 to one by Wall Street traders, none of whom have a genuine buyer’s incentive to keep prices low, because few of them ever actually buy it; they mostly bet on it.

Uhm, that factoid, or a variant thereon, has been tossed around every time this tiresome debate has occurred. It was irrelevant every one of those times. It’s irrelevant now. It means nothing.

But some geniuses in Congress are going to flog this dead horse yet again. FFS.

But this is not the only idiocy that is being resurrected. Ron Wyden D-But you knew that-OR is proposing a revival of the windfall profit tax.

Another ’70s acid flashback. I’m trippin’, man!

pic.twitter.com/Wxw4EMk27e

— streetwiseprof (@streetwiseprof) June 14, 2022

Yeah that worked so well under Carter. Hey! Here’s an idea! Let’s reduce the incentive to invest by reducing payoffs when the investments are most valuable! What could go wrong?

Another hardy perennial: Our ranting senile narcissist in chief is demanding refiners cut prices and increase output. Er, look at the EIA capacity utilization numbers, dude. Refineries are operating flat out.

Apparently they did that, because today they mooted restricting exports instead. Another dumb idea.

And then there’s Ruh Ro Khanna:

Thanks for the heads up on "Ruh Roh" Khanna's insanity. I'll do a little more research and then bring the lumber to him. pic.twitter.com/WOn6Ls9l8X

— streetwiseprof (@streetwiseprof) June 3, 2022

h/t @CantillonCH

Khanna’s brainstorm is–get this–to have the government “buy the dips” and then sell commodities to consumers at low prices.

WHY HASN’T ANYBODY THOUGHT OF THIS BEFORE????

Well, because it’s so stupid only a California Democrat could come up with it.

Of the top of my head, Family Feud fashion, the top 4 reasons why this is stupid:

1. The best traders can’t time the market consistently. Why would anyone possibly believe government GS-13s or whatever could?
2. The government wouldn’t be a price taker–it would be driving prices.
3. Every trader in the world would be trying to front run the government. Talk about creating speculative opportunities! Speculate on what the government is going to do!
4. A California Democrat came up with it.

Bad economic times bring out bad economic ideas. Stupid never goes out of style in politics, and bad ideas never die. And that’s our reality today.

Mark Twain never grows old:

“Reader, suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”

This came to mind when reading about the proposal of Rep. Katie Porter to impose some sort of price control on gasoline:

Oil giant @Shell reported a record $9 billion in quarterly profit—3x its earnings a year earlier. Like @exxonmobil and @Chevron, it plans to use windfall profits to enrich shareholders.

I just introduced a bill to crack down on Big Oil's price-gouging.https://t.co/qsF5wmLJ4Y

— Rep. Katie Porter (@RepKatiePorter) May 6, 2022

Since the beginning of recorded history–and that is not hyperbole–the stock government response to high prices is price controls. The Pharaohs. Hammurabi. Diocletian. And many other examples. And it continues through the ages to more recent history, e.g., rent control in NY starting in WWII, Nixon in 1973.

And the result is always the same: economic disaster. It is price controls result in real shortages: people standing in lines, empty shelves, etc.

Always. If price doesn’t clear the market, waste (e.g., time spent standing in line) will.

But politicians never learn.

Nancy Pelosi (who is old enough to remember gas lines–hell, she’s probably old enough to remember the Code of Diocletian, if not that of Hammurabi) is of course fully on board. Which is an illustration that the adage “those who don’t remember the past are condemned to repeat it” is wrong: many who can remember the past repeat its errors nonetheless.

Elizabeth Warren hasn’t weighed in on this yet, but you know she will, because she’s the main spokes-shrieker for The Gouger Theory of Prices.

The Gouger Theory is stupid on its face. Did oil companies wake up one morning and realize: “Whoa! We coulda jacked up prices and gouged the suckers! What were we thinking?” Did they have some sort of epileptic fit in 2020, when prices crashed? What were they thinking?

No. This isn’t gouging. This is-as it almost always is-fundamentals.

Oil prices are high. But in this week’s edition of “Find the Bottleneck,” that’s only one of the drivers (no pun intended) behind high gasoline and diesel prices. The bottleneck is in refining.

How do we know? Let’s look at the diesel crack:

It’s gone from around $22/bbl to as high as $70/bbl. (And the $22 is high compared to what it was a year ago). (Gasoline crack somewhat similar though not as bad–though it is likely to get so when the peak demand season kicks in.)

A high refining margin means that refinery capacity is constrained. And yes, it is constrained: it’s not as if refiners are exercising market power (i.e., gouging) by withholding output. Here is the capacity utilization in the US over time:

It’s running at pre-Pandemic levels.

And here’s another thing: post-Pandemic capacity is well below pre-Pandemic capacity:

That drop from pre-Pandemic levels is around 5 percent. That’s a lot.

So refineries are running flat out, and refinery capacity is down. What do you get?: big refining margins and high prices at the pump. Yes, it’s good to be a refiner now (though not so much two years ago). But it’s not good because you get to exercise market power. It’s because even under competition it’s highly profitable because of supply-demand fundamentals.

A variety of factors have contributed to this. The loss of a good chunk of Russian oil output is keeping the price of oil up, but the loss of Russian diesel supplies to Europe is probably a bigger factor. The US is to a large extent filling the gap, to the extent it can, by exporting.

But no matter how you break it down, it is clear that this is fundamentals driven. It is not gouging. And capping prices on the delusional belief that it is gouging will wreak economic havoc.

Which has never stopped the Democrats before, I know. (And Republicans too, e.g., Nixon).

One thing here does deserve emphasis. The decline in capacity is directly attributable to the Pandemic. Correction: it is directly attributable to the horrible policy choices that politicians and bureaucrats forced on us in the name of the Pandemic. The lockdowns in particular.

Like many, many things going on in commodity world right now, the current spike in product prices overall, and relative to crude, is yet another baleful consequence of completely mental decisions to shut down economies and crater the economics of producing and processing commodities.

In other news of economic-related political hysteria, there is also a lot of finger pointing going on about baby formula. I don’t have the information at hand to analyze in the same way as I can refined petroleum prices, but I can say what it isn’t. It isn’t “oligopoly.”

But again, those educated in politics (did I really use “educated” and “politics” in the same sentence?) and not economics immediately seize on this as an explanation.

Er, the baby formula business was an oligopoly a year ago. And a year before that. And a year before that. So . . . why all of a sudden did they supposedly decide to create a shortage? And pray tell–how do you make money if you aren’t selling stuff?

So whenever Congresspeople, or people who buzz around them like insects (yeah, I’m looking at you, journalists) come up with some economic brainstorm, remember Twain. They’re idiots. Dangerous idiots.

The LME restarted trading of nickel. Well, sort of. In the first five sessions prices were limit down, and trading stopped as soon as the limits were hit. The LME deemed two subsequent sessions “disrupted” and declared the trades in these sessions “null and void.”

In other words: more mulligans after the trade cancellations that followed the spike to $100K/tonne prices. The LME should change its name to the London Mulligan Exchange. Which is not a good look.

Departing LME CEO Matthew Chamberlain tried to shift blame last week, claiming that the problem was that the exchange did not have visibility into risk due to the fact that approximately 80 percent of Tsingshan’s nickel position was in the form of OTC trades with big banks, such as JP Morgan. This is weak excuse. It is highly likely that the banks hedged their Tsingshan exposure on the LME, so the exchange saw the positions, but just didn’t know for sure exactly who was behind them. But the LME has known for months (years actually) that Tsingshan was the elephant in the nickel ring, and that the banks who were short the LME were almost certainly hedging an OTC exposure. The LME should have been able to add two and two.

The price increases today and in the previous session suggest that the short covering is ongoing, and that the “I’m going to hang on to my position” rhetoric from Tsingshan, and the insinuations that the banks were allowing it to extend and pretend, are therefore not correct. It (and perhaps other shorts) are trying to reduce positions. Continued gyrations are therefore likely, and a default that would make recent “disruptions” look like child’s play is not out of the question. The fear of this is likely what is causing the LME to take actions (voiding trades) that only further blacken its already dusky reputation. To a fox caught in a trap, chewing off a leg is the best option.

The tumult in the commodity markets has led to suggestions that major commodity trading firms, e.g., Glencore, Trafigura, Gunvor, Cargill, may be “Too Big to Fail.”

I addressed this specific issue in two of my Trafigura white papers, and in particular in this one. The title (“Not Too Big to Fail”) pretty much gives away the answer. I see no reason to change that opinion in light of current events.

First, it is important to distinguish between “can fail” and “too big to fail.” There is no doubt that commodity trading firms can fail, and have failed in the past. That does not mean that they are too big to fail, in the sense that the the failure of one would or could trigger a broader disruption in the financial markets and banking system, a la Lehman Brothers in September 2018.

As I noted in the white paper, even the big commodity trading firms are not that big, as compared to major financial institutions. For example, Trafigura’s total assets are around $90 billion at present, in comparison to Lehman’s ~$640 billion in 2008. (Markets today are substantially larger than 14 years ago as well.). If you compare asset values, even the biggest commodity traders rank around banks you’ve never heard of.

Trafigura is heavily indebted (with equity of around $10 billion), but most of this is short term debt that is collateralized by relatively liquid short term assets such as inventory and trade receivables: this is the case with many other traders as well. Further, much of the debt (e.g., the credit facilities) are syndicated with broad participation, meaning that no single financial institution would be compromised by a commodity trader default. Moreover, trading firm balance sheets are different than banks’, as they do not engage in the maturity or liquidity transformation that makes banks’ balance sheets fragile (and which therefore pose run risk).

Commodity traders are indeed facing funding risks, which is one of the risks that I highlighted in the white paper:

The extraordinary price movements across the entire commodity space have resulted in a large spike in funding needs, both to meet margin calls (which at least in oil should have been reversed with the price decline in recent days–nickel remains to be seen given the fakakta price limits the LME imposed) and higher initial and maintenance margins (which exchanges have hiked–in a totally predictable procyclical fashion). As a result existing lines are exhausted, and firms are either scrambling to raise additional cash, cutting positions, or both. As an example of the former, Trafigura has supposedly held talks with Blackstone and other private equity firms to raise $3 billion in capital. As an example of the latter, open interest in oil futures (WTI and Brent) has dropped off as prices spiked.

To the extent margin calls were on hedging positions, there would have been non-cash gains to offset the losses on futures and other derivatives that gave rise to the margin calls. This provides additional collateral value that can support additional loans, though no doubt banks’ and other lenders terms will be more onerous now, given the volatility of the value of that collateral. All in all, these conditions will almost certainly result in a scaling back in trading firms’ activities and a widening of gross margins (i.e., the spread between traders’ sale and purchase prices). But the margin calls per se should not be a threat to the solvency of the traders.

What could threaten solvency? Basis risk for one. For examples, firms that had bought (and have yet to sell) Russian oil or refined products or had contracts to buy Russian oil/refined products at pre-established differentials, and had hedged those deals with Brent or WTI have suffered a loss on the blowout in the basis (spread) on Russian oil. Firms are also likely to handle substantially lower volumes of Russian oil, which of course hits profitability.

Another is asset exposure in Russia. Gunvor, for example, sold of most of its interest in the Ust Luga terminal, but retains a 26 percent stake. Trafigura took a 10 percent stake in the Rosneft-run Vostok oil project, paying €7 billion: Trafigura equity in the stake represented about 20 percent of the total. A Vitol-led consortium had bought a 5 percent stake. Trafigura is involved in a refinery JV in India with Rosneft. (It announced its intention to exist the deal last autumn, but I haven’t seen confirmation that it has.). If it still holds the stake, I doubt it will find a lot of firms willing to step up and pay to participate in a JV with Rosneft.

It is these types of asset exposures that likely explain the selloff in Trafigura and Gunvor debt (with the Gunvor fall being particularly pronounced.). Losses on Russian assets are a totally different animal than timing mismatches between cash flows on hedging instruments and the goods being hedged caused by big price moves.

But even crystalization of these solvency risks would likely not lead to a broader fallout in the financial system. It would suck for the owners of a failed company (e.g., Torben Tornqvuist, who owns ~85 percent of Gunvor) but that’s the downside of the private ownership structure (something also discussed in the white papers); Ferrarri and Bulgari sales would fall in Geneva; banks would take a hit, but the losses would be fairly widely distributed. But in the end, the companies would be restructured, and during the restructuring process the firms would continue to operate (although at a lower scale), some of their business would move to the survivors (it’s an ill wind that blows no one any good), and commodities would continue to move. Gross margins would widen in the industry, but this would not make a huge difference either upstream or downstream.

I should also note that the Lehman episode is likely not an example of a domino effect in the sense that losses on exposures to Lehman put other banks into insolvency which harmed their creditors, etc. Instead, it was more likely an informational cascade in which its failure sent a negative signal about (a) the value of assets held widely by other banks, and (b) what central banks could or would do to support a failing financial institution. I don’t think those forces are at work in commodities at prsent.

The European Federation of Energy Traders has called upon European state bodies like European Investment Bank or the ECB to provide additional liquidity to the market. There is a case to be made here. Even though funding disruptions, or even the failure of commodity trading firms, are unlikely to create true systemic risks, they may impede the flow of commodities. Acting under the Bagehot principle, loans against good collateral at a penalty rate, is reasonable here.

The reason for concern about the commodity shock is not that it will destabilize commodity trading firms, and that this will spill over to the broader financial system. Instead, it is that the price shock–particularly in energy–will result in a large, worldwide recession that could have financial stability implications. Relatedly, the food price shocks in particular will likely result in massive civil disturbances in low income countries. A reprise of the Arab Spring is a serious possibility.

If you worry about the systemic effects of a commodity price shock, those are the things you should worry about. Not whether say Gunvor goes bust.

In a weird counterpoint to the LME nickel story, another big clearing-related story that is causing a lot of consternation in derivatives circles is FTX exchange’s proposal to move to a direct clearing model that would dispense with FCMs as intermediaries. Instead of having an FCM interposed between a customer and the clearinghouse, the customer interfaces directly with the FTX Derivatives Clearing Organization (DCO).

What is crucial here is how this is supposed to work: FTX will utilize near real time mark-to-market and variation margin payments. Moreover, the exchange will automate the liquidation of undermargined positions, again basically in real time.

The mechanics are described here.

FTX describes this as being the next big thing in the derivatives markets, and a way of addressing systemic risks. Basically the pitch is simple: “real time margining allows us to operate a pure no credit/loser pays system.”

FTX touts this as a feature, but as the nickel experience demonstrates (and other previous episodes demonstrate) it is not. Margining generally can be destabilizing, especially during stressed market conditions, and the model FTX is advancing exacerbates the destabilizing potential of margining.

The mechanical means of addressing margin shortfalls on a real time frequency increases the tight coupling on the exchange, and is tailor made to create destabilizing positive feedback loops: prices move a lot leading to margin shortfalls in real time that trigger real time trades that accentuate the price movement. It is like seeding the market with huge numbers of stop orders, which are inherently destabilizing. Further, they can create incentives to manipulate. Anyone who can get some idea of where the stops are can “gun the stops” and trigger big price moves.

This instability potential can be exacerbated by the ability of traders to hold collateral in the form of the “underlying” (i.e., crypto, at present). Well, the collateral value can fluctuate, and that can contribute to margin shortfalls which again trigger stops.

Market participants can mitigate getting stopped out by substantially over-margining, i.e., holding a lot of excess margin in their FTX account. But this is a cash inefficient way of trading.

It’s not clear to me whether FTX will pay interest on collateral. It seems not. Hmmm. Implementing a model that incentivizes holding a lot of extra cash at FTX and not paying interest. Cynic that I am, that seems to be a great way to bet on higher interest rates! Maybe that’s FTX’s real game here.

I would also note that the “no leverage” story here reflects a decidedly non-systemic view (something that I pointed out years ago in my critiques of clearing mandates). Yes, real time margining plus holding of substantial excess margin reduces to a small level the amount of leverage extended by the CCP/DCO. But that is different than reducing the amount of margin in the system as a whole. People who have borrowing capacity and optimal total leverage targets can fund their deposits at FTX with leverage from other sources. They can offset the leverage they normally obtain from FCMs by taking more leverage from other sources.

In sum, FTX is arguing that its mechanism of direct clearing and real time margining creates a far more effective “no credit” clearing system than the existing FCM-intermediated structure. That’s likely true. But as I’ve banged on about for years, that’s not necessarily a good thing. The features that FTX touts as advantages have very serious downsides–especially in stressed market conditions where they tend to accelerate price moves rather than dampen them.

Insofar as this being a threat to the existing intermediated system, which many in the industry appear to fear, I am skeptical. In particular, the cash inefficiency of this mechanism will make it unattractive to many market participants. Not to be Panglossian, but the existing intermediated system evolved as it did for good economic reasons. It trades off credit risk and liquidity risk. It does so in a somewhat discriminating way because it takes into account the creditworthiness of market participants (something that FTX brags is unnecessary in its system). FTX is something of a corner solution that the market has not adopted despite the opportunity to do so. As a result, I don’t think that corner solution will have widespread appeal going forward.

If you use the official LME nickel and copper prices from Monday, before the exchange stopped trading of nickel, you can determine that the value of the metal in a US nickel coin is worth a dime. As the shutdown lingers, one wonders whether the LME is too.

The broad contours of the story are understood. A large Chinese nickel firm (Tsingshan Holdings, largest in the world) was short large amounts of LME nickel, allegedly as a hedge. But the quantity involved seems very outsized as a hedge, representing something like two years of output. And if the position was concentrated in nearby prompt dates (e.g., 3 months) it involved considerable curve risk.

The Russian invasion juiced the price of nickel, not surprising given Russia’s outsized presence in that market. That triggered a margin call (allegedly $1 billion) that the firm couldn’t meet–or chose not to. That led its brokers to try to liquidate its position in frenzied buying on Monday evening. This short covering drove the price from the close of around $48,000 to over $100,000.

That’s where things got really sick. The LME shut the nickel market. It was supposed to reopen today, but that’s been kicked down the road. But the LME didn’t stop there. It decided that these prices did not “[reflect] the the underlying physical market,” and canceled the trades. Tore them up. Poof! Gone!

Now in a Back to the Future moment echoing the 1985 Tin Crisis, the LME is trying to get the longs and shorts to set off their positions. “Can’t we all just get along?” Well likely not, because it obviously requires agreeing on a price. Which is obviously devilish hard, if not impossible given how much money changes hands with every change in price. (In my 1995 JLE paper on exchange self-regulation, I argued that exchanges historically did not want to intervene in this fashion even during obvious manipulations because of the rent seeking battles this would trigger.)

So the LME remains closed.

Some observations.

First, told ya. Seriously, in my role as Clearing Cassandra during the Frankendodd era, I said (a) clearing was not a panacea that would prevent defaults, and (b) the clearing mechanism was least reliable precisely during periods of major market stress, and that the rigid margining mechanism is what would threaten its ability to operate. That’s exactly what happened here.

Second, clearing is supposed to operate under a “loser pays/no credit” model. That’s really something of a misconception, because even though the clearinghouse does not extend credit, intermediaries (brokers/FCMs) routinely do to allow their clients to meet margin calls. But here we evidently have a situation in which the brokers (or Tsingshan’s banks) were unwilling or unable to do so, which led to the failure of the loser to pay.

Third, by closing the market, the LME is effectively extending credit (“you can pay me later”), and giving Tsingshan (and perhaps other shorts) some time to stump up some additional loans. Apparently JPM and the Chinese Construction Bank have agreed in principle to do so, but a deal has been hung up over what collateral Tsingshan will provide. So the market remains closed.

For its part, Tsingshan and its boss Xiang “Big Shot” Guangda are hanging tough. The company wants to maintain its short position. Arguably it has a strong bargaining position. To modify the old joke, if you owe the clearinghouse $1 million and can’t pay, you have a problem: if you owe the clearinghouse billions and can’t pay, the clearinghouse has a problem.

The closure of the market and the cancelation of the trades suggests that the LME has a very big problem. The exact amounts owed are unknown, but demanding all amounts owed now could well throw many brokers into default, and the kinds of numbers being discussed are as large or larger than the LME’s default fund of $1.2 billion (as of 3Q21 numbers which were the latest I could find).

So it is not implausible that a failure to intervene would have resulted in the insolvency of LME Clear.

The LME has taken a huge reputational hit. But it had to know it would when it acted as it did, implying that the alternative would have been even worse. The plausible worst alternative would have been a collapse of the clearinghouse and the exchange. Hence my quip about whether the exchange that trades nickel is worth a dime.

Among the reputational problems is the widespread belief that the Chinese-owned exchange intervened to bail out Chinese brokerage firms and a Chinese client. To be honest, this is hard to differentiate from intervening to save itself: the failure of the brokerages are exactly what would have brought the exchange into jeopardy.

I would say that one reason Xiang is hanging tough is that the CCP has his back. Not CCP as in central counterparty, but CCP as in Chinese Communist Party. That would give Tsingshan huge leverage in negotiations with banks, and the LME.

So the LME is playing extend and pretend, in the hope that it can either strongarm market participants into closing out positions, or prices return to a level that reduce shorts’ losses and therefore the amounts of variation margin they need to pay.

I seriously wonder why anyone would trade on the open LME markets (e.g., copper) for reasons other than reducing positions–and therefore reducing their exposure to LME Clear. The creditworthiness of LME Clear is obvious very dodgy, and it is potentially insolvent.

Fourth, in an echo of the first point, this episode demonstrates that central clearing, with its rigid “no credit” margining system is hostage to market prices. This is usually presented as a virtue, but when markets go wild it is a vulnerability. Which is exactly why it is–and always was–vain to rely on clearing as a bulwark against systemic risk. It is most vulnerable precisely during periods of market stress.

All commodity markets are experiencing large price movements that are creating extraordinary variation margin flows, potential positive feedbacks, and the prospect for troubles at other clearers. Further, the broader economic fallout from the Ukraine war (which includes, for example, a large recession resulting from the commodity price shocks, or a Russian debt default) has the real potential to disrupt equity and bond markets. This would put further strains on the financial markets, and the clearing system in particular. Central Banks–notably the Fed–had to supply a lot of liquidity to address shocks during the Covid Panic of March 2020. Two years later, they may have to ride to the rescue again.

The Russian invasion of Ukraine has not shocked and awed the Ukrainian military, but it has shocked and awed Germany, fo’ sho’.

In a period of hours over the weekend (and remember, German stores close promptly at 6 and are not open on Sunday), Germany announced that it will:

(a) Increase defense spending to 2 pct of GDP.

(b) Build two new LNG import facilities.

(c) Consider delaying decommissioning its nukes.

(d) Consider all options for energy, including gas, nuclear, and coal: there are no longer any “taboos” on energy sources.

What will Greta say?:

The Germans are saying, in effect: Go away girl. The shit just got real.

I note that (a) and (b) topped the list of Donald Trump’s harangues against Germany, which caused the ruling class to shriek in anger: how dare he insult our dear allies? Actions speak far louder than an apology.

Alas, this reality therapy has not penetrated the thick skulls of the Biden administration. When asked about reversing Biden administration anti-fossil fuel policies, spokesmoron Jen Psaki instead continued to ride the renewables hobby horse. She thereby reinforced the message of the Most Clueless Man in the World, John Kerry, whose big concern about Ukraine is that it might distract Vladimir Putin from focusing on climate change.

Yes, reality is a mother. Enough of a mother to snap even the dreamy Germans out of their green and pacifistic reveries. But not enough of one to do the same in the Biden administration.

When playing Spin the Bottleneck with my students I say to look at what lies between the price of a transformed and untransformed commodity to identify the bottleneck. In my earlier post on the gaping spread between European (and Asian) LNG prices and the price of US gas (which is on the margin for both destinations) I noted two possible constraints: shipping and liquefaction capacity.

Well, it ain’t shipping.

There is a surfeit of LNG shipping capacity. So much that LNG shipping is effectively free between the US and Europe (down from $273K/day in December). Yet the spread remains very wide. So the binding constraint is definitely liquefaction capacity, in the US in particular. Those who have the rights to that capacity–notably firms that entered into contracts with the likes of Cheniere or Freeport that buy gas at the US price and pay a contractually fixed liquefaction/tolling fee–are coining it. They capture the bulk of the existing spread between TTF or UK Balancing Point prices and Henry Hub. (The LNG companies are benefitting only to the extent that they reserved some of their capacity for their own trading, which is rather de minimis).

So in the short run liquefaction capacity is quite valuable. The question is what will its value be over the longer term? Will current events convince enough financiers to provide capital for a large expansion of US capacity? Given the long gestation period of these projects it is a hard issue for banks and equity to analyze.

One thing to note. Another thing I discuss extensively in my classes is the importance of government/regulatory bottlenecks. Such bottlenecks may be a constraint on expansion of US LNG capacity. Many of the projects under development do not have the requisite federal permits. The Biden administration is unlikely to grant more. Thus, like taxicab medallions in NYC, existing permits likely have a substantial scarcity value–thanks to a government-created bottleneck.

This has interesting implications for financing of US LNG projects. Financiers of a given project face less risk of a glut of capacity coming online in a few years, and this should make them more willing to finance already permitted projects. But, of course, they are taking on political risk by doing so: might a new administration change course post-2024? Or might political pressure induce a change in course by the current administration? There are already a lot of political risks in investing in anything fossil-fuel related (attributable to climate hysteria). This is a US LNG-specific risk.

Although conditions have eased somewhat, Europe’s energy situation is still fraught. It has experienced a winter of extremely high power prices and natural gas prices. Some luck with weather in January brought some relief, but who knows what the next months have in store.

As if demand and non-Russia supply fundamentals didn’t pose enough difficulties, Russia has proved a gas supply riddle, mystery, and enigma. The Ukraine situation has only made the situation more fraught, with a prospect that things could get very cold in Europe if the conflict between Russia and Ukraine goes hot.

In anticipation of this, the Biden administration has played its by now familiar role of supplicant, appealing to major LNG suppliers–notably Qatar–to increase output and divert supplies to Europe, and to major buyers (e.g., Japan) to direct supplies to Europe.

Good luck with that. There is nothing that can be done to augment global supplies in the short run, let alone by enough to address a material loss of gas from Russia.

The world LNG industry is operating at effectively full capacity. Although supplies produced anywhere can physically go anywhere, there are no more additional supplies to be had. So if Russian gas exports decline, LNG cannot fill the gap.

This is illustrated by the US, which recently became the world’s largest supplier of LNG. Note how US exports have remained essentially constant (at about 300 bn cubic feet/month) since around March 2021, despite skyrocketing prices for gas:

There’s another way to see that liquefaction capacity is the bottleneck. This is the spread between the price of LNG in Asia (JKM) and Henry Hub NG:

My teaching mantra (repeated last night to my Energy Derivatives students!) is that spreads price bottlenecks in the transformation process. The spread depicted here captures two potential bottlenecks in transforming US produced gas into gas delivered in Asia (or Europe): US liquefaction capacity and shipping costs. Shipping costs have increased, but not nearly enough to explain the rise in the spread in 2021, especially the explosion starting in mid-September. This is a clear indication that US liquefaction capacity is a binding constraint. The extreme volatility in the spread also demonstrates this. Shocks to demand in Europe or Asia can’t be accommodated by adjustments in supply, so all the burden falls on the spread. Thus, even slight demand shifts can lead to big spread moves.

As for reallocating supplies between Europe, Asia, and South America, Mr. Market can handle this, and is indeed handling it to a considerable degree. As the demand balance shifts between Asia and Europe, LNG carriers are changing destinations in mid-voyage. In an extreme case a ship that had already transited the Panama Canal en route to Hawaii reversed direction, transited the canal eastbound, and delivered its cargo in the UK. In short, what is going on is a classic example of how the price mechanism allocates resources to their highest value use, and how commodity traders optimize flows. (It also largely validates the predictions of my 2014 white paper on LNG.)

The main impediment appears to be contractual. Specifically, destination clauses in legacy contracts, specifically those for Qatar Gas. These clauses prevent the buyer from reselling the cargo to other markets.

Perhaps the administration was begging Qatar to relent on these, but if so, their appeals appear to have fallen on deaf ears (despite the US promoting Qatar to “major non-Nato ally). Qatar says it views its contractual commitments as sacrosanct:

“Keeping our contractual word is sacrosanct in Qatar,” said Kaabi, implying that it will not be possible to divert to Europe gas shipments already contracted for delivery to other countries without their consent.

This smacks of dishonesty. It is not the buyers‘ consent that matters here: if the price is right, Asian buyers would be happy to ship contracted gas to Europe if the price is right. And it appears that the price is right: the “arb” between Asia appears open (i.e., the TTF price is above JKM by more than the cost of shipment). So what’s stopping it from being closed? Almost certainly Qatar’s failure to consent to waiving the destination clauses (in its supersekret contracts). (Destination clauses limit the ability of the buyer to divert cargoes to other locations, and are basically a means of price discrimination.)

Relatedly, Qatar has said it is willing to sell gas to Europe . . . as long as the Europeans consent to destination clauses. Oh, and Qatar is exploiting Europe’s straits by demanding Europe “resolve a long-running EU probe into Qatar’s long-term gas contracts, for the EU to be less dependent on spot sales and more on long-term contracts to boost its energy security.”

Kind of Russian, when you think about it. When you have them by the short ones . . . . With “allies” like these!

In brief, Europe is SOL, especially if there is a material disruption in Russian gas supplies. The world capacity of LNG is maxed out and cannot fill any supply void. The market is working to allocate supplies efficiently, but that process is impeded by an opportunistic actor that really doesn’t want the spot market to work.

Meaning that the best that post-religious Europe can do right now is pray for balmy weather, high winds, and Russian forbearance. Good luck with that.

Due to the immovable object of price caps and the irresistible force of spiking natural gas and power costs, about 20 retail energy suppliers in the UK have gone toes up. Most of these have been addressed using what is called the Supplier of Last Resort (SoLR) mechanism, whereby customers of the failed firm are transferred to another supplier. (SoL sounds about right!) This mechanism effectively socializes losses:

Energy suppliers that rescue customers via the supplier of last resort can recoup their costs through an industry levy that is funded by bills.

Although the foregoing suggests that all UK energy consumers share in the costs, energy market regulator Ofgem suggests that the customers of failed firms may bear some of the costs:

Could bills go up?

When we appoint a new supplier using the Supplier of Last Resort process, we try to get the best possible deal for customers.

Suppliers we appoint will likely put you on a special ‘deemed’ contract when they take on your supply. This means a contract you haven’t chosen. A deemed contract could cost more than your old tariff, so your bills could go up. However, they are covered by the energy price cap Ofgem sets, which ensures you get a fair price if you are put on one. 

When contacted by the new supplier, it’s best to ask to be put on their cheapest tariff or shop around if you want to. You won’t be charged exit fees. This is a challenging time in the market and we know that there may not be many tariffs available when shopping around right now.

Deemed contracts can cost more because the supplier takes on more risk. For example, they might have to buy extra wholesale energy at short notice for new customers. So they charge more to cover these costs.

Up to last week, all the failures had been dealt with using this mechanism. But the failure of Bulb (Dim Bulb?) was evidently too big for Ofgem to deal with using the SoL mechanism. Instead, it resorted to a “Special Administration Regime” which basically nationalizes Bulb. This regime permits the government to “make grants and loans to the company in administration and may also give guarantees for any sum borrowed while it is in administration.”

That is, SAR is essentially a bailout/nationalization of losses and risk.

Ofgem notes:

The energy price cap, which sets a maximum price for customers on standard default tariffs, will remain in place to protect millions of people from the sudden increases in global gas prices. 

(Aside: It is impossible to protect millions of people from the sudden increase in global gas prices. It is only possible to determine–based on political mechanisms–which millions pay and how much. So this statement is typical government bullshit.)

Thus, given the price cap and the fact that Bulb is now owned by the UK government, Boris now has a big short position in natural gas. So how is he going to manage it?

I have heard that the government approached Vitol, which told them to fuck off. So . . . what next?

The company still has to procure energy at market prices and sell them at fixed prices. Since the government is now the residual claimant, it has a short exposure and can take this exposure on the balance sheet, as it were, and essentially run a naked short.

Or it can try to hedge by buying gas forward. But this is not a trivial problem. This is not a position of fixed size that faces only price risk that could be hedged using fixed quantities of swaps/forwards/futures. There is volumetric risk as well: cold weather increases both the price of gas and the amount of gas that must be supplied. A sophisticated hedge would involve both forward fixed price purchases and weather derivatives. Or through the purchase of a sophisticated structured product that has payoffs that depend on both volumetric and price variables.

I’m guessing that the government is not into sophistication, or frankly, capable of it. As a result, it is likely to be at a severe disadvantage in negotiating a price on a structured product or weather derivatives or long dated forwards.

It is also likely sweating out the hedger’s hindsight dilemma. If it doesn’t hedge and prices spike it will catch hell because of the large losses passed on to taxpayers. But if it hedges and prices don’t spike or in fact decline, it will catch hell too: you idiots overpaid!!!! Both of these judgments are based on hindsight, but even though hedging decisions should be evaluated ex ante on the basis of how they effect risk, inevitably they are evaluated ex post based on how they pan out.

Consider California in the aftermath of its 2000-2001 electricity crisis. It entered into long term contracts at what retrospectively was the height of the crisis, and thus paid higher prices than it would have had it procured on a short term basis. Of course, California attempted to recover by suing the contract sellers, claiming it was a nefarious manipulative scheme. Alas, it succeeded to some degree.

The best solution would be to do what clearinghouses do when a big member collapses–auction off the positions. This is what NYMEX did when the hedge fund Amaranth collapsed due to natural gas futures and swap losses in 2006: JP Morgan and Citadel assumed the positions in exchange for consideration. Similarly, when Lehman collapsed in 2008, the CME auctioned off its futures portfolio.

Even in these situations, however, there is always controversy about whether the price is right. Assertions that the buyers of Lehman’s futures positions received a windfall (i.e., bought on the cheap) led to litigation (filed by the Lehman bankruptcy trustee) and considerable controversy. (Here’s my take on the issue.)

Note that the factors mentioned above mean that the pricing in any putative auction of Bulb obligations is likely to be more discounted, and thus subject to more controversy, than the Lehman positions. As in the Lehman case, the positions will be auctioned in a stressed market. Moreover, as noted above, the exposures are far more complex and difficult to manage than Lehman’s rather vanilla (though large) futures positions. That complexity will bring a discount. Furthermore, apropos California circa 2001, the bidders realize that they are subject to government attempts to clawback any gains that result ex post due to favorable fundamentals (e.g., an unexpectedly warm winter). That is, the bidders may fear that the government will actually acquire a long option position, and hence they will be short an option: if prices spike, the auction “winner” will bear the brunt, but if they don’t the government will claim that it was exploited and over payed.

That is, unless the government can credibly commit to adhering scrupulously to the results of the auction, the auction may well fail to attract any bidders.

NB: credible commitment is not one of most modern governments’ strong suits. (This is likely one of the reasons Vitol told the government to bugger off. It realized that it was assuming a totally skewed position–heads they lose, tails they don’t win.).

According to the FT article linked above (amazingly factual and informative for a current day FT article, BTW) the government rejected two offers to assume the Bulb portfolio. I surmise that the bids were discounted heavily to reflect the factors mentioned above and Ofgem accordingly rejected them.

So I’m guessing the government will wear the risk. Perhaps it will try to manage it–and do it badly. Or more likely it will just let it ride. Maybe it will bet on Covid, thinking that the new variant or the new variant after that or the new variant after that will cause governments (stupidly) to lockdown again and crater economic activity and hence gas demand.

I note that Bulb might not be the end of the story. As noted above, the price caps remain in force, meaning that other suppliers may fail in the future–including those that have already gone through the SoL process. The government would be the ones SoL then. That is, the government not only has the Bulb liability–it has a big contingent liability that could dwarf Bulb.

Ofgem has already hinted at this:

In a letter to Kwarteng justifying the decision to pursue a special administration for Bulb, published on Wednesday, Ofgem’s chief executive Jonathan Brearley said the supplier of last resort mechanism was already “under considerable” strain from managing the failure of 20-plus other energy companies in recent months.

So Boris’s already big short could get bigger.

And perversely, it could influence government policy on COVID. Doing something (like lockdowns) that would crush energy demand would benefit its short energy position (existing and contingent). Talk about moral hazard.

Good luck with that Boris! Or should I say, good luck with that, Limeys?