Streetwise Professor

Historically, oil prices and stock prices were negatively correlated, or exhibited a close to zero correlation.  During the financial crisis, the equity-oil correlation spiked.  In recent weeks, it has plunged, and become sharply negative.

Some people try too hard to explain this pattern.  To me it has little to do with QEII, and the explanation is relatively simple.  It depends on what are the important shocks at any particular time.  When macro demand shocks predominate, correlations will be positive; when oil supply shocks are important, correlations will be negative.

During the financial crisis, there was slack oil production capacity, and price movements were demand driven.  Prices plummeted when demand crashed in the post-Lehman days.  Prices rebounded when economies around the world started to recover.  The economic crash and recovery drove stock prices lower then higher.  So during the crisis and recovery period, the state of the macroeconomy drove oil demand, and drove stock prices and oil prices in the same direction.

In contrast, the Mideast turmoil has generated oil supply shocks.  Declines in oil output, and increased likelihood of greater future output declines cause oil prices to go up.  These output declines also tend to reduce economic growth, and if severe enough, can tip economies into recession.  Thus, these adverse output shocks tend to cause stock price declines  because stock prices reflect the health of the broader economy.

In brief, the historically high positive correlation between oil and stock prices during the late-2008-early-2010 period reflected the fact that the primary shocks driving both markets during that period were macro shocks that influenced the demand for oil.  The negative correlation we observe now is due to the fact that the predominant shocks are oil supply shocks that will adversely affect the real economy.

The title of the FTAlphaville piece I linked to asks whether the correlation breakdown is “permanent.”  I permanently wonder why people have a tendency to believe that the most recent change will last forever.  No, the correlation shift is not permanent.  When supply shocks abate, and when (macro) demand shocks intensify, the correlation will tack again.

The lack of a coherent Strategic Petroleum Reserve strategery has apparently been an issue for quite awhile.  John McCormack points me to something he wrote for Regulation in 1996:

Owners of above-ground crude oil and refined product inventories have an important role to play. It was just such a role that the Strategic Petroleum Reserve (SPR) was meant to serve but has not. While it has accumulated a crude-oil stockpile of well over half a billion barrels, the SPR has never had a coherent, systematic strategy for selling crude oil during periods when prices spiked upwards. Only small amounts were sold from the stockpile during the 1990-91 Persian Gulf War, and then only after prices had begun to decline from their peak. For the stock- pile to have been of any use during periods of distress, SPR managers needed to have a coherent strategy in place and should have communicated their intentions beforehand. Part of the Energy Department’s reluctance to sell barrels from the SPR resulted from fears that they would be reducing the stockpile before the shortage was greatest. They could have avoided this problem by doing time swaps that would not permanently reduce the stockpile.

The Senate Permanent Subcommittee on Investigations published a report in 2003 (almost exactly 8 years ago, in fact) that also ripped the SPR for its failure to act in a commercially reasonable way, thereby distorting oil prices.

Given that a Cato publication and a Carl Levin-chaired committee came to identical conclusions, I think it’s safe to say that SPR has not operated according to sound economic principles.

The SPSoI report also has a lot of stuff on manipulation, including a lot of quotes/cites from me before I was SWP 🙂  I talked extensively with one of the staffers who authored the report while he was preparing it.  I haven’t read it in years and on re-reading was kind of taken aback to see how much of what I told him made it into the final report.  So, even if I do say so myself, it’s a pretty good primer on manipulation generally, and oil market manipulation more particularly.

Numerous futures markets heavyweights, including CME, ICE, and BlackRock are up in arms over a CFTC rule that would require delisting of a futures contract that had more than 15 percent of its volume traded outside the exchange’s central order book.  Their opposition–anger, really–is justified.

The Commission’s logic is that it wants to protect the price discovery process in centralized markets.  It recognizes that block trades and other off-exchange trades can mitigate price impact on large transactions, e.g., in hedging trades.  Verifiably uninformed traders have an incentive to trade off exchange because this allows them to avoid paying the adverse selection-related costs incurred in an anonymous market; it can also reduce execution risk.  Loss of some uninformed order flow reduces liquidity on the centralized market, and can reduce the informativeness of the prices on that market.

Quantifying the impact of all these changes is impossible.  Much of the effect is to transfer wealth from one group of uninformed traders (those who trade on the centralized market) to another (those who can avail themselves of the block market or other off-exchange trading venues.)  In my JLEO “Market Macrostructure” paper I demonstrate that the net effect can be positive, i.e., the benefit to the latter can exceed the loss suffered by the former.  The cost of a decline in price informativeness cannot be quantified.  Period.  Moreover, even here things are ambiguous.  A decline in the amount of uninformed trading on the central market tends to reduce the amount of informed trading–that’s why price informativeness declines.  But some informed trading is rent seeking–it involves spending real resources to acquire information in order to achieve a transfer of wealth.  This is inefficient.  Reducing this activity actually improves welfare.

In other words, nobody knows how much block trading/off-exchange trading activity is the right amount.  Least of all the CFTC.

One thing is for sure, though.  The marginal cost of block trading doesn’t become infinite when block trading volume is 15 percent of the total.  But that is what the CFTC rule implicitly assumes.  Moreover, even if the marginal cost (including all relevant costs and benefits) of block trading is positive when it totals 15 percent of volume, shutting down the centralized market if block volume exceeds 15 percent makes no sense at all.  A market with “too much” block trading activity still contributes to price discovery.  It still provides a cheaper place to trade than no centralized market at all.  Maybe its value isn’t maximized when there is too much block trading, but shutting it down sure does minimize its value.  It’s like cutting of your nose to spite your face.

Presumably the CFTC believes that no market will ever be shut down.  That any exchange facing delisting of a contract will change the block rules (e.g., increasing the minimum block size) in order to reduce block trading and avoid a shutdown.

But in adopting this change-your-rules-or-the-contract-gets-it strategy, the CFTC presumes that it knows the right amount of block trading.  It knows no such thing.  Indeed, the basis for its threshold is purely arbitrary–a joke, actually:

In the second largest category, involving 128 contracts from all asset classes which included contracts with large and small open interest, the average amount of off-exchange trading over the three-month period ranged from 0% to 15%. The Commission believes that this second category of contracts, where there was actual centralized market trading to observe, provides a reasonable basis for establishing a minimum centralized market trading requirement. Accordingly, from this second category the Commission took the upper range of the maximum average amount of off-exchange trading, and proposes that a maximum of 15% of total trading volume of a contract would be an allowable amount of off-exchange trading in order to protect the price discovery process of trading on the centralized market.

So, the staff looks at some historical numbers for historical off-exchange trading activity (including, apparently, exchange for physicals and exchange for swaps, etc.), the Commission picks a number at the top of the range, and declares it “reasonable” to apply this number to all markets going forward.  That’s not analysis: that’s arithmetic.  It involves no serious consideration of any of the relevant issues and trade-offs relating to on- and off-exchange trading.

The opposition of the exchanges is particularly interesting here.  Exchanges internalize many of the effects of their block trading and EFP rules.  To the extent that block trading reduces liquidity on the centralized market, it reduces the derived demand for trading on that market–and hence reduces the fees an exchange can charge and the quantity of trades there, which combine to reduce the exchange’s revenue from that source.  It can collect revenues from block trades; these revenues reflect the benefits that block trading provides.   Through the effects of its rules on these different revenue streams, the exchange internalizes, albeit perhaps imperfectly, the costs and benefits of those rules on execution costs and liquidity for alternative ways of completing trades.  (This is different, I would add, from internalization or third markets, where a third party “skims” uninformed order flow and does not internalize the effects on the liquidity of a central market.)  Thus, the exchange is in a much better position to know, and has a stronger incentive to know, the liquidity effects of block rules than does the CFTC.  It can balance and has the incentive to balance these effects to craft an efficient rule.  This argues strongly in favor of letting the exchanges make their own rules.

Exchanges don’t directly internalize any benefits flowing from more informative prices.  Nobody does–including the CFTC.  The rent seeking argument I mentioned above means that these benefits may not even be positive–they may be negative, once the costs of information are taken into account.  Imposing an entirely arbitrary standard based on a calculation that a fifth grader could make, and which cannot–cannot–quantify even approximately the benefits and costs at issue is an act of regulatory overstretch that is far too characteristic of this Commission.  It denies those who have some information about some relevant costs and benefits–the exchanges, with regard to the effects of the rules on trading costs–from taking that information into account when establishing their rules.  It substitutes its own judgment for what is the “right” amount of off-exchange trading when that judgment is predicated on complete ignorance.

The Commission has a lot on its plate.  The Commissioners, with some justice, complain about their crushing work load repeatedly.  Here’s a suggestion: they can lighten their burden by avoiding dealing with issues about which the Commission completely lacks the information necessary to craft constructive regulations.  The off-exchange trading rule is a perfect example of that.  One can have nice philosophical arguments about these issues, but a rational regulatory triage strategy would relegate such debates to academics and focus on more pressing matters about which it is possible to get enough information and knowledge to craft sensible rules.

I’m not holding my breath.

Today’s WSJ online has a short piece quoting Daniel Yergin counseling against tapping the Strategic Petroleum Reserve in response to Mideast turmoil. Yergin argues that it is desirable to keep the stockpile untouched as a hedge against the possibility of worse disruptions in the future. Insofar as commercial storage is concerned, economic theory highlights two factors that are relevant in determining the optimal timing of adding to or drawing from inventories. My forthcoming book goes into these factors in detail.

The first is that it is optimal to draw down on storage in response to adverse supply shocks that are expected to be transitory. This means that current supply is below expected future supply, making it less desirable to hold inventories to meet future consumption needs. Well-functioning markets move things from where they are relatively abundant to where they are relatively scarce. A temporary supply shortfall means that the present has become more scarce, relative to the future, making it desirable to shift some consumption from the future to the present. When some inventories are available, this intertemporal shift can be achieved by drawing down on stocks.

In contrast, supply shocks that are expected to persist should have minimal impacts on storage decisions as such shocks do not affect supply today relative to what is expected in the future. Since scarcity today relative to future scarcity isn’t affected by a highly persistent shock, there is little or no need to change inventory to move consumption from the future to the present.

The second factor is uncertainty about fundamentals. Inventories are in part a hedge against uncertainty about future demand and supply conditions, a buffer against adverse supply or demand changes in the future. An increase in uncertainty about future supply increases the precautionary demand, leading to an increase in inventory holdings. This is the factor that Yergin emphasizes, and which I analyze in detail in chapter 5 of the forthcoming book.

In the current situation these considerations are in conflict. It is likely that the effect of the effect of the loss of Libyan production will be relatively transitory as this production will be brought back on line when the situation, which appears to be reaching a climax, stabilizes, and because other suppliers, notably Saudi Arabia, have pledged to expand output. This would tend to cause a decline in inventories. On the other hand, the risk of future supply disruptions—not excluding major disruptions in Saudi Arabia—has increased dramatically. This would tend to lead to an increase in inventories.

Movements in the forward curve suggest that the first effect is dominating. The contango in WTI has declined and Brent has also moved into a backwardation. The WTI curve has become slightly humped at the short end. Such moves are associated with declines in inventories.  That said, the effect of the increased uncertainty has probably led to smaller stock drawdowns.

The foregoing relates to commercial storage decisions. SPR is not operated on a commercial basis. That said, it would probably make sense to take commercial considerations into account when making storage decisions, if only to reduce the cost to the taxpayer. The fact that SPR is not operated on commercial principles, but is a political animal with difficult to predict decisions likely has some feedback effects on commercial storage decisions; with respect to politics, some, such as MA Rep. Markey, are calling for the SPR to release supplies into the market. Commercial storers have to take into account their expectations about SPR actions when deciding how to make their own storage decisions.

It would seem to be very hard to predict what SPR will do given its political-military nature. Clarifying SPR’s operational methodology would assist private parties to make rational storage decisions that would assist in reducing price volatility.

The big news in Exchangeworld is the likely merger of NYSE-Euronext and Deutsche Borse.

This reflects in some sense a return to financial normalcy in the aftermath of the crisis.  The years leading up to the crisis saw a plethora of exchange mergers and combinations, but the pace of consolidation slowed noticeably in 2008-2010.  Now it is picking up again.

Both NYSE-Euronext and DB operate cash equity and derivatives exchanges.  The former operates NYSE, of course, and also European equity markets in the Netherlands, Portugal, France, and elsewhere, and the LIFFE derivatives exchange in London.  The latter operates the German stock market, a US-based options market ISE (a purchase in the pre-crisis boom which turned out to be a rather bad deal for DB) and the Eurex derivatives exchange which trades equity options and a wide range of financial futures.  DB is highly vertically integrated; most importantly, it operates its own execution and clearing platforms in both equities and derivatives.  LIFFE historically outsourced its derivatives clearing to LCH.Clearnet, but is also vertically integrating into clearing (although it still contracts with LCH for some clearing services).

Cost savings are the major driver of this merger.  There are substantial scale and scope economies in execution systems.  In derivatives, moreover, there are substantial scale and scope economies in clearing.  In particular, margining and netting efficiencies reduce customer capital costs.

The competitive effects are likely to be relatively small, even though that has been a focus of a lot of the commentary.  Cash equities are already ruthlessly competitive, especially in the United States: RegNMS socialized order flow, eliminating any tipping effects, as demonstrated by the precipitous decline in NYSE market share from the mid-80s to the mid-20s in the years following RegNMS.

With respect to derivatives, the LIFFE and Eurex do not compete head to head in any major product.  Cross-product competition is relatively tame in futures.  And just as with the CME-CBT merger, putting LIFFE short term interest rate futures and UK government bond futures and Eurex European bond products on the same platform would facilitate spreading trades and enhance liquidity and reduce trading costs and execution risks for customers.

Nor do LIFFE and Eurex compete head-to-head with any CME product.  Thus, the direct competitive effect of the merger on CME is also likely to be relatively mild.  By reducing trading and clearing costs, a LIFFE-Eurex combination may attract some business from CME product groups to its product groups, but again, these inter-product class cross elasticities do not appear to be large.  Order flow has not been socialized by regulatory fiat in derivatives on either side of the Atlantic, meaning that the order flow network effect is still in place.  This means that LIFFE and Eurex could not credibly compete against CME on its home turf (each had conspicuous failures trying): it also means that a combined LIFFE-Eurex will face daunting obstacles in trying to do so.  Indeed, I doubt they will seriously try; twice burned, thrice shy would be a reasonable motto.

Consistent with this, CME Group’s stock price has been up close to 2 percent since the news of the potential tie up became public.

The biggest uncertainty surrounding the deal involves European antitrust approval.  As noted above, the merging exchanges are not direct competitors in any major product.  In the US, in the mergers of CME and CBT and CME and NYMEX, that fact was decisive in avoiding  Justice Department challenges.  It should be in Europe too, but I’m not as familiar with European antitrust thinking or precedents so I’m not sure they’ll see it the same way.

The most interesting question involves clearing.  European policymakers have been critical of vertical integration in clearing.  (The USDOJ is too, but only disclosed its (economically nonsensical) objections after the CME-NYMEX merger closed.)  They deem vertical integration as anticompetitive, and have failed to consider seriously the efficiencies that integration can generate (a subject I’ve written a lot about on SWP and my academic research).

Given this skepticism, the Euro antitrust folks may view this merger as an opportunity to open up access to clearing at Deutsche Borse and LIFFE.  That is, I could see them conditioning approval of the merger on the parties’ agreement to open up access to their clearing services.  It will be interesting to see whether they attempt to do so: I estimate that there is a non-trivial probability of this happening.  If they try, it would likely be a deal killer.  DB in particular has been adamant that integration is an essential part of its model and strategy, and LIFFE has adopted that view as well.  A deal becomes much less attractive–and, in my opinion, unattractive–if it requires a fundamental transformation of the exchanges’ business models.

The news of the potential deal has sparked considerable speculation about other tie-ups.  One commonly heard belief is that CBOE is the odd-man out, and that it should tie up with CME.  Other than the fact that both have “Chicago” in their names, these entities don’t have a lot in common, or a lot to gain by combining. In particular, there are no benefits on the clearing side. There are no economies on the regulatory/compliance side.  There are not really big advantages on the system side either.  So, other than savings on letterhead and some management salaries, there is nothing to be gained by merging.

It is likely that many more possible combinations will be mooted and discussed in the coming days.  I’ll be among those discussing them, but that will have to wait.  For teaching calls.  It’s rough work, but somebody has to do it.

This article from John Helmer’s Dances With Bears provides a fascinating case study on the operation of the Russian natural state.  He describes how the government, in the forbidding form of Oleg Sechin, guides (to put it euphemistically) negotiations between consumers and producers of metals:

Deputy Prime Minister Igor Sechin, who supervises the Russian metals and mining sector, convened a meeting with the federal government’s industry administrators and price regulators, along with representatives of the steel and carmakers. Mordashov attended for Severstal, along with Igor Komarov, chief executive of AvtoVAZ, Russia’s largest carmaker. Others attending included the two other domestic auto sheet suppliers, Magnitogorsk and Novolipetsk, and other automakers — GAZ, Sollers, and Kamaz, which builds mostly trucks, buses, and utility vehicles.

Sechin listened to the applications, and then issued his orders. Steelmaker Severstal was told to reopen negotiations with AvtoVAZ over the former’s proposed 30% price hike for auto steel supplies. The Federal Antimonopoly Service (FAS), which had earlier ruled that the Severstal price was in line with raw material cost growth and international price benchmarks, was also ordered to reopen its inquiry with different comparative criteria.

That last touch, with Sechin directing the FAS to get its mind right and revise its methodology in order to generate the politically approved results, is priceless (no pun intended).

Note too how the government is more than willing to use tax and trade policies in order to manipulate domestic prices in order to achieve the desired allocation of rents between consumers and producers;

The cane wasn’t mentioned or waved about. But Sechin didn’t need to remind everyone in the room that the government is considering a tax or duty on exports of steel, maybe iron-ore too, unless the producers curb their appetites and make an agreement on a new domestic price.

Documents leaked fron the federal Ministry of Economic Development, and published in a Moscow newspaper on January 27, reveal that two options for the export duty level have been proposed — one fixed at 10% for steel and 30% for iron-ore; and one a sliding scale tied to international prices for these commodities. The more the Russian exporters try to capitalize on rising international steel and iron-ore prices, the bigger the margin the Kremlin plans to take from them as their cargoes leave the port, possibly to add as cost and sale price subsidies to the carmakers.

According to Vladimir Zhukov, steel analyst for Nomura in Moscow, “we have been told that the prime cause for the government thinking in this direction is an attempt to help the domestic car industry which struggles to achieve decent profitability levels (if any profitability at all).”

Zhukov’s report for Nomura’s clients suggests that rises in coking coal, scrap and iron-ore are likely to engender a steel price rise over the year of about 15%. Zhukov adds that “we understand from industry sources that Russian auto manufacturers are already buying galvanized steel (the main steel product supplied to car manufacturers) at some 10-15% discount to Europeans (approximately $850/t vs $930-1000/t). Therefore, introducing export duties on steel will widen this discount even further.”

States like Russia use state power to fine-tune the allocation of wealth between different individuals, firms, and sectors.  (Yes, this happens in the US too, but the process is quite different; in particular, it is fenced in with a variety of political and legal constraints that make Sechin-like interventions impossible.)  This is a linchpin of a broader strategy to maintain political equilibrium.  Creative destruction is an anathema there: these efforts to maintain stability are antithetical to economic dynamism and innovation.  Hence, the actual operations of the government undermine the soaring rhetoric about modernization.

The process Helmer describes also provides an illustration of a point I’ve made several times before.  Namely, that the Russian government relies heavily on  export and import taxes as a means to manipulate rent distribution for political purposes.  This is incompatible with WTO obligations, meaning that when Russia joins the organization it is almost certain to be involved in chronic conflicts with it.  (For corporate analogies, just look at the ongoing warfare between AAR and BP over TNK-BP, and between Telenor and Vimpelcom.)

And speaking of broad strategies to maintain political equilibrium, another element in this strategy is information control.  Along those lines, Russia has denied entry to Guardian reporter Luke Harding, a consistent critic of Putin specifically and the Russian government generally.  The beat goes on.

Fed Chairman Ben Bernanke’s flippancy in dealing with serious questions is becoming more and more disturbing.  He responded to legitimate questions about the credibility of the Fed’s promises to cut back on its expansive policies if inflation appears to be picking up by saying that he could raise interest rates in five minutes, if need be.  Procedurally, this is true, but substantively, this is a non-answer because it completely ignores the credibility issue: would the Fed have the political will to implement controversial rate hikes when the economy is still less than robust (as today’s employment report makes plain)?

But yesterday his flippancy soared to new levels (sort of like the monetary base and the Fed balance sheet).  In response to questions about the effects of QE2 on inflation around the world–notably food price inflation that has helped spark unrest in Egypt and elsewhere–Bernanke was dismissive:

Answering questions after a speech at the National Press Club in Washington, Mr Bernanke said that rising food prices in the emerging world reflected the growing wealth of their populations and, in some countries, a failure to tackle inflation.

“They can, for example, use monetary policy of their own. They can adjust their exchange rates, which is something that they’ve been reluctant to do in some cases,” Mr Bernanke said.

Here’s more:

“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries,” he said in answering a question from the audience. “It’s really up to emerging markets to find appropriate tools to balance their own growth.”

Here’s an analogy.  Neighbor Ben is lighting bonfires in his yard in a windstorm.  He responds to your complaints that the flames and sparks from his fire have torched your bushes and threaten to set your house alight by saying: “You have all the tools you need to address the problem.  You could buy a fire extinguisher.  You could soak down the roof of your house.  You could move.”

Food price spikes in particular have been fueled largely by supply shortages, but the boom in commodity prices is so widespread–from copper (now over $10K/tonne) to oil ($100+ for Brent), to cotton (leading to an extraordinary exchange intervention) that it is difficult to deny that expansive US monetary policy has something to do with it.  I say again.  Bernanke has justified QE2 by citing deflationary fears: when–ever–has a deflationary cycle been accompanied by spiking commodity prices?  Usually commodity prices plunge the most.  At least, this should be sparking some cognitive dissonance, a recognition that this isn’t your grandfather’s Depression–even if said Depression was the focus of your academic research.  (Generals fighting the last war are very dangerous–to their own side.)

Bernanke is also rhetorically slippery.  He says that “it is entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries.”  That is a non sequitur.  It is entirely possible–and indeed extremely plausible–that US monetary policy has a lot–a lot–to do with excess demand pressures in emerging markets.  That’s the underlying shock: at least it’s one, big, undeniable shock.  The channels of transmission are plainly evident.  Whether countries have the policy tools to respond to that excess demand is an entirely different issue; whether they use them is another.  The source of excess demand pressures and the response to it are completely distinct.  Your failure to buy a fire extinguisher to defend yourself against Neighbor Ben’s pyromania does not mean that the pyromania is an illusion.  It is illogical to claim that because countries have not responded to X the way Bernanke would prefer, X therefore does not exist.  And QE2 is the big X factor.

Bernanke may have let the cat out of the bag and revealed an important–but not publicly emphasized–rationale for QE2 in his remark that countries “can adjust their exchange rates.”  Namely, this suggests that QE2 is intended primarily to reduce the value of the dollar.  To put pressure on countries–most notably China–to let their currencies rise relative to the dollar.  By a lot.  This is, in essence, a big game of chicken between Bernanke and policy makers around the globe–and most importantly, in Beijing.

Inflation is painful.  Currency appreciation brings its own kinds of pain, in the short run, anyways.   Countries are understandably–predictably–reluctant to let it happen.  QE2 has put them between a rock and a hard place.  And the choice is particularly discomfiting in China.  The Chinese have their own rather deep concerns about the robustness of the economy and the potential for social unrest.  Moreover, historical grievances and a current sense of ascendency make them particularly reluctant to knuckle under to the US.  So the game of chicken is likely to continue, and end with a crash rather than a saving swerve by the Chinese.

But even if the game is between the US (and the Fed in particular) and China, the repercussions are global in scope.  The collateral damage is already large, and threatens to spin out of control.  We are in a Year of Living Dangerously, and despite Bernanke’s flat (but illogical) denials, a major source of that danger is US monetary policy.

The controversy over the merits of the CME-NYMEX crude oil futures contract (West Texas Intermediate, WTI, also known as light crude, CL) vs. the Brent alternative is heating up again. In recent months, the spread between WTI and other crudes has widened, with WTI trading substantially lower than Brent, and US Gulf Coast prices (e.g., Louisiana Light Sweet–LLS–and Mars blend).

Critics of WTI question the long run viability of the contract. This is economically non-sensical. If there is a problem with WTI, it is a short run one; the very price relations that have drawn criticism provide the signal and incentive that will lead to its correction in the “long run”–as economists define it. Not “in the long run we are all dead” long run, but in the time frame that it takes to make adjustments to fixed capital such as pipelines and refining. This long run will arrive far before most of us are dead (based on reliable actuarial information:)–a period measured in months, rather than many years.

The WTI “disconnect” as it is sometimes termed reflects fundamental conditions in the oil market. (As an aside, those who obsess about the impacts of speculation should explain how speculation can wildly distort levels of prices but fundamentals drive intra-commodity price relations/spreads.) Increasing Canadian and US oil production has ensured that the US Midcontinent is well-supplied with crude. Indeed, along with demand that is still somewhat sluggish, this increased supply has led to increased inventories of crude in beautiful, windswept Cushing, OK. Cushing is the largest storage location in the US, and is the delivery point for the CL contract. At present, oil cannot flow from Cushing to the Gulf Coast. Gulf Coast refineries rely on US domestic crudes produced in the Gulf of Mexico (GOM) and imported crudes. The abundant supply of crude to the Midcontinent combined with the current inability of oil to flow from the Midcontinent to the Gulf has led to the widening basis.*

If you have been long WTI and short LLS (or some other Gulf Coast price) that relative price change is a problem (although it has been a boon if you have been short WTI and long the Gulf). But that problem is also an opportunity. It is a signal of the value of investments in capital that can move oil from the Midcontinent to the Gulf, and in refining capacity in the Midcontinent that can soak up some of that additional oil.

And indeed, a pipeline project–the third stage of the Keystone pipeline–is currently awaiting regulatory approvals.  With timely approval, the pipeline could go online in early-2013.

Indeed, adjustments are occurring even in the short run: the price relations are such that it is attractive to ship oil by rail–almost a throwback to the Rockefellar days–from the rapidly growing Bakken fields in North Dakota to the Gulf.  Moreover, Midcontinent refiners are operating at substantially higher rates than those elsewhere in the US.   (It is likely that in the longer run that refining capacity in the Midcontinent will expand relative to capacity in the Gulf to reflect the increased supplies of crude in regions tributary to the Midcon.)

Ironically, environmentalist opposition supposedly intensified by the Mocondo spill is the main obstacle to timely completion of Keystone.  Ironic because pipeline transportation is safer than deepwater production and seaborne transport (although it is not without environmental risk).  So delaying the pipeline only increases reliance on the riskier alternative.

So, like many economic “problems”, this one is self-correcting if the market is allowed to respond rationally to price signals.  Economic actors are ready to respond rationally.  Now it remains to be seen whether the political actors will do so.  Always a much more problematic proposition.

Several people have asked me whether it would be advisable to develop a new futures contract that would price off of seaborne crude or domestic production in competition with seaborne crudes: an LLS contract, for instance.

Having been intensely involved in the design of several commodity futures contracts, I am less than enthusiastic.  Sometimes the “long run” in designing a futures contract–going from the idea to the actual implementation–is longer and more treacherous than doing something like building a pipeline over hundreds of miles of Oklahoma and Texas prairies.  The implementation details are very difficult to get right.  Moreover, there are many parties with conflicting interests who try to influence the design to benefit them.  A futures contract is a one-size-fits-all endeavor, and it is very difficult to choose which suit gives the least bad fit to the most people.

Moreover, there is a kind of Heisenberg principle at work.  Designing a futures contract around a particular location and grade can change the pricing behavior of that location and grade.  You have to be sure that the logistics and infrastructure are robust enough to handle the demands of being a delivery point (or cash reference point).  That’s not easy to do.

What often happens is that dissatisfaction with one delivery design leads to inquiries which prove that that design is the worst possible one, except for all others that could be tried.

With respect to WTI, the economic factors that are the fundamental source of the current criticism could be a boon in the longer run, especially if the market is allowed to function and capital adjusts in response to changes in production and consumption patterns.  Historically, the US market was in supply deficit, and WTI traded at a premium to attract Brent in addition to other foreign crudes.  But currently the forward curves for WTI and Brent show WTI at a discount going out years.  This means that the market is anticipating that Cushing will be abundantly supplied for years–while Brent/North Sea production is inexorably declining.

The major problem that raises worries about the long run viability of a futures contract design is lack of supply.  Long run changes in grain marketing patterns put the terminal market in Chicago into terminal decline (no pun intended).  That caused serious difficulties with CBT corn, wheat, and soybean futures contracts.  Those problems took years to correct, and only after extremely rancorous infighting over how to change the contracts to address the problem.  (Efforts that I was involved in from 1990 through 1997–that timeline alone speaks volumes.  And I can speak authoritatively about the rancor, having had some of it directed my way–almost resulting in a fistfight with a prominent grain trader.  True story.)

The increased Canadian and North Dakota production, reflected in part by the forward WTI discount vis a vis Brent, suggests that over the longer term the Cushing-based WTI contract does not face the prospect of a similar supply problem.  Moreover, the delivery in-store (or through pumpover) design for the CL contract offers many advantages over the much more cumbersome and opaque Brent pricing mechanism, not least due to the fact that Brent trades in huge cargoes whereas delivery in-store at a market served from a variety of supply sources with a variety of demand outlets permits greater flexibility in logistics and trade sizes.

In sum, the conditions that have created the wide spreads are self-correcting:  those self-same spreads give the incentive to make adjustments in transportation (and also production and consumption) that will re-integrate Midcontinent prices with waterborne prices.  And it’s also important not to exaggerate the magnitude of the de-linkage.  As I documented in a study released about a year ago, even during the throes of the financial crisis when spread and basis relations were also well out of historical norms, WTI still exhibited high correlations with other crude prices, including LLS and Mars.  (I am working now to update the main results of that study.)

In a dynamic market, changes in supply and demand patterns are inevitable.  By necessity, futures contract designs are relatively static–particularly so for something like crude oil, where contracts are traded going out to ten years so you just can’t change contract designs willy-nilly and strand a lot of open interest in the out months/years.  This mismatch between dynamic markets and static contract designs means that from time to time the contract will get out of alignment with the fundamentals.  Sometimes that mis-alignment is likely to be enduring–as with Chicago-based grain and oilseed contracts, which necessitated a major change in design.  Sometimes that mis-alignment is fleeting, because the price effects of the mis-alignment lead to adjustments on various margins that tend to bring things back into alignment.  That will almost certainly happen with WTI–if regulators allow it to happen.

And one point deserves repeating: the change in supply conditions that is causing the changes in price relations that are drawing so much attention will also help ensure the long run viability of the WTI contract.  If the supply is there, you can build pipelines to get that supply from low price locations to high price ones.  But you can’t base a futures contract on a market with no supply.

*Note how this represents a fundamental, and salutary change over conditions in the 1990s.  At that time, declining domestic production was turning the Midcontinent into a deficit region, and the Seaway Pipeline was built to bring crude from the Gulf to Cushing and the Midcon.

Writing in Commodities Now, Reuters reporter John Kemp takes issue with my criticism of the CFTC proposal on position limits. I appreciate the attention, but I’m underwhelmed by his arguments.

There are a lot of details, but the gravamen of his complaint is that my view on the purpose of position limits is far too narrow:

Pirrong defines the rationale for intervention too narrowly. Large leveraged positions run by the Hunt Brothers did indeed threaten to bring down their own brokers and several other financial institutions. But systemic risk is not the only reason for regulators to intervene to prevent market manipulation.

Kemp directs his beef at the wrong guy.  His real problem is with the CFTC because these were the only–I repeat only–reasons the CFTC set out it its NOPR.  My critique of the proposal is that it was a vastly overinclusive way to achieve the objectives the CFTC set out.  Again, the objectives the CFTC set out.  I was responding to what was in the proposal, but I did mention quite pointedly that the CFTC was utterly silent on whether speculation was culpable in the mid-2000s price spikes, or those going on now.  How is it possible to respond to arguments and assertions that are not made?

Since it was the CFTC that was setting out the rationale for its proposed intervention, if that rationale is too narrow, Kemp should direct his ire where it belongs–the CFTC–not where it doesn’t–yours truly.

Kemp also critiques my views on manipulation and the proper way to deter it.  Oh no!  Please don’t throw me in the manipulation briar patch, Brer Fox!

Actually, born and bred in the briar patch, John.  We are agreed that past efforts to deter manipulation through ex post enforcement have been troubled, at best.  In this, Kemp is no doubt late to the game, because I’ve been making that argument since the mid-1990s.

That said, I’ve noted that manipulation is not inherently “unprosecutable” (a word Kemp lifts from Jerry Markham).   The problems with detecting, deterring, and punishing manipulation can be corrected by a proper understanding of the economics, and a judicious use of, yes, econometrics–something that apparently sends Kemp into apoplexy.

Moreover, I have made very concrete recommendations as to how manipulation law can be reformed to address the problems it has experienced.  (Not that you would know that from reading Kemp’s description of my views and arguments.)  The problem is that instead of taking a new, economics-based approach to the problem, Congress keeps returning to the vapory SEC 10(b)-5 “manipulative contrivance or device” standard, like a dog returning to its own vomit.  Doing the same thing over and over again and expecting different results is insane.  I’ve recommended specific and practical ways to stop the insanity.

As an aside, Kemp laments that manipulators have only been subject to civil, rather than criminal, sanctions.  There are a couple of issues here.  The first is that criminal sanction–imprisonment–is socially inefficient when defendants are not judgment proof.  The second is that Kemp’s lament actually supports the point I made in the previous paragraph.  Judge Miller in Houston found the existing anti-manipulation statutes unconstitutionally vague, and threw out criminal indictments against BP propane traders.  The suggestions as to how to correct the law would go a long way to addressing that vagueness problem that impedes criminal prosecution.

Speaking of econometrics, here Kemp is extremely misleading, and puts words into my mouth that I did not utter, and which do I endorse.  He says that I propose that the CFTC not “set limits or commence enforcement proceedings unless econometric tests showed an unequivocal effect” [emphasis added].

If there is anything unequivocal, it is that his statement is unequivocally false, for I never said any such thing.  Indeed, insofar as manipulation is concerned, he turns reality on its head.  For what I have shown in numerous articles, a book, and in testimony, is that econometric evidence and economic analysis generally is the best way of proving manipulation, rather than being an obstacle that makes prosecution of manipulators virtually impossible.  It is a sword that can be wielded against manipulators, not  a shied that defends them: although it is effective as a shield protecting the innocent.  Rigorous analysis of data is the best way to cut through trader BS, and prosecutor ignorance.

And that’s the point: we want methods that avoid false positives and false negatives.  My work shows that econometrics, when combined with rigorous economic reasoning and other economic tests that are not econometric per se, can do just that.

Before characterizing my views, John, you might want to be more familiar with what they actually are.

Even with respect to the issue of whether speculation has distorted prices in ways other than the Hunt-type scenario, I have been quite open about the basic limits of econometric analysis.  Here’s what I wrote in a piece in Regulation last summer:

One of the most important functions of markets is to discover prices; to provide a mechanism whereby information about supply and demand dispersed among millions can be aggregated.  Thus, no one has the information to know what the price “should” be; if someone did, we wouldn’t need markets.  But this always makes it very difficult to rebut assertions that a particular market price is distorted by speculation, or to prove that they were.

Moreover, in that article, I use some econometrics, but only very little.  I instead utilize some non-econometric approaches to test the implications of the speculative distortion story.  Thus, to attribute to me a slavish and myopic devotion to econometrics is just wrong.  I have a very catholic view of what kind of evidence is persuasive.

But I am a firm believer that data and evidence should be decisive.  Kemp argues that “policymakers must act on the balance of probabilities.”  Fine.  But just where, pray tell, are those probabilities to come from?  Kemp bashes econometrics, but advances no alternative.  Zero.  Zip.  Nada .

Sorry, but that just doesn’t cut it.  Econometrics is one tool that can be used to inform judgments about probabilities.  There are other tools–qualitative comparisons, and rigorous analysis of the economic logic of purported causal connections between speculation and price distortions, for instance–that can also inform those judgments.  The best approach integrates statistics, econometrics, qualitative comparisons and rigorous economic reasoning.  That’s the kind of approach I favor, and the kind of approach I’ve used–though you would never guess that in a million years if your only impression of my work is Kemp’s description thereof.

In the end, Kemp takes refuge in the position that as a matter of law, Congress has required the imposition of position limits, and that’s the end of that.  He worries that the CFTC could be sued if it failed to adopt such limits.

But even that legalistic defense is incomplete.  Congress has mandated the imposition of limits to achieve a specific purpose: the prevention and diminution of “unwarranted fluctuations” in prices.  Limits that are unnecessary to achieve that goal–because such unwarranted fluctuations are extremely unlikely to occur–or limits that are so overinclusive that they impede the achievement of other Congressionally mandated objectives, shouldn’t hide behind the fact that courts may find the exercise of such powers Constitutional.  “We do it because we can” is a recipe for regulatory mischief that undermines the very goals that Kemp claims to endorse.

My criticism of the CFTC NOPR is that it (a) identified a way in which large positions could cause unwarranted fluctuations, and (b) imposed limits that were completely unnecessary to address the very problem the CFTC identified.  Maybe Kemp has different theories regarding (a).  If so, he should spell them out, and specify his proposed remedies so that they can be evaluated and critiqued in order to ensure that they are indeed problems and the remedies are an efficient and effective way to address them.

In the end, I guess I do agree with Kemp on one thing: it comes down to an issue of the burden of proof.  I believe in markets more than regulators.  He apparently takes the opposite view.  I am more than willing to debate this anytime, anywhere.

But contrary to what Kemp insinuates, I do not believe that markets are unerring, that market power is not a problem, and that certain laws and regulations can improve the performance of markets.  I am not some sort of Dr. No, insisting upon unreasonable level of empirical support to reject the hypothesis that the Market Is Always Right.  (Indeed, a former colleague, upon reading my work on manipulation, referred to me as a “Chicago apostate.”)  I have a presumption in favor of markets, but it is a rebuttable presumption.  And with respect to manipulation in particular, I have both rebutted the widespread view that manipulation is not a problem, and recommended specific, targeted legal responses to mitigate that problem.

When it comes to speculation and position limits, however, those who have questioned markets have come no where near to rebutting the presumption in favor of markets.  I note–indeed emphasize–again that the CFTC does not even try beyond the specific areas identified in the NOPR: areas which Kemp believes are too narrow.  But Kemp hasn’t provided a credible alternative either.

Given the havoc that bad regulations routinely inflict on markets, a credible story and at least some evidence should be required to support a particular policy proposal.  A fair acknowledgement of the potential for unintended consequences is also appropriate.   I note too that Kemp does not even attempt to critique the unintended consequences of the CFTC proposal that I lay out in my comments.

When it comes to the specifics, Kemp ironically endorses my view–although he does not acknowledge this.  He says:

Reversing the burden of proof, it is worth asking opponents why anyone would want to run positions above the very high levels set out in the CFTC’s proposals. Are there legitimate reasons to want to run very large net positions, including in the spot month? Or is the only reason to exercise market power?

Uhm, that’s very close to what I recommend.  Give the CFTC the authority to question the legitimacy of very large positions, and intervene accordingly if there is no legitimate reason.  But that’s a far, far, different thing from a blanket prohibition of positions in excess of a particular size.

In sum, I stand by my specific criticisms of the CFTC position limit proposal.  Moreover, I emphasize that Kemp has presented a distorted view of my arguments, beliefs, and work.  His arms must be tired from giving a straw man such a thrashing.

But I’m still standing.

I have written a comment letter about the CFTC’s proposed rule on position limits, which I will submit tomorrow.  A draft is here.  It’s fairly long, so I’ll summarize it here.

I have said repeatedly that it is imperative for the Commission to identify the specific problems that it believes position limits will mitigate, and how they will do so.  Creditably, in its NOPR, the Commission does set out specific ways in which large, concentrated positions can inefficiently destabilize markets.  It is best described as a Hunt Brothers scenario, in which a levered player takes a large concentrated position in a market.  Such a leveraged player may be forced to liquidate, and the liquidation of such a large position can cause extreme price moves, and perhaps, pose a systemic risk.

Fair enough.  I’ve written about the Hunts in the past, and have made similar points. So that is a danger.  But crucially, the CFTC does not identify any other ways in which large positions can cause “unwarranted” price fluctuations, which is the basis for its position limit mandate.  Therefore, per the CFTC’s own analysis, its position  limits should focus on addressing a reprise of the Hunt situation.

But the major problem with the CFTC proposal is that it will constrain the trading of many market participants who in no way pose the dangers that neo-Hunts would.  That is, the proposed limits are over-inclusive.

In particular, they will constrain trading by exchange traded funds (ETFs) which are (for the most part) unleveraged.  Indeed most ETFs are completely collateralized.  Moreover, even if an ETF is big, it is different than a single trading entity like the Hunts because ETF trades are driven by the decisions of thousands of ETF investors.

In other words, ETFs are nothing like the kind of speculator–and the only kind of speculator–the CFTC has identified as a danger, but they will suffer collateral damage as a result of the CFTC’s limits.

They will not be the only innocent casualty.  Many other “massive passives”–such as pension funds–will also be affected, even though they do not pose the risks that the Commission uses to justify the imposition of limits.

The problems with the proposal don’t end here.  In particular, although “crowding out” is not explicitly in the new proposal (in contrast to the Commission’s proposal of January 2010), the new proposal has a feature that is just as pernicious, and just as inane: the “within-class” limit.

Due to the powers granted by Frank-n-Dodd, the CFTC now has the power to regulate positions in both OTC swaps and futures, whereas before it only had authority over the latter.  The Commission proposes to create two classes of positions: the futures class and the OTC class.  It proposes several limits imposed on the classes collectively and individually.  For one of the limits, the two classes will be netted against one another, and any speculator must have a net position for all months and a single month that are less than or equal to the speculative limit.  But in addition, each speculator’s OTC position must be smaller than the spec limit, and its futures position must also be smaller than the spec limit.

Here’s the problem.  Assume for simplicity that the limit is 100.   Consider a swap dealer who is short 150 swaps to customers, and hedges this using 150 futures.  This complies with the across-class limit, because it nets out to zero.  But it violates the futures class and the OTC class limits.

This feature therefore limits the ability of intermediaries–swap dealers–to hedge risks.  It is effectively a tax on swap dealers, and will reduce liquidity in the swap market.

There are reasonable grounds to suspect, based on the past statements of some Commissioners, that this is a feature rather than a bug from their perspective.  In my opinion, however, it is flat wrong.  OTC market making is a legitimate activity, and OTC deals (hedged by exchange transactions) are often the most economical way for some market participants to take on the investment or speculative positions they desire.  There is no reason to penalize this activity the way the proposed rule does.

Indeed, by limiting liquidity the rule threatens to exacerbate large price moves in response to shocks.  Prices have to move more in less liquid, less flexible markets in order to accommodate big shocks.  Stifling liquidity through the within-class rules is therefore counterproductive.

I would also note that the Commission provides no economic justification for this restriction.  In particular, it doesn’t even try to show how this restriction addresses the Hunt Problem that is the sole substantive justification for the limits in the first place.

The Commission also fails to justify the size of the limits it proposes, which approach 2.5 percent of open interest for large markets.  To put things in perspective, the Hunts’ position was over 25 percent of the market at times.  So maybe 25 percent held by a single leveraged trader poses a risk: how does that justify a  2.5 percent limit on everybody, including non-leveraged traders who are in fact agents for myriad individuals making independent trading decisions (e.g., ETFs)?

The Commission also fails to recognize that its limits could drive business into the physical markets, thereby distorting prices producers receive and consumers pay.  This is perverse, given that the ostensible purpose of the limits is to prevent and diminish such distortions.

In sum, the non-spot month limit proposal is fundamentally defective.  It identifies a problem, and then identifies a blunderbuss-like “solution” that will hit a lot of trading activity that does not and cannot cause this problem.

The spot-month limits are flawed too, because they are logically inconsistent.  The proposal limits caps spot-month delivery-settled derivatives positions at 25 percent of deliverable supply, but does not explicitly place a cap on the amount of deliverable supply a speculator can hold.  The proposal caps cash-settled positions at 5 times the delivery settled limit, i.e., 125 percent of deliverable supply, and also permits the holder of cash-settled positions to hold 25 percent of deliverable supply.

Spot month limits can be justified as a means of preventing corners.  Well, corners can be carried out by holders of cash-settled positions as well as delivery-settled ones.  Indeed, that happened a lot in the Brent market in the 90s and early-00s, and may in fact be happening right now.  Somebody can manipulate a cash-settled contract by buying excessive quantities in the cash market, driving up prices, and thereby artificially inflating the settlement price of the derivative.

If the objective of the limits is to prevent market power manipulations in both cash-settled and delivery-settled markets, the limits are logically inconsistent.  The delivery-settled limit implicitly assumes that it is possible to distort prices by accumulating less than 25 percent of deliverable supply.  Well, you can do that with the cash-settled contract, and then get a profit on a position that is five times larger.

In sum, the position limit proposal is a good example of bad regulation.  It inflicts harm on “massive passives” (perhaps intentionally) even though this type of trader does not pose the only threat that the Commission has identified: this is a massive fail.

I should also note that the proposed rule provides not a word of justification of the widespread view that speculation caused the price spikes of the 2007-2008 period, or is causing the current runup in commodity prices.  It certainly provides no evidence.  But such price spikes are routinely evoked in Congress, the press, and even in statements by Commissioners, as evidence of the need for such limits.  Since the Commission apparently does not have the confidence in such a belief to include it as a justification for limits in the formal proposed rule, this should play no role in deliberations over the rule going forward.  To do so would be to play bait-and-switch.

Instead, the rule should be evaluated solely on the basis of its efficacy and efficiency in addressing the specific problems with speculation that the Commission has identified.  When this is done, it is clear that the rule is grossly excessive because it impedes legitimate conduct that poses none of the risks that the Commission believes warrant regulation.  The rule should therefore be rejected, and if replaced at all, replaced with something that is targeted at the specific ill that the Commission has diagnosed.