Streetwise Professor

Not like they would, but anyways . . .  

The Treasury Department today released a letter on “Regulatory Reform Over-The-Counter (OTC) Derivatives” [sic–“in”? “for”? “of”?].  There are a few good ideas in it, but on balance the bad far outweighs the good.  

The centerpiece of the proposal (which has received a warm welcome from Congressional powers like Barney Frank and Collin Peterson) is to mandate clearing for “all standardized OTC derivatives.”  “Standardized” is not defined, but the letter suggests how this will be determined: If a clearinghouse offers to clear it, it’s standardized: “For example, if an OTC derivative is accepted for clearing by one or more regulated CCPs, it should create a presumption that it is a standardized contract and thus required to be cleared.”  

On Tuesday, I gave a presentation at the Atlanta Fed conference where I reiterated my argument–which debuted here on SWP–that mandating clearing is a bad idea.  Even for standardized products (my argument nowhere depends on standardization, except to the extent that there is some correlation between standardization and the magnitude of information asymmetries), it is quite possible that information costs are higher in cleared markets than in bilateral markets.  For particular transactions, involving particular transactors, it is possible that information costs are lower in a bilateral trade.  These lower information costs can make it efficient NOT to clear such deals; for other trades, in the same or similar instruments, clearing may be more efficient.  

In a nutshell, there is no basis for the presumption that the costs of clearing are lower than the costs of bilateral trades.  Moreover, I have not seen a credible argument showing that the social benefits of clearing exceed the social costs, but the private benefits are smaller than the private costs; such a showing would be necessary to justify a mandate  for clearing.  At the Atlanta Fed conference, Ed Kane of Boston College (the moderator of my session) argued that the safety net arising from deposit insurance and the implicit promise to bail out too big to fail banks could lead to such a circumstance.  I do not see the economic basis for this conclusion.  Moreover, there have been cases in the past–namely at the CBOT in the 1920s and the LME in the aftermath of the Tin Crisis–where exchanges resisted government pressure to adopt clearing even though there was no safety net that could have caused a divergence between private and social costs/benefits.  

As I said at the Atlanta Conference, my issue is not with clearing per se.  It is with who decides what gets cleared.  Chuck Vice from ICE (no, I did not make that up;-) had chided me after my talk where I cast doubt on the virtues of clearing for some products and participants by saying “I thought you were my friend, Craig.”  I replied: “I am your friend, Chuck.  If you (i.e., ICE) build a clearing system, and market participants come–as happened in energy–more power to you.  That’s great.  What I’m worried about is the ‘We’re from the government and here to help you’ problem.”   By substituting its judgment–an ill-informed judgment IMHO–for the judgment of market participants who (a) have better information on the costs and benefits, and (b) have skin in the game, and hence an incentive to make the right decisions (though since information and incentives are imperfect, they will some times make decisions that an omniscient agent would not), the Treasury risks reducing efficiency. This is a serious risk, in my view.

I have yet to hear any indication from the Treasury, Congress, or the Fed that the issues relating to information costs, and the implications thereof for the benefits of clearing have been acknowledged, let alone addressed.  Since information costs are an essential determinant of the efficiency of any risk transfer mechanism–which is what clearing is–this is a serious omission that undermines any presumption that the proposal is based on a thorough consideration of the relevant considerations.  

Some other issues.  First, the Treasury letter is framed in a very dishonest way.  It starts by saying “[a]s the AIG situation has made clear, massive risks in derivatives markets have gone undetected . . . even if those risks had been better known, regulators lacked the proper authority to mount an effective policy response.”  As its first proposed policy response, it recommends mandatory clearing of standardized products.  But the AIG products were highly non-standardized, and it is extremely unlikely that these products would ever be clearable.  But by linking clearing with AIG, the letter suggests that the former would have prevented the latter.  Nothing in any of the proposals would have had any effect on any of the AIG deals.  This linkage is dishonest, in my view; a classic bait-and-switch.  If a firm did something like that in a securities prospectus, the SEC would nail it.  Similarly, if somebody did something similar in an infomercial, FTC would be all over them.  

Second, the standardization issue will raise no end of difficulties.  It will create an incentive for parties who recognize that the costs of clearing exceed the benefits to enter into non-standard transactions.  The letter says somebody must “ensure that customized OTC derivatives are not used solely as a means to avoid using a CCP.”  The subject of the sentence is “CCPs.”  So, are we to believe that CCPs are to investigate bilateral transactions, and make a judgment on the motives for such deals?  There is a real conflict of interest here, as the CCP has the incentive to force business its way, and look at all non-standardized deals with suspicion.  (I should also note that if the dominant CCP is a member-owned entity dominated by banks, they may influence things in the other direction.)  More likely, the regulator will be required to make such judgments.  So, CFTC (or whomever ends up being the regulator) is supposed to put itself in the heads of transactors, and decide what their motives are for a particular trade?  This is a recipe for litigation, conflict, and most importantly, legal uncertainty.  

This will raise all of the issues that created problems under the Grain Futures Act and the CEA.  Those laws required “futures” to be traded on exchange, but allowed cash market contracts to be traded bilaterally.  So, what is a future?  What is a cash market contract?  Who knows?  In part, the answer depended on the economic purposes of the transactions.  Same now with the “standardized” vs. “non-standardized” distinction.  Such distinctions are recipes for dispute, and invitations for financial engineering to circumvent the clearing requirement.  The possible implications for legal certainty are particularly disturbing.  

Third, the letter emphasizes the role for “robust margin requirements.”  There is no recognition that margining can actually contribute to systemic risks, and that the rigid types of margining that CCPs perform may be particularly susceptible to this problem.  Margin calls can induce liquidations that move prices away from equilibrium values, and set off positive feedback mechanisms that destabilize the market.  Similar problems can arise in OTC markets, but the greater flexibility in these sort of arrangements, including the ability to utilize a broader range of collateral, can mitigate the problem there.  It is by no means clear that rigid CCP-style margining reduces systemic risk; it can increase it in some circumstances.  

On the issue of margins, I was interested to hear Chuck Vice (of ICE–I just like saying/writing that;-) say that ICE Trust took an “agnostic view” of the credit risk of member firms in setting margins, and therefore would charge everyone the same margin level that would be sufficient to cover the likely loss on a particular position during an extreme market move.  Bug or feature?  Chuck thinks feature.  I think bug.  Different members pose different default risks (just look at disparities in CDS spreads among the members of ICE Trust), and this would suggest the optimality of different margins–that is done in the OTC market.  One size fits all doesn’t fit everybody when people are of different sizes.  In the OTC market, parties can customize collateral levels to reflect risks, and this has virtues.  

Back to the Treasury letter . . .  

Another pernicious proposal is that the CEA be amended “to authorize the CFTC and SEC to impose . . . . The movement of standardized trades onto regulated exchanges and regulated transparent electronic trade execution systems.”

Again, this is the GFA/CEA redux–like those laws, this proposes to force a subset of all trades onto centralized exchanges, or electronic trade execution systems that are very exchange-like.  The reason for such a mandate is not stated.  Nor do I think it exists.  What externality is being internalized?  At what cost?  What is the basis for substituting the government’s judgment as to how trades should take place for the judgment of the transactors themselves?  

This is certainly a boon for the CME, and arguably ICE.  And shazaam, their stock prices took off after the release of the letter.  Who would have thought?  

Again, as under pre-CFMA CEA/GFA, the on-exchange/off-exchange distinction will lead to dispute, litigation, and legal risk.  

One could argue that exchanges are more transparent, and that transparency is a benefit.  However, other parts of the letter–namely, the requirement that all trades (including non-standard ones) be reported to a trade repository made available to regulators, and the development of a price reporting system–address the transparency issue.  Indeed, these are better ways to address transparency concerns than either clearing or forced exchange trading.  I said just that in my FRB Atlanta presentation, and in my academic writings on the subject.  Exchange trading may be sufficient to produce price transparency, but it is not necessary.

The transparency proposals are something I support.  Indeed, I view those as something of a vindication, as I was advocating such measures in energy markets in the 2003-2004 period.  The Data Hub lives!  

One issue with post-trade price and position transparency is the effect it will have on liquidity.  JP Morgan’s Eric Beinstein raised such concerns in his talk at the Fed conference.  This was a big deal with London dealers in the stock market, who feared that premature disclosure of trades would make it more difficult for them to lay off positions that they took on from customers.  Therefore, it may be advisable that some reporting delay be permitted.  

The letter also addresses market manipulation, fraud, and other abuses: “The CEA and securities laws should be amended to ensure that the CFTC and the SEC have . . . . Clear and unimpeded authority . . . to police fraud, market manipulation, and other market abuses.”  This is a red herring.  Relatedly the letter says that “under current law [OTC markets] are largely excluded from or exempted from regulation.”  This is wrong if it is meant to refer to exemptions from the manipulation or fraud provisions of the CEA.

CFTC already has authority to police manipulation of “any commodity traded in interstate commerce” and this clearly would extend to OTC swap markets as currently constituted.  Even the much (and wrongly, in my view) maligned CFMA did not exempt any market from the anti-manipulation or anti-fraud provisions of the CEA.  So, why is this language in the proposal?  Ignorance?  

More unfortunately, the letter recommends giving regulators the ability to set position limits on OTC market positions.  As I’ve written  in my book on manipulation, and often on SWP, position limits are an inefficient way to combat manipulation and fraud.  Ex post action is a better way.   CFTC should be better able to do this with better information about positions, so position limits are not advisable.

The problem, though, is not with CFTC’s powers or information.  It is with its willingness and ability to use them.  CFTC’s record in anti-manipulation litigation is hardly glorious.  Moreover, the legal precedents–especially CFTC decisions like in re Indiana Farm Bureau and in re Cox & Frey–have seriously undermined the deterrent force of government and private ex post litigation.  Treasury and Congress would do much more to improve deterrence by writing legislation to clarify manipulation law to undo the pernicious effects of these decisions.  Without doing that, Treasury is fooling itself when it says (in Geithner’s letter to Harry Reid, linked at the bottom of the link above) that  “With CCPs, trade repositories, and other market participants providing the CFTC and SEC with a complete picture of activity in the OTC derivatives markets, they should be able to detect and deter all such market abuses [emphasis added].”

As if.

Information is NOT the binding constraint.  When a manipulation is suspected, the subpoena power is sufficient to obtain the requisite information–and it is usually the efficient way.

I repeat: The binding constraints are (a) the intellectual confusion inherent in existing manipulation precedents; (b) the intellectual confusion at CFTC and other regulatory agencies when it comes to manipulation; and (c) the vague language defining manipulation in the relevant statute, which is ultimately the source of intellectual confusions (a) and (b), and which stemmed quite clearly from Congress’s own intellectual confusion.  I have been saying this since 1994.  So, don’t listen to me.  I’m used to it.  But don’t fool yourselves into believing that you will reduce manipulation efficiently through position limits and the collection of more information that is mis-used because of a failure to understand the economics of manipulation.

The letter also recommends actions to ensure that derivatives are not marketed to unsophisticated parties.  I have not analyzed this issue in detail, but it is my sense that this is another area in which ex post litigation, including private actions (including class actions) would be a preferable way to handle the problem.  Trying to write rules to determine ex ante who is, and who isn’t, sufficiently knowledgeable to enter into derivatives trades is extremely problematic.  I also worry about the incentive this provides for people to take risks, and then attempt to back out of losing contracts by claiming that they were duped.  Maybe they were, but I think there should be a pretty high standard of proof required to support such a finding.

In sum: There are a few good ideas in the Treasury proposal.  Very few.  The biggest, most important proposals are wholly misguided, in my view.  They reflect, again in my view, (a) a shockingly incomplete analysis of the relevant economics, (b) an unjustified and unsupported presumption that regulators’ and legislators’ judgments are superior to those of private transactors, and (c) a failure to identify market failures that the proposed regulatory changes would fix.

John Taylor of Stanford gave a very nice keynote speech at the FRB Atlanta Conference on Financial Crises & Innovation.   It was a very different speech than Bernanke’s, and much more critical of government as a cause of the crisis, and a potential source of systemic risk in the future.   Indeed, Taylor listed three major sources of systemic risk going forward that have been featured prominently on SWP as well:

·           Massive expansion of US government indebtedness.  Interestingly, Taylor said that “[t]here is certainly no  stimulus effect from such deficits, and they put a very heavy burden on the not so distant future.”  

·           A dramatic expansion of the Fed balance sheet, and serious questions about the credibility of any Fed promise to withdraw liquidity from the system, thereby leading to a substantial threat of inflation.

·           An undermining of the rule of law, primarily illustrated by the administration’s heavy-handed efforts to subvert bankruptcy law and debt contracts in the Chrysler case, as well as actions on executive compensation and forcing out CEOs.

I couldn’t agree more, obviously.   I think these are all major threats.   The first in particular is becoming greater by the day.   The second will become more acute as the Fed proceeds with various initiatives to acquire securities, thereby ballooning its already bloated balance sheet into the trillions, and as political pressures to avoid doing anything that could abort a recovery bias the Fed towards ease even if and when inflationary pressures become manifest.   The last is a new development, and it bears attention to see whether the government takes any further steps along this path.

Taylor’s overall theme was that massive government failure is a real possibility, and that government is a major source of systemic risk.   Agreed.   This is a message that bears repeating over and over again as regulatory and legislative nostrums are pushed in the coming months.

At today’s session, AEI’s Vincent Reinhart made a point that I’ve also emphasized on SWP.   I’ve said that the biggest lesson of the Great Depression is that people learned the wrong lessons from the Great Depression, and passed useless or counterproductive legislation as a result.   Reinhart said, in a similar vein, that the most important thing going on today is the battle over the narrative as to what caused the financial crisis, because that narrative will determine what policies are adopted going forward.   He stated that the narrative of the Great Depression was wrong, and that as a result the regulatory and legislative response was wrong too.   He fears that the emerging dominant narrative is similarly misguided, and will lead to similarly damaging results.

Taylor’s talk was an attempt to counter the conventional wisdom narrative, and advance a counter-narrative.   Sadly, I think that this is an uphill battle indeed.   But, as Reinhart says, it is a battle that needs to be fought.

As I was getting on the plane to come back home, a reporter sent me an advanced copy of a letter that Geithner has sent to Congress outlining plans for regulation of the OTC derivatives market.  That letter embodies a particular narrative that I believe is particularly, and perniciously, in error.  This illustrates the relevance of Reinhart’s point.  I will deconstruct that letter in detail tomorrow, time permitting.  

Oil was down almost 10 percent today, following the decline in equities.  But that’s not what I find intriguing.  What I find intriguing is that the price of oil was able to rise above $50/bbl, and stay there for awhile, despite extremely weak fundamentals.

These two FT Alphaville blog posts set out the story in detail.  They document continuing increases in inventories.  Specifically, both crude inventories and refined product inventories have been continuing their increase even as prices have inched upwards.  The increase in US refined plus crude stocks is a 4 standard deviation move–bigger than observed in almost 30 years.  Tanker rates are falling even as firms are chartering both clean and dirty tankers to store products and crude.  Refinery capacity utilization is at very low levels.

In a conventional theory-of-storage model, the increase in inventories would reflect a decline in demand/increase in supply that would also result in lower prices; the accumulation of inventories would slow, but not stop, the decline in prices.  Given that supply has actually dropped (due to OPEC output cuts), this would mean that demand has continued its precipitous drop.  

In the past I’ve argued that inventories and prices can move in the same direction when fundamental uncertainty increases.  An increase in fundamental volatility leads to increases in precautionary inventory holding.  The only way to accommodate this demand for higher inventories is to raise prices.

But that doesn’t seem to be a plausible explanation of what’s been happening in the last couple of months.  Some indicators of fundamental uncertainty, such as the VIX equity volatility index and credit spreads have actually eased in past months while the oil price was rising.  

So that leads me to another explanation, similar to the one advanced by the Diapason Commodities guy quoted in one of the FT pieces: Inflationary expectations.    

So what was behind the recent strength in crude prices? According to Corrigan most likely the same thing that was behind the equity rally – people investing in commodities and ‘real assets’ as an inflation hedge. As he explains:

This inflationary policy is already beginning to push people towards increasing their exposure to real assets — hence the rise in commodities and stocks   – a phenomenon very similar   to that which took place after the American devaluation of 1933, well ahead of the recovery in real output.  

Given the dismal news about the real economy, that’s the only thing that makes sense to me (in both the equities and commodities markets).  (Though Chinese strategic inventory accumulation is probably playing a role too.  That could be seen as inflation related too, however, as it involves the Chinese exchanging nominal claims, US dollar denominated securities, for real commodities.  That is a reasonable response to inflationary expectations; tends to reduce the demand for dollars; and cause an appreciation in the dollar prices of real commodities.  It is a Chinese contribution to quantitative easing.)  

You might say: “But the CPI and PPI actually dropped last month.  Inflation is the least of our worries: deflation is a more pressing concern.”  I would argue that these price measures are backwards looking; asset and commodity markets are forward looking.  And looking forward, there are many signs pointing to a potential spike in inflation.  It is not a probability one event, but the huge monetary overhang poses acute challenges to the Fed, and other central banks that have engaged in quantitative easing.  If they do not walk a very fine line, inflation could very well flare up.  And the line will be very hard to walk, because of the politicization of the Fed and other central banks, and the inherent credibility problem in anti-inflation policies as economies pull out of recession/depression/banana (a reference to Alfred Kahn’s quip in the 70s).  Therefore, it is not surprising to me that the dollar value of equities and commodities has strengthened somewhat recently.  

I will be keeping an eye on the connection between commodity prices and measures of fundamentals, especially inventories and capacity utilization.  Bearish fundamentals plus firming prices are a strong signal of potential stagflation.

A brief comment about today’s equity selloff.  I was actually surprised at the rally in stocks in recent weeks on bank earnings news.  I was surprised because I thought these earnings announcements said nothing about the main issue involving banks–the values of the assets in their portfolios.  Making money trading in an illiquid environment with wide bid ask spreads (because many competitors have exited the market), and intermediating in a market with a relatively steep term structure, is no surprise.  But what inquiring minds want to know is whether the banks are really solvent or not, and the answer to that question depends on the performance of all the bad assets.  It appears that today’s decline was related directly to inferences about the continued, and perhaps increasing, severity of this problem.  Inferences derived from reading between the lines in various bank earnings statements.  

For my part, I am paying little attention to bank earnings.  I am looking for clues about solvency.  And today suggests that the market is adopting a similar approach.

Commentor lisa castigates me for illogic/inconsistency in my analysis of Russian oil export policy, and what I claim is its serial dishonesty with OPEC.  You’re wrong, lisa, and I have the data to prove it.

In a nutshell, my analysis was: (a) that Russia was not choosing its oil export duty to discourage exports as part of a cooperative strategy with OPEC to raise world oil prices, (b) that to the contrary, Russia was choosing its oil export duty to maximize revenues, and take advantage of OPEC’s output cuts by selling as much oil as possible at the higher price produced by OPEC output cuts, and hence (c) Russia’s professions of solidarity with OPEC are deeply dishonest.  

From today’s Bloomberg:

OPEC agreed at three meetings last year to cut output by 4.2 million barrels a day, a 14 percent reduction to 24.845 million, as prices fell from a record $147.27 on July 11. The group reduced pumping by 1.2 percent in March, according to a Bloomberg News survey of oil companies, producers and analysts. The 11 members with quotas produced 25.06 million barrels.

As shipments declined, deliveries from exporters that aren’t in OPEC rose by 670,000 barrels a day in January. Russian overall exports climbed 6.3 percent in February and 2.2 percent in March, according to the Energy Ministry. Brazilian total exports more than doubled in both February and March, according to Brazil’s Trade Ministry.

The IEA has similar data for the period over which OPEC was cutting.  According to the IEA March report (the April report is subscription only), in December, Crude seaborne exports from the former Soviet Union (FSU) rose 410m bbl/d over November (ex BTC pipeline, which is mainly Azeri exports).  Total exports ex BTC rose 640m bbl/d (this includes some Kazahk exports via the Druzhba pipeline) in December vs. November.  Transneft exports rose 590m bbl/d.  In January, total seaborne exports ex BTC rose 150m bbl/d relative to December, and total exports ex BTC rose 170m bbl/d.  Transneft exports fell slightly.  

Russian product exports also rose.  Total exports of refined products from the FSU rose 150m bbl/d Nov-Dec, and another 150M bbl/d Dec-Jan.  Russian exports increased more than this, because, as IEA states, Ukraine and Belarus banned fuel oil exports during the Gas War.  

IEA also states that Russia oil production increased in January.  At the same time Russian oil output was nudging upwards, domestic consumption was falling dramatically due to the dramatically weakening Russian economy (a pronounced weakening that the IEA report remarks about several times):

Given the worsening economic outlook for Russia coupled with dismal oil demand readings for January, we have sharply revised down our oil demand prognosis for 2009.  Total oil product demand contracted 7.2 percent year-on-year in January, according to preliminary data, with all product categories bar gasoline posting sharp losses.  In particular, LPG, gasoil, naptha, and residual fuel oil–barometers of industrial production and power demand–shrank by 21.2%, 7.3%, 5.1%, and 4.0% year-on-year, respectively.  Moreover, a product associated with both consumer confidence and air freight–jet fuel/kerosene–fell by 10.4%.  [Note that since these are year-on-year figures, and consumption had increased from last January into the 3rd quarter, the falls in domestic consumption since 3Q08 are even larger than these figures.]

If Russia had been choosing its export duty to reduce exports as part of a coordinated strategy with OPEC to support oil prices, basic economics implies that: (a) exports would fall, (b) output would fall, and (c) domestic consumption should rise, or at least fall by a smaller amount than output (as setting taxes to reduce exports should divert output into the domestic market).*  In fact, (a) exports rose, (b) output rose slightly, and (c) domestic consumption plummeted. This pattern is consistent with my earlier analysis of the level of the Russian oil export duty. In essence, Russia set the export duty to divert supplies from the domestic market to the world market, exactly the opposite of what it would have done if it were acting in concert with OPEC to raise world prices.

In contrast, it is interesting to note that February 2009 OPEC output was approximately 8 percent lower than in the fourth quarter of 2008, and almost 10 percent lower than in the third quarter. Declines in Saudi output have been even more dramatic, falling 16.5 percent from their third quarter levels, 11 percent from the 4th quarter, and 5 percent from December.

In brief, it is abundantly clear that Russia set its export duty to take advantage of OPEC output cuts, encouraging exports, encouraging output, and stifling domestic consumption, rather than discouraging exports and production and encouraging domestic consumption, as would have been the case that it was attempting to reinforce OPEC actions.

And OPEC has noticed. From the Bloomberg piece:

Algerian Oil Minister  Chakib Khelil, who held the group’s rotating presidency in 2008, said March 17 that he was disappointed Russia hadn’t cut production to support prices. Suppliers need prices in a $60-to-$75 range to support production of higher-cost resources, Saudi Arabian Oil Minister  Ali al-Naimi  said on March 16 in Geneva.

Russia also lowered export duties this month to $15 a barrel from $15.70 in March to boost exports, the IEA said in the April 10 report. Brazilian production will rise 7.2 percent in 2009 to 2.54 million barrels a day, the IEA said.

And from the WSJ:

Mr. Sechin claimed Russia cut production and exports in recent months but most OPEC officials weren’t buying it. Exasperated, they say independent data show Russia boosted exports by almost 700,000 barrels a day the past six months, even as OPEC members shaved their own production.

As I’ve said before, this is actually one Russian policy that I endorse.  Undercutting the OPEC cartel is just dandy with me.  

That said, the whole episode demonstrates that Russia’s public statements about its policy goals are completely unreliable.  You need to look at what they do, not what they say.  And the oil case is an excellent example of how their actions give the lie to their words.

Combine this with Turkmenistan’s fury over the gas explosion (and the drastic cut of purchases that apparently caused it), the ongoing rancor between Ukraine and Russia (for which Ukraine also bears substantial culpability), the frictions over energy with Poland, Lithuania, and Belarus, and you get the picture.  The Russian Dale Carnegies: Putin, Sechin, and Lavrov, winning friends and influencing people through energy policy.

* Holding demand constant, a change in export duty intended to reduce exports to help support the world price would lead to a rise in domestic consumption.  Both world demand and domestic demand were likely falling, certainly in November-December, and domestic demand into 1Q09.  With falling for Russian oil, if Russia had chosen its export duty in coordination with OPEC output cuts in order to support world prices, exports should have fallen.  Exports can decline due to  a reduction in output and a smaller fall (or rise) in domestic consumption.  To help support the world price, declining export and domestic demand should have resulted in a decline in output, and a smaller decline in domestic consumption.  As noted above, however, Russian output increased slightly, and domestic demand plummeted.

Great News!  All is not well between Russia and Turkmenistan.  Although happy talk emanated from Moscow in the aftermath of  Turkmenistan President Gurbanguly Berdymukhammedov’s state visit to the Rusisian capital, developments in the weeks following the visit are definitely not to Putin’s and Medvedev’s liking:

Turkmenistan has delivered its clearest statement to date that it wants to see the development of a direct gas export pipeline system to carry thecountry’s gas to European markets.

A commentary on the official Turkmenistan.ru web site on Saturday  stressed the importance of “the shortest and most convenient routes” to new markets, but it did not directly say that Turkmenistan was looking for either a trans-Caspian gas pipeline to Azerbaijan or its onward connection to Europe via the Caucasus. Instead it spoke of the need for “diversification of energy supply and involvement of new countries and regions in the geography of energy routes.”

“The statement is a clear indication that the Turkmens are looking much more actively to Europe,” Dr Jennifer Coolidge, Executive Director of Caspian and Gulf Consultants, which specializes in analysis of Turkmen energy affairs,said.

The statement was unexpected because it came just a few days after Turkmenistan President Gurbanguly Berdymukhammedov visited Moscow for talks which Russia announced had paved the way for joint development of a new $1.2 billion East-West pipeline within Turkmenistan.

In an apparent reference to Russia’s halting of all gas exports to Europe via Ukraine on January 7, the statement said new routes were needed “to diversify supply of Turkmen natural gas and build the reliable and stable system to transit Turkmen energy to international markets.”

The foreign ministry commentary also indicated Turkmenistan’s unhappiness over price negotiations with Russia. The statement attacked the idea that international consortiums of gas producers should serve as “supranational  regulators of the price policy” — an apparent criticism of Russia’s work in promoting the Gas Exporting Countries Forum – and specifically attacked monopoly practices in gas trade whilst praising competition.

“The only true scheme to fix the natural gas prices is direct agreements between sellers and buyers,” the statement said.

Turkmenistan has a particular dispute with Russia in this regard, as Turkmen gas has been a staple of Ukraine’s gas supply for decades. But in recent years Turkmenistan has had to sell this gas to intermediary Russian  companies — first Itera, then EuralTransGas and currently RosUkrEnergo –only to see Russia then selling this Turkmen gas on to Ukraine at much higher prices.

Dr Coolidge considered that the sharp tone of the statement should be considered a declaration by Turkmenistan that it was not prepared to have its policies determined by Russia on either the issue of export routes or the price for Turkmen gas exports.

“Coming immediately after the Moscow visit, it is a clear indication of sending Turkmen gas to Europe directly and of securing greater independence on pricing.” she said.

She added that Turkmenistan remains concerned as to whether it will in fact receive the price for 2009 deliveries that it had negotiated with Russia  before the Ukraine dispute in January.

Turkmenistan has delivered its clearest statement to date that it wants to see the development of a direct gas export pipeline system to carry thecountry’s gas to European markets.

A commentary on the official Turkmenistan.ru web site on Saturday  stressed the importance of “the shortest and most convenient routes” to new markets, but it did not directly say that Turkmenistan was looking for either a trans-Caspian gas pipeline to Azerbaijan or its onward connection to Europe via the Caucasus. Instead it spoke of the need for “diversification of energy supply and involvement of new countries and regions in the geography of energy routes.”

“The statement is a clear indication that the Turkmens are looking much more actively to Europe,” Dr Jennifer Coolidge, Executive Director of Caspian and Gulf Consultants, which specializes in analysis of Turkmen energy affairs,said.

The statement was unexpected because it came just a few days after Turkmenistan President Gurbanguly Berdymukhammedov visited Moscow for talks which Russia announced had paved the way for joint development of a new $1.2 billion East-West pipeline within Turkmenistan.

In an apparent reference to Russia’s halting of all gas exports to Europe via Ukraine on January 7, the statement said new routes were needed “to diversify supply of Turkmen natural gas and build the reliable and stable system to transit Turkmen energy to international markets.”

The foreign ministry commentary also indicated Turkmenistan’s unhappiness over price negotiations with Russia. The statement attacked the idea that international consortiums of gas producers should serve as “supranational  regulators of the price policy” — an apparent criticism of Russia’s work in promoting the Gas Exporting Countries Forum – and specifically attacked monopoly practices in gas trade whilst praising competition.

“The only true scheme to fix the natural gas prices is direct agreements between sellers and buyers,” the statement said.    Turkmenistan has a particular dispute with Russia in this regard, as Turkmen gas has been a staple of Ukraine’s gas supply for decades. But in recent years Turkmenistan has had to sell this gas to intermediary Russian  companies — first Itera, then EuralTransGas and currently RosUkrEnergo –only to see Russia then selling this Turkmen gas on to Ukraine at much higher prices.

Dr Coolidge considered that the sharp tone of the statement should be considered a declaration by Turkmenistan that it was not prepared to have its policies determined by Russia on either the issue of export routes or the price for Turkmen gas exports.

“Coming immediately after the Moscow visit, it is a clear indication of sending Turkmen gas to Europe directly and of securing greater independence on      pricing.” she said.

She added that Turkmenistan remains concerned as to whether it will in fact receive the price for 2009 deliveries that it had negotiated with Russia      before the Ukraine dispute in January.

She said the consideration of new routes “fits into the discussions that the Turkmen authorities have been having with Austria’s OMV and Germany’s RWE on a Caspian Energy Corp.”

The Caspian Energy Corp.’s stated aim is to assess prospects for development of a trans-Caspian gas pipeline. This would then be able to hook into the existing South Caucasus Pipeline from Azerbaijan to Turkey, enabling it to connect up with the planned Eur7.9 billion ($10.6 billion) Nabucco pipeline project, in which both companies are also involved.

The EU-backed Nabucco pipeline is intended to carry Caspian gas on strictly commercial terms all the way to the Austrian hub at Baumgarten, with European Union officials specifically arguing that Nabucco should be seen as a way of attracting large volumes of gas — eventually as much as 60-120 Bcm/year — from Turkmenistan, as well as Azerbaijan, to Europe.

During Berdymukhammedov’s Moscow visit, an aide to Russian President Dimitry Medvedev said March 25 that the two presidents would sign during one of their future meetings an agreement on developing a major internal pipeline intended to connect the giant South Yoloten field with coastal producing  regions near the Caspian port of Turkmenbashi.

But on March 30, the Turkmen authorities announced that Berdymukhammedov had instructed the “Turkmengaz” state concern to announce an international tender for design and construction of the 30 million mt/year East-West gas  pipeline with a length of 800-1,000 km.

Such a pipeline would play a vital role in ensuring that any  trans-Caspian pipeline system to Europe would be able to access the giant South Yoloten field, which the UK’s Gaffney Cline declared last September contained a minimum of 4 trillion cubic meters of gas-in-place.

Russian accounts had said the aim of the east-west line was to provide a feeder for the planned Caspian Coastal pipeline, intended to run from the Turkmenbashi area to Russia.

The April 4 statement stressed the importance of a planned conference in Ashgabat over April 23-24 at which Turkmenistan hopes to gain further global support for its proposals to enhance “reliable and stable transit of energy to international markets under the aegis of the UN.” The conference is also expected to serve as a sounding board for companies seeking to take part in the East-West pipeline tender.

To summarize: Turkmenistan has taken a very brash, public, and outspoken position in direct opposition to virtually every Russian/Gazprom position on major gas policy issues, namely control of transportation, pricing, intermediaries, and a “Gas OPEC.”  Russia wants to control the transportation of gas, and ensure that Turkmen gas transits Russia on its way to European markets; Turkmenistan wants direct access to Europe.  Russia wants to control the marketing of gas, via shady intermediaries; Turkmenistan wants to deal with the consumers of its gas directly.  (Side note: another illustration of Russia’s/Gazprom’s peg-the-needle hypocrisy, given its constant demands to have direct access to downstream customers in Europe, and now in the US.)  Turkmenistan is worried that the Russians won’t pay what they’ve agreed.  Russia is seriously shopping the idea of a “supranational” cartel of gas exporters; Turkmenistan flatly opposes this idea so near and dear to Putin’s heart.

They must be fuming in the Kremlin and the White House on the Moskva, especially after

Medvedev said that Moscow and Ashgabat will soon sign new agreements on natural gas production and transportation, RIA Novosti reported. “We studied in detail cooperation in the fuel and energy sector, including progress in the implementation of very important accords, such as the intergovernmental agreement on the Caspian pipeline, and other projects,” Medvedev said after talks in Moscow with Berdymukhammedov.

. . . .

Russian presidential aide  Sergei Prikhodko  told journalists that Energy Minister  Sergei Shmatko  would soon head for Ashgabat to fine tune an agreement on the East-West gas pipeline, to link northeastern Turkmen deposits with the Caspian gas pipeline. He said the Russian and Turkmen leaders would soon meet again to sign the deal.

Given Turkmenistan’s defiance on every major issue, and its recent blunt statements regarding the pipeline explosion (arising from Russia refusing to accept contracted deliveries of gas, according to Turkmenistan), somehow I think that Medvedev can put his pen away.

This raises the question: What accounts for Turkmenistan’s sudden obstreperousness?  Things are so opaque in that part of the world, it’s very hard to say.  My guess is that Gazprom’s/Russia’s acute financial difficulties, and its desperation to get out of contracts to buy gas at high prices, have demonstrated clearly to the Turkmens that they cannot be dependent on Russia, as Russia will screw them at every turn. Moreover, they may sense that Russia/Gazprom are in a weak position right now due to the financial crisis, and so there is now a glittering opportunity to slip out of Moscow’s suffocating grip.  Maybe too the European move in Ukraine gave the Turkmens some indication that the game may be changing.  And, certainly, there must be all sorts of byzantine diplomatic maneuverings going on involving the US, the EU, and China, as well as Russia.

Whatever the reason, Ashgabat’s newfound spunk is very welcome.  I say again: let us hope that Foggy Bottom and Brussels will seize this opportunity, although, I share R’s doubts that they will.

Turkmenistan’s foreign ministry issued an exceedingly blunt statement blaming Gazprom for an explosion in a Turkmen gas pipeline.  The explosion allegedly followed an unexpected curtailment of Russian imports of Turkmen gas:

Turkmenistan, however, in a burst of undiplomatic language, blamed Russia for the pipeline disruption, saying Russia’s gas export monopoly Gazprom (GAZP.MM) had “irresponsibly” cut imports of gas and caused the accident.

The undiplomatic diplomatic response:

Turkmenistan’s foreign ministry said in a statement Gazprom cut gas imports on April 8 without warning its government in the capital of Ashgabat.

“Such actions by Gazprom Export are ill considered and irresponsible because it created a real threat to peoples’ lives and health and can lead to unpredictable ecological consequences,” the ministry said.

“Such an approach (low gas imports) is a unilateral, rude violation of the terms of the take-or-pay gas supply contract,” the ministry said in an unusually harsh statement. Gazprom is a state controlled firm and Turkmenistan has repeatedly called Moscow one of its most important strategic partners.

Now, let’s take our minds back to the dark, distant past; like, say, March, 2009.  Can anybody remember the bleating from Putin and Gazprom about how unacceptable it was for Ukraine and Europe to take unilateral actions in gas transportation without consulting with, or considering the interests of, the supplier of the gas?  I knew you could.  If Ashgabat is to be even partly believed, Russian took unilateral action  that caused a serious accident  without consulting the supplier of gas.  Kremlin/White House whinges about respecting their rights/interests would be less nauseating if they kept their hypocrisy somewhat in check, rather than giving it full, neurotic, narcissistic play at every opportunity.   (I acknowledge that anything coming from the Ex-Sov space needs to be taken with a dose of skepticism, but since Gazprom/Putin are among the world’s most brazen liars, Turkmenistan wins my vote on the relative credibility scale here.)  

So why would the Russians cut imports of Turkmen gas?  One hypothesis is that it is payback for Turkmenistan’s audacity in issuing an international tender for a new gas export pipeline–a pipeline that Gazprom had assumed it would build:

Russia began a “gas war” with Turkmenistan after the Central Asian nation called an international tender last week to build a pipeline, hurting relations as  OAO Gazprom  expected the contract, Kommersant said.

The tender for the East-West link from the biggest gas field in the Commonwealth of Independent States came as a surprise for Russia, the Moscow-based newspaper said.

Turkmenistan accused Gazprom of causing an explosion on a pipeline to Russia via Uzbekistan yesterday by reducing supply “sharply.” The country had exported 70 million to 80 million cubic meters of gas a day via the link before the blast cut shipments completely, Kommersant said.

I have another hypothesis.  Gazprom is sucking wind, and badly.  To mix medical metaphors, it is hemorrhaging cash, and those problems will only get worse in the coming quarters as the lagged adjustment in gas export prices will drastically cut the price Gazprom gets for its sales to Europe, and as volumes decline as well due to seasonal factors and the severe economic downturn in Europe.  

And here’s the major point.  The company also outsmarted itself by buying large quantities of Turkmen gas at  fixed prices that seemed like a good idea at the time, but which retrospectively turned out to be far above the current market price, and likely prices going forward.  (It’s a bitch being long flat price and short floating price in a bearish environment.  But schadenfreude is so sweet when Gazprom is involved!)  Note the Turkmenistan foreign ministry statement explicitly mentions “take-or-pay” contracts–this means that Gazprom was contractually obligated to take the full volume at the above market price, even if it had no market for the gas.  

So, one reasonable hypothesis is that a cash-strapped Gazprom probably tried to get Turkmenistan to give it a break on the take-or-pay obligations; Turkmenistan told Gazprom to pound sand; and Gazprom/Russia decided to welsh on the contract, unilaterally cutting its acceptance of deliveries.  Any pique over the Turkmenistan’s temerity at acting as an independent nation rather than a satrapy of Gazprom/Russia just provided another motive for Gazprom to stiff/punish the Turkmen.

Keep this episode in mind the next time Gazprom/Putin/Medvedev/Russia mention anything having the remotest connection with commercial morality or professionalism.  

The best thing about this is that it suggests that Turkmenistan is actually showing backbone and standing up–in a very public, in-your-face sort of way–to Gazprom and Russia.  There is an opportunity here.  I just wonder if anybody in DC (Foggy Bottom in particular) or Brussels is smart enough to take advantage of it.

The second best thing is that it provides evidence that Gazprom is under intense financial pressure.  And if Gazprom is under intense financial pressure, so are Putin and the rest of the coterie of parasitic capos that feast off it.

Michel and DR have a bet on the performance of the Russian economy in 2009.  I’m Shocked! Shocked! to see gambling at Craig’s Cafe SWP!

Russia Economy Watch has a very thorough description analysis of the subject of the bet.  Some highlights (lowlights?):

According to Deputy Economic Development Minister Andrei Klepach last week, Russia’s economy shrank by 7 percent year on year in the first quarter of 2009, a staggering turnaround for an economy which has just enjoyed eight years of solid oil-fueled growth.

“These figures are worse than we expected,” Klepach said at a press conference in Kiev,citing preliminary figures. Klepach also stated that net capital outflows reached $33 billion in the first quarter of 2009, following record outflows of $130 billion in the second half of last year.

. . . .

The Russian State Statistics Service have also released official gross domestic product figures for the fourth quarter of 2008. GDP was up 1.2 percent year on year, the worst reading for any quarter since the first quarter of 1999, and down from a revised 6 percent in the previous three months. The World bank are now suggesting that the present slump may be deeper than the one that followed the government debt default and ruble devaluation in 1998.

Certainly the data are bleak. Industrial production contracted for a fourth consecutive month in February – falling by 13.2% year on year – as the credit squeeze and falling incomes eroded demand for metals, cars and consumer goods. Retail sales contracted in February for the first time since February 1999. Unemployment was also up, at 8.5 percent in February, the highest level since January 2005.

Manufacturing output plunged with the collapse in demand in the last two months of 2008, and it is likely to contract further in 2009. According to Rosstat five of 14 major manufacturing industries reported outright output declines in 2008, with electronics, electrical, and optical equipment hardest hit (-7.9 percent), followed by textile and sewing (-4.5 percent) and by chemicals (-4.2 percent). Most of the dislocation took place in November and December 2008, when total manufacturing output respectively fell 10.3 and 13.2 percent (year-on-year). As credit continues to tighten and demand to fall, manufacturing is likely to contract further in 2009. According to recent statistics, manufacturing output dropped 24.1 percent in January 2009, compared with January 2008, and 18.3 percent in February 2009, compared with February 2008. In February 2009 the most significant declines were registered in the production of electro-technical and optical equipment (-46.6%), other non-metal products (-33.3%), and transport and transportation equipment (-31%).

. . . .
The latest data we have to hand confirm the ongoing character of the contraction. The Russian economy is thought to have declined by 5.4 percent in March compared with March 2008, according to the latest GDP indicator estimate provided by VTB Capital. The VTB GDP indicator also registered an average 4.4 percent contraction for the first three months of 2009, which would be the worst decline since the economy shrank 5.1 percent in the fourth quarter of 1998. The difference between the VTB estimate and the 7% estimate put forward by Klepach would lie in the fact that the VTB indicator does not include contstruction, and construction activity has declined sharply in recent months, so the two pieces of data are consistent with one another.

. . . .

As a result of this contraction in output and weakening in the labour market real incomes have declined substantially in Russia since the autumn of 2008. Rising unemployment and worsening enterprise finances (wage arrears have increased considerably) have meant that in the fourth quarter of 2008 alone, real disposable income dropped 5.8 percent year on year, and by 10.2 percent in January 2009 (again year-on-year). And unpaid wages as a share of total enterprise turnover tripled to 0.12 percent in December 2008, compared with August 2008. The stock of wage arrears as of March 1, 2009 (8 billion rubles or about USD 240 million) remains small but is likely to increase as the crisis grows. At the present time such arrears are thought to affect up to 450,000 people, significantly less than 1 percent of total employment. Growth in real wages came to a complete halt in January-February 2009, following double-digit increases in previous years.

. . . .

Inflation was spurred at the start of the year by the weakening ruble, which pushed up import prices, helping the annual rate jump to 13.9 percent in February from 13.4 the month before. The ruble has now lost 29 percent against the dollar since August. The most recent spike in inflation is evidently producing quite a headache for the Central Bank, since chairman Sergei Ignatiev last week that if April’s inflation is “significantly less” than it was a year ago, the central bank may consider cutting interest rates for the first time since 2007, giving some kind of monetary relief to an economy which is badly in need of it. Russia’s inflation rate went as high as 15.1 percent last June, and has since come down somewhat from that peak, but really the record of the central bank in containing inflation has been pretty abysmal.

Bank Rossii has been forced to raise its refinancing rate twice since last November, to the current level of 13 percent, in an attempt to limit the amount of rubles available to banks and companies and to slow the decline of the ruble against the dollar. On the other hand the central bank may be in danger of excessive optimism at this point, with Ignatiev telling journalists that his expectation was that the economy may pick up within “several months,” thus trying to offer hope that Russia’s banks won’t suffer that “second wave” of crisis that Finance Minister Alexei Kudrin said may hit as bad loans eat up capital. I am of the opinion that Kudrin is right to be cautious here.

Rising delinquency “is a serious problem, but I don’t share the opinion that a second phase of the crisis is unavoidable,” is Ignatiev’s view. Overdue retail loans rose to 4.4 percent as of 1 March from 3.2 percent on 1 September. “I believe the most serious phase of the economic crisis is over,” Ignatiev told journalists. Would that he were right, unfortunately I think he is wrong, the worst is still ahead.

Obviously the continuing inflation is a problem for Russia’s central bank since they would obviously like to offer monetary easing to the economy, just as the U.S. Federal Reserve, the European Central Bank and the Bank of England are doing by bringing their benchmark rates close to zero to bolster banks and pull their economies out of recessions. Bank Rossii last cut the refinancing rate in June 2007, and it has now increased the repurchase rate charged on central bank loans four times since November.

REW does note that various measures indicate that the rate of contraction in the Russian economy slowed in March; the economy was still contracting, but not as rapidly as in February, which in turn exhibited a lower rate of contraction than January.

To me, the most interesting aspect of all this is the policy dilemma.  The inflation issue mentioned above is a serious issue.  As I’ve mentioned before, Russia is in a stagflationary situation, which makes it very difficult to use an expansive monetary policy.  (Not that I think that US or UK policy is to be emulated.  We’re just facing a stagflation down the road.)  

A more severe contraction than forecast by the government also puts Russian government finances in a serious bind:

While the Organization for Economic Cooperation and Development and the World Bank are forecasting that the Russian economy will decline by 5.6 percent and a 4.5 percent, respectively, in 2009, the Russian government is still stubbornly holding fast to its official forecast of a 2.2 percent fall. Publicly government officials are sticking to their view, and diiging in around the idea that they expect a recovery in the final quarter. Deputy Economic Development Minister Klepach said that the government forecast takes into account a package of anti-crisis measures currently being debated by lawmakers that should bolster domestic demand and help boost GDP. Without it, the economy could contract by 4 percent to 5 percent, Klepach noted.

The Central Bank, on the other hand, continues to forecast a 4.5 percent contraction for the current year.

The Russian Cabinet approved last month a revised budget containing the first deficit in 10 years. The budget anticipates a deficit of 7.4 percent of projected gross domestic product, but since the current forecast is for a GDP contraction of only 2.2%, the final deficit may be considerably larger. The Finance Ministry is now transfering money from the Reserve Fund to cover the deficit, and anticipates using some 2.7 trillion rubles this year to help fund the budget gap.  

The Ministry of Finance has released the main parameters of its revised federal budget for 2009 which is based on lower oil prices (USD 41 a barrel, Urals) and a drop in budget revenues from the original 21.2 percent of GDP (under the old assumption of USD 95 a barrel) to 16.6 percent, or RUB 6.72 trillion. At the same time, expenditures will be increased by RUB 667.3 billion to RUB 9.69 trillion, to produce a deficit of RUB 2.98 trillion (about 7.4 percent of GDP), a massive reversal of the fiscal position from the 4.1 percent surplus in 2008.  

The total consolidated general government deficit is expected to be around 8 percent in 2009 deficit and will be financed largely from the Reserve Fund (7 percent of GDP) with modest domestic borrowing (up to 1 percent of GDP). With a large fiscal deficit, however, and the need to preserve some reserve fund resources for the uncertainty likely to extend into 2010, the space for more fiscal stimulus this year appears limited.

So the level of the contraction which the Russian economy undergoes in 2009 really is rather big beer, since it will condition the size of the eventual fiscal deficit, and the percentage of the Reserve Fund which will need to be used this year. If there is no rebound in oil prices in 2010 then Russia’s position can complicate on a number of fronts, since the Central Bank Reserves will be significantly depleted, the Reserve fund also, and there may be less room for fiscal easing in the face of potential credit rating downgrades, while monetary easing may also prove difficult given the need to support the currency, and protect Central Bank Reserves. All in all, 2010 could be a very hard year for Russia and its citizens.

Putin is touting the efficacy of his fiscal policy measures;

Prime Minister Vladimir Putin defended his handling of Russia’s economic crisis on Monday, telling lawmakers a 3 trillion-rouble ($90 billion) aid package would ensure the country survived a “very difficult 2009”.

“What should — and must — be said with all certainty is that Russia will overcome the crisis,” a confident Putin said in a 65-minute report to the State Duma (lower house), his first as prime minister.

“The country will beyond all doubt keep its position as one of the largest economies of the world.”

Amazingly, Putin also forecast that inflation would fall soon.  Right.  

I think a more realistic appraisal is that the likely prolonged economic downturn will put tremendous pressure on the Russian budget, thus draining the reserve funds, and putting tremendous pressure on the Central Bank to inflate.  

Russia’s fate depends now, more than ever, on a worldwide recovery.  Russia is a high beta country, due to its dependence on raw material exports.  The US Fed’s unprecedented loose monetary policy may also provide help to Russia by helping to prop up the prices of Russian exports.  But Russian policymakers have very few levers to pull.  They are at the mercy of the world economy.  And therefore, so are the betting men on SWP;-)

Last month Senator Maria Cantwell (Duh-W) announced two pieces of legislation to ”  help prevent future energy price bubbles and market manipulation“:

The first, S. 672, which she introduced on Mar. 24, would give the Federal Energy Regulatory Commission authority to issue cease-and-desist orders against manipulative schemes in progress. The US Securities and Exchange Commission and Commodity Futures Trading Commission already have this authority, she noted.

She said the bill also would make FERC able to freeze the assets of any entity suspected of market manipulation. It would give the commission authority to temporarily change or suspend power rates for up to 30 days during an energy emergency caused by market manipulation. And it would have any potential natural gas refund accrue from the time FERC brought a case (an approach currently used in electricity markets, according to Cantwell) instead of when it actually proves it.

“It will allow FERC to act more like a cop catching a robbery in progress instead of trying to piece together what happened at a crime scene after the fact,” she said.

Yes, we are expected to nod and trust the formulation of rules regarding the operation of our vast, and enormously complex financial markets to the likes of Senator Cantwell, who is apparently rather ill-informed about ordinary policing activities, let alone about the relevance of the possibility that cops may now and again interrupt an armed robbery at the Quickie Mart (Apu! Duck!) to the determination of the efficient way to reduce the frequency of manipulation and “excess speculation” in energy markets.  

First off, the premise of Cantwell’s analogy is wildly inaccurate.  Just how often do cops intervene while felonies are in progress?  Virtually all police work is done after the crime has been committed.  Cops respond to the calls of victims, or alarm calls, and in the vast majority of cases arrive after the perpetrators have fled.  Then begins the arduous process of “trying to piece together what happened at a crime scene after the fact.”  That’s exactly what cops spend most of their time doing.  Either Senator Cantwell watches way too much TV, or not enough.

Second, even if one were to grant that cops have the authority to intervene in crimes in process, and sometimes utilize that authority, that does NOT imply that this is the best way to fight market manipulation.  The law and economics of the trade-off of prevention vs. deterrence is very well understood.  (Steve Shavell wrote a very thorough article on the subject in the JLE in the early-90s.)  Deterrence–piecing together what happened after the fact, and imposing sanctions on those found to have committed harms–works best exactly in conditions like those that characterize a market manipulation.  Specifically, a real manipulation is readily detectable after the fact.  As Judge Easterbrook has written, “an undetected manipulation is an unsuccessful manipulation.”  Moreover, manipulators are typically not judgment proof.  That is, they are typically quite wealthy, and can afford to pay fines or other punishments equal to the harm they inflict.  Those that aren’t judgment proof are the firms whose manipulations failed spectacularly, and ruined the perps financially.  From a deterrence perspective, that isn’t a big deal, because fining successful manipulators can make the payoff to manipulation negative in every state of the world (fines when your manipulation succeeds; financial ruin when it doesn’t).  These are the conditions that make deterrence preferable to prevention.

Indeed, information considerations strongly favor ex post deterrence (as I argue in my 1996 book on manipulation).  Manipulations often unfold very quickly.  Moreover, the most distinctive effects of manipulation, such as the collapse in prices that follows the end of a corner (the “burying the corpse” effect), are virtually unmistakable after the fact, but cannot be observed while the corner is in progress. As a result of this fact, and others,  regulators necessarily have far less information about whether prices are distorted while a manipulation is in process, than after the fact.  Due to this information disadvantage, both “false positives” (intervening when a manipulation is not in reality occurring) and “false negatives” (failing to intervene in a real manipulation) are more likely when one attempts to act during an alleged manipulative event, than to wait and impose damaging sanctions after the manipulation is over.  Indeed, given that a mistaken intervention in a market would be extremely disruptive, false positive interventions are very costly.  That is, mistakes are much more likely, and the costs of mistakes are higher, when regulators attempt to intervene in real time, rather than to deter manipulation through the imposition of penalties.  (Moreover, private actions by those harmed by manipulation also have a strong deterrent effect, can rely on the superior information available after the fact, and can also fill the deterrence gap when regulators fail to act even after the end of a manipulation, as is too often the case.)  

Moreover, the costs of ex post deterrence only need be incurred when a manipulation has actually occurred, whereas maintaining a “police force” and surveilling every market is quite costly, and these costs must be incurred even when no manipulation is occurring.  

In other words, Cantwell is only 180 degrees off.  But it was one of her better days, I’m told.  

A couple of other entertaining thoughts.  First, the article states:

FERC would welcome this additional authority, according to one of the hearing’s witnesses, Anna Cochrane, acting director of the commission’s enforcement office. “Congressional action to give the commission cease-and-desist authority for violations of the [Federal Power Act] and [Natural Gas Act] and the ability to freeze assets of entities that violate the market manipulation rules would give the commission the same enforcement tools that both the SEC and CFTC have long possessed. In addition, authority to temporarily suspend market rules on file under the FPA when necessary to protect against potential abuse of market power could be useful,” she said in her written statement.

Imagine that.  A government agency that would “welcome . . . additional authority.”  Shocking.

Second, the article notes that CFTC and SEC have this authority.  With respect to market manipulation, it is seldom used.  

More humor:

Cantwell said the second legislation the hearing would examine would establish an office within EIA to collect and analyze information from physical and paper oil markets. This would improve EIA’s ability to predict future energy prices and help regulators police markets more effectively, she said.

In his written testimony, McCullough said no federal agency has been directed to investigate and explain last year’s extraordinary crude oil price changes despite oil’s arguably being the US economy’s most important commodity.

“The inability of the federal government to fully investigate oil price behavior in 2008 is fundamentally a data problem. Perhaps it is not a coincidence that oil is the most opaque of our nation’s energy supplies. The transparency legislation that you are discussing today is a step in the right direction because it will expand EIA’s ability to track oil inventories within the US by owner,” he said.

Sure.  EIA will be just dandy at forecasting energy prices.  And how is EIA, which has no enforcement authority, supposed to coordinate with CFTC and FERC (and perhaps soon, the FTC, when it puts its oil manipulation rule into effect), which do?  

“McCullough,” by the way, is Robert McCullough, Jr.  He is one of several people, e.g., Michael Masters, who routinely testifies before various House and Senate committees on energy market speculation and manipulation issues, and just as routinely parrots exactly what Cantwell, et al, want to hear.  The regular presence of this tiresome cast of courtiers, who IMO have little if any demonstrated expertise, and who routinely make idiotic arguments unsupported by logic or evidence, make the hearing process look like Kabuki theater, or a show trial.  It’s not intended to raise issues, find facts, sift evidence, or air serious disagreements.  Instead, it’s purely a theatrical production, with a pre-scripted outcome, intended to convey the impression of investigation, inquiry, and debate.

In the scheme of things, manipulation should be one of the easier things to regulate and deter in financial markets.  Nonetheless, Congress and various alphabet soup regulatory agencies (GFA, CEA, SEC, FERC, and probably soon, FTC) have made a complete botch of it for going on 87 years now.  (Yeah, I know.  But I’m feeling generous today.)  Yet we’re supposed to have confidence that that same Congress and same array of regulators (plus some more) have the knowledge, competence, and incentives to legislate and regulate much more complex and arcane aspects of the operation of the financial markets (e.g., clearing, “excess” speculation, product design).

Just remember the three big lies.  The check is in the mail.  I’ll respect you in the morning.  And the biggie: I’m from the government, and here to help you.

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OK, that’s hyperbole.   But my work in the case in Josef A. Kohen, Breakwater Trading LLC and Richard Hershey v. Pacific Investment Management Co. (“PIMCO”) was the focus of some attention in the argument heard before a 7th Circuit panel headed by the formidable Judge Richard Posner.   Here’s an MP3 of the hearing. Defendant PIMCO had appealed class certification in the case, and the hearing related to the question of whether Judge Guzman’s (the trial judge) decision to certify should stand.

Listening brought back memories of my grad school days, specifically the Economics of Legal Organization Workshop at Chicago.   Posner, Stigler, Becker, Telser, Peltzman and other heavyweights would sit in the first row.   Usually the speaker would utter perhaps two sentences, and then one of the front row crowd, and often Posner in particular, would jump in with a question expressing extreme skepticism, criticism, or incredulity.   That’s what happened to PIMCO’s lawyer.   Two sentences, and up pipes Judge Posner with a very, pointed, shall we say, question.

I’m biased, and an amateur observer of these sorts of things, but overall I think it went pretty well for the good guys.

The WSJ has a long article based on an exclusive interview with your fave and mine, Igor Sechin.  It is full of the usual his-lips-are-moving whoppers, but this one stunned even me, even as predisposed as I am to snort at pretty much anything old Eyegore has to say:

And he was quick to point out that Russia became a major oil exporter in the 1970s in response to demand in the West amid the Arab oil embargo. “Now they tell us, ‘You have Dutch disease, you’re a resource economy.’ But you yourselves asked us to be that way,” he said.

Sorry, but WTF is he talking about?  Yeah, the USSR was just eager to please the US and the West in the early-to-mid 1970s.  We said “jump”, and Brezhnev said “how high, boss?”  

Please.  The Soviets exported oil because (a) there was money in it, (b) they needed a lot of money, given that the rest of the economy was going to hell (especially the agricultural sector, which couldn’t feed the country), and (c) they had absolutely nothing else to sell that anybody wanted.  

What is it about Russians that they are responsible for absolutely nothing?  It’s always “The Devil (i.e., America) made me do it!”  They are wanna be Masters of the Universe, but everything is out of their control.  Sheesh.

Here’s another one from Putin’s Pinnochio:

Mr. Sechin is Moscow’s point man for warming relations with the Organization of Petroleum Exporting Countries. But he said Russia, the largest oil producer outside the cartel, isn’t ready to accept membership in the group, despite its pleas.

“It would be irresponsible for Russia to join OPEC because we can’t directly regulate the activity of our companies,” he said, as nearly all are privately owned.  (Emphasis added.)

Spare me.  

First, Russia taxes oil exports.  It is perfectly feasible for Russia to regulate the activities of its companies indirectly through the oil export duty mechanism.  Russia can achieve any level of exports it wants by adjusting the duty.  And it has been adjusting it–downwards, thereby encouraging oil exports.  (Maybe Sechin was quite deliberate in including the word “directly” in his answer, knowing quite well that this is an irrelevance, given the ability of the government to control exports via the tax mechanism, without directing companies to do anything.)  

Second, “nearly all are privately owned”–except the one that is by far the biggest, Sechin’s own Rosneft.  And, does he really expect us to believe, with Khodorkovsky in the dock, Mechel’s CEO Igor Zyuzin contemplating what Putin meant about “sending a doctor” (and given Russian healthcare, that is a frightening prospect), BP-TNK’s Dudley fleeing the country, etc., that if Putin or Medvedev told the owners/managers of these “privately owned” companies to cut exports, that they wouldn’t salute and ask “how much?”  

Sechin repeated his call to segment and “gasify” the oil market:

Mr. Sechin called for a gradual but major overhaul of the international oil trade, adding tight regulation and longer-term supply contracts, eliminating “economically unjustified intermediaries” and reducing speculation. Russia is the world’s No. 2 crude exporter.

Russia doesn’t like open markets and price discovery.  It likes market segmentation and backroom deals.  

In the add insult to injury category, Sechin uttered these Orwellianisms:

Mr. Sechin hailed  BP  PLC’s TNK-BP Ltd. joint venture in Russia as a sign of Russia’s openness to foreign investment in the sector. But he singled out secretive Siberian giant OAO Surgutneftegaz as “Russia’s best private oil company.”

Investors have criticized Surgut for refusing to release international-standard financial accounts or details of its ownership structure.

Surely, from Sechin’s perspective, black hole Surgutneftegaz is indeed the ideal energy company.  And yes, the whole BP-TNK fiasco is just a shining illustration of how an Investor’s Paradise has risen from the ashes of the former Worker’s Paradise.  Orwellian, like I say.

I actually appreciate the fact that Sechin has become much more open.  By speaking publicly, he reveals his utter mendacity, and in so doing, provides a revealing glimpse at the equally mendacious regime in which he serves.