Streetwise Professor

For a perfect illustration of why the UN (and most NGOs and most of those talking about Great Resets and the like) represent a grave threat to the lives, health, and livelihoods of those whom they claim to want to help, consider this ignorant drivel on the introduction of water futures on the CME from  Pedro Arrojo-Agudo, the UN’s “special rapporteur on the human rights to safe drinking water and sanitation.” (Hey! He’s not just an everyday run of the mill rapporteur! He’s a special rapporteur!).

According to Bloomberg, water futures “risks a price run-up for a resource that ‘belongs to everyone’ and is a vital tool in combating the Covid-19 pandemic.” Further:

“The news that water is to be traded on Wall Street futures market shows that the value of water, as a basic human right, is now under threat,” Arrojo-Agudo said in a statement. “It is closely tied to all of our lives and livelihoods, and is an essential component to public health.”

Beyond the fact that the reference to “Wall Street futures market” is ignorant (and an offense to Chicagoans!), this short statement is packed with more substantive economic ignorance.

Oh, the blather sounds good: water is “a human right” that “belongs to everyone.” Yay! But it’s exactly this kind of crypto-socialist blather that wreaks great harm when put into actual policy.

For one thing, something that “belongs to everyone” ends up belonging to no one. Or more precisely winds up being grossly misallocated or misused or wasted. Those who don’t own have no incentive to utilize wisely. They have too little incentive to avoid polluting. They have little incentive to increase availability or quality. Indeed, I warrant that many–and arguably the lion’s share–of the problems that Mr. Arrojo-Agudo is rapporteuring about (or whatever it is that rapporteurs do) are directly attributable to the lack of property rights in water, or grossly suboptimal rights. Relatedly, they are directly attributable to the lack of market mechanisms built on property rights to allocate a scarce resource–clean water–and the reliance on political mechanisms plagued by rent seeking and corruption to do so.

It’s not easy to design and enforce property rights for water, for a variety of reasons. Some of these reasons inhere in the nature for water. For example, designing and enforcing rights to an aquifer are challenging. But many of the problems are political, and public choice in nature. Look at the conflicts over water in the American West for myriad illustrations.

But grasping the nettle of these challenges, and even doing it imperfectly, is distinctly preferable to the policies that arise from an “it belongs to everyone” attitude. That is a recipe for dissipation, waste, and pollution. Water socialism works just as badly as all the other kinds.

As for the “speculative bubble” fears, such creatures are far more common in the fevered imaginations of the likes of UN rapporteurs, NGO nudniks, etc., than in the wild. They hysteria over an oil price bubble in 2007-2008 is an example. This is something that even Paul Krugman and I agree on. Show me a commodity price bubble, and I have a high degree of confidence that it can be explained by fundamental factors. Indeed, interventions intended to combat these bubbles almost always lead to less efficient resource utilization than the alleged bubbles themselves. Price “bubbles” in commodities are usually simply the bearers of bad fundamental tidings.

That is, attempting to suppress “price run-ups” makes things worse, not better.

I’ve already opined that I consider it unlikely that the CME/Nasdaq water futures will register much trading volume, for relatively technical reasons. The same reasons apply to other possible water futures contracts. So Mr. Arrojo-Agudo should direct his nervous energy to other subjects.

But the anti-property, anti-market mindset that the UN rapporteur embodies is a grave threat to prosperity and health. This mindset makes people poorer and more miserable wherever it rules policy. Which is why the UN, NGOs, Great Resetters, and the like pose a far greater danger than all the speculative bubbles ever stacked one atop the other.

The biggest intellectual defect of modern environmentalism–and there are many–is its monomania. The obsession with greenhouse gases has led it to advocate drastic changes in the production and consumption of energy without regard for the non-GHG-related consequences of these changes, including in particular the environmental consequences.

Fossil-fuels are carbon intensive, but the alternatives to fossil fuels and fossil-fueled vehicles, heaters, appliances, etc.–electricity generated by wind and solar, batteries, vastly expanded transmission networks, electric cars and appliances–are incredibly material intensive.

Many–most–of these materials need to be mined. Electric vehicles and batteries utilize massive amounts of metals and minerals, e.g., copper, nickel, cobalt, lithium. The mining of these things generates massive amounts of pollution of the air and water and the ground.

Just a few examples. Many of the largest Superfund sites in the US are defunct copper mines, like the Berkeley Pit in Montana, where decades after its retirement the country’s largest earthen dam holds back–hopefully!, as I’ll discuss in a moment–6.5 trillion gallons of toxic sludge. And the mine itself is now a 900 foot deep, mile long, toxic lake.

What did I mean about “hopefully!”? Well, there have recently been massive failures of containment dams at mines in Canada, Brazil (at least two) and Australia, which have cost hundreds of lives and massive ecological and economic damage.

Even when there are not such catastrophic failures, the accumulation of toxic tailings is hardly green.

And tailings are not the only issue. Let’s talk about air pollution, shall we? Specifically with a mineral that will be crucial to the production of massive batteries–nickel.

Riddle me this: what city has the worst air pollution in Russia, and among the 10 most polluted in the world? If you answer “Norilsk”, you’re a winner. Why? Nickel production. The world’s largest nickel mine and processing facility located there spews out “four million tons of cadmium, copper, lead, nickel, arsenic, selenium and zinc” per year. And the river runs a beautiful красный for good measure. Not very зеленый!

The “green” electrification of the entire world will require massive amounts of rare earths. The vast bulk of rare earths are produced in China. Not because it is uniquely endowed with them–they are actually quite common. Because only the Chinese are willing to accept the pernicious environmental impacts of rare earths mining.

And it’s not just environmental impact. It is historical impact as well. Rio Tinto obliterated a 40,000 year old archeological site to expand an iron ore mine. The “Sacred Valley” in Peru is also being mined extensively.

These things are happening at current scale, and they are an inevitable consequence of industrialization. But the question is whether the benefit of reducing GHG emissions justifies increasing commensurately these impacts. For you multiply these environmental consequences by many times when you consider the impact of multiplying electrical vehicles and appliances and batteries by many, many times.

Wind and solar generation facilities also consume massive amounts of material. Many of these are mined, or involve polluting production processes (including not immaterially–pun intended–concrete, which is a major GHG producer).

But there’s also the land. I’m so old that I can remember (though I was very young at the time–so I’m not THAT old!) Lady Bird Johnson campaigning against the visual blight of highway billboards. Quaint, really: they were a ribbon of eyesores, at most. In contrast, the amount of wind and solar facilities required to achieve the grandiose objectives of the Green New Deal or its proposed counterparts around the world (ya I’m looking at you Boris) would create square mile after square mile of eyesores.

Not to mention (a) displacing land from other productive uses, and (b) creating large risks for fauna, especially birds. Wind farms are collections of bird blenders, and solar farms bird fryers.

The lack of thought to environmental consequences behind grandiose “carbon neutral” visions is also apparent in the failure to consider the substantial diseconomies of scale in wind and solar. Meaning that costs will rise disproportionately to increases in renewables generation.

You can expand wind output on an intensive margin–siting windmills closer together. But this cannibalizes the wind, leading to output per turbine decline with density, and hence rising costs. You can expand wind output on an extensive margin–devoting more land to wind farms. But this also reduces average and marginal productivity because it requires expanding into progressively less windy places. Moreover, it results in higher average and marginal costs, because even holding windiness constant, the marginal value of the displaced land in alternative uses increases (because holding windiness constant, you’ll develop on the cheapest, least productive land first).

Solar is hard to expand on the intensive margin, but expansion on the extensive margin faces the same sources of rising cost as wind.

Meaning that these plans to substitute wind and solar for existing fossil fueled generation at the same time as dramatically substituting electricity for other forms of energy (e.g., electric cars instead of ICEs, electric appliances instead of gas) will inherently result in steeply rising costs.

Steeply.

If you look at countries (or states like California) that have even been able to get a mere ~20 percent of their electricity generation from renewables, you will see they are also the countries where electricity is most expensive. Usually by a factor of 2 or 3 or more than those that rely on conventional generation. Given the inherent increasing cost nature of renewable production, think of how much more expensive it will be to produce close to 100 percent of total energy consumption from renewables.

Rational people take into account trade-offs. Drastic reductions in GHGs involve massive costs. Many of these costs are environmental. The environmental pollution–real pollution, not the sort-of-pollution of say CO2–that will result from the massive production of materials necessary for electric vehicles, electric appliances, large scale storage batteries, transmission lines, wind turbines, and solar installations is staggering. Staggering. The consumption of natural resources–not just those buried in the earth, but the earth’s surface–will be prodigious. The cost of energy will rise, which will make people poorer: and the poorest will be hardest hit.

I often use Jefferson Davis’ proposed epitaph for the Confederacy–“Died of a Theory”–to illustrate the destructive tendencies of those wedded to a single principle, to the exclusion of other considerations. Unfortunately, it is too early to use it as an epitaph for modern environmentalism, because that is all too alive. But the idea fits. Monomaniacally wedded to theories of climate change and GHGs, modern environmentalists are pursuing a course that will, paradoxically and perversely, wreak massive environmental destruction.

How green is my valley? After the greens get done with it–not very green at all.

In the past, I’ve written about ABCD singing the blues. That is, in recent years the big ag trading firms have struggled to make money. This year, things have turned around.

And the explanation is what it always is: volumes and margins. Period.

In a nutshell, flows to China have picked up substantially, and flows from US competitors have abated due to weather issues:

China agreed to buy $36.5 billion in agricultural commodities from the U.S. in 2020 under the phase-one trade deal, up from $24 billion in 2017, the year before the trade war started. The Asian nation has already bought record amounts of corn, and soybean purchases for the current season are running at their strongest pace in data going back to 1991. U.S. exports of pork are at a record and there’s also been rising sales of beef and sorghum.

A drought that’s delaying planting in Brazil is also boosting prices, as it could force Chinese buyers to buy even more from the U.S. In the Black Sea region, dry weather has also hurt Ukraine’s corn crop and is threatening wheat plantings in top grower Russia at a time countries are bringing purchases forward and hoarding food.

The ABCDs have assets worldwide, but their asset base is still US-focused, so they are are seeing bigger flows through their midstream assets in the US, which translates into bigger margins:

The elevation margin, or the price difference between crops loaded onto ships at Gulf ports and the cost of a bargeload delivered to New Orleans, hit the highest level since at least 2016 earlier this year, according to Bloomberg calculations using Commodity3 data.

Bean crush margins are also very high.

And no, contrary to the standard narrative (and to the BBG piece), it has nothing to do with flat prices rebounding. Zero. Zip. Nada. Corn and soybean prices are not markedly different now than when trader profits were languishing:

Nor (contrary to the lead paragraph in the BBG article) are corn and soybean flat price volatilities markedly higher now than when ABCD were singing the blues.

What matters is flows, and where a firm’s assets are relative to those flows. For a variety of reasons, flows out of the US are strong now. This, in turn, increases the demand to utilize assets (such as barge or ship loading facilities) that handle those flows, increasing the prices thereof (i.e., handling margins). When volumes and margins go up, shazam!, profits go up.

That’s the way it has always been, and always will be.

As if to add a QED (with an exclamation point) to my last post, Facebook and Twitter cranked the censorship amp to 11 in an attempt to suppress dissemination of the New York Post story about the release of material from one of Hunter Biden’s laptops. Among the censored, inter alia: the NY Post itself, White House press secretary Kayleigh McEnany, and the GOP House Judiciary.

After I read about McEnany’s Twitter account being suspended, I told a friend that I estimated the over/under on how many days before they blocked Trumps account at 2.

The under won. Twitter suspended him today.

This was after Jack Dorsey had said that censoring the article was wrong and that Twitter had made communication errors in explaining its actions.

Translated: “We need to lie better.”

The ostensible justification for this was that the information had been acquired by hacking.

GMAFB.

Crack addict whoremaster Hunter dropped off the laptop (3 actually, 2 of which were unrecoverable) for repair. He didn’t pick them up, or pay for them, for 90 days. Meaning that they were the property of the repair shop. No hacking involved. Hunter surrendered this laptop–and the information on it.

And by the way: a real hacker would have blackmailed Hunter/Joe/the DNC.

It’s not as if Hunter doesn’t have a record of such dumbassery. He left a crack pipe and cocaine in a rental car that he dropped off. While he was in rehab.

And as if Twitter, FB, etc., are routinely sooooo cautious about the dissemination of articles that include information not provided voluntarily by the subject.

You know, like articles about Trump’s tax returns, which were metaphysically obtained illegally and without his consent.

Of course the biggest news is that emails on the computer that show Joe Biden was lying about talking with his son about Burisma, or meeting with Burisma people.

The campaign is trying now to tell the truth slowly, by claiming that the meetings weren’t official, and were perfunctory.

Because yeah, when you are trading influence, you always do that in official meetings.

To me the more interesting angle is the revelations about Hunter’s dealings with, and flacking for, and arranging meetings for, CEFC, the dodgy Chinese energy company. So dodgy that its CEO, for whom Hunter carried water, is now in prison.

CEFC, you might recall, was the alleged buyer of a stake in Rosneft. I called bullshit on that deal when it happened.

And yes, it was bullshit. A crooked deal between crooked companies in crooked countries.

These are the kinds of scumbags that Hunter Biden was taking money from, in order to make it rain in DC. Something that wouldn’t have been possible had his father not been Joe Biden.

Birds of a feather.

Insofar as Twitter and Facebook is concerned, the mask is off–as if it was ever really on. These companies are basically arms of the Biden campaign, the Democratic Party, and the anti-Trump establishment. Perhaps it’s not surprising that Jack Dorsey is trying to cover for a drug addict, but the motive goes deeper than that. It is deeply partisan. To the bone.

Which doesn’t make Twitter or Facebook any different than the NYT or the WaPo. But that raises the question: why do they have legal protections as “platforms” that traditional news outlets don’t? And whereas the NYT, etc., face competition–e.g., from the NY Post–as platforms Facebook and Twitter do not. Indeed, they are clearly attempting to quash competing viewpoints.

We are supposed to FREAK OUT over Russians paying less than $100 grand to buy cheesy FB ads because that’s a grave threat to democracy, but we’re supposed to allow Facebook and Twitter to engage in far more consequential election interference?

Why, exactly?

The very informative RBN Energy blog notes “Look What You Made Me Do – Permian Crude Producers Waste No Time In Ramping Up Production“:

Crude oil supply news comes in from all angles these days, bombarding the market daily with fresh information on producers’ efforts to ramp their volumes back up now that the global economic recovery is cautiously under way. Crude demand is rising, storage hasn’t burst at the seams yet, and prices have come a long, long way in just a few weeks. Permian exploration and production companies, having avoided a fleeting, longshot chance that the state of Texas might regulate West Texas oil production, are responding to higher crude oil prices as free-market participants should. The taps are quickly being turned back on, unleashing pent-up crude and associated gas volumes that, you could say, were under a sort of quarantine of their own for a while. Today, we provide an update on the status of curtailments in the Permian Basin.

The story mentions “the taps.” US shale regions, Permian in particular, are as close to something that can be turned on and off like a tap as anything in the history of the oil business.

You will recall that Igor Sechin’s brain flash in responding to the Covid-caused demand crash was to spurn Saudi importuning to extend output cuts, which spurred the steamed Saudis to increase output, thereby turning a hard fall in prices into a bona fide crash. A crash that hurt Russian producers generally, and Rosneft specifically, extremely hard.

The reasoning for Sechin’s strategy was that US shale producers had been the main beneficiary of previous output cuts, and he wanted to drive them out of business. Predatory pricing, in other words.

But as the RBN post indicates, this strategy, like most predatory pricing strategies, doesn’t work if the target can rope-a-dope and recover when you attempt to raise prices. That’s exactly what’s happening.

Yes, some companies have gone bankrupt–but bankruptcy is different than destruction. (Igor might not know this. Seriously.) And yes, the industry is facing more stringent financing conditions–but if prices rise these will ease too, and drilling activity will resume.

In other words, Sechin failed to realize that not only is predatory pricing almost always a futile strategy, it is particularly futile when unconventional US oil production is concerned. The Saudis found this out in 2014-2015, but Igor either wasn’t paying attention, or didn’t learn the lesson.

Predation doesn’t pay. This is hardly a new insight, or one not demonstrated by repeated experiences–including experience involving Igor’s intended prey.

Sechin’s predatory endeavors work when they involve exploiting the Russian legal system. In the marketplace, not so much. But we all knew that Igor is basically a thug, and not all that bright.

The June 2020 WTI contract expired with a whimper rather than a bang yesterday, thereby not repeating the cluster of the May contract expiry. In contrast to the back-to-back 40 standard deviation moves in April, June prices exhibited little volatility Monday or Tuesday. Moreover, calendar spreads were in a modest contango–in contrast to the galactangos experienced in April, and prices never got within miles of negative territory.

Stronger fundamentals certainly played a role in this uneventful expiry. Glimmers of rebounding demand, and sharp supply reductions, both in the US and internationally, caused a substantial rally in flat prices and tightening of spreads in the first weeks of May. This alleviated fears about exhaustion of storage capacity. Indeed, the last EIA storage number for Cushing showed a draw, and today’s API number suggests an even bigger draw this week. (Though I must say I am skeptical about the forecast power of API numbers.). Also, the number of crude carriers chartered for storage has dropped. (H/T my daughter’s market commentary from yesterday). So the dire fundamental conditions that set the stage for that storm of negativity were not nearly so dire this week.

But remember that fundamentals only set the stage. As I pointed out in my posts in the immediate aftermath of the April chaos, technical factors related to the liquidation of the May contract, arguably manipulative in nature, the ultimate cause of the huge price drop on the penultimate trading day, and the almost equally large rebound on the expiry day.

The CFTC read the riot act in a letter to exchanges, clearinghouses, and FCMs last week. No doubt the CME, despite it’s Frank Drebin-like “move on, nothing to see here” response to the May expiry monitored the June expiration closely, and put a lot of pressure on those with open short positions to bid the market aggressively (e.g., bid at reasonable differentials to Brent futures and cash market prices). A combination of that pressure, plus the self-protective measures of market participants who didn’t want to get caught in another catastrophe, clearly led to earlier liquidations: open interest going into the last couple of days was well below the level at a comparable date in the May.

So fundamentals, plus everyone being on their best behavior, prevented a recurrence of the May fiasco.

It should be noted that as bad as April 20 was (and April 21, too), the carnage was not contained to those days, and the May contract alone. The negative price shock, and its potentially disastrous consequences for “fully collateralized” long-only funds, like the USO, led to a substantial early rolls of long positions in the June during the last days of April. Given the already thin liquidity in the market, these rolls caused big movements in calendar spreads–movements that have been completely reversed. On 27 April, the MN0 spread was -$14.45: it went off the board at a 54 cent backwardation. Yes, fundamentals were a major driver of that tightening, but the early roll in the US (and some other funds) triggered by the May expiration clearly exacerbated the contango. Collateral damage, as it were.

What is the takeaway from all this? Well, I think the major takeaway is not to overgeneralize from what happened on 20-21 April. The underlying fundamentals were truly exceptional (unprecedented, really)–and hopefully the likelihood of a repeat of those is vanishingly small. Moreover, the CME should be on alert for any future liquidation-related game playing, and market players will no doubt be more cautious in their approach to expiration. It would definitely be overlearning from the episode to draw expansive conclusions about the overall viability of the WTI contract, or its basic delivery mechanism.

That mechanism is supported by abundant physical supplies and connections to diverse production and consumption regions. Indeed, this was a situation where the problem was extremely abundant supply–which is an extreme rarity in physical commodity futures markets. Other contracts (Brent in particular) have chronic problems with inadequate and declining supply. As for WTI being “landlocked,” er, there are pipelines connecting Cushing to the Gulf, and WTI from Cushing has been exported around the world in recent years. With the marginal barrel going for export, seaborne crude prices drive WTI. With a better-monitored and managed liquidation process, especially in extraordinary circumstances, the WTI delivery mechanism is pretty good. And I say that as someone who has studied delivery mechanisms for around 30 years, and has designed or consulted on the design of these contracts.

Matt Levine wrote a typically amusing piece highlighting the role of Trade at Settle (TAS) contracts in the 4/20/20 oil futures debacle:

But actually a lot of oil changed hands at those negative prices. Not because a bunch of investors came to the market all at once looking to sell, and no one would buy from them at negative prices, but for a more technical reason. Some oil traders use “trade-at-settlement” contracts: Instead of buying (or selling) oil futures at the market price at the time of your trade, you agree in advance to buy (or sell) them at whatever the official 2:30 p.m. settlement price is that day. 1  This is a good trade, for you, if your job is to obtain the day’s settlement price: For instance, if you run an index fund or exchange-traded fund that is benchmarked to that price, using TAS futures guarantees you the benchmark price. If you invest in oil futures and your boss fires you if you miss the benchmark, you might use TAS futures, that sort of thing. If you are a savvy oil trader attuned to minute-by-minute changes in supply and demand and trying to capture as much value as possible from your skills, you’ll probably just trade the futures at their current prices, selling if the price is too high and buying if it’s too low. But a lot of oil traders are doing something else, something a bit more passive, and for them the ability to guarantee the settlement price is useful.

He goes on to ponder whether the TAS mechanism could be manipulated, and whether manipulation could have contributed to the settlement fire that Red Adair couldn’t have put out:

The basic pattern—agree in advance to buy (sell) stuff at the official settlement price at some fixed future time, and then sell (buy) a bunch of that stuff in the minutes leading up to the official settlement time with the effect of pushing down (up) the price at which you are buying (selling)—is incredibly common, and the gradation from “sensibly pre-hedging the exposure you will get at settlement” to “sloppily pre-hedging the exposure you will get at settlement” to “manipulating the market to push down the price you will get at settlement” is blurry. If you type in a chat room “lol I’m gonna pound out 500 contracts to push down the settlement price and make fortune on my TAS trades, I am really ripping those muppets’ faces off, hope I don’t go to prison bro, hashtag fraud hashtag crime hashtag manipulation,” you will get in trouble. But if you don’t type that, and you quietly sell the 500 contracts and the price goes down, then as far as anyone knows that was just pre-hedging.

So could somebody have popped CLK20 with a TASer last Monday?

Funny you should ask. I wrote a paper on TAS manipulation a while ago. My interest was sparked by the CFTC’s action against Dutch trading firm Optiver, which the agency accused of doing exactly the kind of thing Levine writes about in crude, gasoline, and heating oil futures back in March, 2008. You can read the complaint–and listen to some actual “ripping those muppets’ faces off” trader braggadocio.

How does manipulation work here? First, to make manipulation profitable, there has to be an asymmetric price response to purchases and sales. If the manipulator’s purchases impact prices the same as sales, just buying and selling a lot can’t move prices in a profitable direction. Indeed, the manipulator would have to pay transactions costs (crossing the spread, brokerage, etc.) and this would cause the trading to be unprofitable.

The model in the paper derives conditions under which purchases and sales of TAS have a smaller impact on prices than do trades in the underlying futures. The basic idea is that if information is short-lived, or if there is intense competition among informed traders, new information will be incorporated into prices very quickly. Under those circumstances, informed traders will not want to trade TAS: their information will already be incorporated into the price by the time settlement occurs. Thus, TAS is a mechanism that allows traders to signal that they are uninformed: many “muppets” choose to trade TAS, and the informed don’t. Thus, the price impact of TAS trades is smaller than the price impact of regular outright trades: trades move prices because of the possibility that they are motivated by private information, so trades that are unlikely to be privately informed move prices less than trades that are more likely to be so.

This creates the asymmetry that makes manipulation possible: the manipulator buys, say, the TAS and then sells in quantity immediately before and during the settlement period and profits as Levine describes.

This type of manipulation is particularly pernicious because manipulative trades have persistent price impacts because they cannot be distinguished from informed trades (or liquidity trades, for that matter). Note that in Optiver, prices did not reverse after the firm’s trades,

This strategy is likely to be particularly profitable when markets are relatively illiquid, as in an illiquid market outright trades have bigger price impacts. Liquidity (measured by the bid-ask spread, quantity at the top of the book, price impact coefficients, etc.) has plummeted for everything since the CovidCrisis began, and the decline in CL liquidity has been particularly pronounced. Moreover, contracts close to expiration are less liquid anyways. Add to this the extreme physical constraints (which mean that small shocks to fundamentals have big price impacts) and the raging uncertainty about the logistical situation at Cushing, and it is likely that small volumes at the settle could have big impacts on prices.

To this I would add that an unexpected shortfall in buy orders (due to shorts exercising market power) at the settle could have price impacts, and exacerbate the price impacts of sell orders by exacerbating order imbalances.

Thus, the potential for a big asymmetry in price impact was pronounced on that fatal Monday.

In sum, it is not implausible that the market did indeed get TASed. Or at the very least, a TASer jolt contributed to the collapse. (Sort of like in this video!)

A final remark on the economic benefits and costs of TAS trading. TAS is a form of “cream skimming”–i.e., the skimming off of uninformed order flow. This tends to make the order flow in the regular continuous market more toxic, which reduces liquidity in that market. For this reason, other cream skimming mechanisms used primarily in equity markets (payment for order flow, dark pools, block trades) are frequently criticized. (This is why some regulators, particular in Europe, have attempted to curb such activity and force more trading into “lit” venues.)

I showed in my Market Macrostructure paper that things aren’t so simple. If the regular market isn’t perfectly competitive, the increased competition from a cream skimming mechanism can improve welfare. Moreover, there are distributive effects here: the uninformed traders who can utilize the TAS mechanism (e.g., those who are hedging exposures tied to the settlement price) benefit, while uninformed traders who can’t lose. Informed traders can lose too. Moreover–and this is a point that is almost always overlooked–some informed trading is essentially rent seeking (e.g., trading on information that will be released shortly anyways, and accelerating its incorporation into prices has little effects on resource allocation decisions). Reducing rent seeking informed trading is a good thing.

All in all, the role of the TASer is yet another piece of the 4/20/20 WTI WTF puzzle. The forensic analysis of this entire episode will be fascinating.

Just another day at the Globex, folks. May WTI up a mere $49.88 on its last trading day at the time I write this paragraph, a while before the close. (Sorry, can’t calculate a percentage change . . . because the base number is negative!) That’s just sick. But at least it’s positive! ($12.25. No, $9.96. No . . .) (This reminds me of a story from Black Monday. My firm did a little index arb. We called the floor to get a price quote on the 19th. Our floor guy said “On this part of the pit it’s X. Over there it’s X+50. Over there it’s X-20. I have no fucking idea what the fucking price is.”)

But June has been crushed–down $7.35 (about 35 percent). Now the May-June spread is a mere $.83 contango. That makes as little sense as yesterday’s settling galactic contango (galactango!) of $57.06. (Note that June-July is trading at at $7.71 and July-August at $2.65.

I’m guessing that dynamic circuit breakers are impeding price movements, meaning that the prices we see are not necessarily market clearing prices at that instant.

A few follow-ons to yesterday’s post.

First, the modeling of the dynamics of a contract as it approaches expiration when the delivery supply/demand curve is inelastic, and some traders might have positions large enough to exploit those conditions to exercise market power, is extremely complicated. The only examples I am aware of are Cooper and Donaldson in the JFQA almost 30 years ago, and my paper in the Journal of Alternative Investments almost a decade ago.

Futures markets are (shockingly!) forward looking. Expectations and beliefs matter. There are coordination problems. If I believe everyone else on my side of the market is going to liquidate prior to expiration, I realize that the party on the other side of the contract will have no market power at expiration. So I should defer liquidating–which if everyone reasons the same way could lead to everyone getting caught in a long or sort manipulation at expiration. Or, if I believe everyone is going to stick it out to the end, I should get out earlier (which if everybody else does the same results in a stampede for the exits.)

In these situations, anything can happen, and the process of coordinating expectations and actions is likely to be chaotic. Cooper-Donaldson and Pirrong lay out some plausible stories (based on particular specifications of beliefs and the trading mechanism), but they are not the only stories. They mainly serve to highlight how game theoretic considerations can lead to very complex outcomes in situations with market power and inelasticity.

One thing that is sure is that these game theoretic considerations don’t matter much if the elasticities of delivery supply and demand are large. Then no individual can distort prices very much by delivering too much or taking delivery of too much. Then the coordination and expectations problems aren’t so relevant. However, when delivery supply or demand curves are very steep–as is the case in Cushing now due to the storage constraint–they become extremely relevant.

Perhaps one analogy is getting out of a theater. When there are many exits, there won’t be queues to get out and little chance of tragedy even if someone yells “fire.” If there is only one exit, however, hurried attempts of everyone to leave at once can lead to catastrophe. Moreover, perverse crowd dynamics occur in such situations. That’s where we were yesterday.

About 90 percent of open interest liquidated yesterday. That is why today is returning to some semblance of normality–the exit isn’t so crowded (because so many got trampled yesterday). But that begs the question of why the panicked rush yesterday? That’s where the game theoretic “anything could happen” answer is about the best we can do.

About that storage constraint. My post yesterday focused on someone with a large short futures position raising the specter of excessive deliveries by not liquidating that position, thereby triggering a cascade of descending offers until the short graciously accepted at a highly profitable price.

But there is another market power play possible here. A firm controlling storage could crash prices (and spreads) by withholding that capacity from the market. The most recent data from the EIA indicates about 55 mm bbl of oil storage at Cushing. That’s about 80 percent of nameplate capacity (also per EIA.). Due to operational constraints (e.g., need working space to move barrels in and out; can’t mix different grades in the same tank) that’s probably effectively full. Therefore, someone with ownership of a modest amount of space could withhold it drive up the spread. If that party had on a bull spread position . . .

Third, we are into Round Up the Usual Suspects mode:

And first in line is the US Oil ETF. There has been a lot of idiotic commentary about this. They were forced to take delivery! (Er, delivery notices aren’t possible before trading ends.) They were forced to dump huge numbers of contracts yesterday! (Er, they publish a regular roll schedule, and were out of the May a week before yesterday’s holocaust. They also report positions daily, and as of yesterday were 100 pct in the June.)

Not to say that USO can be implicated in hinky things going on in the June right now, but as for May–that dog don’t hunt.

Fourth–WTF, June WTI? Well, my best explanation is that the carnage in the May served to concentrate minds regarding June. No doubt risk managers, or risk systems, forced some longs out as the measured and perceived risk for June shot up yesterday. Others just decided that discretion was the better part of valor. The extremely unsettled positions no doubt impaired liquidity (i.e., just as some wanted to get out, others were constrained by risk limits formal or informal from getting in), leading to big price movements in response to these flows. If that’s a correct diagnosis, we should see something of a bounceback, but perhaps not too much given the perception (and reality) of an extremely asymmetric risk profile, with going into expiry short being a lot more dangerous than going into it long. (This is why expectations about future conditions at delivery can impact prices well before delivery.)

Fifth, on a personal note, in an illustration of the adage that the apple doesn’t fall far from the tree (and also of Merton’s Law of Multiples) my elder daughter Renee completely independently of me used “WTI WTF” in her daily market commentary yesterday. I’m so proud! She also raised the possibility of negative prices some time ago. Good call!

And I finish this just in time to bring you the final results. CLK goes off the board settling at $10.01, up a mere $47.64. CLM settles at $11.57, down -$8.86. The closing KM20 spread, $1.56.

Someday we’ll look back on this and . . . . Well, we’ll look back on it, anyways.

Today was one of the most epochal days in the history of oil trading, which is saying something. The front month May contract–which expires tomorrow (21 April, 2020)–(a) settled at a negative price of -$37.63, (b) declined $55.90 from the previous day’s settlement, and (c) exhibited a trading range of $58.17, which is about 3.5x Friday’s settlement price.

Even these eye-popping numbers don’t tell the full story. The last traded price was -$13.10. Note that the settlement price is based on the volume weighted average price during the last two minutes of trading, so an average price of $-37.63 in the last two minutes and a last traded price of -$13.10 means prices moved more that $25/bbl in these minutes.

And we’re not done yet! As I write at 1841 CDT, the price is up to -$5.00–an increase of $32.63.

That there’s what they call volatility, folks.

To put these numbers in perspective, the largest trading range on the any day of the last three trading days of CL contracts from 2000-2019 is $26.65, a day around the time of the financial crisis and the aftermath of Hurricane Ike (October 2008 contract): here’s what I wrote about that event. The median intra-day range on the last three days is $1.6, the mean is $1.5, and the standard deviation is $1.47. So we are around a 40 standard deviation event here.

The largest daily price change during the last 3 trading days is $16.37, with a median of $.73 and a standard deviation of $1.45.

The calendar spread is also extreme, settling at $58.06 between the June and the May. Meaning that if you had storage, you could get paid to take delivery, sell it forward, and lock in that $58.06 (net of what the storage costs you). I guess you could call that the megacontango.

All in all, a historically unprecedented day.

The proximate cause of these wild gyrations, and unprecedented negative prices is, of course, the collapse of demand and the looming exhaustion of storage space, including at the delivery point of Cushing, OK. But although this is a necessary condition for today’s events, it is not a full explanation.

The storage issue has been known for weeks, and discussed intensely. It had been priced in to a considerable degree: contango was already at a historically high level. What information about the availability of storage arrived between Friday and today? Unlikely to be anything that could cause such chaotic price movements.

The likely cause is the difficulty of liquidating about 100,000 open contracts (100 million barrels!) in such extreme technical conditions. It is plausible, and indeed likely, that strategic behavior–perhaps rising to the level of manipulation–is the major cause of how prices moved today against the background of conditions that were widely known on Friday.

Let me start out by noting that something similar, though not as extreme, occurred during the demand collapse and associated flooding of storage during the Financial Crisis. As I documented here, the expiries of the January, February, and March 2009 WTI contracts saw what were then historically unprecedented price collapses. So did other US grades of oil. Here’s a picture from the linked document:

The big downward spikes in the front month-back month spreads correspond with the days around expiry.

How does strategic behavior/market power/manipulation play into this? The model of short manipulation in my 1996 book (only $169 paperback–buy two!) and 1993 J. of Business article formalizes the argument, but the intuition is fairly straightforward. Manipulation exploits frictions and bottlenecks. (My article/book refer to “frictional manipulations.”). There is now a huge friction/bottleneck in Cushing–constrained storage. This bottleneck makes the demand curve for crude at Cushing extremely inelastic, and means that the movement of even small excess quantities of oil into that location will cause prices to decline dramatically.

In these conditions, a trader, or a group of traders with modest-sized short positions can exercise market power by delivering even a small amount of oil over and above the quantity that should flow to Cushing. This drives down the price and allows the trader or traders to cover his (their) position(s) at artificially low prices.

In this situation, the storage bottleneck is the gasoline, the exercise of the market power is the match. With 100,000,000 barrels of open long positions needing to liquidate, given the storage constraint, the resulting conflagration can be epic.

This is, at this stage, a hypothesis. It is a possible explanation of the beyond extreme movements observed today. Under the circumstances, it is a very plausible explanation, and one that deserves scrutiny. And given the amount of money that changed hands today (~$6 billion on a mark-to-market basis) I’m sure that it will get it.

The only parallel I can think of is the onion market in 1955, when the movement of a couple of superfluous carloads of onions into Chicago, and delivery thereof against futures, caused the price to crash below the cost of the bags that they had to be delivered in. There was no demand for the onions (being perishable, and people eat only so many hot dogs), so many of the excess plants ended up getting dumped into the Chicago River. (Which, in 1955, probably improved the water quality.) (Another irony being that Chicago means “stinky onions” in the Miami-Illinois Indian language.)

In 1955, demand was inelastic because onions are perishable (i.e., they can’t be stored). In a way, the lack of storage space makes oil perishable. Even if that analogy isn’t perfect, the economics are the same: an economic constraint (the non-storability of, or the lack of storage space) leads to extremely inelastic demand that makes short market power manipulation possible.

Tomorrow is the last trading day for CLK20. Strap it up! It’s going to be a wild ride.

What a helluva few weeks it’s been, eh boys and girls? By way of post mortem (hopefully?) rather than prediction, here’s my take.

Under “normal” circumstances, two factors drive asset valuations: expectations of cash flows, and the rate at which investors discount those cash flows. COVID-19–Wuhan Virus, to call it by its proper name–has has profound influence on both.

WV has caused a major aggregate supply shock, and an aggregate demand shock, and these amplify one another. The aggregate supply shock stems from shutdown of productive capacity due to social distancing. And people who aren’t working aren’t earning and aren’t spending, hence the aggregate demand shock.

These developments obviously reduce the income streams from assets (e.g., corporate profits). That’s a negative for stocks.

As an aside, these factors defy traditional policy prescriptions. Monetary and fiscal policy are focused on addressing aggregate demand deficiencies, i.e., trying to move demand-deficient economies (where demand deficiencies arise from price rigidity and nominal shocks) back to the production possibilities frontier. Supply shocks shrink the PPF. Pushing the PPF back to its normal state in current circumstances is a function of public health policy, and even that is likely to be problematic given the huge uncertainties (that I discuss below) and the dubious competence of government authorities (which I discussed last week).

The pandemic nature of WV also makes it the systematic shock par excellence. It hits everyone and every asset class, and cannot be diversified away. A big increase in systematic risk results in a big increase in risk premia, meaning that the already depressed expected cash flows on risky assets get discounted at a higher rate, leading to lower valuations.

A lot higher rate, evidently. Why? Most likely because of the extreme uncertainty about the virus. Data on how infectious it is, how many people have been infected, the fatality rate, how it will be affected by warmer weather, etc., are extremely unreliable. In other words, we know almost nothing about the salient considerations.

This is in part due to lack of testing, and to inherent defects in the testing: those who get tested are disproportionately likely to be symptomatic, exposed, or hypochondriacal, leading to extreme sample selection biases. The tests are apparently unreliable, with high rates of false positives and false negatives. The RNA tests cannot detect past infections. It is in part due to the novelty of the virus. Is it like influenza, and will hence burn out when temperatures warm? Or not?

Another major source of uncertainty is due to the fact that the initial outbreak in China was covered up by the evil CCP regime. (Which now, in an Orwellian twistedness that only totalitarian regimes can muster, is boasting that it will save the world. And which is blaming the United States for its own abject failures. Which is why I insist on calling it the Wuhan Virus–so go ahead, call me a racist. IDGAF.) Thus, data from Ground Zero is lacking, or wildly unreliable. (Ground One–Iran–is equally duplicitous, and equally malign.)

This huge uncertainty regarding a major systematic factor leads to even greater discount rates–and hence to lower stock prices.

And then there is the truly disturbing factor. These textbook causal channels (lower expected cash flows, higher discount rates) have in turn caused changes in asset prices that force portfolio adjustments that move us into the realm of positive feedback mechanisms (which usually have negative effects!) and non-linearities. This represents a shift from “normal” times to decidedly abnormal ones.

When some investors engage in leveraged trading strategies, big price moves can force them to unwind/liquidate these strategies because they can no longer fund their large losses. These unwinds move asset prices yet more (as those who placed a lower valuation on these assets must absorb them from the levered, high-value owners who are forced to sell them). Which can force further unwinds, in perhaps completely unrelated assets.

Not knowing the extent or nature of these trading strategies, or the degree of leverage, it is virtually impossible to understand how these effects may cascade through the markets.

The most evident indicators of these stresses are in the funding markets. And we are seeing such stresses. The FRA-OIS spread (known in a previous incarnation–e.g., 2008–as the LIBOR-OIS spread) has blown out. Dollar swap rates are blowing out. The most vanilla of spreads–the basis net of carry between Treasury futures and the cheapest-to-deliver Treasury–have blown out. Further, the Fed has pumped in huge amounts liquidity into the system, and these alarming spread movements have not reversed. (One shudders to think they would have been worse absent such intervention.)

One thing to keep an eye on is derivatives clearing. As I warned repeatedly during the drive to mandate clearing, the true test of this mechanism is during periods of market disruption when large price moves trigger large margin calls.

Heretofore the clearing system seems to have operated without disruption. I note, however, that the strains in the funding markets likely reflect in part the need for liquidity to make margin calls. Big margin calls that must be met in near real-time contribute to stresses in the funding markets. Clearinghouses themselves may survive, but at the cost of imposing huge costs elsewhere in the financial system. (In my earlier writing on the systemic impacts of clearing mandates, I referred to this as the Levee Effect.)

The totally unnecessary side-show in the oil markets, where Putin and Mohammed bin Salman are waging an insane grudge match, is only contributing to these margin call-related strains. (Noticing a theme here? Authoritarian governments obsessed with control and “stability” have a preternatural disposition to creating chaos.)

Perhaps the only saving grace now, as opposed to 2008, is that the shock did not arise originally from the credit and liquidity supply sector, i.e., banks and shadow banks. But the credit/liquidity supply sector is clearly under strain, and if parts of it break under that strain yet another round of extremely disruptive knock-on effects will occur. Fortunately, this is one area where central banks can palliate, if not eliminate, the strains. (I say can, because being run by humans, there is no guarantee they will.)

Viruses operate according to their own imperatives, and the imperatives of one virus can differ dramatically from those of others. Pandemic shocks are inherently systematic risks, and the nature of the current risk is only dimly understood because we do not understand the imperatives of this particular virus. Indeed, it might be fair to put it in the category of Knightian Uncertainty, rather than risk. The shock is big enough to trigger non-linear feedbacks, which are themselves virtually impossible to predict.

In other words. We’ve been on a helluva ride. We’re in for a helluva right. Strap it tight, folks.