Streetwise Professor

I’ve been predicting since the Whither NYMEX post almost exactly two years ago that CME would acquire NYMEX. That forecast took one major step closer to realization today, with the CME’s confirmation that it was engaged in merger talks with NYMEX. The parties have agreed to a 30 day exclusive negotiation period.

The timing of the move is very sensible. The CME just completed the integration of CBT products onto Globex. With the integration successfully completed, it is free to make its next move. The smooth segue from integration to offer suggests that this was the strategic plan all along.

As I’ve stated numerous times, the deal makes eminent sense. NYMEX already uses CME’s Globex trading system, and is contracted to do so for another 8 years. This always gave CME a leg up in any contest for NYMEX, as an alternative suitor would have to circumvent that contractual obstacle, and then migrate NYMEX business to a new platform, a costly and potentially risky endeavor. Moreover, the CME/NYMEX tie up offers far more substantial economies on the clearing side than any alternative combination–and remember, clearing is where the money is. Furthermore, NYMEX has made excellent headway in OTC energy clearing, which fits in very well with CME’s strategy of penetrating the OTC clearing business.

I don’t anticipate any antitrust issues. CME and NYMEX products are far less closely related than CME and CBT products, so if the Justice Department didn’t consider the latter a single market for antitrust purposes, they won’t consider the former to be such. Another suitor could arise–possibly NYSE-Euronext–but the economics make the CME the logical winner even if a would-be spoiler appears.

So now the question becomes: Whither ICE? I stand by my prediction that ICE will join up with NYSE-Euronext.

There is also speculation that CME will snap up the KCBOT and MGEX. That may well be, though ICE might compete for those vigorously. It has already purchased the WCE and NYBOT, so the two smaller grain exchanges would fit nicely in that portfolio. Moreover, I’ve noted before that the Chicago exchanges (now singular) always liked having Kansas City and Minneapolis around; they weren’t serious competitive threats, and their existence helped secure support from the Missouri and Minnesota congressional delegations on legislative issues of interest to the Merc and the Board. For that reason, they may be more valuable to CME as independent exchanges, but against that it must be said that it doesn’t make much economic sense for those two exchanges to survive. The cost of offering the KCBOT and MGEX contracts on CME (or ICE) is trivial compared to the cost of operating stand alone exchanges.

So, the consolidation process seems to be in its last phase. If the NYMEX deal goes through, only ICE and CBOE remain of the major independents. CBOE’s situation may become resolved fairly soon. The SEC approved a CBOE rule change that prevents CBOT members from asserting ownership rights in CBOE. This clears the way for the Delaware Chancery Court to rule on the issue. Once that is clarified, CBOE can have an IPO, and once that happens, it will probably be snapped up by somebody soon afterwards. Thus, it is likely that by the end of this year the exchange consolidation movement in the US will be complete, or nearly so. Then the main theater will shift to international alignments. More on that to come.

I was quoted in this article in the Chicago Tribune about the just announced competitor to the CME.

A couple of points. First, as I’ve pointed out in my academic research, an entrant exchange has a chance against an incumbent if it (or its owners) control enough order flow to generate sufficient liquidity to narrow the incumbent’s execution cost advantage. The owners of the CME’s new competitor do control a decent fraction of order flow in Treasuries and Eurodollars, so this exchange has a leg up as compared to earlier would-be competitors. Nonetheless, I am skeptical that this is sufficient to allow the upstart to prevail. It is a necessary condition, but not a sufficient one.

Indeed, previous attempts to compete in the US Treasury complex have failed miserably despite the direct involvement of large banks. BrokerTec Futures (BTEX) was formed in 2001 by a consortium of 14 big banks, investment banks, and brokerages (including some involved in the latest venture) . Although BrokerTec was very successful in trading cash Treasuries, it failed miserably in Treasury futures in competition with the CBOT, and the banks pulled the plug a couple of years later. BTEX was sold to Eurex US shortly before Eurex entered the US market. The major bank/owners of BTEX were given an equity stake in Eurex US, and they had incentives to direct additional order flow to Eurex US; Eurex would boost each bank’s equity stake based on how much revenue (and hence trading volume) that bank threw Eurex US’s way. That didn’t work either.

A couple of lessons: (1) Although big players do have a lot of order flow, they haven’t had enough to “tip” the Treasury futures market in their direction, and (2) the definition of insanity is doing the same thing repeatedly, and expecting a different outcome. Here we have essentially the same players implementing essentially the same business model based on the same economic theory (re control of order flow)–but we’re supposed to believe that the outcome will be different this time. If you think so.

Indeed, the CME is in a better position than CBOT was when Cantor and then BrokerTec and then Eurex made a run at the Treasuries. CBOT was still largely floor based when each of the electronic competitors entered. Thus, the entrants arguably had a technology differentiator that appealed to a large potential set of market participants (although Cantor’s setup was stupid–users couldn’t enter orders into the electronic system directly, but had to phone it in to a Cantor clerk who entered it. Gee, I wonder why that didn’t work?) Moreover, at the time its earlier competitors surfaced, CBOT was going through managerial turmoil and intense internecine conflict over strategic direction regarding the fate of the floor, and was not renowned for its managerial nimbleness and foresight; the political battling often hamstrung management. Furthermore, entrants were not at a disadvantage in attracting traders participating in other interest rate products, especially Eurodollars, and especially Treasury-Eurodollar spreaders. Spreaders, for instance, had to trade multiple platforms regardless of whether they traded the Treasury leg at the CBT or elsewhere.

In contrast, CME is fully electronic, with a robust and proven trading platform–so no technological differentiator. Moreover, CME management is very good, and CME is not beset by the political infighting that often paralyzed CBOT around the turn of the millennium. And perhaps most importantly, spreaders and others trading both Eurodollar futures and Treasuries can execute on a single platform–CME Globex. Somebody who wants to trade the Treasury leg on the CME’s new competitor still has to trade the Eurodollar leg on CME. If the entrant decides to list Eurodollar futures too in order to overcome this disadvantage, it will be faced with the task of building two liquidity pools and wresting two complexes from an incumbent. Won’t say it can’t be done. Will say it has never been done before.

Second, this is a case of back to the future–a return of exchanges to the customer-owner mutualized model. The question arises : who will benefit if this new mutual succeeds? Even if the CME is charging supercompetitive fees for its services, the entrant’s success does not mean that fee levels in the industry will become competitive. Given the tippiness of order flow, if the entrant succeeds it will likely gain a near monopoly position. In the event, the monopoly rents will just move from the CME to the new exchange–and its big bank owners.

So, this should be viewed as a battle over rents. The efficiency effects of this entry are likely to be negative because real resources will be expended in this contest in which either (a) the incumbent monopoly will survive, or (b) it will be replaced by a new monopoly. This rent dissipation is wasteful. Indeed, if the bank-backed exchange prevails, efficiency may suffer because this outcome could dampen competition in the OTC space where the CME is endeavoring to encroach on the big banks’ turf.

Tom Fowler of the Houston Chronicle quotes me in a blog post spurred by US Asst. Attorney Belinda Beek’s mentioning during jury selection in the manipulation trial of several former El Paso traders that onions were not covered by the Commodity Exchange Act. As I noted to Tom, onion futures were banned due to intense political pressure from onion farmers after several episodes in which the price of onion futures plummeted, at times falling below the price of the sacks in which they were shipped.

Interestingly, in 1972 similar events in the potato market led to the proposal of a bill to ban potato futures. This bill failed, however, in part because a USDA study of what happened in onions after futures trading was banned; the USDA study did not find any evidence that the ban had affected pricing patterns. In a 1963 article in the Journal of Farm Economics Roger Gray found that if anything, the ban increased volatility of onion prices.

The potato contract died a somewhat unnatural death a few years later due to several spectacular manipulation attempts, but this time Congress did not commit the murder. In one of these manipulations, in 1976, both a big long and a big short were trying to manipulate the contract simultaneously, with the short trying to ship huge quantities of potatoes from Idaho to Maine (the delivery point) and the long tied up most of the railroad cars on the Bangor & Aroostook Railroad (in which delivery had to be made). There was a large default against the futures contract. The default severely damaged NYMEX’s reputation. Here is a court case that provides some of the lurid details.

Ironically, the demises of the onion and potato contracts were perhaps the best things that happened to the CME and NYMEX, respectively. The loss of these contracts forced each exchange to innovate to find replacements. CME developed meat futures (including the legendary pork belly contract, which is now fading away but was once the hottest thing in town) to replace onions. NYMEX, under the leadership of Michael Marks, developed energy futures. (Which, funnily enough, a commenter on the Fowler post says should be banned. La plus ca change.) Necessity as the mother of invention, futures exchange edition.

The common feature of potatoes and onions is perishability. Perishability makes prices inherently volatile, and also can make some manipulative strategies possible. Indeed, short manipulations are likely to be more profitable for things like onions and potatoes than other products because dumping additional supplies on the market can depress prices sharply because the perishable good must be consumed almost immediately. This allows someone short futures to profit substantially.

OPEC is trying to lay blame for high oil prices anywhere but on its own doorstep:

Mr El-Badri said, however, that the the “US should help to resolve the problem” and enumerated several factors, among them bottleneck in refining, geopolitical concerns and the weakness of the US dollar, that were affecting the oil price.

“The US has not invested in refining capacity in 30 years. The refineries are operating at 80 per cent. That is not adequate,” Mr El-Badri said. “We have also the problem of the dollar,” the secretary general added.

Mr. El-Badri is either laying on the bullshit with a big trowel, or he needs a lesson in basic economics. (My money is on the former alternative.) “Bottlenecks in refining” cannot explain current high oil prices. Indeed, refining bottlenecks cause the price of crude to decline relative to the price of refined products. An outright decline in refining capacity should cause the price of crude to fall. Consider the extreme case where there is no refining capacity at all. In this case, the price of crude would be zero because there would be no use for it as it could not be refined into anything useful. Crude would be as it was before Drake–a nuisance, a pollutant.

In fact, refining margins have declined substantially as crude prices have risen. An increase in demand for refined products would cause an increase in the price of crude–but the price of refined products would rise even more. Indeed, if refiners were operating at absolute capacity (infinite marginal cost of refining an additional barrel–the extreme bottleneck), an increase in demand for refined products would cause the price of gasoline and heating oil to rise, but the price of crude would not budge as due to the putative bottleneck in refining the increase in demand for refined products would NOT translate into a rise for the derived demand of crude. Moreover, US refineries have been operating at 80 or better for years. Sure, no refineries have been built from scratch, but refining capacity has continued to grow as refiners expand existing facilities. And memo to Mr. Al-Badri, with the exception of the 2005-2006 time period, refining has hardly been a wildly lucrative business. If it were the major bottleneck, refining would be a lot more profitable.

Thus, the simultaneous rise in the price of crude and a decline in refining margins is flatly inconsistent with El-Badri’s “explanation.” It is instead consistent with an adverse crude supply shock. Such a shock causes the price of crude to rise and refining margins to decline. Therefore, contrary to El-Badri’s babbling, price relations in the petroleum markets point directly to crude supplies–and crude suppliers–as the culprit.

The dollar story is also so much eyewash. Econbrowser does a very good job at debunking this chestnut. The price of crude is rising in terms of other currencies, and variations in the value of the dollar are not significantly correlated with changes in the price of oil.

So, let’s give El-Badri’s explanations the respect they deserve–none–and move on to the interesting issue. OPEC says it won’t raise output. There could be two reasons for this: they don’t want to, or they can’t. There are clearly some countries (notably Iran and Venezuela) that don’t want OPEC to increase output. But there are a lot of folks out there–notably Matt Simmons–that have been trumpeting the view that Saudi Arabia in particular is facing an inexorable decline in production, and is incapable of enhancing output even if it wanted to. Simmons and the peak oil crowd are the most outspoken on this issue, but there is reason to doubt whether the Saudis actually have the capacity to increase output. There is an intense debate over whether the recent decline in Saudi output was volitional, or instead resulted from the peaking of its megafields. That debate won’t be resolved any time soon, but OPEC’s (and KSA’s) refusal even to consider increasing output, and their lame rationalizations of the causes of the recent runup in oil prices, lend some credence to the view that Saudi Arabia has less available productive capacity than it claims.

I was quoted extensively in this article on energy speculation by Isabelle Cleary. The photo is not, shall we say, representative of my current appearance. Whether that is a good thing or a bad thing is a matter of some dispute in certain quarters, most notably in chez Pirrong.

Substantively, Isabelle’s article is a good and thorough one, which is not surprising because she is a knowledgeable reporter. (I say this not just because she quotes me now and again, but because it’s true.) At the very least, it’s nice to see a balanced presentation of the issues regarding speculation and manipulation in the energy markets.

From Reuters an article on Russian fuel shortages:

Russia’s transportation fuels market is facing its biggest crisis in almost 20 years as severe shortages force some retailers to close their filling stations.

As global oil prices beat records, Russian firms are rushing to export both crude oil and refined products. That, combined with outages at refineries in central Russia, has caused a spike in wholesale gasoline and diesel prices.

The shortages have forced wholesalers to ration supplies to retailers, who in turn are unable to pass on higher costs after pledging to the Kremlin to keep pump prices stable ahead of a Dec. 2 parliamentary election. . . .

In May of this year, major oil firms pledged to keep petrol prices capped until the 2008 presidential elections despite rising wholesale prices.

As day follows night, price controls–even informal ones (although given enforcement mechanisms in Russia one would be well-advised to live up to such pledges)–lead to shortages.

There is an interesting contrast between what is going on in Russia and events in China. In Russia, the state is apparently not using compulsion to force recalcitrant refiners from selling petrol at unremunerative prices, nor is it subsidizing consumption, whereas both things are going on in China. Hence, Russian refiners are selling more abroad, and there are shortages at home, whereas in China there are few shortages.

And speaking of China, the FT’s Energy Special had this tidbit about the situation there, which is consistent with my earlier conjectures:

The companies have been given a degree of licence to go offshore in search of energy assets, but at home they are constrained by numerous regulations, most importantly the government’s power to set prices.

The price controls, which have turned into a price freeze in the last six months of this year, as part of a raft of measures to control inflation, have prompted an almost annual stand-off between the government and Sinopec, the main refiner, in recent years. China last raised prices at the pump 17 months ago.

With the government declining to allow local prices to rise in line with global levels, refiners have been losing tens of millions of dollars on imported oil.

At the year’s end, they have usually been compensated out of public funds.

In the meantime, however, the companies play cat-and-mouse with the government, cutting production, to register their displeasure with government policy, resulting in embarrassing shortages.

So, through subsidies and compulsion, the Chinese government has encouraged sufficient production to meet demand at the subsidized prices. The shortages that occur appear to be a Sinopec bargaining tactic. In contrast, Russia is living with shortages.

Apropos my earlier analysis of the food price freeze pledge, the experience in the Russian gasoline market foretells coming shortages for basic food products, and I have read some reports of hoarding. This is especially true inasmuch as the inflation rate appears to be rising more rapidly than forecast. This may reflect the injection of liquidity into the market in response to concerns about the stability of the Russian banking system during the subprime credit crisis.

And there is also reason to wonder whether, in light of these increasing inflationary pressures, whether the government will have the stones to allow fuel and food producers to raise prices post-election, given that they know that prices will spike dramatically when they do. Their choice in March: a price spike, or growing shortages, either of which may take the bloom off of Putin’s rose pretty quickly come April. Thus, short-term political calculations have put the Russian government in something of a box. I guess they’ll worry about that tomorrow, just like Scarlett O’Hara.

In the frenzy over (nearly) $100 oil, everybody–be they politicians or spokesmen for supermajors or OPEC–are desperate to deflect blame. OPEC representatives make risible statements that an increase in OPEC output would not cause prices to fall. (Who knew?) Oil industry folks say that fundamentals can’t justify current prices. Politicians bloviate (well, more than usual), mutter darkly about manipulation, and propose various whacked-out policy nostrums. But all agree on one thing: Speculators Are to Blame. Like the Claude Rains character in Casablanca who orders his gendarmes to “round up the usual suspects” after Humphrey Bogart shoots the Gestapo agent in front of his eyes, whenever energy prices spike, the hue and cry goes up to round up the speculators.

Of late, Exhibit A in case against energy speculation is based on the CFTC’s Large Trader Reports. These reports show that long “non-commercial” positions have been increasing along with prices. “Aha!” go the anti-speculators: “See, those speculators are buying, and driving up prices. If we curtail ‘excess’ speculation, we’ll get oil prices back down.”

Err, not exactly. Leaving aside the myriad deficiencies in the large trader reports–they are a very imprecise measure of actual speculative and hedging activity because there is no reliable mapping between “non-commercial” and “speculation” or “commercial” and “hedging” (commercials speculate too, you see)–there is a serious conceptual problem here. Rather than relying on some abstract, academic analysis to try to make this point, I think this problem can be illustrated best with a contrast.

Believe it or not in this age of record nominal gold prices, but in the 1990s and early-2000s, many gold market participants claimed that gold producer hedging–forward sales of gold–was depressing gold prices. Now let’s work through this. If gold hedgers were net short, since derivative contracts are in zero net supply, that means that gold speculators were net long–just like the current situation in oil. And similarly, if oil speculators are net long today, that means that oil hedgers are net short. So riddle me this: how is it possible that a short hedging imbalance caused gold prices to be too low but is causing oil prices to be too high, and how is it possible that a long speculative imbalance is causing oil prices to be too high, but caused gold prices to be too low?

In other words, if I applied the gold bug theory about low gold prices (short hedging imbalance causes prices to be too low) I would conclude that current oil prices are too low, and if I applied the current theory about high oil prices (long speculation causes prices to be too high) I would conclude that gold prices in the 90s were too high. Does this mean that for prices to make Goldilocks happy (i.e., for prices to be “just right”), net hedging is zero and net speculation is zero? Put differently, the same theory can be used to reach the exact opposite conclusions about whether prices are too high or too low; I can use the exact same data on the composition of open interest to support either conclusion depending on my political/rhetorical/economic purposes. In other words, this “theory” provides no practical guidance whatsoever as to whether prices are higher or lower than they “should be.” It is, to be blunt, pure garbage.

The contrast between the gold and oil markets illustrates the pitfalls of overinterpreting accounting identities. Speculative and hedging positions have to add up to zero, and whether one number is positive and the other negative, or vice versa, is of no use in evaluating which is driving prices.

Another article in today’s WSJ on Chinese energy price controls. This article confirms what I had conjectured in earlier posts. Specifically, that (a) price controls are encouraging consumption, but (b) through a combination of cajoling and subsidies, the government has prodded/induced major refiners (notably Sinopec, for whom I’ve taught the last two years) to produced enough refined products to avoid shortages.

Here’s what I infer from the recent developments. This is conjecture, but is consistent with the news coverage I’ve seen. In recent years, government subsidies have been sufficient to induce Chinese refiners, notably Sinopec, to produce sufficient oil to meet demand at the artificially low official price. The continuing increase in the price of oil has made Sinopec uncertain about the credibility of government promises (explicit or implicit) to make good its losses from selling fuels at the artificially low prices, so it has cut back on output, or at least not expanded output sufficiently to keep up with burgeoning demand. This has led to episodes of shortages, lines, etc., which has the government worried. So it is trying to deal with the situation by a mixture of policy tools. It is trying to reduce the excess demand by increasing the official price. At the same time, it is ratcheting up the pressure on Sinopec and other refiners.

This Rube Goldberg approach reflects a problem I mentioned when interviewed about Russian food price controls–once in place, they are very hard to get rid of even as their costs escalate. Politically, the Chinese government feels that it cannot cut the Gordian knot and eliminate the controls. Similarly, it has concerns about the political ramifications of rationing, particularly in rural areas which are already restless and less than enamored with the government. But at the same time rising oil prices make it progressively more expensive to subsidize output of refined products, which puts strain on the budget. So the government is resorting to tried-and-true authoritarian/communist techniques–ratcheting up the pressure on producers. As for one of the expedients, forcing refiners to defer maintenance in order to sustain output in the short run just kicks the can down the road. There will be more refinery outages in the future, putting more pressure on the rickety edifice. And refiners will be very reluctant to invest in new capacity. Someday–perhaps some day soon–the whole thing will come a cropper. And it won’t be pretty.

I am in the process of putting together some back of the envelope calculations regarding the impact of price controls and subsidies in developing nations, like China, on overall market demand, and hence on prices. The basic idea is to determine (a) the elasticity of demand in such countries, (b) total consumption in these countries, and (c) the amount of the subsidy. Given these figures, it will be possible to estimate (at least crudely, no pun intended) how much oil consumption would fall if these countries were to let domestic energy prices rise to meet world prices. Presumably energy demand in such countries is more elastic than in the US or Western Europe, as energy comprises a larger share of expenditures in such countries (even at subsidized prices). Nonetheless, I would wager that price controls (combined with subsidies or other measures like those in China to ensure supplies meet the quantity demanded at the controlled prices) contribute substantially to demand for oil, and hence are contributing to high world oil prices.

This somewhat goofy article from Slate does contain something of interest:

China’s CPI rose 6.5 percent between August 2006 and August 2007, thanks in part to an 18.2 percent year-over-year increase in the price of food. Beijing has responded in part by telling government officials not to use the word inflation. But it is also taking action. The International Herald Tribune reported that China hasn’t permitted gasoline prices to rise since May 2006, when oil was about $70 per barrel. (Yesterday, oil closed at nearly $94 per barrel.) And in September, China froze prices on certain household staples.

The unanswered question here is how the price control is being managed. I didn’t notice any gas lines in Beijing when I visited there this summer, and haven’t read any stories about shortages. This suggests that refiners’ (e.g., Sinopec, CNPC) purchases of crude are being subsidized, or the refiners are being forced to produce sufficient gasoline to meet demand at the artificially low controlled price. If either is the case, there is some positive feedback going on here that is contributing to the higher world oil price. If either through subsidy or compulsion refiners are satisfying the excessive quantity of gasoline demanded (relative to the efficient quantity) at the artificially low price, the price control is contributing to an increase in the world demand for oil, thereby increasing the world oil price. That is, the price control on gasoline encourages consumption, bumping up world demand for oil, leading to higher prices.

Price controls on gasoline are not uncommon–I have read about such controls being in effect in Iran and Iraq, for instance, and would not be surprised if they were quite common. How these effect the world oil price depends on how the controls are implemented. If they reduce the incentive to refine crude into gasoline, because they are not offset by subsidies to refiners or forcing refiners to incur losses while supplying the excessive quantity demanded at the artificially low price, then these controls tend to reduce demand for crude and restrain prices. If, on the other hand, through subsidy or compulsion refiners are induced to meet the excessive quantity of gasoline demanded at the artificially low price, the price controls perversely increase the demand for crude, and thereby raise prices that consumers in non-price controlled countries pay.

I just recently blogged on plans to introduce price controls on food in Russia. I speculated (pun intended) that “I expect that these developments will lead, in turn, as day follows night, to publicity/propaganda campaigns against ‘speculators’ and ‘hoarders.'” From my lips (or fingertips, as it were) to Vlad’s ears–or at least to the ears of the RF’s Federal Anti-Monopoly Service, and in record time too. From a 25 October, 2007 Moscow Times article by Max Delaney (of the Moscow Delaneys?):

In a further sign that authorities are actively cracking down on retailers, the Federal Anti-Monopoly Service announced Tuesday that it had opened up to 40 investigations against traders accused of speculating on food price rises, RIA-Novosti reported.

“The investigations primarily concern the abuse of monopolistic positions in the food goods sector,” said Andrei Tsarikovsky, deputy head of the service.

The service has checked markets selling milk, butter, meat and cheese in the Krasnoyarsk, Tomsk, Perm, Penza, Rostov and Ivanov regions, Tsarikovsky said.

I wonder if the Anti-Monopoly Service reassigned some of its personnel from its investigation of Gazprom in order to carry out these inquiries. Only kidding.

On a more serious note, we can expect much more of this sort of strongarming when the “voluntary” price freeze goes into effect and the elections near. It is exactly these sorts of tactics that will: (a) exacerbate shortages of goods, and (b) stoke corruption. I’ve seen this movie before, and believe me, it doesn’t get any better in the second reel.