Streetwise Professor

The most common defense of Russia’s/Gazprom’s increasing the price of gas to Ukraine, Belarus, Azerbaijan and others is to deny that the motive is political, and to claim instead that these consumers are now being charged the same market price as the Western Europeans. There is a kernel of truth to this, but it obscures the crucial question: just what kind of market is this?

Some markets are competitive. Some markets are not. The market for Russian and most Central Asian gas falls squarely under “not.” Gazprom has a state enforced monopoly on the transit of gas across Russian territory. Moreover, the Russian government is aggressively playing the “Great Game” in Central Asia and the Caucasus to stymie development of any alternative transport routes. For instance, Russia used its overwhelming leverage against Armenia to get that impoverished nation to limit the size of a gas pipeline from Iran, thereby ensuring that the pipe could not be used to transport Iranian gas into Europe.

Russia’s central geographic position, and its heretofore successful efforts to impede development of alternative transportation routes gives the transit monopoly Gazprom great market power. It is effectively a monopsonist upstream, and can exploit this monopsony power to depress the purchase price of gas from Turkmenistan and other “independent” suppliers. Moreover, because the supply of gas into Europe from non-Russian sources is constrained (and will continue to be so unless and until Europe invests in substantial LNG capacity), Russia faces a downward sloping demand for its gas in Europe, which gives it some monopoly power. Indeed, Eastern and Central Europe have even fewer alternatives to Russian gas, and are even more vulnerable to the exercise of market power.

This combination of monopoly and monopsony power is reflected in the chasm between the purchase price of gas from Turkmenistan and Kazakhstan–about $45-$65 per mcm for years, lately raised to $100 per mcm–and the price in Europe–upwards of $230 per mcm. Based on a price of $230 to Germany, and a price in Turkmenistan of $65, this translates to a price difference between consumer and producer of about 3.5 cents per mcm per kilometer. This represents a markup over the Turkmenistan price of about 63 percent per 1000 kilometers. (Even at the now higher Turkmenistan price of $100, the shadow price of transportation is about 2.8 cents per mcm per kilometer, and the markup is 42 percent per 1000 kilometers.)

To put things in perspective, the basis (i.e., the price difference) between the price of gas in Chicago, and the price of gas at the AECO hub in Alberta, a distant Canadian gas supply location, averaged a little over 1 cent per mcm per kilometer from November 2003-January 2007. The markup is about 5.5 percent per 1000 kilometers. Examining the AECO-Iroquois route (Iroquois is a gas hub in New York state), the average basis worked out to about 1.5 cents per mcm per kilometer in 2003-2007, and the markup was about 7.5 percent of the AECO price per 1000 clicks. Iroquois is often quite congested, especially during the winter, so it tends to exhibit a wide basis compared to other locations in North America. Nonetheless, the Europe-Turkmenistan basis dwarfs the Iroquois-AECO basis, and dwarfs the Chicago City Gate-AECO basis even more.

Now, some of the disparity arises because of Gazprom’s inefficiency. (If the exercise of market power doesn’t bother them, global warming worriers should fret about the massive amounts of methane–a greenhouse gas much more potent than CO2–that leaks from Gazprom’s pipes.) But a healthy chunk reflects a market power rent that exists in the no-entry Russian market but does not exist in the much more competitive North American gas transportation market.

The Europeans have importuned Russia to open its gas transportation system. Sorry, not going to happen. This arrangement is too lucrative for the Russian government and the various hogs that feed at the Gazprom trough. This market is not competitive, and is unlikely to become so any time soon.

So let’s call a spade a spade. Let’s not pretend that the price of gas in Europe is a competitive market price. It’s not. It’s a monopoly market price, supported by a state-enforced entry barrier. It deserves no deference from supporters of free markets. The subsidized prices that once prevailed in Ukraine and Belarus don’t deserve deference either; nor does the highly subsidized domestic Russian price.

But two wrongs don’t add up to a right. This has long been a dysfunctional market supported by the dysfunctional exercise of government power. The old dysfunction was to subsidize the consumption of energy by inefficient manufacturing enterprises. The new dysfunction is to extract monopoly and monopsony rents. Prices were too low before. They are too high now (for consumers–still too low for producers).

So, the next time I hear someone repeat the mantra that Gazprom is just charging “the market price,” I will be tempted to sing a few bars from the Minor Threat song “I don’t wanna hear it”:

I don’t want to hear it
‘Cause I know that none of it’s true
I don’t want to hear it
Sick and tired of all your lies
I don’t want to hear it
When are you gonna realize…

That I don’t want to hear it
Know you’re full of ****

Except, I’ll probably fill in the ellipses. ‘Cuz I am–The Streetwise Professor.

Big hat tip to former students Monika and Samir for bird-dogging the data for me. Mucho obligo.

Mikhail Khodorkovsky and his colleague Platon Lebedev are the subject of new charges in Russia. These charges involve money laundering, supposedly involving sham sales of oil.

As yet, the charges have not been circulated publicly, and the evidence is unlikely to be. All indications are that the trial will be tightly controlled, and the result a foregone conclusion. The holding of the trial (illegally, as I understand it) in a prison complex in the isolated Siberian backwater of Chita rather than Moscow; the Kafkaesque procedural machinations; the intimidating security presence in Chita (complete with squads of Spetsnaz commandos in black balaclavas toting automatic weapons on the streets); and the ongoing intimidation of the defendants’ attorneys all make it abundantly clear that this is not about finding facts and dispensing justice, but is instead all about power. Indeed, as is common in authoritarian and totalitarian states, the blatant and unapologetic mockery of justice and due process is intended to send a message to anyone who dares challenge the authority of Putin and the siloviki.

The more outrageous the charges, and the more sinister the procedure, the more effective the signal. A fair and regular procedure with reasonable charges would be a far less effective method pour encourager les autres. Arbitrary and absurd charges are so much more . . . persuasive. They demonstrate that the law is not a constraint on the state, but its tool. It says “The state can do anything it wants. It can convict you on absurd charges if you challenge it. So be smart—don’t challenge.”

I do not know that Khodorkovsky and Lebedev did not break any Russian laws. However, a just government and legal system convinced of the truth of its charges and the strength of the evidence to back them would not hesitate to risk an open and fair trial operating under internationally recognized standards of due process. The Kremlin’s actions betray no such confidence, and provoke considerable skepticism about the truth of the allegations.

The single-minded intensity with which the Kremlin going after anyone connected to Yukos, which brings to mind Ahab pursuing the White Whale to the ends of the earth, or Inspector Javert hounding Jean Valjean, is truly creepy. The hatred is palpable. This is clearly very personal, which lends credence to the view that the true motive is deeply political, and that Khodorkovsky in particular is a mortal threat to Putin and his coterie.

In some respect, this fear is surprising, because Khodorkovsky is such a polarizing figure that there is reason to doubt his political viability. Like many of those who became unbelievably wealthy in the chaotic 1990s, he is widely resented in Russia, and his fate apparently attracts little public sympathy outside of the increasingly beleaguered liberal community. His supporters point to his corporate governance reforms; his critics claim that these were a newfound religion, and that his allegiance to clean governance was honored more in the breach than the promise during his rise to control of Yukos.

One accusation that seems difficult to credit is that Yukos is just a Russian Enron. The evidence that I have seen suggests just the opposite. Accounts from respectable independent sources state that under Khodorkovsky’s leadership, Yukos’s production and efficiency rose smartly—and that under Rosneft management, the same assets have become markedly less productive. That is, Yukos was a real company with real assets, and managed these assets well.

If it were not, why would the Russian government move heaven and earth to get control of it and its assets? If the US government had seized Enron, what would it have found? A shell of a company with far fewer assets and far more liabilities than it claimed. A knowledgeable government would have never tried to expropriate Enron (knowing that there was little to expropriate); a knowledgeable Kremlin’s expropriation of Yukos gives the lie to the Enron analogy.

What’s more, in a country where the rule of law is a nullity, and the government and its minions are willing to use any foul means to seize assets or cash flows that catch their eyes, it is understandable that corporate managers will engage in creative means to protect their companies’ assets. Again, I have no basis to determine with any certainty that the transactions at issue in the most recent Khodorkovsky allegations did not represent “tunneling” of Yukos assets for the personal enrichment of the firm’s management. I only mean to emphasize there are reasonable alternative hypotheses that could justify the use of complicated financial transactions by a firm rationally paranoid (which, as the Transplants song says, is “way past concerned”) about the predatory intentions of the government.

I obviously have no direct knowledge of which hypothesis is correct. I can observe, however, that the Russian government is bound and determined to avoid an open, transparent, and equitable process by which the evidence for each hypothesis can be presented and weighed by an impartial finder of fact to reach an appropriate verdict. And that speaks volumes.

I flew over Sakhalin Island on my way back to the US from Beijing this summer. During the trip I thought about the Soviet shootdown of KAL 007 over Sakhalin in 1983.

Sakhalin is back in the news for a completely different reason today. Under intense pressure from the Russian government, Shell has agreed to give a controlling stake in a gas production and liquified natural gas processing venture located in Sakhalin to Gazprom. The Financial Times’ coverage of the issue is outstanding; in addition to the linked article, there are several others. Robert Amsterdam has released a critical assessment of the deal.

Shell did itself no favors with the $10 billion cost overrun. This would have upset any residual claimaint–and under the terms of the original contract, the Russian government was a residual claimant, receiving payment only after the project’s revenues were sufficient to cover the original investment outlay. This does not mean that handing control to Gazprom is the best way for Shell to compensate the Russian Federation for any mis-management that contributed to the overrun. Gazprom has no expertise in such large and technically complex offshore projects. It can contribute nothing in terms of management or technical expertise. It can barely manage its sprawling–and somewhat decrepit and declining–existing collection of upstream and midstream assets. It has already announced that it would develop the Shtokman field in the Barents Sea–another project which it probably has no business doing by itself. If the economics of the Sakhalin project were already dicey (as the FT article suggests), Gazprom’s “contribution” will be to make them even dicier.

Some adjustment of the contract, such as requiring Shell and its Japanese partners to eat some of the overrun, would have been a more efficient way to handle the situation. But that wouldn’t have suited Putin and Gazprom. That would have resulted in money received down the road. They want control–now.

Moreover, the means by which the RF and Gazprom muscled their way into control is predictably shameful. Trumped up environmental problems–which again should have been dealt with and compensated for in other, more efficient ways–were the knout that Putin/Medvedev wielded this time to bludgeon Shell into submission. One day it’s taxes, the next day it’s environmental laws. As Roseanne Roseannadana used to say, it’s always something–and something always results in Gazprom walking away with the marbles.

This rent seeking makes some people wealthy, and some governments more powerful, but in the end is wealth destroying. It discourages investment, especially in “strategic sectors” that are most likely to be the next target of Putin’s predation. Moreover, it will result in the inefficient exploitation of Russia’s natural resources. Gazprom’s involvement can only cock up the already cocked-up operation of Sakhalin even more. And it is highly unlikely that Gazprom’s magic touch will enhance Shtokman’s productivity (sarcasm alert!). Russia’s taxation through expropriation creates enormous deadweight losses, but advances the interests of state power and the interests of the connected, who care more about the distribution of rents than the maximization of value.

So much Russia-related news, so little time. At the top of the list, of course, is the Litvinenko story. I can do no better than Russian commentator Leonid Radzikhovskiy:

In the case of Litvinenko, there are so many things that are absolutely incomprehensible – especially from the sidelines – that to try and play the role of a self-styled Dr Watson would be absurd. And I wouldn’t dare to try my hand at Sherlock Holmes.

There are many theories, but few facts. [NB. The morning after I posted this, Edward Lucas said that the Russian phrase “Nyet faktov, tolko versii”–no facts, only theories–fits the situation perfectly. Here, here–great minds!] To extend the Holmes analogy, these are akin to the story of Holmes, Dr. Moriarty and the London-Dover-Canterbury train. Putin had him killed. No, somebody had him killed to make Putin look bad. No, Putin had him killed to make it look like somebody was trying to make Putin look bad. And on and on. I think people should chill until more facts are in evidence.

Regardless of which of these theories–or some even wilder possibility that no one has yet thought of–is correct, one thing is certain: Russia is not a normal country where powerful people play by even slightly civilized rules. Pick your poison: murder by the security forces at the Kremlin’s behest; murder by a rogue element in the security forces; murder by an oligarch; some dangerous plot that backfired on its perpetrator. Every alternative is depressing, and makes one despair for Russia and for everyone who intersects Russian interests in any way.

And much news about Gazprom. The excellent Edward Lucas notes that Gazprom is terribly inefficient, and that as a result Russia faces a gas shortage–which would make it highly unreliable as a supplier to Europe and Asia. Leon Aron of AEI similarly notes the stagnation (at best) of Russian energy output in the aftermath of the Kremlin’s de-privatization of the energy sector. The combination of subsidized domestic gas prices, a Kremlin push to encourage substitution of gas for other fuels (both of which encourage domestic consumption), a decaying infrastructure, and niggardly investment in new capacity all threaten to constrain sharply the amount of gas available for export. There was some talk of raising domestic prices, but that plan has supposedly gone by the board.

Moreover, Russia is supposedly attempting to form a cartel of gas exporting nations. Although Kremlin spokesmen deny this, their denials are risible. They prattle about the “interdependence” of producers and consumers, and say that only a “madman” would do anything to harm its customers. Err, monopolists and cartels exist to harm customers by forcing them to pay excessively high prices. Interdependence my eye. Gazprom’s strategy is to increase European dependence on Russian gas by constraining output of alternative suppliers, or denying the access of these suppliers to the European market (by buying up strategic pieces of the European gas infrastructure).

The Russians repeatedly present the image of symmetry between demanders and suppliers (“mutual interdependence,” “security of demand and security of supply are equally important”) but there is no symmetry here. A fragmented consumer and industrial side with myriad relatively small demanders is in no way symmetric to a highly concentrated supply side. The Orwellian phrase “security of demand” so often repeated by Putin and the Gazpromniks really means: we want no competition; we want to ensure that there are no substitutes for what we sell; we want to make sure that you have to deal with us on our terms.

There are certainly circumstances where a buyer and a seller are locked into a bilateral relationship due to their investment in specific assets, and where there is a symmetric threat of opportunistic holdup. This is not the case here. There are many competing buyers of gas who cannot individually holdup Gazprom. There is one Gazprom that can holdup its customers.

The lack of Gazprom investment in upstream production noted by Lucas, Aron, and this Washington Post article likely arises from a variety of factors. First, a firm with market power restricts output. Not investing in capacity is a credible way of constraining production. Second, as a majority state owned company Gazprom is largely free from capital market discipline. Third, and relatedly, it faces the free cash flow problem from hell. The company throws off huge amounts of cash, which permits its managers to do pretty much what they damn well please without having to satisfy investors. Hence, according to the WaPo article, the company spent $18 billion on non-gas acquisitions, or about 6 times what it spent on investments in gas.

Moreover, I surmise that management’s discount rate is very high. In an environment as volatile–and deadly–as Russia is today for both the ordinary man or the very powerful, planning for the distant future is probably not a high priority. Get what you can today, and let the very tenuous tomorrows take care of themselves. Such circumstances are not exactly conducive to taking the long investment view–and there are few industries where the long view is more relevant than energy given the size of the projects, and the length of the exploration and development process.

The WaPo article also mentions that Gazprom’s pipeline construction costs are two to three times industry norms. To me this suggests a Credit Mobilier-Union Pacific type situation, where inflated prices for materials and equipment flow into the pockets of companies owned by Gazprom managers. Just thinkin’.

Before leaving this Gazprom rant, I have to mention the hilarious statement of Gazprom Vice Chairman Alexander Medvedev: “We are not an instrument of policy because it cannot comply with our commercial structure.” Stop it, Alex, you’re killing me! (That’s a figure of speech there, Alex old buddy. Don’t get any ideas. Can’t be too careful.)

I guess I have time for one more Russia story–there are many more that will just have to wait for another day. Peter Hambro Mining’s (subscription required) share price fell 14 percent after the Russian government threatened to revoke some of its licenses to mine and produce gold. The head of the natural resource ministry’s environmental regulator, Rosprirodnadzor, cited two (somewhat contradictory) explanations for this action: environmental law violations, and a failure to develop projects rapidly enough. As if revoking the licenses is going to expedite the development of these properties.

Another day, another holdup. Rent seeking run amok. Another short sighted decision that will further erode confidence in the security of investments in Russia–another manifestation of the truncation of time horizons in a land where life is too often brutish and short.

Well, it finally happened. The CME and CBOT have announced their intention to merge. On the one hand, it’s not a surprise–this tie up has been mused about for years, and there were talks of a combination in the runup to the CBOT’s IPO not long ago. On the other hand, the timing of the deal was a surprise. There was no serious uptick in rumors or conjectures about an impending deal in the days leading to the announcement.

The economics of the deal are perfectly sensible–as they have been for years. When each exchange was a membership organization, however, politics and rent seeking stood in the way of the combination. As I noted in my 2000 JLE piece on exchanges, the members of exchanges are heterogeneous, and there is considerable disparity in the rents accruing to different members. Thus, any major policy change–including a major merger–is likely to have important distributive effects that raise the cost of implementing this change even if it enhances total member wealth. Indeed, the infamously Byzantine nature of member-owned exchange governance structures is a sensible way to control rent seeking–even though it slows decision making and impedes major strategic moves.

Electronic trading eroded the rents that exchange members–notably the locals and floor brokers who dominated exchange governance–earned from their special skills. As I predicted in my JLE article, the move to electronic trading completely undermined the rationale for the not-for-profit form and member ownership. In the early 2000s, the CME and the CBOT went for profit, and had IPOs. Distributive considerations were muted as a result. The exchange owners became much more homogenous–they were all essentially residual claimants to the stream of rents thrown off by the electronic trading system. All had a common interest in maximizing the share price. This reduced the political opposition to any deal, and made the CME and CBOT owners interested in maximizing the size of the pie, rather than fighting over the division of the pieces. Under these circumstances, the compelling economics of the combination finally prevailed.

What’s next? The exchanges are publicly confident that anti-trust review will not cause problems. Perhaps that’s the case, but I would expect the deal to get some attention from DoJ. It’s a big deal, and those tend to attract attention. Moreover, exchanges have attracted little anti-trust scrutiny in the past, but with sea change in the industry, the tendency towards concentration in trading, and the prospect for further consolidation, that may change. DoJ will recognize that this deal will establish a precedent for future mergers in derivatives, equities, and options, and will likely want to make sure that it is comfortable with it.

The key will be market definition. If it’s an individual futures contract market (e.g., Treasury futures), then there’s no problem–the deal won’t increase concentration as the exchanges don’t compete head-to-head in any contract. If it’s the derivatives markets (including the OTC derivatives market), no problem–because the futures markets are small relative to the overall derivatives markets. If it’s the futures markets (i.e., not individual futures markets, but something like “interest rate futures”)–then there could be a problem.

Economically, I think that the first two are more economically sensible than the third. The third market definition presumes that different futures are close substitutes for one another. This is problematic. Different futures–even relatively related futures such as Eurodollars and Treasuries–are not very good substitutes for hedgers. They may be substitutes for some speculators, but I am doubtful that the relevant cross-elasticities are very high. Moreover, some pairs of contracts are actually complements for some speculators. For instance, traders who spread Eurodollars and Treasury note futures, or corn and live hog futures, consider these contract pairs complements. Thus, there is not a strong prima facie case that “futures” is the appropriate market definition.

The deal also sparks additional speculation about what will happen with other exchanges. As I’ve said before, it makes sense to combine NYMEX and CME. Indeed, NYMEX has some of the same attributes–and weakenesses–as the CBOT. NYMEX has a strong slate of contracts, but like the Board, does not own its trading technology. Moreover, there is another benefit to adding NYMEX to the mix–the economies of scope in clearing. Clearing NYMEX, CME, and CBOT contracts together would be cheaper, and economize substantially on margin, relative to clearing NYMEX separately from CME/CBOT.

Beyond that? CBOE+CME+CBOT? There is already cross margining on index options and index futures, so that limits the potential margin savings. Also, CBOE clears through OCC, and there will remain advantages to clearing options on individual stocks that are traded on multiple exchanges through OCC. CME+CBOT+NASDAQ? That is intriguing, and I’ll give it some further thought.

In the meantime, as a Chicagoan, and a student of exchange history, the merger is somewhat bittersweet. The CBOT has been around since 1848, and has been a world leader in futures trading since the Civil War. There aren’t a lot of American business institutions that have been around for 150+ years, let alone world leaders for over 140. The Board was the scene of many important economic events, the birthplace of many important financial innovations, and the stomping grounds for many colorful, illustrious, and sometimes infamous, characters. The CME is also a storied institution with a distinguished past, but it only came into its own in the 1960s, and particularly the 1970s and 1980s. Indeed, the CME almost died when Congress outlawed trading of onion futures–the exchange’s leading contract–in the 1950s. Thus, this represents the passing of an age, and the passing of the torch from a venerable pioneer to a relative newcomer.

Fortunately, the combined entity will utilize the CBOT’s beautiful and historic building at LaSalle and Jackson (depicted in the background wallpaper of this site), so there will be visible and enduring evidence of the Board’s contribution to the city, and a reminder of the exchange’s glorious past. Moreover, the combination will ensure that Chicago will remain the dominant force in derivatives trading for years to come. So though the name “Chicago Board of Trade” will no longer live on, its legacy will. Modern futures trading was born in Chicago. In the last 20 years the futures industry has grown dramatically around the world, but for the foreseeable “future” its home address will continue to be 141 West Jackson Boulevard, Chicago, Illinois, 60604.

A few thoughts regarding the Amaranth matter.

First, the good. A large hedge fund blows up, losing $6 billion in a matter of days, and the market just chugs along with no problems. Quite a contrast to the tumult that accompanied the demise of LTCM 8 years (to the month) earlier.

Now, that said, we shouldn’t get too complacent about this. For one thing, although the dollar value of Amaranth’s loss dwarfs that of LTCM (which lost about $2 billion in equity), the market is just much bigger today. It remains to be seen whether a fund with the same relative size as LTCM could implode without wider fallout. For another, LTCM’s problems occurred during a time of—indeed were caused by—a general financial crisis sparked by a de facto Russian default. This caused a rush for liquidity, and since LTCM was long illiquid instruments and short liquid ones, it was devastated. Its losses, combined with the fact that it was counterparty to most major financial institutions, threatened to make a bad situation worse. In contrast, Amaranth’s travails occurred during relatively quiescent times in the broader financial markets—although natural gas markets were indeed highly volatile and unsettled. It still remains to be seen whether a major hedge fund collapse in the midst of a financial crisis could touch off an acute systemic problem.

Second, the bad. The Amaranth episode proves again, as if further proof was needed, the danger of the “superstar trader” complex. Gas trader Brian Hunter reportedly made Amaranth $800 million in 2005. Whereas historically the fund had kept a close watch on its traders, requiring them to operate out of its Greenwich, CT offices, Amaranth let Hunter set up his own little empire in Calgary. Moreover, it is plausible that Hunter’s past success made the fund’s management loath to question his judgment in putting on the massive spread trade that apparently brought down the house. For you slow learners out there: big winners need more supervision and oversight, not less.

Third, the ugly. Not that we should be surprised, but the usual suspects in DC immediately leapt into action to use the Amaranth situation to justify yet again (yet again . . . ) their tiresome claim that the OTC energy markets are a threat, and that additional regulation is required. One failproof way to identify quackery is if the doctor always prescribes the same “cure” (nostrum is more like it) regardless of the patient’s symptoms. If anything even remotely untoward happens in the OTC energy markets, Drs. Feinstein, Levin, and Coleman (see, it’s not a purely partisan game) always prescribe greater oversight of electronic OTC trading platforms (read ICE) and the mandatory reporting of large OTC energy derivative positions. Possible manipulation—position reporting. Large investor loss—position reporting. Energy prices go up—position reporting. Energy prices go down—position reporting.

What, pray tell, would the CFTC have done with additional information in the Amaranth case? Since Amaranth’s positions posed no plausible manipulative threat in the immediate term (as they were 2007 gas positions) the CFTC could not have used the information to facilitate a manipulation investigation. Nor was fraud a remotely likely problem. Furthermore, CFTC is not in business to keep adults from losing money by speculating the wrong way. Perhaps the agency might have directed inquiries to Amaranth’s FCMs to determine whether the positions posed a threat to the financial viability of these firms and their other customers. Since there have been no reports that any FCM was seriously injured by Amaranth’s difficulties, however, it is unlikely that such inquiries would have led to any CFTC action that would have had the slightest effect on developments.

Even with regard to matters clearly within the CFTC’s ambit—notably, the prevention of manipulation and fraud—it is highly unlikely that position reporting is all that helpful. Position reporting might—and I emphasize might—facilitate early intervention to prevent a manipulation. As I’ve written in the past, notably in my book on manipulation (now #1,565,885 on Amazon after reaching the low-500,000s in late-August!), however, prevention is inefficient as compared to ex post deterrence. As Judge Easterbrook put it, an undetected manipulation is an unsuccessful manipulation. Highly anomalous price movements are the hallmark of manipulation. Transparent exchange prices, and prices on transparent electronic OTC platforms like ICE, provide the most reliable information regarding manipulation. Anomalous price movements—and the complaints of traders harmed by them—can trigger further inquiry to determine whether a manipulation has plausibly occurred, or is in process. Position information can be requested and obtained at that time. Why incur the cost of routinely collecting and analyzing masses of information about positions, most of which is almost completely irrelevant to detecting, deterring, or preventing manipulation? Put differently, a large position may be a necessary condition for manipulation, but it is clearly not a sufficient one. It is more efficient to utilize scarce enforcement resources to examine circumstances in which the primary indicia of manipulation—anomalous prices—are present, than to scrutinize big positions even when price distortions are not evident.

Ironically, raising the cost of doing business on transparent electronic platforms would likely force business into less transparent ways of transacting. This would reduce the availability of reliable price data that is of essence in any manipulation case.

To those who might say: “well, by the time that prices become distorted it’s too late—we need to catch these things ahead of time” I reply: just how, exactly? All manipulations are associated with big positions, but many big positions are not associated with manipulation in any way. One needs to worry about both type I and type II errors, false positives and false negatives. Raising the costs of accumulating large positions may reduce the frequency of manipulation—but it can also constrain the accumulation of large positions for legitimate business purposes. This is costly. A rifle shot approach directed at particular markets where the signs of manipulation are manifest is more efficient than a shotgun approach like that advocated by Sens. Feinstein, et al.

So I venture a daring prediction: the next time the energy market catches a cold, the flu, colitis, or any other ailment known to man or beast, the Capitol Hill Medicine Show will prescribe its Sure-Fire Senatorial Position Reporting Cure.

Any time that commodity prices reach highs or lows, speculators are invariably the culprits. Today’s energy market is no exception. Many commodity market commentators have been quite upfront in their assertions that current high energy prices (and metals prices too) are due to speculative excess, rather than supply and demand conditions. Now the Senate Permanent Subcommittee on Investigations has endorsed these views (and given them substantial credibility) in a just released a report claiming that fundamental supply and demand conditions cannot explain current high oil prices, and asserting that speculative activity is to blame instead. The report breathlessly repeats claims that speculation in energy markets has inflated oil prices by as much as $25 per barrel.

Where to begin? The report is a farrago of facts, factoids, and falsehoods stitched together to arrive at a conclusion that is miles beyond what the evidence actually supports. Moreover, although I concur that manipulation is a potential problem in energy markets–as it is in all commodity and even financial markets–the report does not even make the effort to show that current price levels are the effect of manipulation. Nonetheless, it sternly recommends a variety of new regulatory initiatives to combat manipulation, suggesting (by implication) that manipulation is the cause of high oil prices. This is a flagrant example of bait-and-switch of a variety that I imagine that the Subcommittee members would vigorously condemn if committed by your local used car salesman.

The report (and most of the other criticisms of speculation) fails on only two points: logic and evidence. Other than these shortcomings, it’s great.

With respect to logic, the report documents (to the extent available–reliable evidence being hard to come by) the growth of speculative activity in energy markets. It draws particular attention to “long only” speculators such as pension funds and other traditional investment vehicles that historically have not participated in the commodity markets to any great extent, but which have increased their exposure to commodity prices in recent years as a way of diversifying their portfolios. These funds typically invest in the commodity market through investment vehicles tied to commodity indices, such as the Goldman Sachs Commodity Index (“GSCI”), which parenthetically have a very high exposure to the energy market. Moreover, the report alleges that these funds typically are index buyers rather than sellers. (NB. This is itself something curious, as the diversification benefits could be obtained by shorting the index too.)

According to the report:

As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the futures contract by a refiner or other user of petroleum (p. 16).

The large purchases of crude oil futures by speculators, have, in effect, created an additional demand for oil, driving up the price of oil for future delivery in the same manner that additional demand for contracts for the delivery of a physical barrel of oil today drives up the price for oil on the spot market.

Well, not exactly. Note that most speculators–and most particularly the long commodity indexed investors–offset their positions prior to delivery. For instance, the GSCI is rolled according to a fixed schedule, meaning that to replicate the index, the nearby futures contract is purchased sometime prior to the expiration month and then sold some days before that contract moves to delivery. Thus, the “rolling” speculator, even if continuously long, does not contribute any additional demand for physical oil. The supply and demand for spot oil determines the spot price, and the long speculator–and indeed, virtually all speculators–do not participate in this physical market.

If anything, the entry of speculators affects the price of energy price risk. That is, it impacts the “drift” in a futures price to an expected future spot price that is based on expectations regarding supply and demand conditions at contract expiration, rather than affecting the price of physical oil. Put differently, derivatives markets are primarily for buying and selling price risks rather than for buying and selling the commodities themselves. The delivery process ensures that futures prices converge to physical spot prices, but the amount of activity in contracts with payoffs tied to a commodity price need bear no relationship to the amount of the physical commodity available, and if speculators (and others) act competitively, the physical spot price will be driven by supply and demand fundamentals regardless of the magnitude of the “side bets” on commodity price risk.

I wish that this was an original analysis that I could take credit for, but it’s actually quite old. That’s because the arguments against speculation like those contained in the Senate report are themselves quite old, and spurred cogent refutations long ago. For instance, back in the day when the concern was about short speculators driving down farm prices rather than long speculators driving up energy prices, a 1901 report from the United States Industrial Commission on “The Distribution of Food Products” stated:

As we have attempted to show, it is a mistake to represent speculation in futures as an organized attempt to depress prices to the producers.

First. Because every short seller must become a buyer before he carries out his contract.

Second. Because, so far as spot prices are concerned, the short seller appears as a buyer not a seller, and therefore, against his own will is instrumental in raising prices. (p. 233).

These arguments apply with equal force to analyses of long speculation, as to the short speculation that was the concern of the report.

Insofar as evidence is concerned, the report points to the the current contango in the energy market and the co-existence of historically high prices and high inventories as a smoking gun that proves that energy prices have become unmoored from fundamentals, and are instead driven by speculation. (NB. “Contango” means that prices for more distant delivery–such as for delivery in a year–exceed the spot price. The opposite situation is “backwardation.”)

It is indeed true that historically, high levels of inventory are associated with low prices, and since contango is associated with high inventories, contango is also typically found in energy markets when prices are low. Current conditions are therefore anomalous (by historical standards) and require some explanation.

In this regard, it is important to understand just what inventories are for. Commodity stocks are a buffer against future adverse supply and demand shocks. Typically it is desirable to accumulate inventories when demand is low (or supply is high) relative to future expected supply and demand. Thus, during a recession, demand is low, and is expected to rise at some future date. Therefore, it is often economically rational to accumulate inventories during a recession. Conversely, during a demand boom, it is typically economically rational to draw down on stocks in anticipation of a fall in demand, or perhaps more likely, the entry of new production capacity. The market often moves to backwardation under these circumstances. Thus, all else equal, inventories are typically high when prices are low, but it is important to remember that the price and quantity are determined simultaneously.

It is also possible to identify circumstances in which inventories may be high during periods when prices are at historically high levels. In particular, this can occur if: demand is already high relative to productive capacity, demand is not expected to dampen soon, entry of new productive capacity takes a considerable period of time and no new large sources of supply are in prospect, and there major risks of future supply disruptions. The current high demand causes current prices to be high. The dim prospect for demand declines or augmentation of supply means that if current inventories are consumed they will not be available to meet expected future demand or offset future production disruptions, nor will they be readily replaced through the entry of new production capacity. Moreover, the possibility of major supply disruption in the future means that even though things are tight today, they could get even tighter in the future–which in turn means that consuming a unit from inventory today may be very costly in the future when that unit is not available in the event of a supply disruption.

In my opinion, these conditions are present in the current energy market. The current demand-supply balance is tight. There are no major supply enhancements on the horizon. Indeed, some major investments in new capacity, most notably Canadian oil sands, will come on line much later than originally anticipated due to bottlenecks in getting labor and materials in place. The world is rife with unrest in major oil producing regions–the Middle East, Venezuela, Nigeria, even Indonesia and Russia. Rightly or wrongly, in light of the devastating effects of Rita and Katrina (and Ivan the year before), concerns about increased frequency and intensity of hurricanes in the major US production region has raised sensitivity about the vulnerability of US output to future weather-related disruption.

In brief, as tight as things are today, there is a very real prospect that they could get significantly tighter in the future. Under these circumstances, holding inventories in the face of high prices makes sense, and certainly these conditions make it very difficult to have a high degree of confidence that market participants are holding too much inventory.

The evidence–most notably comparisons across markets–also casts serious doubt on the validity of the hypothesis that speculation is causing excessive inventory accumulation and high prices in energy.

First note that most indexed money (e.g., funds that are tracking the GSCI) have positions concentrated in the nearby contracts. The GSCI tracks front month contracts. Therefore, per the speculative excess theory, the presence of new speculative longs should lead to less contango, not more.

Furthermore, note that speculators are active in many commodity markets, not just oil. Many participants in industrial metals markets have also argued that speculation, including speculation from funds, has distorted those markets. Prices are indeed high in these markets (notably copper and nickel), but the inventory and term structure patterns are very different. Base metal stocks (again esp. copper and nickel) are at very low levels and these markets are backwardated. This either suggests that speculators are behaving very differently in energy and metals markets (which would be peculiar, as many of the speculators, especially indexed money are in both markets and trade the same way in both) or that there are different fundamentals driving prices in these markets and that speculation is not the overriding determinant of price and inventory action.

(As an aside, I read a brokerage study which claimed that speculators were driving all the price action in metals, and the producers were notably absent. This begs the question: if speculators had driven prices to unreasonably high levels, why haven’t producers sold into the rally in a big way? )

There are other markets that also attract significant speculative action, including participation by indexed money that trades almost exactly the same way in all markets, that are at relatively low price levels. For instance, wheat, corn and soybean prices are currently at relatively low levels. If mindless long speculation driven by commodity-indexed money is the main driver of commodity prices, why are grain prices low when energy prices are high?

Of course these comparisons cannot by themselves rule out the possibility that speculation has some impact on prices. However, they do speak to the broad claims that speculation is the 800 pound gorilla that is moving commodity prices far away from their fundamental values. The Senate report argues that oil prices are perhaps 30 percent too high as a result of speculation. That’s a huge impact. Given that the “story” in the Senate report holds true for industrial metals and grains (and other commodities too) such a huge impact should be manifest in prices and inventories for other commodities. Most importantly, since especially indexed money trades all markets in the indices the same way, we should see high prices, contangos, and high inventories in all these markets if this type of speculation is exerting such a decisive influence on commodity prices.

All these markets exhibit very different patterns, however. Therefore, the burden should be on the advocates of the speculative distortion theory to provide an explanation for this diverse behavior in response to an activity–speculation, especially by indexed money–that is common to all markets.

The arguments over the impact of speculation have gone on for a very long time–in Wealth of Nations Adam Smith wrote about laws against “engrossing” passed in the late-Middle Ages. These arguments have cropped up periodically in the years since, and are made with particular force when commodity prices are low or high by historical standards. These arguments are so durable because they are so superficially appealing, and because they are hard to disprove. After all, nobody knows what the “right” price should be given supply and demand fundamentals, because these fundamentals are unobserved. That is, no direct test of the speculative-excess hypothesis is feasible. However, if it is widely apparent that commodity prices are substantially different from fundamentals, other speculators would see a profit opportunity and tend to act in a way that would mitigate, and perhaps eliminate, the observed deviation. This mechanism is not perfect (for reasons set out by DeLong-Schelifer-Summers-Waldman, among others) but in a world where hedge funds and others can go long or short at will, and where these vast pools of speculative capital have a strong economic incentive to take advantage of price distortions, one must posit very strange behavior on speculators’ parts in order to rationalize long, speculatively-driven departures of prices from fundamentals.

Long as it is (no pun intended), this post only scratches the surface of the economic issues related to speculation. The “real” impact of speculation–on investment, production, and inventory decisions–is of crucial importance, but altogether neglected here. I look to remedy this in future posts. Specifically, I am working on some dynamic programming models that will make predictions about the impact of speculation on price levels, stock levels, and price volatility in a storage economy. This should be directly relevant to the current debate over the stock-price relationship that is the source of so much controversy in the energy market.

Martin Katz of George Mason writes about Russia’s long term challenge from China over Siberia. He echoes several of the points I made in my earlier post. This is a long term issue that will not come to a head in a few years, or maybe a few decades, but the long term trends mean that the Russo-Sinese border is likely to be a major flashpoint.

Columbia professor Padna Desai writes about the Russian demographic problem in The Wall Street Journal. Most of the article supports my analysis from earlier posts, but contrary to my speculation that the future may see a conflict between China and Russia over Siberia, she opines:

Some Russians also fear that the Chinese, seeking to increase trade, will come into the Far East and settle down permanently — and that Beijing will then somehow stake a claim on Russian territory! This is nonsense, of course, but I encountered such fevered scenarios of the “yellow peril” even among some liberal acquaintances on my recent trip to Russia.

I certainly don’t view such a conflict as a probability 1 event, but in my view it is anything but nonsense. Nature abhors a vacuum, and if present population trends continue, Siberia will become a human vacuum–but one with vast mineral wealth that China wouldn’t mind having. It is hard to imagine that a depopulated Siberia coexisting side by side with a vibrant, energy hungry, proud, and confident China is a stable long run equilibrium. Moreover, the Chinese have a long historical memory, with a particular talent for nursing historical wounds suffered at the hands of foreigners. Although the Russians do not rank with the British or the Japanese as exploiters of China during its humiliations in the 19th and early-20th centuries, they were not blameless either. As a result, I wish I shared Ms. Desai’s blithe optimism about Chinese-Russian relations over the long term, but I don’t.

Ms. Desai also suggests that immigration is a solution to Russia’s demographic dilemma. Good luck with that. Ask the Western Europeans how the immigration thing is working out for them. And if it doesn’t work in Western Europe–which it doesn’t, pace Paris car burnings, honor killings in Germany, Britain, and Sweden, etc.–it sure as hell isn’t going to work in Russia.

Addendum. Apparently the world, Goldilocks-like, is looking for a level of immigration that is “just right.” In the US, many people (arguably a majority) think it is too much. In Russia, too little. A couple of quick thoughts. First, what kind of immigrants are we talking about? Immigrants are not homogeneous. Some are skilled. Many are not. What kind of immigrants is it necessary to attract? How can you attract those immigrants (the skilled ones, presumably) without attracting the less desirable ones? Is immigration consistent with social welfare policy? (One of my intellectual heroes, Richard Epstein, said in a seminar at Michigan in the 90s that his primary objection to the welfare state is that it was incompatible with unrestricted immigration. Like many Epstein positions, not quite in the mainstream, but logically consistent and intellectually serious.) Put differently, how can you attract immigrants without attracting a disproportionate number of “gimmie-grants?” Second, where are the immigrants to Russia going to come from? China–maybe. The Middle East–probably not, and given the European experiences, its arguable that this represents the most desirable source of immigrants. And are people from places where it is routinely 35+ degrees C really want to move to where it is routinely 35- degrees C? Central Asia? Again, the disparity between educational attainment in most of Russia and Central Asia is immense, and it is doubtful that Central Asian immigrants will address the Russian labor problem. Third, the difficulties of assimilating immigrants have proven very difficult in Europe and the US, but they are likely to be immensely more difficult in Russia. Russia has no tradition of accepting immigrants. Russia is historically more insular, and arguably more xenophobic than the US or Western Europe (which is not to say by any means that xenophobia is absent in those places–this is an ordinal statement.) Language will be a barrier.

All in all, saying that immigration is the solution to Russia’s demographic challenge is fantasy. It reminds me of the standard economist joke, of which there are several variations, one of which is: An economist and a physicist are on the 50th floor of a high rise hotel. The fire alarm goes off. The economist and the physicist look out the window, and see that the entire lower part of the building is engulfed in flame. The physicist says–“there’s no way out. We’re going to die.” The economist says–“Don’t worry. We’ll just assume the existence of a 50 story ladder.” Assuming immigration to be the “solution” to Russia’s existential conundrum is no more realistic.

Addendum II. Mark Steyn weighs in:

The answer to many of China’s problems lies just across its northern border: the fast depopulating, resource-rich Russian east, which Beijing will wind up with one way or the other. If you read Mark Bassin’s masterful book Imperial Visions : Nationalist Imagination and Geographical Expansion in the Russian Far East, 1840-1865, it’s hard not to notice that the rationale behind the Russians’ sale of Alaska applies just as well to a big swath of their eastern provinces today. A century and a half ago, Grand Duke Konstantin Nikolaevich, the brother of Alexander II, argued that the Russian Empire couldn’t hold its North American territory and that one day either Britain or the United States would simply take it, so why not sell it to them first? The same argument applies now to the 2,000 miles of the Russo-Chinese border. Vladivostok will return to its old name of Haishenwei before too long.

And, given Russia’s own gender imbalance — between sickly men of low life expectancy and long-lived robust women — it doesn’t take much imagination to see a Sino-Russian union as a marriage of convenience in more than just the geopolitical sense. That’s the key difference between transatlantic Ouija boards on China: as the cannier American analysts see it, Beijing is a threat to Washington not because of its strength but because of its weakness.

As always, Steyn provides an interesting perspective. The Alaska II scenario is not implausible, but Siberia is more of an integral part of Russia–both physically and more importantly psychologically–than Alaska ever was. This makes a transactional transfer of Siberia less likely, and a violent one much more likely.

Addendum III. Richard Posner’s observation on the US & Mexico pertains to the feasibility of immigration as a palliative for Russia’s demographic problem:

As soon as per capita income in a country reaches about a third of the American level, immigration from that country dries up. Emigration is very costly emotionally as well as financially, given language and other barriers to a smooth transition to a new country, and so is frequent only when there are enormous wealth disparities between one’s homeland and a rich country like the United States. The more one worries about illegal immigrants, the more one should favor policies designed to bring about greater global income equality.

Since per capita income in Russia is already relatively low, the differential between Russian incomes and the incomes in possible sources of immigration is already small. Moreover, it is likely that the “language and other barriers to a smooth transition to a new country” are substantially greater between Russia and other countries than between the US and Mexico, requiring an even larger income differential to attract substantial immigration. In other words, large immigration is (not surprisingly) something that occurs in rich countries, and is not a panacea for the labor problems of relatively poor ones (like Russia.)

Russian efforts would be better devoted to keeping its high skill people from going west, to the US or Europe, than to attracting low skill people north or east to Russia.

After earlier negotiations went nowhere, the Chicago Mercantile Exchange and the New York Mercantile Exchange entered into an agreement whereby NYMEX contracts will be listed on CME’s Globex system and traded side-by-side with the NYMEX open outcry markets. This followed a brief interval in which NYMEX tried to convince an apparently skeptical (and probably justifiably so) marketplace that its legacy electronic systems (Access and ClearPort) were up to the task of staving off ICE’s challenge.

As I noted in my February post “Whither NYMEX,” the NY exchange was vulnerable due to its technological weaknesses, and viewed in that light the deal makes perfect sense. I surmise that NYMEX played hardball in the initial negotiations, and the CME walked. CME then played its cards perfectly, announcing that it intended to offer energy futures of its own on Globex. Already having its hands full with ICE, NYMEX was in no position to tangle with the biggest kid on the block, so it did the prudent thing and combined with the CME.

NYMEX did what it had to do, but the deal is a coup for CME. It gets a nice revenue stream (with very little additional cost) from an established franchise, whereas competing with NYMEX would have been expensive (with marketing expenses, likely fee waivers, etc.) and of uncertain outcome.

Is this the end of the story, or just the beginning? Methinks the latter. There is a potential double-sided opportunism problem here. CME has the technology. NYMEX has the contracts. They have entered into a contractual relationship whereby they share these assets. If Globex trading of energy contracts takes off, as is reasonably likely, each party is in a position to hold up the other. It is very possible that we will see haggling over fees, threats to walk from the agreement, and so on.

How can these problems be forestalled? Merger. A combination would economize on the transactions costs inherent in the double-sided holdup problem. It could also result in some cost savings, especially on the clearing side.

Whether or not this will occur will depend on how electronic trading fares. If my conjecture that electronic trading of NYMEX energy contracts will take off is correct, the deal is almost imperative. Moreover, such a development will undermine the strength of the floor community who might otherwise oppose the deal. The deal will also be easier to consummate after NYMEX has an IPO.

If things play out this way, then the question will become: Whither ICE? That’s a post for another day.