Oil is crashing, with WTI trading at a 33 handle, down 20+ percent since Friday.
The first leg down in oil prices was caused by the coronavirus demand shock in China. This most recent free-fall is a response to Russia’s refusal to agree with OPEC to extend the existing OPEC+ cuts, and deepen them in response to the demand decline; and the Saudis’ reaction to the Russians, specifically, to put the output pedal to the metal.
The Saudi reaction to the Russians is a classic cartel defector punishment strategy. The Russian demurral is more difficult to understand. One story circulating is that Putin wants to punish US shale. If so, he’s a fool. And worse, a fool who fails to learn from the foolishness of others, e.g., the Saudis whose predatory pricing strategy in 2014-2016 failed miserably.
Yes, cratering the price of oil will inflict pain on US shale producers. They will suffer financial losses, and will curtail drilling and output. But US pain does not equate to Russian gain. Russia will incur substantial losses from prices in the 30s–and more pain if prices go into the 20s, as is possible. But Russia will not recoup this pain with future gains. If and when they (and OPEC) decide they’ve had enough, and curtail output to raise prices, US output will respond accordingly.
US rocks can outwait Putin. Yes, reduced activity will damage the shale supply chain, and it will take some time to recover, but as the Saudis found out in 2016, the flexibility of the US oil sector allowed it to rebound extremely rapidly when prices rose. The resource remained. The human capital remained. When OPEC+ went into effect, US oil output soon exceeded the pre-2014 price crash levels, which sharply limited the upside for the Saudis and Russians.
I am currently putting finishing touches on a paper which, among other things, demonstrates the futility of the Saudi strategy in 2014–and the Russian strategy (if that’s what it is) today. I document learning-by-doing economies in the US shale sector. If these economies are big enough, lost output today due to predatory Saudi or Russian behavior translates into lower US productivity in the future. That means that Saudi/Russian price cutting today raises their rivals’ costs in the future, which could lead to higher future Saudi/Russian profits then.
But the empirical estimates show that the US productivity losses due to foregone learning are very small, and hardly allow the predators to recoup the huge costs they incur from their predatory strategies. Putting the Saudis and Russians together, $10/bbl price cuts today cost them on the order of $230 million/day: $20/bbl cuts cost them around $460 million/day. There is no way that the higher future cost of US oil production due to lost learning opportunities will allow the predators to recoup these losses in the future by raising the ceiling that US shale puts on world oil prices.
Predatory pricing strategies are almost always futile. They are definitely futile with regards to the US shale sector. If Putin is indeed pursuing a predatory path, he is cutting off his own nose to spite his face.
Like virtually all of the papers in this literature, it relies on crude before-after comparisons based on some magic year (2004? 2005? 2006?) during which commodity index investing became important. Even assuming that the rise in index investing was a sort of exogenous shock, this crude method of attributing causation has problems. After all, a lot of other stuff happened after, say, 2004. The rise of China as the predominate force in commodity markets, for instance.
Perhaps this problem would be less troublesome were commodities assigned randomly to “treatment” (part of an index) and “non-treatment” (non-index) groups. But this is definitely not the case. There are systematic differences between index and non-index commodities, so it is difficult to know whether the effects documented in Brogaard et al are due to a correlation between these systematic differences and the performance measures they utilize.
Ah. The performance measures. That raises yet more issues. The paper claims that firms with exposure to index commodities experienced lower returns on assets (i.e., operational income/assets) post-indexation than their non-index-exposed counterparts.
So what is the implicit model of the market in which these firms operate? If the presumption is that the markets are relatively competitive, why would you expect profit margins to change over a period of several years? Even assuming that indexation increased costs via the channels posited by the authors, in equilibrium this would lead to (a) an initial decline in profits, (b) exit (meaning fewer assets and lower output), and (c) a return of profits to the competitive level. Meaning that actually looking at assets or output would be a better measure of how indexation affects cost than profit margins.
If, conversely, the presumption is that these markets were imperfectly competitive prior to the indexation shock, the fall in profit rates could be a good thing, rather than a bad thing. It could indicate that indexation resulted in more intense competition/lower market power.
This is particularly interesting, given that this was a period in which measured profit rates were rising generally in the economy, a phenomenon which some (not I, but some) attribute to declining competition. Now, there are big problems with that literature (problems that the late great Harold Demsetz identified in the 1970s, but which modern scholars have forgotten), but take it at face value. Declining profits/margins could be interpreted as a signal of increased competitiveness and efficiency. A feature, not a bug.
And via a channel exactly contrary to that posited by Brogaard et al. They posit that indexation reduced the informational efficiency of commodity prices. But an increase in informational efficiency would tend to reduce market power–and reduce margins/profits. Note that many firms HATE the introduction of futures, or increased trading of futures, of their main inputs or outputs. Precisely because futures trading increases the informational content of prices which undermines an information asymmetry that generates profits for major producers and consumers.
Which brings me to that information channel. Brogaard et al measure informativeness using the autocorrelation in commodity returns.
Really?
They basically find that autocorrelations went up, which they interpret to mean that commodity futures markets became weak form inefficient (or further from weak form efficiency).
Again: really?
Taking their argument literally, it means that speculators were able to eliminate predictable movements in prices prior to indexation, but weren’t able to do so afterwards. This stretches credulity to its limits. After all, “financialization” of commodities also saw the entry of banks and hedge funds into commodity trading. We’re supposed to believe they left easy money on the table?
This purported reduction in price efficiency raises another issue. When I read about return autocorrelations I think time-varying expected returns. So the Brogaard et al result suggests that index commodity returns became more time-varying after indexation became a thing.
Arguably the primary impact of indexation was to integrate more closely commodity prices and stock and bond prices, and in particular, ensure that systematic risk was priced more consistently across commodities and financials. We know that equities and bonds have time varying returns. It is plausible that the documented increase in time variation in expected commodity returns reflects this integration, and is yet another feature rather than a bug.
If so, commodity prices that more accurately reflect the pricing of risk should lead to better investment decisions, not worse decisions. Further, these better investment decisions need not be associated, over several years, the operational performance measures they employ.
Indeed, along the lines of a paper that I wrote a few years back, indexation improves the allocation of risk and reduces the cost of commodity price risk to firms. In equilibrium, this would lead to lower rates of return. Which is exactly what Brogaard et al find.
Pursuing this further, I note that the authors do not use sensitivity to commodity prices as a means of determining whether firms are exposed to commodity prices, on the basis that hedging can reduce price exposure. Yes, but consider the following. Hedging is costly. Hedgers frequently pay a risk premium to speculators. This leads them to hedge less, which leads to high exposure. If indexation reduces hedging cost (as my paper implies), at the margin, firms will hedge more, and bear less risk. This reduces expected profits (which incorporate compensation for risk).
This has at least two implications. First, the average profit rate of firms exposed to hedgeable commodity prices (which are precisely the commodities that are included in indices) should decline post-indexation: this is consistent with the Brogaard et al finding. Second, firms should hedge more–leading to lower exposure to commodity prices. Brogaard et al do not test this latter implication. (Admittedly, this raises complications. Firms may limit commodity exposure in ways other than hedging, and a lower cost of hedging can lead to a substitution of hedging for these other means, leading to offsetting effects which reduce the commodity exposure impact of cheaper hedging.)
The upshot of all this is that the conclusions that the authors advance–namely, that indexation resulted in poorer real outcomes in terms of performance and investment–are not supported by their empirical findings. That is, there are alternative hypotheses that are consistent with the empirical findings that are diametrically opposed to their hypothesis.
This paper is well done within the analytical confines that its authors select. But that’s exactly the problem with this literature. The analytical confines exclude important channels of cause and effect. Most importantly, these confines make implicit assumptions about the degree and nature of competition that either make their results problematic, or mean that their results have diametrically opposed implications to those of the chosen analytical framework.
Meaning that the debate on the effects of indexation are still very much open, and that finance and economics scholars have largely failed to devise reliable tests to distinguish indexation-is-bad hypotheses from indexation-is-good hypotheses. Which is precisely why the debate is still open.
On Thursday, the CFTC voted along party lines to approve a proposal on position limits. The party line vote reveals a salient fact: the proposal represents a virtual abandonment of the Commission’s earlier proposals (2011, 2013, 2016). Indeed, virtually all of the features that I criticized in the earlier proposals are gone, and the current proposal largely mirrors the recommendations of the Energy and Environmental Markets Advisory Committee that I served on (before being uninvited by current EEMAC chair Dan Berkovitz). (More on EEMAC below.)
Most importantly, limits outside the “spot month” (which is actually just a few days for some commodities) for energy and metals commodities are gone. Good riddance. They remain for nine legacy ag futures contracts (corn, cotton, and the like), but the any-and-all limits have been expanded substantially.
The rule expands hedging exemptions beyond the prior proposals, and in doing so meets the objections of companies like Vitol. Interestingly, the proposal tidies up the definition of a “bona fide hedge” and makes explicit, rather than implicit, the principle that bona fide hedges are solely for the reduction of price risk.
The Commission did eliminate the “risk management” hedging exemption for swaps dealers, based on an interpretation of Congressional intent and a reading of statute that limits hedging to the management of risk of physical commodity positions. On principled grounds, I object to this. A swap dealer buying an oil swap from an E&P firm facilitates the hedging of a physical position, and hedging that swap via the futures markets serves a classical risk transfer function. A dealer selling an index swap to a pension fund isn’t hedging a physical risk, but it is still serving a risk transfer function and the distinction between physical commodity hedges and non-physical hedges is rather Talmudic.
The practical effect is unknown. In terms of index swaps, most swap dealers are out of the nearby contract when an index (e.g., GSCI) rolls, which is well before the spot month for energy and metals that make up the bulk of most indices. Hedges of the ag portion of these swaps could be affected by the any-and-all limits and the elimination of the risk management exemption, but the dramatic increase in the size of these limits may well greatly reduce any impact. A dealer hedging a swap with payments based on final settlement prices of say NYMEX crude or natural gas could be impacted by the elimination of the exemption, but the spot month limits may be large enough to cushion the impact here as well.
The most interesting feature of the proposal is its rather tortured attempt to address the “necessity” issue that derailed previous proposals in court.
The most important aspect of this is that it appears that the Commission has essentially conceded that a necessity finding is, well, necessary. That raises the issue of the criteria for establishing necessity.
One criterion could be that a limit is necessary only if the risk of speculation causing unwarranted price fluctuations is sufficiently great.
An alternative criterion is that a limit is necessary as long as the risk of unwarranted price fluctuations exists at all, if the contract is important enough.
The Commission took the latter approach, and limited its limits to commodities it deemed were sufficiently important (measured by volume and open interest) so that any unwarranted price fluctuation could lead to impairment of price discovery and risk transfer on a large scale. The closest that the Commission came to taking likelihood of disruption into account is its restriction of the limits to physical delivery contracts that could be cornered or squeezed. This is a logical problem (cash-settled contracts give rise to manipulation too) but this is of secondary importance. But it could be read to limit the Commission’s interpretation as to the source of unwarranted fluctuations to market power manipulation, which would be a good limitation indeed.
A sufficient statistic to infer that the Commission conceded much in its necessity finding is Dan Berkovitz’s freak out on the issue in his dissent.
As a manipulation-related aside, I will note that the spot month limits are justified by the notion that a position in excess of deliverable supply is necessary to execute a market power manipulation (i.e., a corner or squeeze). I have some recent research (which I’ll post and write about soon) showing that this may be a sufficient condition, but not a necessary one. Meaning that the limits will not be sufficient to eliminate market power manipulation.
As oil prices spiraled upwards in 2007 and 2008, I wrote more about the issue, and gained more notoriety. This resulted in my testifying before the House Ag Committee in July 2008 (a day or two before oil prices reached their all time high) and led to a WSJ oped.
Then the Financial Crisis happened, and I focused more on clearing issues, with periodic forays into the speculation debate. But Frankendodd included a provision on speculative position limits in commodities, and the CFTC rolled out a proposal in 2011.
I wrote a comment letter on the proposal. That letter (and others I wrote subsequently) were sufficiently important that in the final rulemaking and in later proposals it or other things I’ve written were cited dozens of times (my name gets 50 hits in the 2016 proposal).
But the impact of the letter on my life went beyond that. Gene Scalia–son of Justice Antonin Scalia, and now Secretary of Labor–retained me to write a declaration criticizing the inadequate cost-benefit analysis in the proposal (it being something required under the law.)
Perhaps most importantly, Blythe Masters at J. P. Morgan liked it, and called to tell me so. She then proposed that I write an analysis of the systemic risk of commodity trading firms for SIFMA. I did–and came up with the wrong answer. So SIFMA spiked the report. But word leaked out, which prompted Trafigura to retain me to write a study (with a subsequent follow-on study) of the economics of commodity trading firms.
I don’t think I’m exaggerating to say that this study proved to be very influential, perhaps because of the lack of competition: writing on the sector was, and remains, very sparse. I have traveled, lectured, and taught around the world based on people wanting to hear what I wrote about in that piece.
The study was also the hook for the New York Times hit piece on me in December, 2013. See! I took money from evil speculators while writing in opposition to limits on speculation! Never mind that I had been consistently opposed to limits years before, and never mind that Trafigura (and other oil traders) are not speculators and use the futures markets mainly for hedging.
(As an aside, I am convinced, but cannot prove, that Gary Gensler was the moving force behind the piece. After all, why else would the NYT devote front page space to an obscure academic? And under the theory of there-are-no-coincidences-comrade, comments on the 2013 revised proposal were due in January, 2014. So December 2013 was the perfect time to kneecap a gadfly. By the way, Gary, how’s that gig as Treasury Secretary working out. Oh. Right. Well maybe you can chair Hillary’s legal defense fund.)
Asides aside, other than frightening my aged parents this article actually was all for the good. It validated me as an influential voice. It also got many very reputable people to rush to my defense, including Thomas Sowell, one of my long-time heroes.
The article raised its head a few years later when I was serving on EEMAC, and was asked to write the (Frankendodd-mandated) report on the committee’s deliberations. I was the dutiful scribe, and honestly recorded the committee’s adamant opposition to the then-outstanding proposal (which included all the bad features jettisoned in the new proposal).
This caused Elizabeth Warren to lose her [insert vulgar metaphor of your choosing here]. This article in particular cracked me up (and still cracks me up): Why Elizabeth Warren Is On the Warpath This Week.
Well, why was she on “the warpath”? Well–me, now that you ask:
The committee, which was established by Dodd-Frank, has nine members. Though it is supposed to express a “wide diversity of opinion” and “a broad spectrum of interests,” eight of the nine members represent companies or industries with a financial interest in killing the position limits rule, or have a personal financial interest themselves.
. . . .
The recent inclusion of Craig Pirrong on the committee is perhaps the most flagrant example. Pirrong, who co-wrote the first draft of the report with James Allison, is a professor of finance at the University of Houston, who has been paid by several industry participants and trade groups for his research into commodity speculation. He was also a paid research consultant for the International Swaps and Derivatives Association, the very group that got the initial rule overturned by the courts.
The CFTC report relies mostly on Pirrong’s research and a presentation he made to the committee last year, which did not include the opinion of anyone who believes in the dangers of excessive commodity speculation. In fact, 10 of the 13 witnesses at EEMAC meetings came from industry, two were representatives of CFTC, and the other was Pirrong. The meetings never mentioned that there would even be a final report. [Er, it’s in the law, you knobs.]
As Public Citizen’s Tyson Slocum, the only non-industry committee member and the only one to dissent from the recommendation, points out, Pirrong was not on the committee until after he co-authored the report. Pirrong “is so new to the EEMAC,” Slocum wrote in a minority dissent, “that I only learned he was a member when he was listed as a co-author.”
I’m so proud. One’s enemies are the best comment on one’s character.
What cracks me up is that it wasn’t a right-wing snarkmeister like me that included “Warpath” in the title of an article about Liz Warren. It was the (by then) far-left New Republic. Freudian slip? Whatever, it’s hilarious.
Alas, understandably but not commendably, Commissioner and EEMAC chair Christopher Giancarlo buckled under the political pressure and withdrew the report. But this was almost certainly a non-event: the proposal was dead in the water, and was only salvaged by saving major pieces overboard. And I’ve sailed on.
What a long strange trip it’s been. The speculation debate has had a first-order impact on the arc of my life for more than a decade. Although the Commission proposal will likely put an end to one chapter of that debate, as I wrote in my first piece in 2006, speculation controversy is a hardy perennial, and will no doubt recur the next time some major commodity price spikes or craters. And maybe I’ll be around to draw more fire–and deliver some–when that happens. And until then, I’ll keep Truckin’ on whatever fits my fancy.
Nota bene: I’m not a Dead Head by any means. But if the song fits . . . Well, not the drugs part!
For 5+ years I have been calling oil-linked LNG contracts a “barbarous relic” (echoing Keynes and the gold standard). This opinion was widely castigated when I first voiced it, but I had a strong basis for it: oil and LNG prices are driven by totally different fundamentals, and as a result oil prices are almost always disconnected with gas market fundamentals.
My presentations include a graphic and some statistics to make the point: correlations between oil and gas prices (measured by the Japan-Korea Marker, or JKM) are about zero, and so are the correlations between gold and gas prices. So it makes about as much sense to index LNG contracts to gold as it does to index them to oil.
Asian utilities buying liquefied natural gas under rigid long-term contracts linked to oil prices risk paying an average of $20bn more each year up to 2022 than if they bought the superchilled fuel directly in the market.
S&P Global Platts, which sets the benchmark LNG price for the region, said there was a “huge disconnect” between the of cost oil-linked contracts and prices in the so-called “spot market” for LNG.
Nice of you to catch up, Platts. This “huge disconnect”–the exact phrase I’ve used in public presentations for years–has been evident in the data . . . for years. Indeed, since the beginning of the JKM index.
Platts spins this as utilities paying too much. It wouldn’t be any better if they paid too little. The point is that divergences between contract prices and product values cause misallocations of resources, including transactions costs associated with trying to circumvent contracts with prices that are misaligned with fundamentals.
There are still some who are in the thrall to the barbarous relic:
Jera, the world’s biggest buyer of LNG, said that oil-linked contracts still often made sense. The spot market was still small and vulnerable to volatile spikes as seen in early 2014, it said, while long-term contracts offered “stable procurement for buyers”, as well as providing a guarantee of demand needed by developers to launch new LNG projects.
This is a jumble of sloppy thinking.
Volatile spikes? If the spikes are driven by gas market supply and demand conditions, tying contract prices to gas prices rather than oil is a feature not a bug. You want prices that reflect fundamentals, and if fundamentals are jiggy, so be it. And, er, last time I checked, the oil market was subject to “volatile spikes” despite its greater size. And this is a bug, not a feature, when it comes to LNG because these oil price spikes are almost always unrelated to gas supply and demand conditions.
That is, it is better to tie LNG contract prices to markets with jumps that reflect gas fundamentals, than it is to tie prices to markets with jumps that don’t.
There can be a role for long term contracts, though the transactions cost (“opportunism”) related reasons for such contracts become less important as the short-term market becomes more liquid. Furthermore, even to the extent that long term contracts facilitate investment, it is a non sequitur to conclude that these long term contracts should be indexed to oil, rather than a gas price (be it JKM, or Henry Hub, or TTF, or whatever). The contracts will perform better–transactions costs will be lower–the lower the likelihood that pricing terms become misaligned with fundamentals. Gas indexing results in lower probability of misalignment than oil indexing.
For years, the mantras in the LNG market have been “security of supply” and “security of demand”, and that long term contracts are the only way to secure it:
David Thomas, an independent adviser with experience at Vitol and BP, said that Japanese utilities “value security of supply and there’s a strong relationship between buyers and sellers” but that was changing as the LNG market became more liquid and Japan’s gas and power markets liberalize.
The oil and refined product markets rely on markets for security of supply and demand. A big refinery or a major oil development are as, or more, capital intensive than an LNG product. But these things get created without long term contracts because liquid markets allow transactions at prices that reflect supply-demand fundamentals.
Long term contracts play a role when spot markets aren’t “thick” enough: under these conditions, opportunism (“holdup”) is a problem, and long term contracts can mitigate that problem. The evolution of spot markets in LNG will progressively mitigate the potential for holdup problems. And as I’ve noted, this is a virtuous cycle: as spot markets become more liquid, the need for long term contracts will decline, which will contribute to greater spot market liquidity, which will vitiate further the need for long term contracts.
As the producer of the JKM index, Platts is obviously talking its book here. But that’s not to say that it’s wrong. It isn’t. And economic reality will inevitably push contracting practices in the LNG market away from the barbarous past. Or perhaps I have the tense wrong there: is pushing would be a better way of putting it.
Vladimir Putin is deeply concerned about the environment, especially about the environmental ravages of evil American technology, notably fracking:
Speaking of the United States, Putin had plenty of words for them as well, accusing the U.S. of ignoring the negative environmental externalities of the nation’s mass-scale shale oil and gas production (fair enough) calling the process “barbaric” and proclaiming that Russia will never use fracking as a means of oil and gas extraction. “We will never frack,” Putin told a representative from Total SA during Moscow’s Russia Calling! conference on Wednesday. “We don’t need to develop shale oil at all. First, we don’t need to increase the supply of oil to world markets, and we have enough oil we can get from the Arctic shelf.” He added, “In spite of all of the economic benefits, we do not need it and we will never do this.”
Well, Putin does have a (rather mysterious) candidate degree in “economic science” from the St. Petersburg Mining Institute, so perhaps he is qualified to give disquisitions on externalities (never mind the plagiarized thesis!). But the externalities lingo was no doubt put into Putin’s mouth by Charles Kennedy (whoever the-F he is). If Putin’s reference to barbarism had anything to do with the environmental impacts of fracking, he was merely blowing smoke up the you-know-what of the environmental movement in the West.
No, if Putin thinks that anything about shale and fracking are barbaric, it is the fact that they have raped and pillaged the oil price on which he and Russia are so dependent, and have created the US LNG industry which constrains Russian market power in European gas markets.
In other words, if there is anything green behind what Putin said, it’s greenbacks, not nature.
As for environmental impact, drilling and producing in the Arctic Shelf is far more environmentally problematic than shale production via fracking.
Putin’s anti-fracking jeremiad is also undermined by Gazprom Neft’s endeavors in this area. It’s also worth nothing that Russia’s Bazhenov layer (which Gazprom Neft is focused on) is arguably the largest shale resource in the world. The impediment has been technology, a problem exacerbated by sanctions, now going on their 6th year.
You can bet that Putin would not be lamenting the barbarities of fracking if Russia had the capability to do it. He is merely trying to rationalize Russia’s technological inability to exploit its shale resources, an inability exacerbated by the consequences of his foreign policy adventurism.
The anti-ban participant, Sam Ori, executive director of the Energy Policy Institute at the University of Chicago, points out that as a result of the fracking revolution, US production accounts for 8 percent of the world total, and eliminating this would dramatically increase prices:
One year after the implementation of a ban, shale-oil production would be down by more than a third. After two years, production would be down 55%. You’re talking about triple-digit oil prices and a possible global economic shock
To which the ban supporter, Kassie Siegel, director of the Climate Law Institute at the nonprofit Center for Biological Diversity, replied: What? Me worry? My magical thinking will save the day!
I think an oil-price prediction is largely a red herring, because I am not talking about banning fracking in a vacuum. My organization and others propose a fracking ban along with other smartly designed programs to speed the development and deployment of clean technologies, support local communities, and offset oil and gas price increases. Government policies that drive a rapid just transition to clean-energy technology can create the largest economic stimulus since World War II.
I’m talking about policies like accelerated clean car and truck standards that rapidly decrease oil consumption in the transport sector and moving the power sector to 100% renewable energy. Other policies like reinstating the crude-oil export ban would also counteract price increases from banning fracking and restricting the supply of oil and gas.
Well-designed government policy in other areas, like tobacco and asbestos, addresses both supply and demand. Climate policy must do the same. The barrier to this is opposition from the fossil-fuel industry, not any insurmountable economic or policy problem.
And don’t you think we need to be a little bit skeptical of anyone’s ability to accurately predict oil prices?
Unpacking this idiocy in its entirety would exhaust my time and my patience. So just a few comments.
“Well-designed government policy” and “smartly designed programs.” Such a comedian! Because we know government programs are always well-designed and smartly designed. Did I say “always”? Sorry. I meant “never.”
Case in point. The brilliant European strategy to reduce CO2 by forcing the replacement of gasoline engines with diesel. Whoops! Not only was it colossally expensive, it was a major mistake because (a) it barely affected emissions of CO2, and (b) greatly increased auto emissions of harmful particulates.
Further, since China is the largest emitter, and the largest growing emitter, of CO2, Ms. Siegel is relying upon the wise beneficence of the CCP to achieve her goals.
Need I say more?
“Accelerated clean car and truck standards that rapidly decrease oil consumption in the transport sector.” First, this is costly, not just directly in terms of replacing a huge stock of existing capital, but indirectly by forcing people to drive lower-quality automobiles. How do we know they are lower quality? Because people don’t buy them voluntarily: they have to be compelled.
Second, auto emissions are a drop in the CO2 bucket.
“Moving the power sector to 100% renewable energy.”
Excuse me a minute. I have to walk my unicorn.
OK. I’m back. One-hundred percent renewables is utterly unrealistic and enormously costly, including in terms of reliability and transmission–and fires started (in places by California) by transmission needed to support renewables generation. Fires which, by the way, emit massive amounts of CO2.
Look at Germany, which I wrote about a few days ago. They are running into a renewables wall well short of 100 percent, and have incurred massive costs (imposed on energy consumers) to get this far.
I note that Ms. Siegel doesn’t mention cement, or steel, or other industrial emitters (which put autos in the shade, btw).
Not to mention that fracking oil has f-all to do with power generation, and fracking gas that supplants coal reduces CO2 emissions.
“Other policies like reinstating the crude-oil export ban would also counteract price increases from banning fracking and restricting the supply of oil and gas.”
Yo. Einstein. We have oil and gas to export because of fracking. If we ban fracking, we’ll have no exports, and the export ban will have zero, zip, nada impact on prices.
Further, export bans reduce the price in the exporting country, but raise prices in the importing country. So I guess Ms. Siegel is an economic nationalist. I bet she looks stunning in her MAGA hat.
“And don’t you think we need to be a little bit skeptical of anyone’s ability to accurately predict oil prices?”
Yo. Von Neuman. This has nothing to do with predicting the level of oil prices. Demand curves slope down. You reduce production, prices go up. In fact, oil demand curves slope very steeply, so if you reduce production a little prices go up a lot.
Not rocket science. Just the law of demand.
And these are the brainiacs who are going to make sure that we have “well-designed” and “smartly designed” government policies.
In the Gilded Age, American financial crises (“panics,” in the lexicon of the day) tended to occur in the fall. Agriculture played a predominant role in the economy, and marketing of the new crop in the fall led to a spike in the demand for cash and credit. In that era, however, the supply of cash and credit was not particularly elastic, and these demand spikes sometimes turned into panics when supply did not (or could not) respond accordingly.
The entire point of the Fed, which was created in the aftermath of one of these fall panics (the Panic of 1907, which occurred in October), was to make currency supply more elastic and thereby reduce the potential for panics. In essence, the Fed had one job: lender of last resort to ensure a match of supply and demand for currency/credit, when the latter was quite volatile.
This week’s repospasm is redolent of those bygone days. Now, the spikes in demand for liquidity are not driven by the crop cycle, but by the tax and corporate reporting cycles. But they recur, and several have occurred in the autumn, or on the cusp thereof (this being the last week of summer).
One of my mantras in teaching about commodities is that spreads price bottlenecks. Bottlenecks can occur in the financial markets too. The periodic spikes in repo rates–not just this week, but in December, and March–relative to other short term rates scream “bottleneck.” Many candidates have been offered, but regardless of the ultimate source of the clog in the plumbing, the evidence from the repo market is that there are indeed clogs, and they recur periodically.
The Fed’s rather belated and stumbling response suggests that it is not fully prepared to respond to these bottlenecks, despite the fact that their regularity suggests that the clogs are chronic. As the saying goes, “you had one job . . . ” and the Fed fell down on this one.
And maybe the problem is that the Fed no longer just has one job, and it has shunted the job that was the reason for its creation to the back of the priority list. Nowadays, the Fed has statutory obligations to control employment and inflation, and views its main job as managing aggregate demand, rather than tending to the financial system’s plumbing.
This is concerning, as dislocations in short-term funding markets can destabilize the system. These markets are systemically important, and failure to ensure their smooth operation can result in crises–panics–that undermine the ability of the Fed to perform its prioritized macroeconomic management task.
One of the salutary developments post-crisis has been the reduced reliance of banks and investment banks on flighty short-term funding. The repo markets are far smaller than they were pre-2008, and the unsecured interbank market has all but disappeared (representing only about .3 percent of bank assets, as compared to around 6 percent in 2006). But this is not to say that these markets are unimportant, or that bottlenecks in these markets cannot have systemic consequences. For the want of a nail . . . .
Moreover, the post-crisis restructuring of the financial system and financial regulation has created new potential sources of liquidity shocks, namely a supersizing of potential demands for liquidity to pay variation margin. When you have a market shock (e.g., the oil price shock) occurring simultaneously with the other sources of increased demand for liquidity, the bottlenecks can have very perverse consequences. We should be thankful that the shock wasn’t a Big One, like October, 1987.
Hopefully this week’s tumult will rejuvenate the Fed’s focus on mitigating bottlenecks in funding markets. Maybe the Fed doesn’t have just one job now, but this is an important job and is one that it should be able to do in a fairly routine fashion. After all, that job is what it was created to perform. So perform it.
The primary reason for my deep skepticism about the wisdom of clearing
mandates was liquidity risk. As I said repeatedly, in order to reduce
counterparty risk, clearing necessarily increased liquidity risk through the
variation margining mechanism. Further, it was–and is–my opinion that
liquidity risk is a far graver systemic concern that counterparty risk.
To which one might say: I sure as hell hope that’s not it, because although there was a lot of price action yesterday, it wasn’t The Big One. (The fact that Fred Sanford’s palpitations occurred because he couldn’t get his hands on cash makes that bit particularly apropos!)
I did some quick back-of-the-envelope calculations. WTI and Brent variation
margin flows (futures and options) were on the order of $35 billion. Treasuries
on CME maybe $10 billion. S&P futures, about $1 billion. About $2 billion
on Eurodollar futures.
The Eurodollar numbers can help give a rough idea of margin flows on cleared
interest rate swaps. Eurodollar futures open interest is about $12 trillion.
Cleared OTC notional volume (not just USD, but all IRS) is around $80 trillion.
But $1mm in notional of a 5 year swap is equivalent to 20 Eurodollar futures
with notional amount of $20 trillion. So, as a rough estimate, variation margin
flows in the cleared IRS market are on the order of 100x for Eurodollars. That
represents a non-trivial $200 billion.
Yes, there are potentials for offsets, so these numbers are not additive.
For example, a firm might have offsetting positions in EDF and cleared IRS. Or be
short oil and long Treasuries. But variation margin flows on the order of $300
billion are not unrealistic. And since market moves were relatively large
yesterday, that represents an increment over the typical day.
So we are talking real money, which could certainly contribute to an
increased demand for liquidity. But again, yesterday was not remotely a truly
epic day that one could readily imagine happening.
A couple of points deserve emphasis. The first is that perhaps it was coincidence or bad luck, but the big variation margin flows coincided with other sources of increased demand for liquidity. But hey, stuff happens, and sometimes stuff happens all at once. The system has to be able to withstand such simultaneous stuff.
The second is related, and very concerning. The spikes in rates observed
periodically in the repo market (not just here, but notoriously in China)
suggest that this market can go non-linear. Thus, even if the increased funding
needs caused by the post Abqaiq fallout wasn’t The Big One, in a non-linear
market, even modest increases in funding needs can have huge impacts on funding
costs.
This highlights another concern: inter-market feedback. A shock in one
market (e.g., crude) puts stress on the funding market that leads to spikes in
repo rates. But these spikes can feedback into prices in other markets. For
example, if the inability to fund positions causes fire sales that cause big
price moves that cause big variation margin flows which put further stress on
the funding markets.
Yeah. This is what I was talking about.
Today’s events nicely illustrate another concern I raised years ago.
Clearing/margining make markets more tightly coupled: the need to meet margin
calls within hours increases the potential stress on the funding markets. As I
tell my classes, unlike in the pre-Frankendodd days, there is no “fuck
you” option when your counterparty calls for margin. You don’t pay, you
are in default.
This tight coupling makes the market more vulnerable to operational
failings. On Black Monday, 1987, for example, the FedWire went down a couple of
times and this contributed to the chaos and the potential for catastrophic
failure.
And guess what? There was a (Fed-related!) operational problem today. The NY
Fed announced that it would hold a repo operation to supply $75 billion of
liquidity . . . then
had to cancel it due to “technical difficulties.”
I hate it when that happens! But that’s exactly the point: It happens. And
the corollary is: when it happens, it happens at the worst time.
The WSJ article also contains other sobering information. Specifically,
post-crisis regulatory “reforms” have made the funding markets more
rigid/less-flexible and supple. This would tend to exacerbate non-linearities
in the market.
We’re from the government and we’re here to help you! The law of unintended
(but predictable) consequences strikes again.
Hopefully things will normalize quickly. But the events of the last two days
should be a serious wake-up call. The funding markets going non-linear is the
biggest systemic risk. By far. And to the extent that regulatory changes–such
as mandated clearing–have increased the potential for demand surges in those
markets, and have reduced the ability of those markets to respond to those
surges, in their attempt to reduce systemic risks, they have increased them.
I have often been asked what would cause the next financial crisis. My
answer has always been: the regulations intended to prevent a recurrence of the
last one. Today may be a case in point.
The night prior to the collapse, the cornerers (notably John Cudahy, of the Cudahy family of meat packers) tried to hammer out an agreement with their bankers to secure financing to fund the deal, but Cudahy’s brother Michael (who ran the family packing establishment) refused to sign. Lacking the ability to fund their positions, the cornerers had to sell, and prices collapsed. (A la Silver Thursday when the Hunt Brothers ran out of money and had to sell. So perhaps this event should be called Pork Wednesday.)
I have spent a good deal of my professional career studying manipulation, so I find these things of academic interest. They are also fascinating from a historical perspective. Not only was this front page news in Chicago, it was front page news around the country: this paper from Omaha is just one example. This is not surprising, given the importance of agriculture in the economy at the time. Agriculture was the biggest industry and employer in the country, and food represented the largest share of consumption, so the vicissitudes of trading on the CBOT and the New York Cotton Exchange were of deep interest to most Americans. Events like those of 2 August, 1893 were a major impetus behind efforts to regulate (or ban) futures trading. These efforts failed until the post-WWI agricultural depression.
And look how big the pork pit was! It would give the 1990s-era T-bond and T-note pits a run for their money.
Further, the ag futures markets were of such economic importance at the time that they created systemic risks. The collapse of the pork and lard corner, occurring in particular as it did when banks were under suspicion due to the Panic, and when there was no deposit insurance or lender of last resort, caused runs on several banks in Chicago due to fears that they had extended credit to the cornerers or one of the four brokerage firms that failed due to the collapse, and hence were insolvent. Two prominent private banks run by Jews failed. The owner of one, Herman Scheffner, committed suicide by drowning himself in Lake Michigan. The owner of the other, Lazarus Silverman, had staved off a run at the onset of the Panic in May, but could not secure funding in New York in August, and suspended payments on 3 August. The failure of these banks, and the heavy withdrawals at others, contributed to a decline in economic activity in Chicago and the Midwest and exacerbated the prolonged depression that gripped the country from 1893 to 1897.
Lazarus Silverman’s story is of particular interest to me, in part due to a family connection (by marriage) and in part due to the compelling nature of the story itself. Silverman had immigrated from Bavaria before the Civil War, and started a business as a bank note broker which developed into one of the premier private banks in Chicago. His bank on Dearborn Street was quite the edifice:
He advised Senator John Sherman on monetary questions, and was a major financier of the development of iron ore in the Mesabi Range. An early investor in Chicago real estate, he was one of the giants of the Chicago financial community during the Gilded Age.
Although his assets exceeded the liabilities of the failed bank, it could not avoid bankruptcy. Nonetheless, due to his great stature and respect in the community, he was basically allowed to serve as his own bankruptcy trustee. Even though the bank’s debts were discharged in bankruptcy and he was therefore under no legal obligation to do so, he spent the remainder of his life repaying its unsecured creditors. After the failure, he conducted his real estate business out a building he had commissioned and whichA now houses the Standard Club.
In my recent post on position limits, I suggested that at most spot month limits are justified as a means of constraining market power manipulation. It is important to note, however, that setting spot month limits at levels that approximate stocks in deliverable position may not be sufficient to prevent the exercise of market power during the delivery period, with the resultant deleterious effects on prices.
The basic motivation for position limits equal to stocks is predicated on a model of manipulation that makes particular assumptions about market participants’ beliefs. I pointed out the importance of this assumption in my 1993 Journal of Business article on market power manipulation. In one model of that paper, I assume that market participants believe that a large long who takes delivery will resell what is delivered, and will not consume it. In the other model, market participants believe that the large long will consume (or otherwise withhold from the market) some fraction of what shorts deliver to him.
Under the first set of beliefs, it is indeed a necessary condition for profitable manipulation that a long’s position exceed inventories in deliverable position. It is this kind of manipulation that spot month limits pegged to inventories can prevent.
However, under the second set of beliefs, a large long with a position smaller than inventories in deliverable position can exercise market power and inflate prices. Spot month limits based on inventories cannot prevent this type of manipulation.
I recently completed a paper that incorporates this insight into a standard signalling model. In the model, there are two kinds of longs: (a) “strong stoppers,” who have a real demand for the deliverable commodity, place a higher value on it than others, and who will consume at least some of what is delivered to them, and (b) manipulators, who have no real demand for the deliverable and who will resell what is delivered. Shorts do not know which type is standing for delivery.
In the model, a long submits an offer to sell his futures position at a specified price prior to expiration. The strong stopper submits an offer above the price that would prevail in the absence of a strong stopper (reflecting his high valuation of the commodity). I show that under different out-of-equilibrium beliefs there is a pooling equilibrium in with the manipulator mimics a strong stopper, and submits a high offer price at which he is willing to liquidate.
In the pooling equilibrium, the shorts deliver a quantity that exceeds the quantity that they would deliver if they knew the long was a strong stopper: this reflects the fact that they realize that the manipulator will resell what is delivered, and the shorts can repurchase it at a depressed price. However, in this equilibrium the manipulator sells some of his futures position at a supercompetitive price, and earns a supercompetitive profit even though he has to “bury the corpse” of a manipulation.
Crucially, the manipulation can succeed even if the long’s position is smaller than inventories, as long as the flow supply curve is upward sloping at such quantities. The flow supply curve can be upward sloping merely due to the theory of storage: an anticipated depletion of stocks increases the value of the remaining inventory. Therefore, if shorts anticipate a positive probability that a long will consume what is delivered, the theory of storage implies that the supply of deliveries is an increasing function of the futures price at expiration.
Thus, a futures position in excess of inventories in deliverable position may be a sufficient condition to exercise market power, but it is not a necessary one. If shorts are uncertain about a long’s motive for taking delivery, and some longs are strong stoppers who will consume what is delivered and thereby deplete inventories, manipulators can mimic strong stoppers and extract a supercompetitive price even with a position smaller than inventories.
One implication of this analysis is that reliance on spot month position limits is not sufficient to prevent market power manipulations. Additional measures, what I have called “ex post deterrence” since my 1996 Washington and Lee Law Review article, are also necessary. In my earlier work I argued that they are necessary because it was unlikely that position limits could adjust to reflect inevitable changes in inventories. This new paper shows that even if they could so adjust limits, they would be inadequate. Market power manipulation facilitated by fraud (i.e., falsely pretending to have a real demand for the commodity) can occur even if position limits prevent a long from obtaining a position during the delivery period that exceeds stocks in deliverable position.
This analysis also implies that equating “deliverable supply” with “inventory in deliverable position” is wrong. The supply available at the competitive price may be smaller than inventories–and indeed, far smaller than inventories–when shorts do not know the “type” of long standing for delivery.
The traditional model of deliverable supply is predicated on a view of manipulation shaped by the big corners of history, in which there was little doubt about the motivations of a large long. But as the court in the Cargill case noted, “[t]he methods and techniques of manipulation are limited only by the ingenuity of man.” Exploiting shorts’ ignorance about his motive for taking delivery, a long can ingeniously exercise market power even with a position smaller than deliverable supply.
This is a possibility that is only dimly recognized in the existing regulatory structure in the US. Most importantly, it implies that a reliance on preventative measures like position limits alone is inadequate to reduce efficiently the frequency and severity of market power manipulation. Ex post measures are required as well.
