Streetwise Professor

July 16, 2018

Oil Spreads Go Non-Linear (Due to Infrastructure Constraints), To the Chagrin of Many Traders: The Pirrong Commodity Catechism in Action

Filed under: Commodities,Economics,Energy,Exchanges — cpirrong @ 3:59 pm

When I wrote about the demise of GEM Trading a few weeks ago, I hypothesized that sharp movements in various spreads had been its undoing.  A story in Reuters says that GEM was not the only firm rocked by these changes.  Big boys–including BP, Vitol, Trafigura, and Gunvor–have also suffered, and the losses have caused traders their jobs at Gunvor and BP:

The world’s biggest oil traders are counting hefty losses after a surprise doubling in the price discount of U.S. light crude to benchmark Brent WTCLc1-LCOc1 in just a month, as surging U.S production upends the market.

Trading desks of oil major BP and merchants Vitol , Gunvor and Trafigura have recorded losses in the tens of millions of dollars each as a result of the “whipsaw” move when the spread reached more than $11.50 a barrel in June, insiders familiar with their performance told Reuters.

The sources did not give precise figures for the losses, but they said they were enough for Gunvor and BP to fire at least one trader each.

The story goes on to say that binding infrastructure constraints are to blame, which is certainly the case.  But implicit in the article is a theme that I have emphasized for literally years (I recall incorporating this into my class lectures in about 2004).  Specifically, bottlenecks imply that marginal transformation costs (e.g., marginal costs of transporting oil between Cushing and the GOM) tend to rise very steeply when capacity constraints are reached.  That is, when you are operating at say 90 percent of capacity, variations in utilization have little impact on marginal transformation costs, but going from 95 to 96 can cause costs to explode, and basically go vertical as capacity is reached.

This has an implication for spreads.  Another part of the Pirrong Commodities Catechism is that spreads equal marginal transformation costs, and are essentially the shadow prices on constraints.  The behavior of marginal transformation costs therefore has implications for spreads: in particular, spreads can be very stable despite variations in the utilization of transformation assets, but as utilization nears capacity, the spreads become much more volatile.  Moreover, and relatedly, small changes in fundamentals can lead to big moves in spreads when constraints start to bind.  The relationship between fundamentals and spreads is non-linear as capacity constraints become binding, and well, here spreads have gone non-linear, to the chagrin of many traders.

Put differently, spread trades aren’t always “widowmakers” (as the article calls them)–sometimes they are quite safe and boring.  But when bottlenecks begin to bind, they can become deadly.

There is one odd statement in the article:

“As the exporter of U.S. crude, traders are naturally long WTI and hedge their bets by shorting Brent. When the spreads widen so wildly, you lose money,” said a top executive with one of the four trading firms.

Well, why would you hedge WTI risk with Brent?  You could hedge your WTI inventory by selling . . . WTI futures.  The choice to “hedge” WTI by selling Brent is effectively a choice to speculate on the spread.  That brings to mind the old Holbrook Working adage that hedging is speculation on the basis.  The difference here is that most, say, country grain elevators about which Working was mainly writing had no choice in hedging instrument (at least not in liquid ones), and perforce had to live with basis risk if they wanted to eliminate flat price risk.  Here, BP and Gunvor and the rest had the choice between two liquid instruments, and if the “top executive’s” statement is correct, deliberately chose the one that exposed them to greater spread (basis) risk.

So this isn’t an example of “sometimes stuff happens when you hedge.”  The firms chose to expose themselves to a particular risk.  They took a punt on the spread, which was effectively a punt that infrastructure constraints would ease.  They lost.

In my 2014 white paper on commodity trading firms (sponsored by Trafigura, ironically) I noted that to the extent that they speculate, commodity trading firms tend to speculate on the spreads, rather than flat prices, because that’s where they have something of an information advantage.  But as this episode shows, that advantage does not immunize them against risk.

This also makes me wonder about the risk models that the firms use, which in turn affect the sizes of positions traders can put on, and where they put them on.  I, er, speculate that these risk models don’t take into account the non-linearity of spread risk.  If that’s true, traders would have been able to put on bigger positions than they would have been had the risk models accurately reflected those risks, and further, that they were incentivized to do these trades because the risk was underpriced.

All in all, an interesting casebook study of commodity trading–what can go wrong, and why.

Correction: Andrew Gowers, head of corporate affairs at Trafigura says in the comments that (a) Trafigura did not suffer a loss, and (b) the company had told this to Reuters prior to the publication of the article.  I have contacted the editor of the story for an explanation.

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July 13, 2018

Blockchain Wunderkinds: Solving Peripheral Problems, Missing the Big Picture

Filed under: Blockchain,Cryptocurrency,Economics,Exchanges — cpirrong @ 7:52 pm

Ethereum wunderkind Vitalik Buterin delivered a rant against centralized crypto exchanges:

“I definitely personally hope centralized exchanges burn in hell as much as possible,” Buterin said speaking to TechCrunch.

When bitcoin, the original cryptocurrency, was founded in 2008 by the anonymous Satoshi Nakomoto, the point was to create a decentralized financial future that renders middlemen useless. Nearly 10 years later, the centralized exchanges — those folks sitting in the middle of buyers and sellers — are among the most powerful players in the market for digital currencies such as ethereum and bitcoin.

Bloomberg News estimates they brought in $3 million a day last year. And exchanges such as Gemini and Coinbase are expanding at a clip, bringing on talent from Wall Street.

“It’s hard to ignore the irony that an asset created to allow decentralization is currently almost completely traded on centralized exchanges,” Peter Johnson, a vice president at Jump Ventures, said in an interview. Buterin, however, wants the crypto community to focus more on decentralization so that cryptos can more frequently trade peer-to-peer. Buterin’s remarks come as so-called decentralized exchange gain more attention.

Like many of his arrogant ilk, Buterin ignores the lesson of Chesterton’s fence: why does this thing you do not like and do not understand exist?

Yes, blockchain and cryptocurrencies allow peer-to-peer transactions.  They were largely designed to facilitate such transactions.  For some, the motivation is ideological: an anarchic belief in radical decentralization, and a deep distrust of centralized institutions.

But just because blockchain and related technologies reduce the costs of peer-to-peer transactions, doesn’t mean that such transactions are cheaper than centralized trading on exchanges.  Transacting requires finding a counterparty.  It requires negotiating a price (for a standardized thing, like a Bitcoin–negotiations of other terms for more complex things).  Negotiating a price is costly when information about value is diffuse, so in a decentralized setting not only is it necessary to search for counterparties, it is advantageous to search for information about prices to (a) find the best price, and (b) to be able to negotiate with better information about value .

Centralization reduces the cost of finding a counterparty.  It enhances competition, which tends to reduce bargaining costs.  It leads to better and more symmetric information about prices, which also tends to reduce bargaining costs.  Further, centralized markets can support specialized intermediaries–market makers–who specialize in smoothing out idiosyncratic temporal imbalances in buy and sell order flow, which further reduces trading costs.

Because of these features, centralized trading is frequently an emergent outcome of individual decisions, and one that economizes on transactions costs.  This is clearly what is happening in crypto world.  Indeed, the main puzzle at present is why there are so many exchanges.  The centripetal forces of liquidity will likely result in a huge consolidation in this space.

Buterin and others are attempting to find ways of mitigating some of the disadvantages of bilateral trading (bilateral just being another, more conventional, way of saying “peer-to-peer”).  Reducing the ways of finding people who want to take the other side of a transaction, for example.  But I am highly skeptical that these measures will overcome the inherent advantages of centralizing trading of homogeneous things that large numbers of people want to buy and sell pretty much 24/7, to the point that peer-to-peer will supplant centralized trading.  Buterin can rant all he wants, but centralization is here to stay, and if anything, this segment of the market will become more centralized.

Buterin’s error is seemingly the opposite of those who bewail the lack of centralization in some markets, e.g., those who want to make swaps trading more centralized and who rail against bilateral OTC transactions, but it is really the same mistake. Those who see too much centralization in some markets, and those who see too little in others, fail to recognize that trading mechanisms are emergent orders that develop diverse niches to accommodate the fact that transactors and transactions are heterogeneous.  Centralization is efficient for some transactors and transactions: bilateral/OTC for others.  That’s why we see both.

(This is a point I made at a Platts blockchain conference in November, BTW.  The theme of my talk was where decentralization can work, and where it is likely inefficient.  Trading of standardized instruments was one of the main cases I discussed.)

Alas, the ignorance of techno-geniuses is not limited to trading mechanisms.  One of the supposed benefits of blockchain that is that it allows the ownership of anything–a painting, a house, you name it–to be divided into shares, with the fractional interests recorded in an immutable register, and traded peer-to-peer.  That is, block chain facilitates equitization of assets.  A breakthrough!

Uhm, not really. The benefits of equitizing assets and risks has been long, long understood by economists.  In particular, it has long been understood that equitization facilitates more efficient risk sharing.

But long ago, economists also recognized that despite these apparent benefits, in fact very few assets and risks are equitized.  A vast literature has come up with explanations why.  Information and incentive problems–moral hazard and adverse selection–are notable among these.  A prosaic example: If I sell off shares in my car, what incentive do I have to maintain it properly and to economize on wear and tear and to reduce the probability of theft?  Who pays for maintenance? Who decides on what maintenance is needed?  When I sell the shares, I am likely to have better information about the value and condition of the vehicle, which would subject the buyers to an adverse selection problem, meaning that I am likely to get a low price for the shares–so why bother selling them?  There are other transactions cost problems associated with measurement (who verifies exactly what the asset is?) and opportunism and governance and control.   Related to the centralized trading point, if an asset is highly idiosyncratic/unstandardized, the desire to trade fractional shares will be small.

A potentially slightly cheaper way of recording and transferring fractional ownership does not address these far, far, far more fundamental impediments to equitizing (or should I say, “tokenizing”?) assets and risks.  But the coder geniuses miss the forest for the trees.  They see the issue that their technology can address, and think that it will be revolutionary, only because they do not understand the broader economic issues in play, and therefore think everyone born before them or who does not code must be an idiot.

No, not really.  They are looking at the capillaries, and missing the heart, veins, and arteries.

It reminds me of the Mark Twain quote: “When I was a boy of fourteen, my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished at how much he had learned in seven years.”  Except seven years haven’t passed for the Buterins of the world, and frankly, I seriously doubt that they will.  Instead, they inhabit a techno-Groundhog Day.

All of this is symptomatic of blockchain hype and froth.  There is an indication that we have reached peak hype.  R3, a bank-led blockchain consortium, is contemplating an IPO.  To me this is a signal that those on the inside of blockchain development, especially in the area where its benefits have been particularly hyped (finance/payments/settlement/fintech) understand that the reality will never match the hyperbole, so it’s best to sell out while hyperbole reigns supreme.  (Yes, they claim that they are being approached by those looking to buy the whole thing, but take that with a big grain of salt–I view it merely as part of the sales pitch.  “This is a hot little property right now.  Better get in before someone snatches it away.”)

In brief: don’t be the greater fool.

I think that blockchain and DLT will have some viable commercial applications.  But I am highly confident that they will not be nearly as revolutionary as the True Believers claim.  This is in large part due to the fact that it is clear that the True Believers have an extremely narrow, blinkered understanding of the broader economic issues associated with transacting, ownership, risk transfer, incentives, and governance.  Blockchain may address some issues, but many–if not most–of these issues are secondary or tertiary, not fundamental.  Some things are done more efficiently in a centralized fashion–the trading of standardized instruments being one.  Some things are not equitized/tokenized not because it is technically infeasible/prohibitively costly to issue and record fractional interests, but because fractional ownership entails substantial incentive and information problems.

So don’t believe the hype.  And take a pass on those R3 shares, if they do come to market.

Addendum: the dominance of crypto exchanges is even more remarkable, given how they, well, pretty much suck.  They are hardly comparable to modern futures or equities trading exchanges.  Yet people still strongly prefer to trade on rather clunky platforms with major potential security issues where you can’t easily convert digital into fiat currency and which are likely rife with manipulation than peer-to-peer.  That tells you something.

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July 8, 2018

The CFTC Intervenes to Prevent Moral Hazard in the CDS Market–But Why the CFTC?

Filed under: Derivatives,Economics,Politics,Regulation — cpirrong @ 8:36 pm

The WSJ reports that the CFTC engaged in extraordinary efforts to prevent manipulation of the CDS market by Blackstone Group.  Blackstone had bought about $333 million in protection on homebuilder Hovnanian, and then extended a low-interest loan to the company to induce it to make a technical default on debt the company itself owned (having bought it back).  The CFTC caught wind of this, and put on the full court press and eventually, uhm, persuaded (by intimating that it considered such behavior manipulative) Blackstone to negotiate an exit from the CDS with its counterparties.

In the Allen-Gale taxonomy, this would be best characterized as an “action-based” manipulation, as opposed to trading-based, or information-based.  It is clearly not a market power manipulation.

The conduct at issue is clearly a form of rent seeking–a set of transactions engineered for the purpose of obtaining a wealth transfer.  Unlike a market power manipulation, the direct welfare costs of this activity were probably small, and limited to the costs of negotiating with Hovnanian, and executing the CDS transactions.  However, as in most manipulations, the big costs here were indirect.  Blackstone’s scheme undermines the CDS market as a risk transfer mechanism.  In effect, Blackstone’s stratagem was a form of moral hazard, in that the insured could affect the probability of loss.  Moral hazard raises the cost of insurance, and leads to suboptimal risk transfer.  (Yes, I know that CDS market participants shudder at the use of the word “insurance” to describe CDS, in part because they want to avoid insurance regulation.  I am not using the word in its legal sense, but in an informal way to describe a risk transfer mechanism.)

CDS are particularly prone to moral hazard because individuals (notably, the managers of corporations) can do things to trigger defaults, and CDS can provide them directly or indirectly with an economic incentive to do so.  Further, CDS contracts are incomplete (i.e., not all possible contingencies can be specified) and often as a result contain ambiguities that clever rent seekers can exploit to win a payoff.

The CFTC’s actions are therefore laudable.  What’s particularly curious about this, however, is precisely the fact that it was the CFTC that intervened here.  Under Title VII of Frankendodd, the SEC has jurisdiction “over ‘security-based swaps,’ which are defined as swaps based on a single security or loan or a narrow-based group or index of securities (including any interest therein or the value thereof), or events relating to a single issuer or issuers of securities in a narrow-based security index”–the CFTC has jurisdiction over everything else.

The Hovnanian CDS are clearly in the SEC’s ambit, and not in the CFTC’s.  But in the case of the Hovnanian CDS, the SEC has been conspicuously absent. IIt is not mentioned at all in the WSJ piece.)  Curious, that.  Even more curious given the jealousy with which the SEC (like most government agencies) defends its turf against perceived incursions–especially the CFTC.   Why did the SEC let the CFTC take the lead on this, without a peep of protest?  And why did the CFTC apparently overstep its authority?

Things could have become interesting had Blackstone persisted with its scheme, and the CFTC filed an action against it.  In the event, an obvious legal response by Blackstone would have been to claim that the CFTC had no legal authority to take enforcement action.

Given this legal issue, the CFTC’s intervention may have less of a deterrent effect on future manipulations than an SEC intervention would have.

The SEC does not have the reputation of being a shrinking violet by any means, but it has been noticeably shy in some high profile events, the Hovnanian CDS story being one, and Tesla being another.  Makes me wonder . . .

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July 6, 2018

Tesla Will Become a Real Car Company When Elon Becomes a Real Boy

Filed under: Economics — cpirrong @ 6:51 pm

Last week Tesla achieved Elon Musk’s stated milestone of building 5000 Model 3’s in a week.  After an initial burst of enthusiasm which saw the stock price jump upwards, the market was unimpressed: the stock turned down on the day, and is now down $41.3 since 29 June (that’s almost 12 percent).

The company only hit the target (well, in actual fact it missed by a few hours) by making  extreme–and I mean extreme–efforts.  Putting a new assembly line in a tent.  Cannibalizing spare parts.  Cutting production on higher margin Model S vehicles.  Jettisoning quality tests.  Dragooning people into overtime without warning contrary to previous company policy.

Thus, the market’s reaction is not surprising.  Tesla didn’t prove that it could meet a production target under normal conditions: it proved absolutely that it couldn’t.  That is, it proved exactly the opposite of what Musk had intended.

After the “achievement,” Elon Musk tweeted that Tesla had proved that it was finally a real car company.  No, it hadn’t: a normal car company would never been in the situation of behaving like some Soviet enterprise in the 1930s rushing and cutting corners to meet The Plan, lest everyone wind up in The Gulag.

Which is perhaps an especially apt analogy, given Elon’s behavior during this period, and the cult of personality that he has cultivated.

When Musk tweeted about “a real car company” the thought that came to mind was Pinocchio, who wanted to be a real boy.  Given Elon’s propensity to stretch the truth–well, lie, actually–in a way that would shame Pinocchio, that’s an apt analogy too.

There will no doubt be a serious hangover as a result of the rush to meet Musk’s self-imposed target.  Labor relations at Tesla were already poor–they are no doubt awful now.  The company also has had serious build quality and service issues.  I shudder to think of the build quality of the cars thrown together in that last minute frenzy.  Musk’s already crumbling credibility has taken a hit.

For the last, Elon has no one to blame but himself.  His repeated failures to achieve any of the lofty predictions he has made  (failures that would have brought the SEC down on pretty much anyone else) meant that failure to meet the 5000 cars or bust pledge would have been devastating.  So Elon had to pull out all the stops, even though by doing so he in fact revealed the emptiness of his boastful prediction, and could well have produced 5000 busted cars.

For Tesla to become a real car company, Elon will have to become a real boy–or at least a real CEO, rather than a cult leader impersonating a CEO.  Alas, I doubt that will happen, because of one difference between Elon and Pinocchio: Pinocchio realized he wasn’t real, but I don’t think Elon has the same self-awareness.

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Chinese Oil Futures: Performing As Predicted

Filed under: China,Commodities,Derivatives,Economics,Energy — cpirrong @ 6:27 pm

The recent introduction of Shanghai oil futures has resulted in a lot of churn in the front month, and very little activity in even the 1st and 2nd nearby:

China’s new oil futures are a hit with investors but they’re facing commitment issues.

While daily volume in the yuan-denominated contract has increased five-fold since its debut in late-March amid steady growth in open interest, almost all trading is focused in front-month, September futures.

. . . .

It suggests that, for now, traders are using the futures principally to speculate on short-term price fluctuations, as opposed to hedge long-term consumption or production, according to Jia Zheng, a portfolio manager at Shanghai Minghong Investment Co.

Which is pretty much what I predicted on the day of the launch:

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

. . . .

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.


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July 3, 2018

When It Comes to Its Pathetic Military, Economic Powerhouse Germany Can’t Even Manufacture Decent Excuses

Filed under: Economics,Military,Politics — The Professor @ 8:15 pm

Trump sent a letter admonishing European nations that have failed to meet their solemn promise to spend 2 pct of GDP on defense.  In reply, Merkel dispatched her Defense Minister, Ursula von der Leyen, to deliver a whinge that would embarrass a teenager explaining to mom why he hasn’t cleaned his room.  For the last 10 years.

Shall we begin the beating? Let’s!

Nato, she said, was not just about “cash” — but also about “capabilities” and “contributions”.

Just what “contributions,” exactly? Tiresome, supercilious lectures, with a heavy emphasis on Germany’s moral superiority?  Nothing that actually goes boom or risks killing anyone downrange, apparently.

And what capabilities? By Germany’s own accounting, its lack of readiness is “dramatic”:

What’s wrong with the Bundeswehr?

  • Bartels pointed to “big gaps” in personnel and equipment. At the end of 2017, no submarines and none of the air force’s 14 large transport planes were available for deployment due to repairs.
  • Other equipment, including fighter jets, tanks and ships, was outdated and in some cases not fully operational because of bad planning or a lack of spare parts. Some air force pilots were unable to train because too many aircraft were being repaired.
  • Soldiers have experienced increasing levels of stress and there was a lack adequate leadership due to some 21,000 vacant officer posts.
  • The report said the government needed to pursue reforms “with greater urgency” and increase defense spending.
  • A lack of funding and inefficient management structures and planning were behind the problems. Germany has cut defense spending since the end of the Cold War. In 2017, it spent about 1.2 percent of its economic production in 2017 on the armed forces, which is below the 2 percent target recommended by the NATO alliance.

Other than that, they’re a powerhouse!

Tanks? Did you ask about tanks? Planes?

The Bundeswehr is due to take over leadership of NATO’s multinational Very High Readiness Joint Task Force (VJTF) at the start of next year, but doesn’t have enough tanks, the Defense Ministry document said.

Specifically, the Bundeswehr’s ninth tank brigade in Münster only has nine operational Leopard 2 tanks — even though it promised to have 44 ready for the VJTF — and only three of the promised 14 Marder armored infantry vehicles. [An American tank company has 14 M1s, by the way.  A company.]

The paper also revealed the reason for this shortfall: a lack of spare parts and the high cost and time needed to maintain the vehicles. It added that it was also lacking night-vision equipment, automatic grenade launchers, winter clothing and body armor. [It would probably be more efficient to list what they aren’t lacking.]

The German air force is also struggling to cover its NATO duties, the document revealed. The Luftwaffe’s main forces, the Eurofighter and Tornado fighter jets and its CH-53 transport helicopters, are only available for use an average of four months a year — the rest of the time the aircraft are grounded for repairs and rearmament.

And I guarantee you, these problems are NOT because of intense use and deployment.  It is neglect and stinginess–pure and simple.

German leadership is apparently deaf.  So deaf that they can’t even hear Trump:

Bundeswehr Chief of Staff reacts: Volker Wieker defended the military, saying “no complaints have come to my ear either in Germany or from our allies.” He did however admit that combat-readiness needed to be improved.

Back to Frau van der Leyen:

“You can easily spend 2 per cent of GDP on defence without actually offering anything to Nato,” she said in Berlin on Tuesday evening. “The question for Nato is not just how much you spend nationally on defence, but how much does the country provide in terms of contributions that Nato needs.”

Maybe so, if this example of pointless military expenditure is representative of the best Germany can do.  But if you don’t spend squat you clearly won’t offer anything to Nato.  And squat is pretty much what your contributions are to Nato needs.  Training with broomsticks and shouting “bang! bang!” is not what Nato needs.

So let’s see whether you can spend money on defense and buy some capabilities with it, shall we?  Let’s put that vaunted German efficiency to work!

Germany, Ms von der Leyen stressed, was the second-largest supplier of troops to Nato behind the US, as well as the second-largest supplier of troops in Afghanistan.

Germany also has the second-largest population and economy in Nato, and on a per capita basis and a GDP basis, so it should supply the second-largest number. Even so, it definitely does not pull its weight.  It is a free-rider by every measure whose contribution does not match its population or economic heft.

Insofar as Afghanistan is concerned, Germany has suffered fewer KIA there than not just the US, but the UK, Canada, and France.  On a per capita basis, it has suffered far fewer than Australia, Italy, Poland, Denmark (which has suffered only 14 fewer KIA, despite its vastly smaller population–and the disdain with which Germans treat them), Spain, the Netherlands, Georgia, Latvia, Estonia, New Zealand, Norway, Hungary, and the Czech Republic.

None of which, I might add, hosted anything like the Hamburg Cell of Al Qaeda for years.

Given that record, any decent, self-respecting government official (perhaps an oxymoron!) would pass over Afghanistan in silence.

The minister also pointed to the prominent role of the German Bundeswehr in Nato’s push to bolster the security of member states in eastern Europe.

Prominent? Like how, precisely?  The VJTF is the primary Nato contribution to the security of eastern Europe, and we’ve already seen just how pathetic Germany’s contribution to that is.

“To be clear: we stand by the 2 per cent goal that we set ourselves in Wales. We are on the way to meeting it. And we are ready, and have shown that we are ready, to take on substantial responsibilities inside the alliance,” the minister said.

“We are on our way to meeting it.” On your way? When will you get there? In time to celebrate Putin’s 90th birthday?

I can guarantee you that this pathetic response will not mollify Trump.  To the contrary–it will only make him more pissed off.  Meaning that the next Nato summit will be loads of fun!

In other news, Germany says that sanctions will not affect Nord Stream 2:

Germany has been assured by the United States that any sanctions imposed on Russia will not affect the building of a gas pipeline to bring Russian gas to Europe, a spokeswoman for the German economy ministry said on Friday.

The spokeswoman said that guidelines provided by the United States suggested that construction of Nord Stream 2 would be unaffected.

I dunno, Fritz.  Sounds like a dare to Trump, and if he takes you up on it, it will be to screw you, not the Russians.  And continuing to make pathetic excuses for reneging on Nato commitments just might spur him to do so.

Finally, Merkel, who has become the epitome of the careerist politician who clings to power at all cost, jettisoned her supposedly principled moral stand on refugees and agreed to set up camps at the German border to detain them for processing.  Her Bavarian gadfly, Horst Seehofer, was apparently mollified by this concession.

The Social Democrats in the coalition have yet to sign off.  I would not be surprised if Merkel uses their opposition to renege on her commitment to Seehofer–it is probably as firm as her commitment to boost defense spending.

I will not be surprised at anything Merkel will do to hang on to power.  No doubt she will suffer pretty much indignity to do so. Because that is pretty much her overriding concern, to which everything else is subordinate. Meaning that I sincerely hope that Trump continues to bust her chops about Nato, and pretty much anything else, for that matter.

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June 28, 2018

A Tarnished GEM: A Casualty of Regulation, Spread Explosions, or Both?

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 6:28 pm

Geneva Energy Markets LLC, a large independent oil market maker, has been shuttered.  Bloomberg and the FT have stories on GEM’s demise.  The Bloomberg piece primarily communicates the firm’s official explanation: the imposition of the Basel III leverage ratio on GEM’s clearer raised the FCM’s capital requirement, and it responded by forcing GEM to reduce its positions sharply.  The FT story contains the same explanation, but adds this: “Geneva Energy Markets, which traded between 50m and 100m barrels a day of oil, has sold its trading book after taking ‘significant losses’ in oil futures and options, a person close to the company said.”

These stories are of course not mutually exclusive, and the timing of the announcement that the firm is shutting down months after it had already been ordered to reduce positions suggests a way of reconciling them. Specifically, the firm had suffered loss that made it impossible to support even its shrunken positions.

The timing is consistent with this.  GEM is primarily a spread trader, and oil spreads have gone crazy lately.  In particular, spread position short nearby WTI has been killed in recent days due to the closure of Canadian oil sands production and the relentless exports of US oil.  The fall in supply and continued strong demand have led to a rapid fall in oil stocks, especially at Cushing.  This has been accompanied (as theory says it should be!) by a spike in the WTI backwardation, and a rise in the WTI-Brent differential (and other quality spreads with a WTI leg).  If GEM was short the calendar spread, or had a position in quality spreads that went pear-shaped with the explosion in WTI, it could have taken a big hit.  Or at least a big enough hit to make it unviable to continue to operate at a profitable scale.

Here’s a cautionary tale.  Stop me if you’ve heard it before:

“The notional value of our book was in excess of $50 billion,” Vonderheide said. “However, the actual risk of the book was always relatively low, with at value-at-risk at around $2 million at any given time.”

If I had a dollar for every time that I’ve heard/read “No worries! Our VaR is really low!” only to have the firm fold (or survive a big loss) I would be livin’ large.  VaR works.  Until it doesn’t.  At best, it tells you the minimum loss you can suffer with a certain probability: it doesn’t tell you how much worse than that it can get.  This is why VaR is being replaced or supplemented with other measures that give a better measure of downside risk (e.g., expected shortfall).

I would agree, however, with GEM managing partner Mark Vonderheide (whom I know slightly):

“The new regulation is seriously damaging the liquidity in the energy market,” Vonderheide said. “If the regulation was intending to create a safer and more efficient market, it has done completely the opposite.”

It makes it costlier to make markets, which erodes market liquidity, thereby making it costlier for firms to hedge, and more difficult to enter and exit positions.  Liquidity reductions resulting from this type of regulation tend to be most acute during periods of high volatility–which can exacerbate the volatility, perversely.  Moreover, like much of Frankendodd and its foreign fellow monsters, it tends to hit small to medium sized firms worse than bigger ones, and thereby contributes to greater concentration in the markets–exactly the opposite of the stated purpose.

As Reagan said: “The most terrifying words in the English language are: I’m from the government and I’m here to help.” Just ask GEM about that.

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May 24, 2018

Gazprom and Its Connected Contractors: The Credit Mobilier Scheme, With Russian Variations

Filed under: Commodities,Economics,Energy,History,Russia — The Professor @ 6:05 pm

A couple of SWP friends were kind enough to send me a copy of the swan song of one Alex Fak, an erstwhile senior analyst at Sberbank.  Alex lost his job because he committed a mortal sin: telling the truth, in this instance about the monstrosity that I have savaged for years–Gazprom.

Alex said that the oft-heard question “why does Gazprom do such stupid things?” is off base because it presumes that the company is run in the interest of shareholders: if it were, its unmatched record of value destruction would indeed be stupid.  However, Mr. Fax opined that the company’s actions over the decades are definitely not stupid if you evaluate them from the perspective of its contractors, who make massive amounts of money building obscenely negative NPV projects.

Why does this persist, in the Putin era, which allegedly cracked down on oligarchic thievery? Well, one reason is that the biggest contractors happen to be owned by–wait for it–the two biggest friends of Vova: Gennady Timchenko (a hockey buddy) and Arkady Rotenberg (a judo buddy).*  Putin did not eliminate oligarchs, so much as replace them with his cronies.  Calling out such connected men by name is no doubt why Mr. Fax is an ex-Sberbank analyst.  And saying this kind of thing puts him at risk of being an ex-person.

The Gazprom MO described by Mr. Fak  represents a continuation of, and a mega-sizing of, the bizness model of the 1990s, when the “red directors” of state-owned firms tunneled out huge amounts of funds by having their firms buy supplies and services at seriously inflated prices from firms owned by their relatives.

Indeed, in the pre-Cambrian days of this blog–2006(!)–I hypothesized that Gazprom and its contractors were in effect a Russian version of Credit Mobilier, the construction firm that the Union Pacific hired to build the railroad.

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’.

Thomas C. Durant was the president of the Union Pacific–and the major shareholder in Credit Mobilier.  The UP paid Credit Mobilier around $94 million, and Credit Mobilier incurred only about $50 million in costs to build the UP.   The Gazprom arrangement is somewhat different given that neither Timchenko nor Rotenberg are executives at the Russian gas giant, but the basic idea is very similar. (I also noted early on that Transneft, the oil pipeline monopoly, operates on the same model.)  Gazprom and its contractors operate on the Credit Mobilier model, with Russian variations.

Once upon a time Gazprom CEO Alexei Miller boasted that he would make Gazprom the world’s first trillion dollar company.  Today it’s market cap is south of $55 billion.  Hey! anybody can be off by two orders of magnitude, right?

This is not surprising, because maximizing value to shareholders is not, nor has it ever been, the objective of Gazprom.  The objective is, and always has been, to divert resources to the politically connected via wasteful capital expenditures (that happen to be the revenues of the likes of Timchenko and Rotenberg).  Alex Fak understood this, and paid the price for shouting that the emperor had no clothes.

Both Gazprom and Rosneft are world leaders in destroying value, rather than creating it.  But this is a feature, not a bug, given the natural state political economy of Russia, which prioritizes rent creation and redistribution to the elite. And this is precisely why Russia’s pretensions to great power status rest on economic quicksand.  That should be blindingly obvious, and I am sure that Putin understands this at some level.  But revealed preference suggests that he values enriching his friends more than implementing the economic changes that would make his nation economically and militarily competitive.

*The sums tunneled from Gazprom to Timchenko make me laugh when I think about the oft-repeated allegation that oil trader Gunvor (half-owned by Timchenko) was a source of massive personal wealth for Putin (via Timchenko).  There was much more money to be made much closer to home, and completely outside the scrutiny of bankers and regulators.

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May 17, 2018

Rosneft: The Farce Continues

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 7:22 pm

Remember when the Russian government said it was going to privatize a piece of Rosneft? Hahahaha. That is so 2016–please try to keep up!  In its announcement of “Rosneft 2022” the company proposes to buy back about $2 billion in shares, which is just about 20 percent of the piece sold off in 2016–no, wait–2017–no, wait–2018.  Adding even more hilarity is that the buyback plan was apparently at the insistence of Qatar, the last buyer standing which agreed to buy most of the shares initially privatized, much to the relief of the banks (Intesa and unnamed Russian ones) who were wearing a big piece of the risk.

I’m guessing that this was one of the terms Qatar laid down to absorb the entire hand-me-down stake for the original 2016 price, even though in Euro terms Rosneft’s shares are substantially lower today (despite a rallying oil price!)

Quite the vote of confidence there, eh?  Well, not that that’s surprising.  The conspicuous failure of any Chinese buyer to step into the shoes of disgraced CEFC tells you just how much confidence Rosneft inspires these days.

I am hard pressed to recall such a farcical series of events involving a major company.  If this one of  Russia’s state champions, just think of the shape the palookas are in!

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Today’s Adventures in Trumpland

Filed under: Economics,Energy,Politics,Russia — The Professor @ 6:38 pm

The WSJ reports that the Trump administration has told Germany that the US would restart talks on a trade deal with Europe if Germany pulls the plug on support for the Gazprom-led Nord Stream project.  I find the linkage rather odd, but we’re talking the Trump administration here, and moreover, it may well be a brushback pitch after all of the German-led Eurowhining about the US: “Think it’s bad now? Let’s see what it’s like when I put my mind to it.”

One EU official responded as follows:

“Trump’s strategy seems to be to force us to buy their more expensive gas, but as long as LNG is not competitive, Europe will not agree to some sort of racket and pay extortionate prices,” an EU official said.

I could perhaps take this seriously, were it not for the fact that Germany forces its own citizens to pay “extortionate prices” for power produced by outrageously uncompetitive means as a result of its idiotic energiewende policy.

How extortionate? How uncompetitive? The article claims that US LNG would cost about 20 percent more than Russian gas.  Well, Germans pay approximately 50 percent more for power than the average across the EU, and EU-wide average prices are about double the US average.

In other words, Europe has its own energy extortion racket in place, and doesn’t want to let in any Americans.

The other interesting aspect to this story is that it is yet another example (I’ve lost count of the number) of the alleged Putin pawn Trump taking a major shot at the Russians.  The Russians are not pleased:

The Kremlin shot back immediately as spokesman Dmitry Peskov called the U.S. efforts “a crude effort to hinder an international energy project that has an important role in energy security.”

“The Americans are simply trying crudely to promote their own gas producers,” he said.

All I can say is that if Trump was bought, he sure as hell didn’t stay bought.  Not that any of those who have invested their entire being in the Trump-Russia collusion narrative will bother to notice.

Speaking of the obsessed and delusional, yesterday represented an all time low in the dishonesty of the inveterate Trump haters.  In a meeting with law enforcement officers, Trump called members of the brutal Salvadoran gang MS-13 “animals,” but the media and many politicians widely asserted that he was referring to immigrants as a whole.  If you read the transcript, it is clear that only someone who is deeply and deliberately dishonest could make such an assertion.

The fallback position of these reprobates is that well, MS-13 members are people too, so it is wrong to call them animals.

All right, if that’s what you think–prove it.  Invite a few to move in with you, and you can discuss the nuances of “kill, rape, and control” (“mata, viola, controla“) which just so happens to be the MS-13 motto. (Some say that “rob” is part of the motto too.)  If you’re real nice, they just might honor your request not to bring those icky guns into your house, and will just bring their machetes instead.  After a few verses of Kumbaya, I’m sure that your common humanity will shine through, along with some light illuminating the hole in your neck where your head used to be.

Of course, that will never happen.  Those who are preening and posing would never dare even enter the neighborhoods where MS-13 and similar gangs operate, let alone invite them into their houses.

Further: by defending these beasts, our better thans are condemning decent and innocent people whom they claim to care about to their depredations.

This is the worst kind of moral posing by the worst kind of poseurs.  These are twisted partisan hacks pretending to be moral titans. To let their rank partisanship utterly blind them to the reality of evil, and to ignore those who will have to suffer from that evil, is appalling beyond words.

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