Streetwise Professor

May 19, 2019

G’Day, Greenies: I Frolic In Your Salty Tears

Filed under: Climate Change,Commodities,Economics,Energy,Politics — cpirrong @ 2:18 pm

I promised I would write a post on the Australian power market when a suitable article came along, and that time has come.

Check out the logic. Australia closes its coal plants (highly efficient, reliable, and with a cheap source of fuel given Australia is a dominant coal producer), and replaces them with wind. Wind, being highly erratic, requires (given the closure of the coal plants) gas-fueled plants to offset the variability of wind output, and as a result gas is on the margin most hours in Australia. And Australian power prices are sky-high because . . . LNG exports reduce gas supplies in Australia, keeping the price of gas high.

Riiiggghhhttt.

You cannot make up this stuff.

No. It’s not the first two links in the process that are blamed–the ones that those who are whinging deliberately chose. Instead, it’s the last link, which was an inevitable result of the first two choices.

This is blame shifting on crack.

I should also note that those gas resources that supply exports would not have been developed absent the export market. They would not have been developed to supply the domestic market alone. So LNG exports are a scapegoat for a problem created by conscious decisions by the green left (i.e., the watermelons) to jam renewables down people’s throats.

It is particularly ironic that this article came out shortly before the Australian election, the results of which have caused a complete mental breakdown on the left. The Liberal Party (which is to the right, relatively speaking, Down Under) staged a surprising upset of the Labour Party, resulting in an unhinging comparable to that in the UK after Brexit or the US after Trump. I can’t tell you the number of tweets I read where people–adults, allegedly–confessed to crying uncontrollably.

I frolic in their salty tears.

The irony comes from the fact that the Labour Party is hard core in its support for yet more attempts to decarbonize Australia’s economy. Perhaps they should consider the possibility that a major reason for their rejection at the polls is the anger of many Australians at the consequences of previous climate-driven policies (including sky high electricity prices), and their wanting no more of such nonsense.

The shock on the left at the outcome shows that three years after Brexit and two-and-a-half years after Trump the leftist elites have learned nothing, and forgotten nothing. It is no doubt another example of their perpetual bullshit loop in action. Leftist-friendly views dominate the media. Anyone expressing contrary views is attacked, which leads to self-censorship and preference falsification. So leftist opinions and sentiment dominate public discourse, convincing leftists that everybody agrees with them, except for a lunatic fringe. But in the privacy of the polling booth, people can express their true views, and perhaps do so with a relish, as this is an opportunity to stick it to those who shout them down. The result is shock and dismay on the left.

But they are as ever incapable of learning, instead just writing off their conquerors as cranks and extremists. As annoying as they are, I hope they don’t change. Because as long as they don’t change, they will continue to lose.

Ironically, the left’s climate change obsession is one of the things that doomed them:

Australian conservative Prime Minister Scott Morrison’s surprise come-from-behind win in national elections was fueled by a campaign that focused on fears that economic and climate policies pledged by center-left opponents would end the world’s longest growth streak.

. . . .

Climate change re-emerged as an election issue following a summer of wildfires, drought, floods and extreme temperatures. Voter support for policies aimed at addressing climate change was at the highest level since 2007. But, as in the U.S., divisions grew more stark as the issue gathered steam.
Labor pledged to reduce emissions by 45% from 2005 levels by 2030, after Australia under the conservatives became the first developed nation to abolish a price on carbon in 2014. The party also promised a push on renewable energy and electric vehicles, offering detailed and transparent policies that opened its agenda to months of concerted attack from Mr. Morrison.

Given the track record (e.g., the high electricity prices that motivated this post), this was a target rich environment for Mr. Morrison and the Liberals. And it is evident that they put much steel on the target.

Also ironic is that the Labour Party was defeated in part by the impact of its climate policies on what was once upon a time the bedrock of labor movements and parties around the world: coal miners, and those dependent on coal production. This demonstrates yet again that left parties have basically abandoned their historical constituencies, and are now dominated by effete metropolitans who are not only completely unfamiliar with muscular labor, but actually despise the muscular laborer.

Excuse me while I engage in a little long distance schadenfreude, and scroll through Twitter to witness yet another meltdown by the Bourbon left.

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May 4, 2019

Germany and Sweden Want to Reduce CO2 Emissions in the Worst Way–and Are Succeeding!

Filed under: Climate Change,Economics,Energy,Politics,Regulation — cpirrong @ 5:46 pm

I’ve written often about the economic nightmare that are renewables, specifically wind and solar power. They are terribly inefficient because they are intermittent, and they are diffuse. The intermittency requires maintaining substantial backup capacity. Their diffuse nature means that they are incredibly land intensive. I should also add that renewable energy sources are not miraculously located where loads are. Indeed, they are often located far, far away from load, and therefore necessitate substantial investment in transmission.

How inefficient? This recent University of Chicago study documents that the difference in cost between renewable and conventional generation dwarfs any possible benefit from CO2 reduction. To reprise the old joke: governments that subsidize renewables want to reduce CO2 emissions in the worst way, and they have.

Heretofore the Germans have been the world’s leader in renewable idiocy, with their Energiewende debacle, which has raised power costs to among the world’s highest, and not led to decreases in CO2 emissions (due mainly to the intermittency problem mentioned above). Well played! So how are the Germans going to deal with this? Perhaps by making electricity MORE expensive, by adding a CO2 tax on top of the CO2 cap and trade scheme.

I would say that will be hard to top Germany’s leading position in the ranks of renewables retards, but the Swedes are giving it a gallant try. So get this. The Swedes are replacing cheap zero carbon power (from four nuclear plants) located near load centers like Stockholm with expensive zero carbon power produced my windmills in the frozen back of buggery in the far north of Sweden. One big problem, they are woefully short of transmission capacity from back of buggery to the places where Swedes actually live and work.

This will make power more expensive, and is already constraining economic activity in Sweden. Moreover, it is raising the risk of blackouts.

So the Swedes may be replacing reliable carbon free electricity with electricity free electricity. That will be fun in the winters, eh?

Realistic people who believe that it is necessary to reduce carbon emissions understand that nuclear power is the efficient way to do so, and will become even more efficient with the development of new reactor technologies. It would be far more economical to invest in improvements in nukes than vast wind and solar projects.

But the Swedes appear to still be in the thrall of post-Three Mile Island hysteria (note that the decision to close the plants was made in 1980, a year after TMI) just as the Germans responded to post-Fukushima hysteria by deciding to close all their nukes.

That is, the energy policies of supposedly sophisticated societies are being driven by bugbears and bogeymen–a morbid obsession with CO2, and a view of nuclear power shaped by a nearly 40 year old Jane Fonda movie. This is leading them to force people to rely energy sources that are monstrously inefficient, making said people poorer. (Not to mention that a monomaniacal focus on CO2 leads them to overlook the total environmental impact of wind and solar, which is not a pretty picture.)

The Swedes are also leaders in a modern-day Children’s Crusade (that worked out great the first time, right?) to impose their climate bogeymen on the rest of the world. A rather unfortunate Swedish teenager is going around lecturing the world on the need for drastic action on CO2 now. This is an emotionally manipulative use of children as a substitute for actual argument and analysis and facts. Cynically, it exploits the reluctance of people to criticize children (even though they know nothing, or next to it), especially ones (in the words of the immortal Hank Hill) that ain’t right.

And behold what policies the Swedes want to visit on the rest of us. What they do in Sweden is their business, but they should keep their noses out of everyone else’s.

Makes me more glad than ever that my ancestors bugged out for Minnesota 140 odd years ago. But recent research suggests that they are to blame for Sweden’s current idiocies! I’ve long hypothesized that more independent souls are far more likely to emigrate, leaving the conformists behind. And recent research focusing on Scandinavia provides support for this hypothesis:

The researchers suggest the migration flows, which were small relative to the native population of America but equivalent to about 25 per cent of the total population of Scandinavia, changed the character of Norwegian and Swedish society by removing the most ambitious and independently-minded people.

So Scandinavia’s loss was America’s gain. And if their energy policies are any indication, they are still paying the price today.

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April 28, 2019

Erdogan: Cruisin’ For a Bruisin’

Filed under: Economics,Politics,Turkey — cpirrong @ 7:18 pm

I don’t believe it is an exaggeration to say that Turkey is ruled by a lunatic–Recep Tayyip Erdogan. His increasingly autocratic rule is putting Turkey at serious risk of an economic and geopolitical crisis.

Erdogan dreams of Turkey becoming the dominant power in the Middle East, a modern day version of the Ottoman Empire, including an explicit Islamic orientation–a decisive break with the founder of the Turkish Republic, Mustafa Kemal Ataturk, who eschewed imperial ambitions, and who was avowedly secularist, and indeed, harshly anti-Islam. (Which is one reason Erdogan despises him.)

These ambitions have led Erdogan into some foreign policy disasters, most notably in Syria. At the outset of the Syrian civil war, Erdogan was supporting the rebels and foursquare behind attempts to overthrow Assad. In this he failed utterly. But in the attempt, he (through his intelligence services) provided support to the most radical Islamist elements in Syria–including ISIS.

The Syrian debacle contributed to a serious breach with Europe which has all but eliminated the prospects for Turkish accession to the EU. In particular, his cynical unleashing of waves of Syrian refugees into Europe, and his threats of sending even more, thereby blackmailing the EU into providing Turkey financial aid, have left Turkey friendless in Europe.

Even worse, from a geopolitical perspective, has been his picking fight after fight with the US. The list is long. The extended standoff over an American minister he had imprisoned. His rapprochement with Iran in Syria (which in effect was a concession of his failure to achieve his objectives there), and generally cooperative relationships with Iran, including most notably helping the Islamic Republic circumvent US sanctions by exchanging Turkish gold for Iranian gas. His strident opposition to Israel. His cooperation with another American pariah–Venezuela–which Turkey is helping evade sanctions by agreeing to refine Venezuelan gold. His burning desire to destroy America’s Kurdish allies who have been the only effective local force in the battles against ISIS, said desire driven by Erdogan’s burning hatred of the Kurds in Turkey. This desire to attack Kurds in Syria has led to standoffs (with the serious risk of escalation) with US troops working with them. And last, but by no means least, an agreement to purchase S-400 surface-to-air missile systems from Russia despite the information this could provide the Russians about US F-35 aircraft–which Turkey wants to purchase.

Some of these things–canoodling with Iran, opposing Israel–were not a problem with the Obama administration. They are a big deal with Trump.

The real lunacy is that Erdogan is risking a confrontation with the US at a time when his economy is teetering–in large part due to his mismanagement. The lira dropped significantly last summer, and although it has recovered (a) it is still substantially below the level of 2017, (b) has been dropping steadily since topping out in December, and (c) is poised for another drop due to Erdogan’s inveterate hostility to higher interest rates–well, to interest rates period, which he calls “the mother and father of all evil.” The Turkish Central Bank has been playing games to conceal how weak its reserve position is. These include borrowing dollars from Turkish banks via swaps, putting the dollars as on-balance sheet assets, but treating the swaps as off-balance sheet.

The Turkish economy is in recession, has heavy external indebtedness (which makes its low reserve position all the more dangerous), and has an economic management team that is universally considered to be greatly out of its depth. Erdogan did not help matters when he declared:

The main issue is interest rates. As interest rates are brought down, inflation will fall. The real problem is interest rates. I’m also an economist.

Not only is he not an economist (as his getting the Fisher effect exactly backwards shows), I don’t even think he’s ever even stayed at a Holiday Inn Express. Combining his economic stupidity with his autocratic behavior is a recipe for disaster.

Given this fraught economic situation, Erdogan courts disaster by continuing to pull Uncle Sam’s beard. He is very likely to need the US’s help to stave off economic crisis, and on the flip side, if sufficiently provoked the US could smash the Turkish economy with a mere flick of its fingers.

Erdogan also has domestic political problems. After prevailing in a surprise national election last summer that cemented his changes to the constitution creating a presidential system, his AKP party suffered some stunning losses in local elections last month, most notably a (narrow) loss in Istanbul. Erdogan is attempting to get a do over in the Istanbul election, claiming systemic voting abuses–in a city his party controlled at the time of the election. It is something akin to the Chicago Democratic machine blaming a loss on nefarious Republican voter fraud.

There are many reasons for Erdogan’s near panic over Istanbul. It will give his CHP opponents a highly visible platform and power base, in a city that is widely viewed as the launching pad for Turkish national leaders. (Erdogan was mayor there before becoming prime minister, then president.) Perhaps even more importantly to Erdogan, CHP control of Istanbul threatens to undermine his vast patronage system there (which will undercut his power), and also threatens to expose equally vast corruption (of which Erdogan has already been very credibly accused in the past).

Erdogan is not the type of man who will trim his sails in the face of such fierce headwinds. He will more likely redouble his confrontational efforts, both internationally and domestically, despite his extremely weak economic situation. This is not wise, and will not end well. A bad end to Erdogan is hardly something that should be rued, but his bad end will also mean serious and extended misery for the Turkish people, and a serious potential for even more instability in the Middle East.

This last prospect may be the only thing that saves Erdogan. The potential for turmoil may be the only reason why the Trump administration does not give Erdogan the brusin’ he has been cruisin’ for, not just recently, but since 2003.

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April 25, 2019

A Barbarous Relic, Indeed

Filed under: Commodities,Derivatives,Economics,Energy — cpirrong @ 3:37 pm

In my 2014 whitepaper, I called oil-indexing of LNG contracts a “barbarous relic.” The basic idea is that since oil prices and gas prices are driven by very different supply and demand fundamentals (and increasingly so), oil values and gas values diverge systematically, by large and varying amounts. This means that oil-indexed contracts sent misleading signals that lead to misallocations of consumption and production. These divergences also lead to disputes between the contracting parties, resulting in transactions and renegotiation costs.

A Reuters article from today illustrates that the distorting effects of oil indexation are real, and causing the kinds of dislocations I wrote about 5 years ago:


Asia’s liquefied natural gas market is being distorted as the cost of LNG bought under long-term contracts linked to oil prices jumps to double spot gas cargoes amid tighter U.S. sanctions on Iran’s crude exports and cuts in OPEC oil supply.


The price gap between LNG traded in the spot market and term cargoes linked to benchmark Brent crude oil has stretched to its widest in about 8 years, driving some buyers locked in to term deals to try to delay shipments or look to adjust contracts.

That is, oil-specific fundamentals (OPEC, Iran sanctions waivers) push oil up at the same time that abundant supplies and seasonal factors push LNG prices down.

This is leading to changes in consumption that are almost certainly inefficient because they are a response to crazy price signals:


The price distortion is driving some buyers in China and Japan to request delays in term cargoes, several industry sources told Reuters, although they added that producers had so far resisted making large concessions.
Others are looking to utilize so-called downward quantity tolerances (DQT) in their term contracts from LNG sellers, three of the sources said, requesting anonymity as they were not allowed to talk about the specifics of contracts in public.

Note too the negotiations, and the related transactions costs.

With the growing liquidity in various gas benchmarks (JKM, TTF) and the integration of the world LNG with an existing highly liquid benchmark in the US (Henry Hub), oil indexing is getting to be more of a relic, and more barbarous by the day.

Reuters recently ran another article that identifies a factor that will further encourage the development of LNG spot trade, and gas-on-gas pricing:


The world’s biggest liquefied natural gas (LNG) producers including Shell, Total and Petronas are increasingly selling from global supply pools instead of dedicated projects as buyers leverage a fuel surplus to force ever more flexible deals.


This marks an accelerated turning from traditional long-term contracts that lock customers into taking regular volumes from specific projects under oil-linked pricing formulas.


Global oversupply that has pulled spot LNG prices LNG-AS down by more than 50 percent over the past half-year has producers succumbing to consumer demands for fuel on shorter notice and without sourcing or destination restrictions.


“A more dynamic and liquid LNG market, and the need for greater flexibility by traditional LNG buyers, is providing opportunities for shipping optimisation and trading, and enabling new entrants such as LNG traders,” said Saul Kavonic, head of energy research for Australia at Credit Suisse.

Majors like Shell, Total, Exxon and Chevron are moving aggressively into LNG. (One motive for the Chevron bid for Anadarko was the latter’s Mozambique LNG project.) Aramco is also moving into the market. Large players like this do not need to rely on project finance that banks and the capital markets are willing to supply only if the price risk can be managed via long term contracts with prices that can be hedged on the oil market. It is feasible for them to sell out of a portfolio of projects on a shorter-term or gas indexed basis.

This will make the LNG look even more like the oil market, in which the majors (and national oil companies) supply the market out of a portfolio of production sources. Indeed, in some respects LNG is even more amenable to a portfolio-based strategy. LNG is far more physically homogeneous than oil, allowing a given project to serve a larger fraction of demanders. Moreover, the seasonality of gas demand, and the susceptibility of gas demand to big but rather localized shocks (e.g., the effects of Fukushima, a drought in the Amazon that reduces hydroelectric supply) creates a need for flexibility that is best met through gas portfolios that provide locational and timing optionality.

Such developments will make oil-linking even more of a barbarous relic than it already is–which is saying something.

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April 24, 2019

Elon the Stakhanovite

Filed under: Economics,Energy,Tesla — cpirrong @ 7:02 pm

Our Elon is all about exceeding expectations. Analysts predicted a $1.30/share loss in Q1. Elon scoffed. Piddling! He showed ’em–the actual loss was $2.90.

Overexceeding norms by 123 percent! Stakhanov would be proud.

Joking aside, the Q1 numbers were a bloodbath. A loss of over $700 million. In a quarter, mind. Cash flow was negative $920 million. The company said this is an improvement! A year ago it was -$1.05 billion!

Well, the cash flow numbers would have been worse–and worse than last year–had Tesla spent the anticipated $509 million in capex, instead of the actual $279 million.

Remember what I said about Tesla bleeds cash like a Game of Thrones battle scene hemorrhages blood? That hasn’t changed.

Tell me again why Tesla is a growth company. What other growth company is, or has ever been, on a capex starvation diet? Especially one that claims to have all sorts of new products just on the verge of production.

Revenues also cratered–$4.5 billion v. estimated $5.2 billion, and down from $7.2 billion a mere quarter ago.

A few days before the Q1 earnings release, Tesla held “Autonomy Investors Day” in which attempted to distract attention from its dismal present with Futurama visions of a magical future, with zillions of autonomous robotaxis prowling the world’s thoroughfares. Yeah. Robotaxis. That’s the ticket!

This is just the Musk MO–always try to keep the suckers focused on a brilliant future. The next big thing is around the corner. The problem is, it is always around the corner, and the autonomous vehicles–and Tesla the company–haven’t learned how to turn the corner.

Elon also claimed (based on highly dubious assertions that NVIDIA hotly disputes) that Tesla would create a better chip than one of the world’s leading, and most innovative, chipmakers. Sure! And the problem with production is with the world’s leading battery manufacturer, not the car manufacturing tyro. Sure!

It appears, however, that Elon’s con is less convincing than it used to be. People are figuring it out. Finally. The Autonomy Day was widely panned, and his claims regarding chips widely mocked.

Elon also said “The only criticism and it’s a fair one, sometimes I’m not on time. But I get it done and the Tesla team gets it done.” Sometimes? Try always. And gets it done? Like the rooftop panels? The factory in Buffalo? The $35K Model 3 that is virtually impossible to actually, you know, buy? The innovative vertically integrated clean energy company that would result from the merger of SolarCity and Tesla? (Tesla is basically winding up SolarCity. It is disappearing like the Cheshire Cat. Except there won’t be a smile left when it’s done.)

I will just note in passing that a SpaceX test capsule had an “anomaly” on testing. Pictures show smoke billowing from the test area. I guess “anomaly” is how you spell “fire” now.

Remember that Elon promised no new capital raises. Given that losses are anticipated again in Q2, and that promises of profit in Q3 are dubious given Elon’s track record, how this is possible is beyond me. And again, how that promise can be squared with his promises regarding autonomous vehicles and the Model Y and the semi etc., etc., etc. is even more fantastical.

As I have been saying for a while, this will not end well. And it is looking like that bad end is nigh.

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April 15, 2019

Chartering Practices in LNG Shipping: Deja Vu All Over Again

Filed under: Commodities,Derivatives,Economics,Energy — cpirrong @ 7:28 pm

One of the strands of thought that combined in my analysis of the evolution of LNG market structure is the idea of temporal and contractual specificities. This traces back to my dissertation, in what was published in a JLE article titled “Contracting Practices in Bulk Shipping Markets.” In that article, I addressed something that is a puzzle from the context of transactions costs economics: since the most common forms of asset specificity (especially site specificity) are not present for ships, why are many bulk carriers subject to arrangements that TCE posits address specificity problems, specifically long term contracts or vertical integration?

My answer was that even with mobile assets the parties could find themselves in small numbers bargaining situations and vulnerable to holdup due to temporal specificities: I need a ship at place X NOW, and maybe there is only 1 ship nearby. Or, I have a ship at place Y, but maybe there is only one viable cargo there. Long term contracts can mitigate this problem, but they create a form of externality. If most ships suitable for a given cargo are tied up under long term contracts, and most shippers have contracted for vessels for an extended period, the number of free ships and cargoes at any time will be small, thereby creating opportunism problems in spot contracting, which leads to more long term contracting. In essence, there is a spot (“voyage chartering”) equilibrium where most ships are traded on a spot basis, or a long term contracting equilibrium where they are not.

The article posits that these problems depend primarily on the specificity of the ship to particular cargoes and the “thickness” of trade routes. Cargoes suitable for standard bulk carriers on heavily-transited routes should sail on a spot charter basis: cargoes requiring specialized ships, and/or those on relatively isolated routes, are likely to require longer term ship chartering arrangements, or vertical integration.

By and large, the cross-sectional and time series variations in contracting practices line up with these predictions. One interesting case study that in the time series is crude oil. Prior to the development of spot markets in crude, most of it was shipped on oil company owned ships, or tankers obtained under long term charters. The development of spot markets for crude reduced the potential for holdup by freeing up cargoes. The ability to buy oil spot to replace a shipment that a specific carrier might have a time-space advantage in lifting reduced the ability of that carrier to extract rents. This flexibility also reduced the ability of shippers to extract rents from carriers. This reduced scope for rent extraction and opportunism in turn reduced the need for contractual protections, and soon after the spot crude market developed, the crude shipping market rapidly transitioned towards short-term chartering arrangements and vertical integration virtually disappeared.

One of the examples of long term contracting in my article was LNG shipping. LNG ships have always been very specialized due to the nature of the cargo: the only thing you can carry on an LNG carrier is LNG, and you can’t use any other kind of ship to carry it. At the time (late-80s/early-90s), most LNG was shipped between a limited set of sources (mainly Algeria) and sinks (mainly in Europe), and sold under long term contracts (20 years or more, for the most part). Consistent with the theory, LNG ships were also under long term contracts or owned by either the seller or buyer of LNG.

An implication of the analysis is that as in the crude market, the development of an LNG spot market should lead to more short term charters for LNG shipping. And lo and behold, this is occurring:

The market for LNG freight trade is relatively new and many companies are reluctant to talk about trading strategies, which are still being developed.


“We see LNG shipping as a commodity on its own,” said Niels Fenzl, Vice President Transportation and Terminals at Uniper, an energy firm which along with Shell, pioneered freight trade within the LNG market.


“We were one of the first companies who started to trade LNG vessels around two or three years ago and we see more companies are considering trading LNG freight now.”
. . . .

In general, traditional shipowners prefer to stick with long-term charters, which help them finance building new vessels, and let the energy firms and trading houses deal in the riskier short-term sublets.
But, given the potential money to be made, there are shipping companies focused almost entirely on servicing the LNG industry’s immediate or near-term requirements.

“The spot market is our priority now given the current rate environment as we don’t want to lock our ships in long-term charters prematurely in the recovery cycle,” said Oystein M. Kalleklev, CEO of Flex LNG, a shipping firm founded in 2006.


“We also do believe spot is becoming a much bigger part of the LNG shipping market as well as the overall LNG trade.”

Theory in action, yet again. The parallels to the experience in crude 40 years ago are striking.

And again as theory (although a different theory than TCE) would predict, the development of a liquid spot market is catalyzing the development of paper derivatives markets for hedging purposes. As one would expect, and has happened historically, this new market is primarily bilateral, opaque, and illiquid. But the potential for a virtuous liquidity cycle is there.

One problem at present is that the liquidity in the spot charter market is insufficient to provide the basis for an index that can be used to settle derivatives:

The difficulty for the index is having enough deals to base a price on, according to Gibson.


Also, many transactions are discussed privately, making it difficult to find out what price was agreed.

“In order for Uniper to consider trading on LNG freight indices we would need to see what mechanisms are offered to make the trade possible. If they could work in principle, we would look into using those,” Fenzl said.

But as the spot LNG market grows, and this leads to more spot ship chartering, indices will become feasible and better, which will spur growth in the derivatives market. And there will be a further positive feedback loop. The ability to manage freight rate risk through derivatives reduces the need to manage them through bilateral term contracts, which will further boost the spot chartering market.

One of the lessons of my old work (done when I was a small child! I swear!) is that there is a substantial coordination game aspect to contracting. If everyone contracts long term, that is self-sustaining: to go against that and try to buy/sell spot makes one vulnerable to opportunism and bargaining problems. Shocks (like the 1970s oil shock that transformed that market, or the variety of developments that led to more spot LNG trading in recent years) that lead to increased spot volumes can undermine that long term contracting equilibrium, especially if those volumes are sufficient to activate the positive feedback loop.

We are seeing that dynamic in LNG, and that dynamic in LNG is creating a similar dynamic in LNG shipping, a la oil in the 1970s. It’s deja vu, all over again.

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April 13, 2019

The Russians Aren’t There to Spread Disorder; They are There to Maintain Disorder

Filed under: China,Commodities,Economics,Energy,Politics,Russia — cpirrong @ 4:41 pm

This headline in Bloomberg made me chuckle and think of a famous malapropism from Mayor Daley I: “The policeman isn’t there to create disorder; the policeman is there to preserve disorder.”

The Russians (and the Chinese) are not in Venezuela to create (or spread) disorder, the Russians are in Venezuela to preserve disorder. Quite literally. Because they are there to preserve Maduro, and Maduro has created such chaos and misery that “disorder” seems far too mild a word to describe it. So adapting Mayor Daley’s words to the Russians in Venezuela, it wouldn’t be a malapropism–it would be descriptively accurate. An understatement, even.

Yes, I understand that permitting foreign interference in the Western Hemisphere violates just short of 200 years of American policy, and this is not a precedent we want to set. But in comparison to say the French in Mexico in the 1860s, this is truly small beer.

And consider the fate of Maximillian et al. Not a precedent that the Russians or Chinese should want to emulate.

Venezuela is a disaster–the world’s largest tar baby (literally, in some respects, given the physical characteristics of Venezuelan crude oil). The Russians and Chinese are actually fools if they think that propping up this disastrous regime–which is on the verge of overseeing a record setting decline in economic output–will increase their odds of getting paid back the billions they lent. Every day that Maduro continues in power, and the catastrophe metastasizes, makes the prospects of recovering even a few kopecs all the more remote.

If recouping some of their debt is an objective, the Russians and Chinese would actually be far better off killing Maduro, overthrowing his thugs, and making a deal with the opposition. But Putin and Xi are doubling down on a regime that makes the phrase “failed state” seem like a compliment.

Putin also views an outpost in Venezuela as a military provocation to the US. Whatever. At over 5400 miles from Russia (and over 9000 miles from Shanghai), that outpost would be utterly unsustainable if push came to shove with the US. Russia has no ability to sustain it logistically over that distance–nor does China, really, even though its navy and sealift are not as decrepit as Russia’s.

Fools put bases in places they can’t support. Complete fools put bases in places that they can’t support AND which are located in places that are descending into a state that the creators of Mad Max would have found fantastical.

So let Putin add Venezuela to his collection of failed state allies. It will be an ulcer, not an asset.

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April 10, 2019

Trump’s Energy Infrastructure Executive Order: A Constructive Use of Federal Power, Consonant With the Purpose of the Constitution

Filed under: Climate Change,Economics,Energy,Politics,Regulation — cpirrong @ 7:31 pm

Trump just departed from Ellington Joint Reserve Base here in Houston, ending a quick trip to Texas which included a rally in Houston. The focus of Trump’s visit was the US energy sector (In Texas? Go figure!). As part of that, he announced and signed an executive order limiting the power of states to block or obstruct the construction of interstate oil and gas pipelines.

Overall, I’m not a fan of executive orders, as they tend to be used to override or circumvent normal Constitutional procedures and purposes. There is a strong argument, however, that this order is an exception.

The very genesis of the Constitution traces to commercial disputes between states under the Articles of Confederation. Contention between Virginia and Maryland over navigation of the Potomac and the Chesapeake resulted in the calling of the Annapolis Convention (formally The Meeting of Commissioners to Remedy Defects of the Federal Government) in 1786. Although the Convention itself was something of a damp squid, it did result in the calling of the Philadelphia Convention of 1787, which wrote the Constitution that continues to be the law of the land to this day, 232 years later.

Of course, one part of that document is the Commerce Clause (Article I, Section 8, Clause 3) which grants to the Federal government the power to regulate commerce between the states. This was not an accident, comrades. Preventing protectionism by the states against each other was one of the main reasons for creating a more powerful central government.

State governments always have the temptation and incentive to favor their own constituents at the expense of people in other states. Letting that impulse operate freely would result in a Balkanized country with myriad wasteful restrictions, taxes, tolls, and regulations that would sap wealth. (Consider pre-Revolutionary France, with its oppressive system of local tolls on the movement of goods.) Anticipating that, the Founders expressly sought to limit the protectionist powers of states.

In Gibbons v. Ogden (1824) the Marshall court forcefully exerted the Commerce Clause. Things have likely gone too far since: for example, the Commerce Clause’s delegation of authority over navigable waters to the US government has been pushed to the extreme by using it to impose Federal environmental regulation on an intermittent wet spot on your back 40.

But what Trump is ordering is clearly within the four corners of the Clause as originally conceived. Oil and gas are produced in some states, and consumed in others. Interstate movement is necessary to connect producers and consumers. Further, for myriad motives many states have attempted to obstruct that movement. That is not, and has not been since the formation of the Republic, their prerogative.

The case can be made that the Commerce Clause has proved a Trojan Horse that has facilitated an expansion of Federal power beyond that what the Founders envisioned. But what Trump is ordering is squarely within the intent of the Clause, as drafted and intended.

The dramatic growth in US energy production is being hampered by infrastructure constraints. For many, that is a feature, not a bug: the hostility towards fossil fuel energy in particular by many in the US, especially on the left, makes such infrastructure a schwerpunkt for environmentalists. Knock out the transit links between producers and consumers, and energy will be neither produced nor consumed. They often find it easier to focus their efforts on state and local governments because (a) they are often more biddable, and (b) since you only need to prevail in one or two to delay or derail altogether a pipeline moving across many, the odds of success are higher. (If there are N jurisdictions crossed by a pipeline, and the probability of getting a jurisdiction to block it is P, the probability that it will go through is (1-P)^N, which decreases with N.)

Yes, local communities do have concerns. The question is what is the appropriate remedy for them. A properly applied Takings Clause (with payment of true value for taken property) is one: it prevents subsidization through expropriation. Insofar as environmental issues are concerned, the question is whether ex ante restrictions (i.e., imposing high standards to permit construction) are better than ex post penalties for damage imposed (which provide an incentive for infrastructure operators to take precautions against damage).

Since infrastructure operators are well-capitalized, and unlikely to be judgment proof, and since there are armies of class action attorneys waiting in the wings salivating at the opportunity to sue for damages, ex post penalties are likely to be more efficient than ex ante restrictions, especially ex ante restrictions imposed by state and local governments who internalize the benefits they obtain for their constituents, but who do not internalize the costs that they impose on producers upstream or consumers downstream.

And this is not to say that the Federal government is inevitably predisposed to efficient outcomes. Look no further than the previous administration, which largely embraced the environmentalist hostility to domestic energy development, and which as a consequence used its powers to thwart some important infrastructure developments (e.g., Keystone, which would have proven especially valuable in light of the loss of heavy crude production in Venezuela and to a lesser degree Mexico). So Federal power can be exercised for good or ill when it comes to energy infrastructure. Trump’s order is an example of it being exercised for the good of energy consumers and producers.

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April 8, 2019

CDS: A Parable About How Smart Contracts Can Be Pretty Dumb

Filed under: Blockchain,Derivatives,Economics,Exchanges,Regulation,Russia — cpirrong @ 7:04 pm

In my derivatives classes, here and abroad, I always start out by saying that another phrase for “derivative” is contingent claim. Derivatives have payoffs that are contingent on something. For most contracts–a garden variety futures or option, for example–the contingency is a price. The payoff on WTI futures is contingent on the price of WTI at contract expiration. Other contracts have contingencies related to events. A weather derivative, for instance, which pays off based on heating or cooling degree days, or snowfall, or some other weather variable. Or a contract that has a payoff contingent on an official government statistic, like natural gas or crude inventories.

Credit default swaps–CDS–are a hybrid. They have payoffs that are contingent on both an event (e.g., bankruptcy) and a price (the price of defaulted debt). Both contingencies have proved very problematic in practice, which is one reason why CDS have long been in such disrepute.

The price contingency has proved problematic in part for the same reason that CDS exist. If there were liquid, transparent markets for corporate debt, who would need CDS?: just short the debt if you want to short the credit (and hedge out the non-credit related interest rate risk). CDS were a way to trade credit without trading the (illiquid) underlying debt. But that means that determining the price of defaulted debt, and hence the payoff to a CDS, is not trivial.

To determine a price, market participants resorted to auctions. But the auctions were potentially prone to manipulation, a problem exacerbated by the illiquidity of bonds and the fact that many of them were locked up in portfolios: deliverable supply is therefore likely to be limited, exacerbating the manipulation problem.

ISDA, the industry organization that largely governs OTC derivatives, introduced some reforms to the auction process to mitigate these problems. But I emphasize “mitigate” is not the same as “solve.”

The event issue has been a bane of the CDS markets since their birth. For instance, the collapse of Russian bond prices and the devaluation of the Ruble in 1998 didn’t trigger CDS payments, because the technical default terms weren’t met. More recently, the big issue has been engineering technical defaults (e.g., “failure to pay events”) to trigger payoffs on CDS, even though the name is not in financial distress and is able to service its debt.

ISDA has again stepped in, and implemented some changes:

Specifically, International Swaps and Derivatives Association is proposing that failing to make a bond payment wouldn’t trigger a CDS payout if the reason for default wasn’t tied to some kind of financial stress. The plan earned initial backing from titans including Goldman Sachs Group Inc.JPMorgan Chase & Co.Apollo Global Management and Ares Management Corp.

“There must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the reference entity,” ISDA said in its document.

Well that sure clears things up, doesn’t it?

ISDA has been criticized because it has addressed just one problem, and left other potential ways of manipulating events unaddressed. But this just points out an inherent challenge in CDS. In the case Cargill v. Hardin, the 7th Circuit stated that “the techniques of manipulation are limited only by the ingenuity of man.” And that goes triple for CDS. Ingenious traders with ingenious lawyers will find new techniques to manipulate CDS, because of the inherently imprecise and varied nature of “credit events.”

CDS should be a cautionary tale for something else that has been the subject of much fascination–so called “smart contracts.” The CDS experience shows that many contracts are inherently incomplete. That is, it is impossible in advance to specify all the relevant contingencies, or do so with sufficient specificity and precision to make the contracts self-executing and free from ambiguity and interpretation.

Take the “must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the reference entity” language. Every one of those words is subject to interpretation, and most of the interpretations will be highly contingent on the specific factual circumstances, which are likely unique to every reference entity and every potential default.

This is not a process that can be automated, on a blockchain, or anywhere else. Such contracts require a governance structure and governance mechanisms that can interpret the contractual terms in light of the factual circumstances. Sometimes those can be provided by private parties, such as ISDA. But as ISDA shows with CDS, and as financial exchanges (e.g., the Chicago Board of Trade) have shown over the years in simpler contracts such as futures, those private governance systems can be fragile, and themselves subject to manipulation, pressure, and rent seeking. (Re exchanges, see my 1994 JLE paper on exchange self-regulation of manipulation, and my 1993 JLS paper on the successes and failures of commodity exchanges.)

Sometimes the courts govern how contracts are interpreted and implemented. But that’s an expensive process, and itself subject to Type I and Type II errors.

Meaning that it can be desirable to create contracts that have payoffs that are contingent on rather complex events–as a way of allocating the risk of such events more efficiently–but such contracts inherently involve higher transactions costs.

This is not to say that this is a justification for banning them, or sharply circumscribing their use. The parties to the contracts internalize many of the transactions costs (though arguably not all, given that there are collective action issues that I discussed 10 years ago). To the extent that they internalize the costs, the higher costs limit utility and constrain adoption.

But the basic point remains. Specifying precisely and interpreting accurately the contingencies in some contingent claims contracts is more expensive than in others. There are many types of contracts that offer potential benefits in terms of improved allocation of risk, but which cannot be automated. Trying to make such contracts smart is actually pretty dumb.


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April 7, 2019

The LNG Market’s Transformation Continues Apace–and Right On Schedule

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — cpirrong @ 7:14 pm

In 2014, I wrote a whitepaper (sponsored by Trafigura) on impending changes to the liquefied natural gas (LNG) market. The subtitle (“racing towards an inflection point”) captured the main thesis: the LNG market was on the verge of a transformation. The piece made several points.

First, the traditional linkage in long term LNG contracts to the price of oil (Brent in particular) was an atavism–a “barbarous relic” (echoing Keynes’ characterization of the gold standard) as I phrased it more provocatively in some talks I gave on the subject. The connection between oil values and gas values had become attenuated, and often broken altogether, due in large part to the virtual disappearance of oil as a fuel for electricity generation, and the rise in natural gas in generation. Oil linked contracts were sending the wrong price signals. Bad price signals lead to inefficient allocations of resources.

Second, the increasing diversity in LNG production and consumption was mitigating the temporal specificities that impeded the development of spot markets. The sector was evolving to the stage in which participants could rely on markets to provide security of demand and supply. Buyers were not locked into a small number of sellers, and vice versa.

Third, a virtuous liquidity cycle would provide a further impetus to development of shorter term trading. Liquidity begets liquidity, and reinforces the willingness of market participants to rely on markets for security of demand and supply, which in turn frees up more volumes for shorter term trading, which enhances liquidity, and so forth.

Fourth, development of more liquid spot markets will make market participants willing to enter into contracts indexed to prices from those markets, in lieu of oil-linkages.

Fifth, the development of spot markets and gas-on-gas pricing will encourage the development of paper hedging markets, and vice versa.

Sixth, the emergence of the US as a supplier would also accelerate these trends. There was already a well-developed and transparent market for natural gas in the US, and a broad and deep hedging market. With US gas able to swing between Asia and Europe and South America depending on supply and demand conditions in these various regions, it was likely to be the marginal source of supply around the world and would hence set price around the world. Moreover, the potential for geographic arbitrages creates short term trading opportunities.

When pressed about timing, I was reluctant to make a firm forecast because it is always hard to predict when positive feedback mechanisms will take off. But my best guess was in the five year range.

Those predictions, including the time horizon, are turning out pretty well. There have been a spate of articles recently about the evolution of LNG as a traded commodity, with trading firms like Vitol, Trafigura, and Gunvor, and majors with a trading emphasis like Shell and Total, taking the lead. Here’s a recent example from the FT, and here’s one from Bloomberg. Industry group GIIGNL reports that spot volumes rose from 27 percent of total volumes in 2017 to 32 percent in 2018.

There are also developments on the contractual front. Last year Trafigura signed a 15 year offtake deal with US exporter Cheniere linked to Henry Hub. In December, Vitol signed a deal with newcomer Tellurian linked to Henry Hub, and last week Tellurian inked heads of agreement with Total for volumes linked to the Platts JKM (Japan-Korea-Marker).* Shell even entered into a deal linked with coal. There was one oil-linked deal signed recently (between NextDecade and Shell), but to give an idea of how things have changed, this met with puzzlement in the industry:

The pricing mechanism that raised eyebrows this week in Shanghai was NextDecade’s Brent-linked deal with Shell. NextDecade CEO Matt Schatzman said he wanted to sell against Brent because his Rio Grande LNG venture will rely on gas that’s a byproduct of oil drilling in the Permian Basin, where output will likely increase along with oil prices.


Total CEO Patrick Pouyanne said he didn’t understand that logic.
“Continuing to price gas linked to oil is somewhat the old world,” Pouyanne said on Wednesday. “I was most surprised to see new contracts linked to Brent, especially from the U.S. Someone will have to explain this to me.”

I agree! In fact, the NextDecade logic is daft. High oil prices that stimulate oil production will lead to lower gas prices due to the linkage that Schatzman outlines. If you have doubts about that, look at the price of natural gas in the Permian right now–it has been negative, often by $6.00/mmbtu or more. This joint-production aspect will tend to make oil and gas prices less correlated, or even negatively correlated.

But it’s hard to believe how much the conventional wisdom has changed in 5 years. The whitepaper was released in time for the LNG Asia Summit in Singapore, and I gave a keynote speech at the event to coincide with its release. The speech was in front of the shark tank at the Singapore Aquarium, and from the reception I got I was worried that I might get the same treatment from the audience as Hans Blix did from Kim Jung Il in Team America.

To say the least, the overwhelming sentiment was that oil links were here to stay, and that any major changes to the industry were decades, rather than a handful of years, away. Fortunately, the sharks went hungry and I’m around to say I told you so 😉

I surmise that the main reason that the conventional wisdom was that the old contracting and pricing mechanisms would be sticky was an insufficient appreciation for the nature of liquidity, and how this could induce tipping to a new market organization and new contract and trading norms. These were ideas that I brought from my work in the industrial organization of financial trading markets (“market macrostructure” as I called it), and they were no doubt alien to most people in the LNG industry. Just as ideas about spot trading of oil were alien to most people in the oil industry when Marc Rich and others introduced it in the 1970s.

Given the self-reinforcing nature of these developments, I believe that the trend will continue, and likely accelerate. Other factors will feed this process. I’ve written in the past about how some traditional contract terms, notably destination clauses, are falling by the wayside due to regulatory pressure in Japan and elsewhere. The number of sources and sinks is increasing, which makes the market thicker and mitigates further temporal specificities. The achievement of scale and greater trading opportunities will encourage investment in infrastructure, notably storage, that facilitates trading. Right now most LNG trading involves only one of the transformations I’ve written about (transformation in space): investment in storage infrastructure will facilitate another (transformation in time).

It’s been kind of cool (no pun intended, given that LNG is supercooled) to watch this happen in real time. It is particularly interesting to me, as an industrial organization economist, given that many issues that I’ve studied over the years (transactions cost economics, the economics of commodity trading, the nature and dynamics of market liquidity) are all present. I’m sure that the next several years will provide more material for what has already proved to be a fascinating case study in the evolution of contracting and markets.

*Full disclosure: My elder daughter works for Tellurian, and formerly worked for Cheniere. I have profited from many conversations with her over the last several years. One of my former PhD students is now at Cheniere.

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