Streetwise Professor

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.

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.

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.

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.

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!

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.

In recent weeks, the flat price of crude oil (both WTI and Brent) has moved up smartly, but time spreads have declined pretty sharply.  A common mistake by oil market analysts is to consider this combination of movements anomalous, and an indication of a disconnect between the paper and the physical markets.  This article from Reuters is an example:

Oil futures prices have soared past three-year highs, OPEC’s deal has cut millions of barrels of inventory worldwide and investors are betting in record numbers that prices could rocket past $80 and even hit $90 a barrel this year.

But physical markets for oil shipments tell a different story. Spot crude prices are at their steepest discounts to futures prices in years due to weak demand from refiners in China and a backlog of cargoes in Europe. Sellers are struggling to find buyers for West African, Russian and Kazakh cargoes, while pipeline bottlenecks trap supply in west Texas and Canada.

The divergence is notable because traditionally, physical markets are viewed as a better gauge of short-term fundamentals. Crude traders who peddle cargoes to refineries worldwide say speculators are on shaky ground as they drive futures markets above $70 a barrel, their highest levels for three-and-a-half years, on concerns about tighter supply from Venezuela and the potential impact of U.S. sanctions on supply from Iran.

Investors have piled millions of dollars in record wagers in the options market, betting on a further rally on the back of rising geopolitical tensions, particularly in Iran, Saudi Arabia and Venezuela, and the global decline in supply.

“Guys who are trading futures have a view that draws are coming and big draws are coming,” a U.S.-based crude trader at a global commodity merchant said, adding that demand could ramp up as global refinery maintenance ends.

. . . .

BIG DISCONNECT

Those on the front lines of the physical market are not convinced. Traders say the surge in U.S. exports to more than 2 million bpd has saturated some markets, leaving benchmark prices ripe for a correction.

“There is a huge disconnect between futures and fundamentals,” a trader with a Chinese independent refiner said. “I won’t be surprised if prices correct by $20 a barrel.”

In fact, the alleged “disconnect” is readily explained based on recent developments in the market, notably the prospect for interruption/reduction in Iranian supplies due to the reimposition of sanctions by the US.  The situation in Venezuela is exacerbating this situation.  Two things are particularly important in this regard.

First, the Iranian situation is a threat to future supplies, not current supplies: the potential collapse in Venezuela is also a threat to future supplies (although current supplies are dropping too).  A reduction in expected future supplies increases future scarcity relative to current scarcity.  The economically efficient response to that is to share the pain, that is, to shift some supply from the present to the future by storage.  To reward storage, the futures price rises relative to the spot price–that is, the time spread declines.  However, since the driving shock (the anticipated reduction in future supplies) will result in greater scarcity, the flat price must rise.

A second effect works in the same direction. This is a phenomenon that I worked out in a 2008 paper that later was expanded into a chapter my book on commodity price dynamics.  Both the US actions regarding Iran, and the current tumult in Venezuela increase uncertainty about future supplies.  The efficient way to respond to this increase in fundamental uncertainty is to increase inventories, relative to what they would have been absent the increase.  This requires a decline in current consumption, which requires an increase in flat prices.  But incentivizing greater storage requires a fall in calendar spreads.

An additional complicating factor here is the feedback between inventories or calendar spreads (which are often used as a rough proxy for inventories, given the opacity and relative infrequency of stocks numbers) and OPEC decisions.  To the extent OPEC uses inventories or calendar spreads as a measure of the tightness of the supply-demand balance, and interprets the fall in calendar spreads and the related increase in inventories (or decline in the rate of inventory reductions), it could respond to what is happening now by restricting supplies . . . which would exacerbate the future scarcity. Relatedly, a known unknown is how current spread movements reflect market expectations about how OPEC will respond to spread movements.  The feedback/reflexivity here (that results from a price maker/entity with market power using spreads/inventory as a proxy for supply-demand balance, and market participants forming expectations about how the price maker will behave) greatly complicates things.  Misalignments between OPEC behavior and market expectations (and OPEC expectations about market expectations, and on an on with infinite regress) can lead to big jumps in prices.

Putting to one side this last complication, contrary to what many analysts and market participants claim, the recent movements in flat prices and spreads are not sending mixed signals.  They are a rational response to the evolution in market conditions observed in recent weeks: a decline in expected future supply, and an increase in fundamental risk.  The theory of storable commodities predicts that such conditions will lead to higher flat prices and lower calendar spreads.

When discussing the 1864 election, Lincoln mused that it was unwise to swap horses in midstream.  (Lincoln used a variant of this phrase many times during the campaign.) The New York Fed and the Board of Governors are proposing to do that nonetheless when it comes to interest rates.  They want to transition from reliance on Libor to a new Secured Overnight Financing Rate (SOFR, because you can never have enough acronyms), despite the fact that there are trillions of dollars of notional in outstanding derivatives and more trillions in loans with payments tied to Libor.

There are at least two issues here.  The first is if Libor fades away, dies, or is murdered, what is to be done with the outstanding contracts that it is written into? Renegotiations of contracts (even if possible) would be intense, costly, and protracted, because any adjustment to contracts to replace Libor could result in the transfer of tens of billions of dollars among the parties to these contracts.  This is particularly like because of the stark differences between Libor and SOFR.  How would you value the difference between a stream of cash flows based on a flawed mechanism intended to reflect term rates on unsecured borrowings with a stream of cash flows based on overnight secured borrowings?  Apples to oranges doesn’t come close to describing the difference.

Seriously: how would you determine the value so that you could adjust contracts?  A conventional answer is to hold some sort of auction (such as that used to determine CDS payoffs in a default), and then settle all outstanding contracts based on the clearing price in the auction (again like a CDS auction).  But I can’t see how that would work here.

Let’s say you have a contract entitling you to receive a set of payoffs tied to Libor.  You participate in an auction where you bid an amount that you would be willing to pay/receive to give up that set of payoffs for a set of SOFR payoffs.  What would you bid?  Well, in a conventional auction your bid would be based on the value of holding onto the item you would give up (here, the Libor payments).  But if Libor is going to go away, how would you determine that opportunity cost?

Not to mention that there is an immense variety of payoff formulae based on Libor, meaning that there would have to be an immense variety of (impractical) auctions.

So it will come down to bruising negotiations, which given the amounts at stake, would consume large amounts of real resources.

The second issue is whether the SOFR rate will perform the same function as well as Libor did.  Market participants always had the choice to use some other rate to determine floating rates in swaps–T-bill rates, O/N repo rates, what have you.  They settled on Libor pretty quickly because Libor hedged the risks that swap users faced better than the alternatives.  A creditworthy bank that borrowed unsecured for 1, 3, 6, or 12 month terms could hedge its funding costs pretty well by using a Libor-based swap: a swap based on some alternative (like an O/N secured rate) would have been a dirtier hedge.  Similarly, another way that banks hedged interest rate risk was to lend at rates tied to their funding cost–which varied closely with Libor.  Well, the borrowers (e.g., corporates) could swap those floating rate loans into fixed by using Libor-based swaps.

That is, Libor-based swaps and other derivatives came to dominate because they were better hedges for interest rate risks faced by banks and corporates than alternatives would have been.  There was an element of reflexivity here too: the availability of Libor-based hedging instruments made it desirable to enter into borrowing and lending transactions based on Libor, because you could hedge them. This positive feedback mechanism created the vexing situation faced today, where there are immense sums of contracts that embed Libor in one way or another.

SOFR will not have this desirable feature–unless the Fed wants to drive banks to do all their funding secured overnight! That is, there will be a mismatch between the new rate that is intended replace Libor as a benchmark in derivatives and loan transactions, and the risks that that market participants want to hedge.

In essence, the Fed identified the problem with Libor–its vulnerability to manipulation because it was not based on transactions–and says that it has fixed it by creating a benchmark based on a lot of transactions.  The problem is that the benchmark that is “better” in some respects (less vulnerable to a certain kind of manipulation) is worse in others (matching the risk that market participants want to hedge).  In a near obsessive quest to fix one flaw, the Fed totally overlooked the purpose of the thing that they were trying to fix, and have created something of dubious utility because it does a poorer job of achieving that purpose.  In focusing on the details of the construction of the benchmark, they’ve lost sight of the big picture: what the benchmark is supposed to be used for.

It’s like the Fed has said: “Libor was one crappy wrench, so we’ve gone out and created this beautiful hammer. Use that instead!”

Or, to reprise an old standby, the Fed is like the drunk looking for his car keys under the lamppost, not because he lost them there, but because the light is better.  There is more light (transactions) in the O/N secured market, but that’s not where the market’s hedging keys are.

This is an object lesson in how governments and other large bureaucracies go astray.  The details of a particular problem receive outsized attention, and all efforts are focused on fixing that problem without considering the larger context, and the potential unintended consequences of the “fix.” Government is especially vulnerable to this given the tendency to focus on scandal and controversy and the inevitable narrative simplification and decontextualization that scandal creates.

The current ‘bor administrator–ICE–is striving to keep it alive.  These efforts deserve support.  Secured overnight rate-based benchmarks are ill-suited to serve as the basis for interest rate derivatives that are used to hedge the transactions that Libor-based derivatives do.

Glencore has just announced that the deal to sell Rosneft shares to CEFC has been terminated.  Furthermore, the QIA-Glencore consortium is being wound up, with virtually all of the shares going to QIA:

The members of the Consortium have agreed to dissolve the Consortium originally put in place in December 2016 for the purposes of acquiring a 19.5% stake in Rosneft and will take direct ownership of the underlying Rosneft shares.  In connection with that, the Consortium has today entered into an agreement to transfer a 14.16% stake in Rosneft to a wholly owned subsidiary of QIA (the “Transaction”) the consideration for which will to be used for the settlement of the Consortium’s liabilities. This agreement will become effective on 7 May 2018.

On completion of the Transaction, the Consortium will be wound up and the margin guarantees provided by Glencore will be terminated.  At that point, Glencore will retain an equity stake in Rosneft shares commensurate with its original equity investment announced in January 2017, which amounts to 0.57%, and QIA will hold an equity stake of 18.93%.

Meaning that in reality, as I noted at the outset of the deal, Glencore was basically a straw buyer–a beard–to provide the appearance of western corporate participation in the deal.

The price is also interesting:

The consideration for the Transaction attributable to Glencore’s interest in the Consortium (being 50% of the consideration for the Transaction) is approximately EUR 3.7 billion.

Well, the original December 2016 price was EUR 10.2 billion, meaning that this price is at a 25 percent discount from the original deal.

Who ate this difference?  Glencore?  I doubt it, but if it did, it would raise huge questions about its disclosures (or lack thereof) at the time of the original deal.  Regardless, this is yet another example of Glencore playing with fire.  What comes after trifecta?

I further note that whereas it was rumored that a Chinese state company would step into the shoes of CEFC, this hasn’t happened.  Yet, anyways.

Some state champion, that Rosneft, eh?

Update.  Some arithmetic.  The sums disclosed by today’s announcement basically indicate that Qatar assumed all but Glencore’s sliver at an amount equal to the original amount of the deal agreed to in December, 2016–including the mystery €2.2 billion which pretty much everybody but me and Ivan Tkachaev at RBC missed.  Qatar originally put up €2.5b, Glencore €.3b, and Intesa €5.2b, which adds up to €8b, or €2.2b short of the announced €10.2b.  The difference apparently came from as yet unnamed Russian banks, this in spite of Putin’s claim that Russian banks would not provide financing for a Rosneft “privatization.”

Today Qatar agreed to pony up €7.4b.  Add to that its original €2.5b and Glencore’s €.3b, and voila!, you have . . . €10.2b.  Miraculous, no?  Everybody remains whole!

Here’s the problem though.  Rosneft has been trading pretty much flat in RUB.  On 9 December, 2016, its share price was 370.8 RUB.  Today, it is 386.75 RUB, about 4 percent higher.  However, the RUB has depreciated about 12 percent against the EUR, going from 65.9707 to 75.155RUB/EUR.  So, in EUR terms, Rosneft is worth about 8.5 percent less than in December, 2016, but Qatar is paying the same price today as was agreed to then.

Why would Qatar do this?  Yes (as Ivan T points out to me) ~€1b is pocket change for the QIA, which has a $320b portfolio.  But still, you don’t get rich by gifting ~10 percent of deals.  So is there a side deal?

I’ve long been a Tesla–and Elon Musk–skeptic.  Indeed, I think it’s fair to say that I was one of the earliest doubters: my first posts on Tesla date to almost exactly 5 years ago–May, 2013.

Little has happened in the intervening five years to change my opinion.  Indeed, I make a conscious effort to battle confirmation bias, because most of the Tesla developments reinforce my opinion.  But no matter how hard I try to make the pro-Elon/Tesla case to myself, I come away unconvinced.

My two primary criticisms are (1) that rather than being a visionary genius who will revolutionize autos or space travel or whatever suits his fancy today, Musk is a rent seeker who has been most successful at exploiting government largesse, and (2) he is a serial exaggerator whose promises constantly–with probability one–greatly outstrip the execution.  Here I’ll focus on (2).

There are so many examples to choose from, but I’ll focus on one that I called BS on from the moment the words left Elon’s mouth: the merger of Solar City and Tesla.

The Musk narrative was that this was a strategic masterstroke, that would create a vertically integrated clean energy company: “We would be the world’s only vertically integrated energy company offering end-to-end clean energy products to our customers. This would start with the car that you drive and the energy that you use to charge it, and would extend to how everything else in your home or business is powered. With your Model S, Model X, or Model 3, your solar panel system, and your Powerwall all in place, you would be able to deploy and consume energy in the most efficient and sustainable way possible, lowering your costs and minimizing your dependence on fossil fuels and the grid.”

I ascribed a very different motive to the deal: it was intended to prevent Solar City’s bankruptcy, which would have seriously damaged Tesla’s biggest asset: Musk’s reputation as a visionary genius:

Indeed, Tesla bleeds cash like a Game of Thrones battle scene. Hence the need to rush out the Model S (and collect deposits) while huge questions about production remain. Hence the repeated returns to the equity markets to issue new stock.

Which will now be harder, because paying for Solar City in stock–and hence diluting existing shareholders substantially–mere weeks after a big equity offering will make investors to whom Musk will have to sell stock in the future to meet his voracious needs for money think twice: will he take their money then dilute them again a few weeks or months later?

This move looks very short sighted, and it almost certainly is. But Musk is doing it because he needs to address very pressing immediate concerns, and he’ll worry about the future ramifications when the future comes.

Musk has made a living off of suckers. Suckers in government (including most notably the federal government, and the states of Nevada and California) who have lavished huge subsidies based the dubious environmental benefits of electric vehicles. Suckers enamored with the technology and performance of Tesla vehicles–despite the questions surrounding Tesla’s ability to produce those vehicles.

To keep the suckers coming, Musk has to perpetuate his image as the Great and Powerful Oz. A major fail–like the bankruptcy of Solar City–threatens to pull back the curtain and demolish that image. Musk needs to prevent that from happening. He needs to buy time, and to buy time, he is having Tesla buy Solar City.

Desperate times call for desperate measures. The proposed purchase of Solar City reeks of desperation, because it facially makes no business sense, and is explicable only as a way to keep a con alive.

Enough time has passed to evaluate who was correct.  And Musk has proved me right by deeds, not words.  If the “vertical integration” argle bargle was the truth, Solar City should have expanded.  If I was correct, out of necessity Tesla would have to scale back Solar City dramatically to stem the bleeding of cash.

The latter has clearly happened.  In 1Q18, installations by Solar City are down about 65 percent since 1Q16.  Installations in 2017 were down between 17 and 57 percent from the corresponding quarter in 2016.  The business is clearly in wind-up mode.

But Tesla continues to spout the bull, and truculently at that:

“Regardless of whatever misinformation critics happen to be pushing this week, we are building the world’s first vertically-integrated sustainable energy company, and solar is an important part of that effort,” Tesla said in a statement. “Far from being a cash burden for Tesla, our solar business was actually cash flow positive in 2017, and we expect that trend to continue in 2018.”

Who you gonna believe, Tesla or your lyin’ eyes?

Although Tesla is downsizing its solar business dramatically, legacy contracts and obligations still pose a threat to the merged company.  Elon kicked the can, but it still exists.

The other example is Musk’s earlier promise to revolutionize manufacturing, by almost completely automating the production of the Model 3.   This failed utterly–as even Musk was forced to admit when he conceded that the company was in “manufacturing hell” and that he had underestimated the challenges of automation.

What he had done, in fact, was ignore the experience of the entire automobile industry, which had found decades ago through bitter trial and (mostly) error that automating assembly was impractical.  That experience showed that auto assembly is a tightly coupled process, and that a glitch anywhere in the process can cause cascading failure.  Further, it learned that greater automation exacerbated the tight coupling problem, and greatly increased the risk of such failure cascades.

But Elon knew better.  Until he found out otherwise.

Yet despite earlier expressions of humility about the automation effort, in his crazed earnings call yesterday, Elon doubled down on automation promises, pledging that the Model Y will represent a “manufacturing revolution.”  Further, he promised that this revolution would be televised in 2020–but with no capex until 2019! New model, new assembly process, new plant and equipment, all completed within a year-plus.  Even established manufacturers take years to complete the construction of facilities to build relatively conventional vehicles.

The earnings call may be a watershed–an inflection point.  Musk faced the first serious skepticism from the analyst community, and he did not handle it well.  To put it mildly.  He had what to me appears to be a meltdown at the withdrawal of his narcissistic supply.

As a result, there is widespread shock on Wall Street, and even die-hard boosters (e.g., Adam Jonas of Morgan Stanley) are clearly shaken by Musk’s performance.

This is incredibly important because the only thing that has sustained Tesla through its incessant cash burn is the willingness of the markets to fund him by buying his stocks and bonds on the basis of faith in his reputation as a visionary (the same reputation that compelled the acquisition of Solar City).  That was Tesla’s primary asset–arguably its only asset.  If that Wizard of Oz aura is removed, it is hard to see how Tesla survives.  It still needs massive amounts of cash to implement its existing promises.  It has tapped many fragile sources of funding–customer deposits, and especially, credit from suppliers who wait months to get paid–but still depends on issuing equity and debt to stay afloat.  Doubts about Musk’s competence–and arguably, his sanity–clearly jeopardize Tesla’s ability to do that.

Skepticism will also cause people to revisit Musk’s previous promises, which are almost too long to list, let alone discuss in detail.  Solar roof panels? A national charging network? Autonomous driving technology? A $35K Model 3? Semis? And on and on.

There is also the serious risk that the SEC will start to revisit those promises–AKA “forward looking statements.”  How big does N have to get until the failure to deliver on N out of N promises constitutes securities fraud?

Then there is the issue of looming competition from companies that actually know how to make automobiles.  I also find it bizarre that Tesla’s fate supposedly rests on its ability to build in volume a type of vehicle–sedans–that buyers are shunning to such an extent that established companies are fleeing the space because of low margins.  (The strong preference of American drivers for SUVs and trucks casts doubt on the supposed EV revolution more generally.)

Where do things go from here?  I am obviously bearish, but predicting timing is devilish hard in these circumstances.  The timing of a jump from a high-trust to a no-trust equilibrium is very hard to predict, but these recent events have definitely increased the probability of such a jump.

Perhaps Musk’s hole card is the fact that he owes banks hundreds of millions, collateralized by Tesla stock.  Remember the old joke about if you owe the bank $500K and you can’t pay, you have a problem, but if you owe the bank $500 mil and you can’t pay, the bank has a problem?  Well, that’s a fair summary of the situation facing Goldman, et al.  They have an incentive to prop up the stock price, or at the very least, not to become very public doubters.

Perhaps it is too early to say it is the beginning of the end for Tesla and Musk (but perhaps not).  It is clear, however, that this is the end of the beginning because it is the end of the affair.