Streetwise Professor

Igor Sechin has made a breathless announcement of a discovery of oil in the Kara Sea:

Exxon Mobil Corp. and Russia’s OAO Rosneft have found major amounts of oil and natural gas at their first well in the Arctic, Rosneft said Saturday, offering a glimpse of the potential buried beneath the ice-studded waters north of Siberia.

. . . .

“This is an outstanding result of the first exploratory drilling on a completely new offshore field,” Igor Sechin, Rosneft’s chief executive, said in a statement. Rosneft praised other western partners including Schlumberger Ltd., Halliburton Co. and Weatherford International PLC.

Sechin said the field would become the Arctic equivalent of Saudi Arabia, in terms of reserves.

To which I say: not so fast. First, this is the first well and the full analysis of the results has barely begun, let alone been completed. Second, the area is huge, and a single well cannot provide more than a rough estimate of the productivity of the entire field. Third, ExxonMobil was far more circumspect:

“We have encountered hydrocarbons but it is premature to speculate on any potential outcome regarding the University-1 exploration well,” Alan Jeffers, an Exxon spokesman, said Saturday

Fifth, even if the size of the reserves is similar to those in Saudi, the cost of getting at them, and the technological and logistical challenges of exploiting them, are far greater: even with such assistance, Arctic drilling is a fraught enterprise (just as Shell). Development and production will require the assistance of the “western partners” that Sechin praised, and that assistance is on hold for who knows how long as a result of sanctions. No doubt Perfidious Exxon will be pulling out all the stops to get the sanctions lifted, but betting on that is even more dicey than Arctic oil exploration, at the present political juncture.

But most importantly, one must heavily discount Sechin’s happy talk due to these very same political circumstances. He needs to put on a bold front to counter negative news about the company and its prospects in the aftermath of sanctions. Further, to the extent that he can convince the west that a bonanza awaits only if sanctions are eased he can increase the odds of a lifting of the sanctions. He thus has an even greater incentive to exaggerate than would normally be the case, and note that he is not operating under the same legal restrictions on making forward looking statements as a US CEO would (which could explain Exxon’s reticence, despite the fact it also would like to advance arguments that would undermine the sanctions regime).  Exaggerations therefore are basically costless, and could have a big positive payoff to the extent they are believed. All the more reason not to believe him.

Exxon’s complicity here is disturbing. Understandable, but disturbing. It is dealing with the devil, and although the deal benefits shareholders, these benefits pale with the costs resulting from bolstering a revisionist, revanchist, and expansionist gangster state, and the capos who benefit directly from it. This is a case where state action is warranted on public goods grounds.

Indeed, the more Rex Tillerson squeals, the stronger my conviction that the sanctions are a good idea. Exxon will reap only a fraction of the benefits of cooperation with Rosneft: the larger fraction will accrue to Rosneft and the Russian state, and thereby fuel its predations, and those in the power structure that are the residual claimants. In this case, what’s good for Exxon is good for Putinistan, which given the malign consequences of the latter is precisely why the former should have to suck it up.

Russia is mounting a full-spectrum offensive to grind Ukraine into the dust. Military, paramilitary, diplomatic, political, and economic.

The centerpiece of the economic campaign is, of course, gas. Today Russia’s energy minister threatened a gas cutoff to any country that resold gas to Ukraine, in violation of Gazprom’s sales contracts. Hungary immediately knuckled under.

Energy Minister Alexander Novak asserted that the re-export to Ukraine of gas Europe buys from Russia was illegal and could see some of its nations go without fuel shipments from state energy giant Gazprom for the first time since 2009.

“We hope that our European partners will stick to the agreements. That is the only way to ensure there are no interruptions in gas deliveries to European consumers,” Novak told Friday’s edition of Germany’s Handelsblatt business daily.

Novak’s comments were published only hours after Ukraine’s state energy firm Naftogaz reported an interruption of gas supplies it receives through Hungary.

Naftogaz noted that the apparent cut “came only a few days after a visit to Hungary by representatives from (Russian state gas firm) Gazprom”.

Hungarian Prime Minister Viktor Orban conceded that his country could not risk losing access to Russian gas — responsible for about 60 percent of the country’s supplies — over Ukraine.

“Hungary can not get into a situation in which, due to the Russian-Ukrainian conflict, it cannot access its required supply of energy,” Orban said on state radio.

For its part, the EU disputes Russia’s interpretation of contracts:

The European Union rapped Hungary over the supply interruption.

“There is nothing preventing EU companies to dispose freely of gas they have purchased from Gazprom, and this includes selling this gas to customers both within the EU as well as to third countries such as Ukraine,” Commission spokeswoman Helene Banner said in Brussels.

Any such contractual terms would be, literally, agreements in restraint of trade. They restrain trade between first buyers of Russian gas and others.

Sometimes  restraints enhance efficiency. That is definitely not the case here. The restrictions have one purpose, and one purpose only. To facilitate price discrimination (and hence the exercise of market power) by Gazprom and Russia. This map provides a fascinating visual demonstration of how Gazprom discriminates by price. Adjacent countries can pay dramatically different prices. More distant countries pay lower prices than ones nearer to Russia.

Much of the discrimination is purely economic. Countries with access to few alternative suppliers or few alternative energy sources pay higher prices. But much of the discrimination is political. Note that Belarus and Armenia, reliable Russian clients, pay very low prices, but Ukraine and Lithuania, which bracket Belarus, pay very high ones.

Destination clauses are necessary to maintain these big price differentials. Hence eliminating them would reduce Gazprom’s market power and profitability (though the welfare effects of 3d degree price discrimination are ambiguous) and also reduce Russia’s political leverage. With the ability to resell, those buying at a favored price could resell to those whom Gazprom wants to charge a high price. Gazprom would have to charge pretty much the same price to everyone (though since diversions are not costless it would retain some ability to discriminate, but not nearly as much, especially in the longer run as new infrastructure could be created).

Which makes it all the more bizarre that Europe, and Germany in particular, hyperventilate over far more dubious and abstract theories of market abuse by Google and Microsoft, but meekly let Gazprom run roughshod with textbook monopolist tactics. The lack of a unified energy policy, and unified energy purchasing (Europe could act as a monopsonist) allows Gazprom to play its usual divide and conquer games, of which price discrimination is one obvious result. Expediting the antitrust action against Gazprom would be another way of combating Gazprom’s malign influence.

In the current dispute the stakes are both economic and political/geopolitical. Despite the high stakes, Europe will doubtless limit its response to theoretical objections like those delivered by Helene Banner.

One (bitterly) amusing sidelight to this is despite its market power (the result of Russian law which gives it a monopoly over gas exports and of European acquiescence) Gazprom is still a horrible performer by all conventional metrics. It’s price-earnings ratio is about 3. Contrast that to Shell, Chevron, and Exxon, which have ratios of 10, 11, and 12, respectively. Performance metrics, such as value added per employee or earnings as related to reserves, are horrible.

This is a testament in large part to appalling corporate governance and the insecurity of profits and property in Russia. Speaking of which, there were several developments in the Yevtushenkov/Sistema/Bashneft story today. Yevtushenkov’s house arrest was confirmed and extended, and the Russian government seized Sistema’s Bashneft shares.

I’m never going to run out of material. Never.

Putin keeps ratcheting up the pressure on Ukraine-and the EU. In response to his earlier threats to retaliate against the beleaguered neighbor and the Europeans if they proceeded with a trade association agreement, they agreed to defer implementation of parts of the agreement for 15 months. In particular, though Europe agreed to proceed with lowering barriers on Ukrainian imports, the parties deferred lowering Ukrainian restrictions on imports from the EU to assuage Vlad.

But Vlad was not assuaged. He pocketed that concession-which the parties stated explicitly was made in response to Russian concerns-and is now demanding more:

Vladimir Putin has demanded a reopening of the EU’s recently-ratified trade pact with Ukraine and has threatened “immediate and appropriate retaliatory measures” if Kiev moves to implement any parts of the deal.

. . . .

“We still believe that only systemic adjustments of the association agreement, which take into account the full range of risks to Russian-Ukrainian economic ties and to the whole Russian economy arising from implementation of the agreement, will allow [us] to retain existing trade and economic considerations between the Russian Federation and Ukraine,” Mr Putin says in his letter.

In other words, if Ukraine lowers barriers on European goods, Russia will raise barriers on Ukrainian ones.

The ostensible Russian concern is that better and cheaper European goods will flow to Ukraine, and then on to Russia, undercutting its inefficient producers.

I have to doubt that the concerns are serious, because of country of origin provisions in Russian customs laws. Yes, it is probably true that less restricted import of European goods into Ukraine will make it easier to evade country-of-origin rules, but this hardly seems to be enough of a concern to justify Putin’s ballistic reaction.

And if the concerns are serious, it just goes to demonstrate something I’ve mentioned before: Putin’s recognition of the fundamental inferiority, greater cost, and general non-competitiveness of Russian producers.

This is probably more a political statement than an economic one. Mr. Sovereignty, who Raised Russia From Its Knees, cannot countenance Ukraine being a sovereign entity, and wants to drive it to its knees, and perhaps face down in the dirt. He cannot countenance Ukraine engaging in an independent policy that moves it closer to Europe-and civilization-and further from Russia-and Muscovite barbarism. Knowing that Russia offers nothing positive that can attract friends and allies, it has to coerce vassals.

And note the continued pattern. Putin pockets every concession intended to appease him, and then escalates. He has done that repeatedly militarily in Ukraine, and is now doing it with respect to diplomatic-economic matters involving Ukraine.

You’d think the Europeans would have figured this out by now. Hell, rats in a Skinner Box learn patterns faster than the Euroweenies. But they are so craven and clueless that they make concession after concession. And in response, smart rat that he is, Putin just keeps pushing the lever that delivers the food pellet, and is feasting away.

If the Ukrainians and Europeans cave on this latest demand, Putin will just demand more. They have to draw the line somewhere, and it might as well be here, over the Association Agreement. If they don’t, eventually the line will lie slightly east of Przemsyl.

Some months ago, Morgan Stanley agreed to sell its oil trading business to Rosneft. Now the deal is at risk of unraveling, due to the effect of sanctions on the Russian company:

Rosneft has enough cash to buy the Morgan Stanley unit, which sources said carries a price tag of between $300 million to $400 million. But to operate day-to-day, the business requires billions of dollars of bank lines of credit, funding that is difficult to secure given the sanctions.

Reuters could not learn the precise size of these credit lines, but trading houses that compete with Morgan Stanley such as Vitol, [VITOLV.UL] Mercuria and Trafigura [TRAFGF.UL] each have $30 billion to $40 billion worth of credit lines with dozens of banks.

“This deal just cannot go through. It is not an issue of finding $300 million to buy the business. Rosneft has the money. But it won’t be able to operate it,” one Russian-based source with direct knowledge of the matter said.

Trading is an extremely working capital intensive business. Depending on its size, a supertanker can carry oil worth $50 million-$300 million, and this has to be financed during the period of the voyage. A decent-sized trading operation can have several tankers on the water, plus additional oil in storage, all of which needs to be financed. A major trading operation needs access to billions in funding on a continuous basis.

Typically, traders finance this with bank credit, with the bigger ones using open lines with banks (which offer considerable flexibility). (I discuss commodity trade financing in my white paper, The Economics of Commodity Trading Firms-bonus video!) You cannot compete efficiently in this business without access to such credit/credit lines. Loss of access to credit is a death sentence to a trading firm, and one that can’t get access in the first place will never be born. That’s where Rosneft finds itself now.

This is another blow to Sechin’s (and Putin’s) aspirations to make Rosneft into a peer super major like BP or Shell or Total that have  robust trading operations. The firm’s longer term ambitions have been seriously dented by the withdrawal of western firms from deepwater and unconventional onshore drilling projects in response to sanctions.

This is also a pain for Morgan Stanley, which is under government pressure to exit the physical trading business: it’s not clear that there’s anyone with enough appetite to pay what Rosneft agreed to. But its pain is nothing compared to Rosneft’s, which will remain dependent on traders to market its oil for the foreseeable future.

Breaks me all up.

Earlier this week, Russian authorities arrested billionaire Vladimir Yevtushenkov, 64 percent owner of the Sistema conglomerates, whose holdings include the mobile operator MTS, retail interests, and . . . the independent oil company Bashneft.

Yevtushenkov was put under house arrest for alleged money laundering related to the acquisition of Bashneft. The company has its roots in the Republic of Bashkortostan, and its privatization was a dodgy affair, even by Russian standards. The company ended up under control of the son of the president of the republic, Murtaza Rakhimov. The son-Ural-is now a fugitive in the west.

But all of this is old news. The company was privatized in 2003, and Sistema acquired it in 2009. Litigation over the privatization has been going on since. So why now? Something new must have resulted in the green-lighting of the escalation of an investigation of old news.

As is always the case with Russia, there are numerous competing hypotheses, and the outcome is probably overdetermined. A leading explanation is that Sechin covets Bashneft, and made Yevtushenkov an offer he couldn’t refuse . . . which he promptly did, leading to his current predicament.

Just exactly what that predicament is is obscure, again in a typically Russian way. After a couple of days in which Yevtushenkov was supposedly unable to communicate with anyone by phone or use the internet, Sistema claimed in a press release that the house arrest had been lifted, and Yevtushenkov supposedly spoke to a journalist by phone. But the Investigative Committee denied that the house arrest had been lifted.

Sistema lawyers filed an appeal of the Investigative Committee’s actions agains the company (though apparently not Yevtushenkov) with the Prosecutor General’s Office. This is interesting-and again typically Russian-because the Investigative Committee and Prosecutor General’s Office are sworn enemies answering to different clans within the siloviki. So maybe there is a bulldogs under the carpet clan war component to this as well.

Sistema’s stock price cratered by 35 percent on news of the arrest, and the affair has sent huge shock waves through the Russian business community. Khodorkovsky flashbacks are epidemic, and many are making dire warnings about how this will accelerate capital flight, further demolish Russia’s investment climate, and worsen the already fraught economic conditions.

Which is probably all true. And Putin is perfectly aware of this, yet has permitted this to escalate nonetheless. Either because he’s especially fond of Sechin, or believes that Rosneft’s condition is sufficiently dire in the aftermath of sanctions that it needs a fillip in the form of the acquisition of a relatively progressive, technologically advanced oil producer at a knock-down price, or because he has another, more political agenda. (Note, that once Rosneft acquires it, it will cease to become a progressive, technologically advanced oil producer.) Or all the above. Plus other things.

Don’t discount the political agenda. One of the alleged purposes of the sanctions is to create an uprising of the oligarchs against Putin and the siloviki. In his paranoia, Putin almost certainly believes that’s true: he, and most of those around him, believe that the US is hell-bent on regime change in Russia.

Putin is therefore likely to interpret any disagreement by an oligarch as a challenge to his power. He may not even believe that Yevtushenkov is challenging him politically, but is afraid that a refusal to knuckle under to Sechin can be interpreted by others as an act of insubordination, which would encourage further acts of destabilizing independence unless it is punished ruthlessly. Thus, Yevtushenkov has to pay the price, pour encourager les autres.

The FT quotes many in Russia, some on the record, some anonymously, who claim that this is an indication of how sanctions are actually having the perverse effect of empowering the siloviki and destroying those who would be “friends of the West.” I think the cause and effect is mixed up here. The sanctions are the result of Crimea and Donbas, which could only happen because Putin and the siloviki reigned supreme. Putin attacked each precisely because he and the siloviki were unchecked within Russia: the “liberal” elements in the Russian elite, such as they were, had been kicked to the curb long ago. One can date the definitive decline of the moderate, economy-oriented elements in the elite to Putin’s decision to resume the presidency. Since then the trajectory of repression, revanchism, paranoia, and statism within Russia has been unmistakable. At most, sanctions have accelerated what was an unmistakable and inexorable trend.

I still shake my head at the silly commentaries that were so common at the time of the Putin restoration to the effect that he would have to-have to!-reform and adopt moderate policies in order to rejuvenate Russia’s sputtering economy. Talk about projection and mirror imaging. Nothing of the sort was ever in prospect.

Even overlooking the fact that aging leopards don’t change their spots, Putin’s mental model of the economy does not associate moderate liberal or “neoliberal” actions with economic progress. He is a statist enamored of national champions controlled from the center.  He also distrusts biznessmen outside of his control who could get uppity and pose a political challenge: why do you think that one of his first priorities upon assuming the presidency the first time was to liquidate the oligarchs as a class, and why would you think that he would countenance their renaissance? Thus, both economic and political reasons compelled Putin to move in the exact opposite direction that fuzzy headed, mirror-gazing commentators recommended in 2012-2013. That was happening before the sanctions, and would have continued even if sanctions had never been imposed.

Those of a dialectical turn of mind, or who believe in “the worse, the better”*, might find reasons to welcome any acceleration of the perfection of Putinism, and therefore welcome any tailwinds provided by sanctions. The sooner this happens, the more rapidly the internal contradictions of his economic and political models will become manifest, and lead to his demise. Not that what will replace Putin and Putinism are likely to be anything that would bring a smile to Adam Smith’s face. The Who-meet the new boss, same as the old boss-is likely to be the best guide to a post-Putin Russia. If we ever get there.

That is, the Yevtushenkov affair is just another day in Putinistan. A continuation, not a change in course. If you’re surprised, it only means that you haven’t been paying attention or were too busy projecting.

*This phrase is widely attributed to Lenin, but there is no definitive citation. The concept is found in a novel by Nikolay Chernyshevsky which allegedly influenced Lenin.

This is so amusing, because it is so typical:

Russian Energy Minister Alexander Novak will meet OPEC officials on Tuesday in Vienna, his spokeswoman said, as oil’s price fall piled pressure on Moscow’s budget.

The annual meeting had been planned long before oil fell below the $100 per barrel level critical for Russia’s oil sales which account for 40 percent of state budget revenues.

Russia suffered from a decline of oil production and prices this year and has cut its outlook for oil output as core western Siberian fields become more depleted.

The spokeswoman said that Novak and the officials from the Organization of the Petroleum Exporting Countries had not planned to discuss the prices of oil, which hit 26-month low for Brent crude on Monday.

However, a government source said the measures to prop up the prices have long been discussed at the ministry.

“The talk of closer cooperation with OPEC on prices have long been there,” he said.

So far, Russia, the world’s top producer of conventional oil, has ruled out coordinated action with OPEC to halt the price decline.

Yeah. Novak is scurrying to Vienna, but he’s not going to talk prices. Sure. Tell me another one, but not so funny as I just busted a gut reading that and can’t take too much more.

Putin, Inc. is no doubt in a mild-to-moderate panic at present because Brent has breached $100, and Urals is below that, in the low $90s. Russia needs Urals in the $104 range to meet budget targets, and that’s not counting Crimea or especially a war that doesn’t officially exist but which costs real money to fight.

So off Novak runs to Vienna, in an attempt to get OPEC to prop up the price. Not that Russia will do anything to help, mind you. It’s MO has long been to demand, beg, cajole OPEC to cut output to support prices, while Russia produces to capacity. That’s what Russia did in 2009 when prices cratered into the $30s. OPEC was not amused then, and they won’t be amused now.

If anything, geopolitical considerations, namely Russia’s support of Assad and cooperation with Iran, will make the Saudis in particular even less generously inclined towards Russia.

Meaning that Novak’s mission to Vienna will accomplish nothing, except to provide an entertaining example of Russian all take, no give negotiating style.

There’s an old joke about a pet food manufacturer that mounts an all out marketing campaign for its new brand of dog food. It pulls out all the stops. Celebrity endorsements. Super Bowl Ad. You name it. But sales tank. The CEO calls the head of marketing onto the carpet and demands an explanation for the appalling sales. The marketing guy  answers: “It’s those damn dogs. They just won’t eat the stuff.”

That joke came to mind when reading about the CFTC’s frustration at the failure of SEFs to get traction. Most market  participants avoid using central limit order books (CLOBs), and prefer to trade by voice or Requests for Quotes (RFQs):

“The biggest surprise for me is the lack of interest from the buyside for [central limit order books or CLOB],” Michael O’Brien, director of global trading at Eaton Vance, said at the International Swaps and Derivatives Association conference in New York. “The best way to break up the dual market structure and boost transparency is through using a CLOB and I’m surprised at how slow progress has been.”

About two dozen Sefs have been established in the past year, but already some of these venues are struggling to register a presence. Instead, incumbent market players who have always dominated the swaps market are winning under the new regulatory regime, with the bulk of trading being done through Bloomberg, Tradeweb and interdealer brokers including Icap, BGC and Tradition.

“It’s still very early,” Mr Massad told the FT. “The fact that we’re getting a decent volume of trading is encouraging but we are also looking at various issues to see how we can facilitate more trading and transparency.”

Regulators are less concerned about having a specific numbers of Sefs since the market is still sorting out which firms can serve their clients the best under the new regulatory system. What officials are watching closely is the continued use of RFQ systems rather than the transparent central order booking structure.

Not to say I told you so, but I told you so. I knew the dogs, and I knew they wouldn’t like the food.

This is why I labeled the SEF mandate as The Worst of Dodd Frank. It was a solution in search of a non-existent problem. It took a one-sized fits all approach, predicated on the view that centralized order driven markets are the best way to execute all transactions. It obsessed on pre-trade and post-trade price transparency, and totally overlooked the importance of counterparty transparency.

There is a diversity of trading mechanisms in virtually every financial market. Some types of trades and traders are economically executed in anonymous, centralized auction markets with pre- and post-trade price transparency. Other types of trades and traders-namely, big wholesale trades involving those trading to hedge or to rebalance portfolios, rather than to take advantage of information advantages-are most efficiently negotiated and executed face-to-face, with little (or delayed) post-trade price disclosure. This is why upstairs block markets always existed in stocks, and why dark pools exist now. It is one reason why OTC derivatives markets operated side-by-side with futures markets offering similar products.

As I noted at the time, sophisticated buy siders in derivatives markets had the opportunity to trade in futures markets but chose to trade OTC. Moreover, the buy side was very resistant to the SEF mandate despite the fact that they were the supposed beneficiaries of a more transparent (in some dimensions!) and more competitive (allegedly) trading mechanism. The Frankendodd crowd argued that SEFs would break a cabal of dealers that exploited their customers and profited from the opacity of the market.

But the customers weren’t buying it. So you had to believe that either they knew what they were talking about, or were the victims of Stockholm Syndrome leaping to the defense of the dealers that held them captive.

My mantra was a diversity of mechanisms for a diversity of trades and traders.  Frankendodd attempts to create a monoculture and impose a standardized market structure for all participants. It says to the buy side: here’s your dinner, and you’ll like it, dammit! It’s good for you!

But the buy side knows what it likes, and is pushing away the bowl.

The European Commission’s competition commissioner has scuppered a proposed settlement with Google. The Commission has already taken many pounds of flesh from Microsoft and Intel over the past year, so now it is looking to add some Google cuts to the meat locker.

What about the EU’s case against Gazprom, you ask? <Crickets.>

I’m not a big Google or Microsoft fan, but the accusations leveled against them (and Intel) are highly speculative. Gazprom’s exercise of market power, and its protection of that market power, is almost textbook. The egregious price discrimination, and its use of contractual terms (no re-sale) to support that discrimination, is a blatant example. So on the merits, the Gazprom case should proceed and the Google case should be settled, and on anything but onerous terms.

But the craven Euros quake before Gazprom. Indeed, they seem to be even less willing to confront the company now that Putin is on the war path.

They have a better case against Gazprom, and that case could be a political lever in what is an existential battle over European security: Putin and the Russians have ranted and raved about the case when the Euros did press it some, which indicates that it hits the company, and hence Russia, where it hurts.  But rather than hitting this pressure point, the Euros bury the case and go kick Google instead.

Don’t think that Putin doesn’t notice. And know that it is exactly this kind of cowardice that emboldens him.

It looks like Igor may get his money:

Allocation of over $40 billion from Russia’s National Welfare Foundation for Rosneft oil giantcould be reasonable, as the investment will be repaid, Russian Prime Minister Dmitry Medvedev said in an interview to the Vedomosti newspaper, released Monday.

“This number only seems so impressive, but this is not [supposed to be repaid] within a year,” Medvedev said, answering a reporter’s question on whether Rosneft’s request for $40 billion is feasible.

“The company needs to keep up production, since Rosneft is a major contributor to the budget. In this regard, we have to help them by maintaining the investment level,” Medvedev explained, adding that the government is considering specific ways of aiding Rosneft.

Now, this is Medvedev speaking, so take it for what it’s worth. But it’s my impression that lately Dmitri’s designated role is ventriloquist’s dummy, and if you looked closely you can probably see Putin’s lips moving. This is at least a trial balloon, and perhaps it is laying the groundwork for an official announcement. It is sufficiently controversial within the Russian government that Putin probably does not want to act precipitously and is putting Medvedev out there to see if the proposal attracts too much fire.

This statement likely reflects a couple of realities. First, Sechin’s influence with Putin. The second is the effect of sanctions. Although the EU and US sanctions have not been as draconian as they might be, the FUD factor has worked. Western capital markets and banks are largely shut to Russian companies, especially those subject to sanctions (like Rosneft). Rosneft has maturing debt to refinance, and as Medvedev says, it needs to invest to maintain production.

Output dropped 1.3 percent in August, as the productivity of western Siberian fields continues to drop as they age.

In another indication of the stress that it is facing, Rosneft (and thus Putin/Russia) actually agreed to let China invest in Russian oil fields on terms never extended to a western firm. The Chinese can bring capital, but not the expertise and technology that Rosneft needs to develop the challenging resources on which has staked its future. And the Chinese usually drive a hard bargain. So even with state money, Rosneft will struggle to achieve anything like the lofty ambitions that Sechin has laid out.

The state money will buy some time for Rosneft. Presumably Putin and Sechin are hoping that the state money will get them through the sanctions, which they likely anticipate will fade away in the near-to-medium term. But the FUD factor will continue to limit Rosneft’s access to western capital and western technology. Yes, energy firms and banks will come back if and when sanctions go away, but on terms that will be far less favorable than had been available pre-Ukraine. Putin’s unpredictability has dramatically raised the political risks of investing in Russia, especially in the energy sector.  Future capital will come with strings, and will be reluctant to invest in long term projects that could fall victim to Putin’s next adventure.

In other words, if Putin indeed permits Rosneft to dip deeply into the National Welfare Fund, it will be an acknowledgement that Russia has burned its bridges with western finance and technology.

A lot of CFTC news lately. Much of it involves the agency, under new chairman Timothy Massad, dealing with the consequences of Frankendodd and the overzealous efforts of his predecessor Gary Gensler to implement it.

One of Massad’s priorities relates to clearinghouses (CCPs):

CFTC Chairman Timothy Massad said in a Sept. 5 interview that his agency will bolster examinations of clearinghouses, which process trillions of dollars in transactions and are potentially vulnerable to market shocks or cyber attacks. The agency is working with the Federal Reserve on the effort, he said.

New rules requiring banks and other firms to use clearinghouses owned by LCH.Clearnet Group Ltd., CME Group Inc. (CME) and Intercontinental Exchange Inc. (ICE) have been “a great thing” and have helped regulators “monitor and mitigate risks, but it doesn’t eliminate risk,” according to Massad.

“We’ve got to be very focused on the health of clearinghouses,” he said.

It’s nice to see that the CFTC, as well as prudential regulators, recognize that CCPs are of vital systemic importance. But as I’ve said many times, on four continents: In a complex, interconnected financial system, making CCPs less likely to default  does not necessarily increase the safety of the financial system. Making one part of the system safer does not make the system safer. It can prevent one Armageddon scenario, but increase the likelihood of others.

Gensler babbled repeatedly about the clearing mandate reducing the interconnectedness of the financial system. In fact, it just reconfigures the interconnections. The very measures that are intended to ensure CCPs get paid what they are owed even in periods of crisis can redirect crushing stresses to other vulnerable parts of the financial system. CCPs may end up standing, surrounded by the rubble of the rest of the financial system.

CCPs are deeply enmeshed in a complex web of credit and payment relationships. Mechanisms intended to reduce CCP credit exposure-multilateral netting, high initial margins, rigorous variation margining-feed back into other parts of that web.

There are so many interconnected parts. Today Risk ran an article about how LCH relies heavily on two settlement banks, JPM and Citi. Although LCH will not confirm it, it appears that these two banks process  about 85 percent of the payments between clearing members and LCH. This process involves the extension of intraday credit. This creates exposures for these two big SIFIs, and makes the LCH’s viability dependent on the health of these two banks: if one of them went down, this could cause extreme difficulties for LCH and for the clearing members. That is, OTC derivatives clearing adds a new way in which the financial system’s health and stability depend on the health of big banks, and creates new risks that can jeopardize the health of the big banks.

So much for eliminating interconnectedness, Gary. It’s just been moved around, and not necessarily in a good way.

Again, mitigating systemic risk requires taking a systemic perspective. The fallacy of composition is a major danger, and a very alluring one. The idea that the system gets safer when you make a major part of it safer is just plain wrong. The system is more than just the sum of its parts. Moreover, it can actually be the case that making one part of the system stronger, but more rigid, as clearing arguably does, makes the system more vulnerable to catastrophic failure. Or at least creates new ways that it can fail.

Another issue on Massad’s plate is addressing the conflict between his agency and Europe on giving regulatory approval to each other’s CCPs. It looks like this issue will not get resolved by the drop dead date in December. This will result in substantially higher costs (primarily in the form of higher capital requirements and higher margins), the fragmentation of OTC derivatives markets, and greater counterparty concentration (as US firms avoid European CCPs and vice versa).

The CFTC is also trying to fix its fundamentally flawed position limit proposal, and particularly the defective, overly restrictive, and at times clueless hedging exemptions. Mencken defined Puritanism as “The haunting fear that someone, somewhere, may be happy.” The CFTC’s hedging exemption, as currently constituted, reflects a sort of financial Puritanism: “The haunting fear that someone, somewhere, may be speculating.” To avoid this dread possibility, the exemptions are so narrow that they eliminate some very reasonable risk management strategies, such as using gas forwards to hedge electricity price exposures.

This has caused an uproar among end users, including firms like Cargill that have been hedging since the end of the freaking Civil War. Perhaps their survival suggests they might know something about the subject.

In the “be careful what you ask for” category, the CFTC is wrestling with a very predictable consequence of one of its decisions. In an attempt to wall off the US from major shocks originating overseas, the Gensler CFTC adopted rules that would have subjected foreign firms dealing with foreign affiliates of US banks to US regulations if the parents provided guarantees for those affiliates. Foreign firms definitely didn’t want to be subjected to the tender mercies of the CFTC and Frankendodd regs. So to maintain this business, the parents stripped away the guarantees.

Problem solved, right? The elimination of the guarantee would eliminate a major potential channel of contagion between the dodgy furriners and the US financial system, right? That was the point, right?

Apparently not. The CFTC has major agida over this:

Timothy Massad, the new CFTC chairman, said in an interview he is concerned aboutrecent moves by several large Wall Street firms to sidestep CFTC oversight by changing the terms of some swap agreements made by foreign affiliates.

“The concern has always been that activity that takes place abroad can result in the importation of risk into the U.S.,” Mr. Massad said. He said there is a concern that a U.S. bank’s foreign losses would ultimately find their way to U.S. shores, infecting the parent company in possibly destabilizing ways.

. . . .

The moves mean any liability for those swaps lies solely with the offshore operation, which the banks have said will protect the U.S. parent from contagion. Yet without that tie to the U.S. parent, the contracts won’t fall under U.S. jurisdiction and so won’t be subject to strict rules set by the 2010 Dodd-Frank financial-overhaul law, including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms [i.e., the SEF mandate].

By de-guaranteeing, the US banks have eliminated the most direct channel of contagion from over there to over here. But apparently the CFTC is worried that unless its regulations are followed overseas, there will be other, albeit more indirect, backdoors into the US.

In essence, then, the CFTC believes its regulations are by far superior to those in Europe and elsewhere, and that unless its regulations are implemented everywhere, the US is at risk.

Not too arrogant, eh?

A few observations should make you question this arrogance, and in a  big way.

First, note that the most likely effect of the CFTC getting its way of exporting its regulations into any transaction and any entity involving any affiliate of a US financial institution is that foreign entities will just avoid dealing with any such affiliate. This will balkanize the global derivatives market: ‘mericans will deal with ‘mericans, and Euros with Euros, and never the twain shall meet. This will likely result in greater counterparty concentration. Such developments would create systemic vulnerabilities, and even though the direct counterparty credit channel could not bring that risk back to US banks, the myriad other connections between foreign banks and American ones would.

Second, note the last sentence of the quoted paragraph: “including requirements that contracts historically traded over the telephone be traded publicly on U.S. electronic platforms.” So apparently attempts to avoid the SEF mandate infuriate the CFTC. But the SEF mandate has nothing to do with systemic risk. For this reason, and others, I named this mandate “The Worst of Frankendodd.” But so intent is the CFTC on pursuing this systemically irrelevant unicorn that it is questioning moves by US banks that actually reduce their exposure to problems in foreign markets.

Timothy Massad has the unwelcome task of cleaning up after the elephant parade at the Dodd, Frank & Gensler Circus. Clearing mandates, coordinating with overseas regulators, position limits, and the elimination of affiliate guarantees are only some of the things that he has to clean up. I hope he’s got a big shovel and a lot of patience.