Streetwise Professor

Russian government officials and Duma members  have threatened that if the US and/or EU impose financial sanctions in response to Crimea/Ukraine, Russian corporates will just default on their debt:

A Kremlin aide warned last week that Moscow might refuse to pay off loans to U.S. banks as a retaliation measure against sanctions.

Mikhail Yemelianov from pro-Kremlin party A Just Russia went even further: “If they (the West) freeze our assets, then our companies could stop paying foreign debts. The Russian corporate debt exceeds $700 billion”.

Please.

Banks don’t lend to Russia in large sums on an unsecured basis.  One of the things that caused Putin to freak out in 2008-2009 was that Russian companies (notably Deripaska’s Rusal) had pledged stock as collateral against loans.  Putin got Russian government banks (Sberbank, VTB) to extend credit to these companies so they could pay off the loans to western banks, thereby preventing them from defaulting and having large blocks of shares pass out of Russian hands.

I don’t know about all $700 billion of Russian debt, but I do know a bit about loans to one company mentioned in the linked article: Rosneft.

Rosneft borrowed upwards of $10 billion to finance the TNK-BP acquisition.  The structure of the borrowing shows just how dodgy even the biggest, most politically connected, state enterprises are viewed by western banks.

The loans were structured as prepays, and included trading firms Glencore, Vitol, and Trafigura as part of the structures.  Rosneft entered into off-take agreements with the trading firms that obligate the Russian company to deliver oil to them over the next several years.  The trading firms will then sell the oil, and send the receipts from the sales to the lending banks, thereby paying off the loans.  That is, the banks do not trust Rosneft to pay.  Rosneft never touches the money from the oil sales.   It goes from the trading companies directly to the banks.

In other words, Rosneft’s oil is security for the loans.  And as I noted when the deals were done, real supermajors (as opposed to pretend ones) don’t have to pledge such security in order to borrow.

So what would happen if Rosneft carries through on Yemelianov’s threat?

The only way to do that would be to default on the off-take agreements, i.e.,  to fail to deliver the contracted volumes to  Vitol et al.

Good luck with that.  The second Rosneft fails to deliver on the off-takes, and tries to sell  cargoes pledged to the trading companies on the open market, the trading companies will take legal measures to seize those cargoes to enforce their legal rights.  Knowing that, no buyer in his right mind will contract with Rosneft once it has stiffed Vitol, Glencore, and Traf.  Meaning that Rosneft cannot just walk away from its debt, if it ever wants to export a barrel of oil ever again.

In Rosneft’s case, therefore, the threat to walk away is an empty one.  The banks and trading companies have seen to that in the way the deals are structured.  Precisely because they don’t trust Russian companies enough to lend on an unsecured basis.

I don’t know the structure of every loan provided by western banks to Russian corporates.  But the structure of the Rosneft loans tells you that the banks have zero trust with Russian companies, and demand some form of security against the credit extended: the form of security will vary by the borrower and type of loan.  Meaning that Russian corporates that attempt to retaliate against sanctions by defaulting on obligations to western creditors will suffer major, major pain.

So I say: call the Russians’ bluff.  Impose sanctions.  If Putin forces Russian companies to default in response, they-and he-will pay a far higher cost than anything inflicted on the nations sanctioning Russia.

German utilities claim to be developing work-arounds that would provide Ukraine with gas in the event Russia cuts off supplies due to non-payment, or as part of an economic war against Ukraine.

Now Germany’s major energy utility companies are developing strategies to help Ukraine fill the shortfall if Moscow decides to cut gas supplies. Companies including RWE and E.on are working on plans to supply Ukraine with weeks’ worth of gas.

Currently, Ukraine taps around half of it gas needs from Russia. But last Friday, Russian Gas monopolist Gazprom threatened to suspend deliveries to Ukraine if the country doesn’t pay its outstanding February bill of €1.7 billion ($2.35 billion).

In an emergency, the flow through Europe’s pipelines could simply be reversed, with gas getting pumped from German reservoirs through the Czech Republic and Slovakia directly to Ukraine. Following this year’s especially mild winter, Germany’s reservoirs are much fuller than usual. Even long-term deliveries would be conceivable at the moment.

Ukraine already signed a framework agreement in 2012 with RWE to make the gas deliveries possible. Under the contract, the company has committed itself to delivering up to 10 billion cubic meters of gas per year to Ukraine, which the country was going to use this summer to fill its reservoirs for the coming winter. But RWE executives say they could provide deliveries much sooner.

RWE currently draws its gas from Norway or the Netherlands, both major suppliers in Western Europe. It would also be possible to redirect Russian gas from the Nord Stream Baltic Sea pipeline — which connects Russia and Germany — through pipelines in the Czech Republic and Slovakia to Ukraine.

Color me skeptical.

The article notes that there are clauses in the contracts with Gazprom that preclude redirection of supplies, but the German utilities claim these are readily circumvented: given that gas in German storage reservoirs comes from multiple sources, how  could Gazprom prove its gas has been redirected?

But this is based on the naive view that Gazprom’s sole (or even preferred) recourse against German supply of Ukraine would be to file a legal action.  It could decide instead to retaliate for German shipments of gas to Ukraine by shutting off gas flowing on the Nordstream and Yamal pipelines. Given no gas would be flowing to Germany via Ukraine, if Gazprom did so the German companies would soon be drawing down their stocks rather heavily and be vulnerable to Gazprom’s  tender mercies going forward.

Would they really be willing to take that risk on behalf of Ukraine?

And there is also the matter of the huge political pressure Russia would exert on Germany if RWE and E.on were to attempt such a thing. After all, former Chancellor Gerhard Schroeder chairs the Nordstream board and still exercises considerable influence in Germany, and Germany has proven quite vulnerable to Russian pressure in the past.  Numerous German businesses would be importuning Merkel not to antagonize Russia.

I strongly suspect that this “plan” and the article about it have been created and planted to give Merkel and Steinmeier political cover: “See! We are doing something to help Ukraine.”  But if called upon to perform on their promises, I would expect the Germans to fold like a cheap suit in the face of Russian threats to cut off gas.  And Putin is playing for keeps here.  Don’t think for a moment he won’t do it even though he would incur a greater economic cost than the Germans (and other European consumers of German gas).

And remember, gas is not the only lever.  Coal is the major alternative to gas, but Germany (and also the UK, to an even greater degree) get a large fraction of their coal supplies through Russia.   This is a real game of chicken, and I am not putting my money on the Germans.

That’s because based on experience, and my perception that Germany is trying to get short run political benefits by dispelling serious doubts about its commitment to Ukraine, I do not consider the proposed plan to be very credible.  Just as the French (and British) made promises to the Poles in 1939, and then left them hanging when Poland called on them to deliver, I think there is a strong possibility that these German promises will be of the piecrust variety: easily made, easily broken.

In other words, Ukraine should not base its plans on the assumption that Germany has its back on gas, or anything else for that matter.

Matt Leising has an interesting story in Bloomberg about a consortium of insurance companies that will offer an insurance policy to clearinghouses that will address one of the most troublesome issues CCPs face: what to do when the waterfall runs dry.  That is, who bears any remaining losses after the defaulters’ margins, defaulters’ default fund contributions, CCP capital, and non-defaulters’ default fund contributions (including any top-up obligation) are all exhausted.

Proposals include variation margin haircuts, and initial margin haircuts.  Variation margin haircuts would essentially reduce the amount that those owed money on defaulted contracts would receive, thereby mutualizing default losses among “winners.”  Initial margin haircuts would share the losses among both winners and losers.

Given that the “winners” include many hedgers who would have suffered losses on other positions, I’ve always found variation margin haircutting problematic: it would reduce payoffs precisely in those states of the world in which the marginal utility of those payoffs is particularly high.  But that has been the industry’s preferred approach to this problem, though it has definitely not been universally popular, to say the least.  Distributive battles are never popularity contests.

This is where the insurance concept steps in.  The insurers will cover up to $6 to $10 billion in losses (across multiple CCPs) once all other elements of the default waterfall-including non-defaulters’ default fund contributions and CCP equity-are exhausted.  This will sharply limit, and eliminate in all but the most horrific scenarios, the necessity of mutualizing losses among non-clearing members via variation or initial margin haircutting.

Of course this sounds great in concept.  But one thing not discussed in the article is price.  How expensive will the coverage be?  Will CCPs find it sufficiently affordable to buy, or will they decide to haircut margins in some way instead because that is cheaper?

As I say in Matt’s article, although this proposal addresses one big headache regarding CCPs in extremis, it does not address another major concern: the wrong way risk inherent in CCPs.  Losses are likely to hit the default fund in crisis scenarios, which is precisely when the CCP member firms (banks mainly) are least able to take the hit.

It would have been truly interesting if insurers would have been willing to share losses with CCP members.  That would have mitigated the wrong way risk problem.  But the insurers were evidently not willing to do that.   This is likely because they are concerned about the moral hazard problems.  Members would have less incentive to mitigate risk if some of that risk is offloaded onto insurers who don’t influence CCP risk management and margining the way member firms do.

In sum, the insurers are taking on the risk in the extreme tail.  This of course raises the question of whether they are able to bear such risk, as it is likely to crystalize precisely during Armageddon Time. The consortium attempts to allay those concerns by pointing out that they have no derivatives positions (translation: We are not AIG!!!)  But there is still reason to ponder whether these companies will be solvent during the wrenching conditions that will exist when potentially multiple CCPs blow through their entire waterfalls.

Right now this is just a proposal and only the bare outlines have been disclosed.  It will be fascinating to see whether the concept actually sells, or whether CCPs will figure it is cheaper to offload the risk in the extreme tail on their customers rather than on insurance companies in exchange for a premium.

I’m also curious: will Buffett participate.  He’s the tail risk provider of last resort, and his (hypocritical) anti-derivatives rhetoric aside, this seems like it’s right down his alley.

There’s a lot of talk about exploiting the US energy boom to undermine Putin and Russia.  This boom may have profound effects in the long run, but there is nothing that can be done now that can materially harm Putin in to punish him for his anschluss in Crimea, or subsequent aggressive moves he may make.

Yes, the US restrictions on exports of natural gas and crude oil are economically idiotic, even absent geopolitical considerations.  But even if those bans were eliminated tomorrow (a huge if, given he who sits in the White House-or golfs in Key Largo, as the case may be) Europe’s energy situation would not change one whit.

It would be possible to start moving large quantities of crude if the export ban were lifted, but this would be largely offset by a decline in US exports of refined products.  A major effect of the ban is to distort where crude is refined, not the total supply of crude and refined products (especially in the short run).  The major effect of the ban at present is to benefit US refiners who refine crude that is selling at below world prices because of the ban and export the products.  One study estimates that eliminating the ban would drop world oil prices by cents not dollars.

With respect to natural gas the situation is even less favorable.  Even if DOE granted all pending LNG export licenses, it will be years before product will start flowing.  Cheniere received the first license, in May, 2011, and its facility will not come on line until late-2015 at the earliest.  The company had a head start because it was converting an existing facility built to import LNG: other facilities will take longer to build because they are starting from scratch.

The long run impact of eliminating the export ban depends on the elasticity of supply of gas in the US.  If it is very elastic at current price levels, then yes, once the ban is lifted world prices will fall substantially, and Russia will be hit hard by that.  If supply is less elastic, the impact will be far smaller.  The elasticity of supply will depend crucially on technological factors, including the suitability of new formations to fracking and horizontal drilling, the depletion rates of wells, and the rate of technological innovation.  All of these factors are quite uncertain, and if the experience of the past decade says anything, it says be leery about making predictions about natural gas supply.

In brief: US energy export policy is stupid, but fixing the stupidity will have no appreciable impact on Russia for years.

Similarly, fixing stupid European policies on energy (e.g., fracking bans, massive renewables subsidies like Energiewende) should be done for reasons independent of geopolitics, and even if done tomorrow will have no material impact on European energy prices or Russian energy revenues for years to come.

The main way to impose substantial costs on Russia today via energy would be to impose trade sanctions.  Given the fact that the oil market is essentially global in scope, and that coordinating a global boycott of Russian oil would be virtually impossible, natural gas is a more feasible target.  Europe could boycott Russian gas  unilaterally, and there is no effective way for Russia to sell that gas to Asia or anywhere else.

There is a substantial asymmetry here.  Russia depends heavily on gas exports.  Approximately 25 percent of the Russian government’s revenue comes from Gazprom. The knock on effect on the Russian economy would likely be huge, as severe fiscal constraints would likely put substantial strains on the Russian banking system.

Yes, Europe would be hurt by higher prices and lower consumption of gas.  But gas comprises a far lower percentage of European expenditures than it does of Russian income, meaning that the hit on Europe would be far smaller.  Moreover, some of the impact could be mitigated by substantially increasing coal imports, increased Norwegian production, and some diversion of LNG from Asia to Europe, especially to the UK (which has excess LNG import capacity and could use LNG to displace North Sea gas which it could then pipe to Europe).   Moreover, winter is ending, and the cost of a supply interruption in the spring and summer would be far less than the cost in the winter.

But I doubt that is going to happen, because of another asymmetry.  The asymmetry in political will.  Old Europe has no stomach for a confrontation with Putin over Crimea, Ukraine, or much of anything else. (And yes, Donald Rumsfeld was an a$$hole-a claim I can vouch for based on family experience-but the Old Europe vs. New Europe formulation does capture an essential truth, especially where Russia is involved.) This lack of intestinal fortitude means that Old Europe-and especially Germany-is unwilling to pay any price to punish Putin.  Talk is free, and that’s all they are willing to pay.

And don’t think for a moment that Putin hasn’t based his plans on exactly that calculation.

In an attempt to scare off any attempt at sanctions, Russia has threatened retaliation: Lavrov has told Kerry any such moves will “boomerang.”  Other Russian officials have said that Russia can insulate itself from the west, thereby making it immune to any sanctions.

The retaliation that has been threatened includes expropriation of the assets of western companies.  A quite predictable Russian reaction, and typically self-destructive.  Any such expropriation would just cement Russia’s reputation as a lawless country where foreign investors rush in where angels fear to tread.  Russian equity valuations would crater, and direct investment would too.  Capital flight would accelerate.  The costs inflicted on Russia would dwarf those inflicted on the US and Europe, and would last for years.

Other that that, a great plan!  Another major asymmetry: any Russian retaliation would harm Russia far more than Europe or the US.  Some boomerang.

It reminds me of the old joke about the genie who grants the muzhik one wish, with one condition: anything the muzhik wishes for he gets, but his neighbor gets double. The muzhik thinks for a minute, then says: “I wish that you pluck out one of my eyes.”

All that said, I do not think that economic sanctions in the form of boycotting Russian energy or other exports, or cutting off imports (e.g., of drilling equipment) are the most effective, or the least costly, way of imposing costs on Putin and the elite on whom he depends. As I have said since Georgia, 2008, the best way to attack Putin and the elite is to go after their money in the west. (This policy is getting widespread publicity now.  I will lay claim to being a very early advocate.)

Such a measure is targeted on those who make the decisions, rather than Russia and Russians generally: as such, it could not be used by Putin to claim that the west was waging a war on Russia.  Indeed, it could undermine his political support not just among the elite who would be paying the price for his adventures, but among the broader population who are already disgusted by corruption and who would be unlikely to have any sympathy for that corruption being exposed, and the ill-gotten gains being seized.  The cost on western economies would very small indeed.  It would represent a victory for the rule of law.

But this would impose some costs on some very connected people in the west.  Moreover, precisely because it would strike so deeply at Putin it would cause him to lose his sh*t, and fear of that causes the Euros to shrink away from it in terror.

But this is something the US can pursue unilaterally.  Yes, given that most dirty Russian money is in Europe or the Caribbean, these measures would be much more effective if the Europeans participated. But the US still can wield considerable power (note how it forced Switzerland to heel on tax issues-not something that I agree with, btw, just pointing out that the US has leverage) and indeed, the mere threat of exposing what it uncovers could make the Europeans think twice.

But again, there is a lack of will.  Hope drives policy: “If we concede Crimea to Putin, he will stop.”

In sum, there is a powerful policy tool at our disposal.  A far better tool than is available in most such circumstances.  Other tools (sanctions) are more costly.  Yet other supposed tools-increasing US energy exports-are chimerical.

If we’re serious, we’ll use it.  But I have my doubts that we’re serious. If Europe (and to a lesser degree the US) has demonstrated anything in recent years, it is that they are past masters at kicking the can.  Crimea, Ukraine, and Putin are likely to be just another can.

Major banks are having major concerns about the risks associated with CCPs in the aftermath of a failure of  a Korean brokerage firm that resulted in the mutualization of losses on the KRX.  The firm failed due to a fat-finger error (puts? calls? whatever!) and its margins were insufficient to cover its trading losses.

This experience is making CCP member firms re-evaluate the risks of CCPs, the risk controls implemented by CCPs, and the incentives of CCPs to control risk.   They realize that CCPs do not eliminate counterparty risk so much as redistribute it.  They are concerned about the incentives that CCPs have to manage those risks unless they have substantial exposure to them (“skin in the game”).

But here’s the thing.  This particular sequence of events is exactly what CCPs are best suited to handle: the insuring of idiosyncratic risks.  In this instance, the idiosyncratic risk was an random operational error at a single brokerage.

But that’s not why the G20 advocated clearing mandates.  The G20 went down the clearing path to mitigate systemic risk, which occurs when a shock hits many institutions simultaneously.  That is a very different beast indeed.

If banks lie awake at night worrying about the incentives of CCPs to mitigate idiosyncratic risks, they should never sleep ever if they think about systemic risk.  CCPs are ill-adapted to handle systemic risk precisely because risk pooling/diversification works for idiosyncratic risks, but not systematic ones.

Put differently: the failure of the Korean brokerage did not create a wrong way risk.  The failure did not cause a hit to the default fund when the non-defaulting members were under financial strain.  But defaults that occur during a crisis situation are laden with wrong way risk: losses are mutualized precisely when the members of the default fund are least able to bear them.

So if banks are concerned about the potential for a CCP failure in response to a bad realization of an idiosyncratic risk, think about the appropriate level of concern about the viability of CCPs in response to systematic risks.

A bite of kimchi can have a truly bracing effect. Would that regulators around the world take heed of the lessons of recent events from the land of kimchi.

And now for something completely different . . . finance.  (More Russia/Ukraine later.)

The Bank of England wants to put a stay on derivatives contracts entered into by an insolvent bank, thereby negating some of the priorities in bankruptcy accorded to derivatives counterparties:

he U.K. central bank wants lenders and the International Swaps and Derivatives Association Inc., an industry group, to agree to temporarily halt claims on banks that become insolvent and need intervention, Andrew Gracie, executive director of the BOE’s special resolution unit, said in an interview.

“The entry of a bank into resolution should not in itself be an event of default which allows counterparties to start accelerating contracts and triggering cross-defaults,” Gracie said. “You would get what you saw in Lehmans — huge amounts of uncertainty and an uncontrolled cascade of closeouts and cross defaults in the market.”

The priority status of derivatives trades is problematic at best: although it increases the fraction of the claims that derivatives counterparties receive from a bankrupt bank, this effect is primarily redistributive.  Other creditors receive less.  On the plus side, in the absence of priorities, counterparties could be locked into contracts entered into as hedges that are of uncertain value and which may not pay off for some time.  This complicates the task of replacing the hedge entered into with the bankrupt bank.   On balance, given the redistributive nature of priorities, and the fact that some of those who lose due to the fact that derivatives are privileged may be systemically important or may run, there is something to be said for this change.

But the redistributive nature of priorities makes me skeptical that this will really have that much effect on whether a bank gets into trouble in the first place.  In particular, since runs and liquidity crises are what really threatens the stability of banks, the change of priorities likely will mainly just affect who has the incentive to run on a troubled institution, without affecting all that much the overall probability of a run.

Under the current set of priorities, derivatives counterparties have an incentive to stick longer with a troubled bank, because in the event it becomes insolvent they have a priority claim.  But this makes other claimants on a failing bank more anxious to run, because they know that if the bank does fail derivatives counterparties will get a lion’s share of the remaining assets.  By reducing the advantages that the derivatives couunterparties have, they are more likely to run and pull value from the failing firm, whereas other claimants are less likely to run than under the current regime.  (Duffie’s book on the failure of an OTC derivatives dealer shows how derivatives counterparties can effectively run.)

In other words, in terms of affecting the vulnerability of a bank to a destabilizing run, the choice of priorities is something of a Hobson’s choice.  It affects mainly who has an incentive to run, rather than the likelihood of a run over all.

The BoE’s initiative seems to be symptomatic of something I’ve criticized quite a bit over the past several years: the tendency to view derivatives in isolation.  Triggering of cross-defaults and accelerating contracts is a problem because they can hasten the collapse of a shaky bank.  So fix that, and banks become more stable, right? But maybe not because it changes the behavior and decisions of others who can also bring down a financial institution. This is why I am skeptical that these sorts of changes will affect the stability of banks much one way or the other.  They might affect where a fire breaks out, but not the likelihood of a fire overall.

In one of his famous papers, Durability and Monopoly, Coase conjectured that a durable goods monopolist could not exercise market power because he could not credibly commit to reduce output.  Let’s say that the monopolist had a stock of the good equal to X.  He sells the monopolist quantity of .5X.  Once he does that, he has an incentive to sell half of the remaining half.  Then he has an incentive to sell half of the half of the remaining half.  And on and on.  Understanding this, consumers believe that the monopolist will eventually sell all X units, and hence will pay no more than P(X)-which just happens to be the competitive price.  Due to the inability to precommit, the monopolist cannot charge a monopoly price and extract a monopoly rent.  (Stokey and others have proved Coase’s conjecture formally.)

The other day I was speaking to someone in the aluminum business.  He related a conversation with a Russian guy who traded for Rusal-Oleg (“The Living Neanderthal”) Deripaska’s aluminum company.  Since the Crisis, huge stockpiles of aluminum have built up.  These stocks weigh on prices.  Rusal and others are keeping these supplies off the market, but that still doesn’t support prices because consumers realize that they will eventually be released.  Rusal (and others) cannot credibly commit not to sell these ingots in the future.

What a dilemma.

But the Russian Rusal trader had a solution.  He said: “If only there was a way to make all this aluminum radioactive! Then all our problems would be solved!”

And he’s right: once contaminated, the metal would be unsaleable. Credibility problem solved.

Call it the Aluminum Meets Polonium Solution to the Coase Conjecture.

Russia has invaded Crimea-and hence has invaded Ukraine.  No Obamaesque circumlocutions about “uncontested arrivals” can gainsay that very basic fact.  The Russians have occupied a major Ukrainian air base in the peninsula, and have given an ultimatum to all Ukrainian military units to surrender their posts.

Yes.  All unopposed. So I guess that makes it OK.

But what to do about it?

First: a no brainer.  Eject Russia from the G8, and reschedule a meeting of the G7 somewhere far away from Sochi (as is scheduled for June).  But seeing as that it is the Obama administration and various EU factotums that will make the decision, no brainer is probably asking a wee bit too much.

Second: pressure FIFA to strip Russia of the 2018 World Cup.  Even though the thought of Putin blowing another $50 billion on a vanity project has some appeal.

@libertylynx suggests persuading the Saudis to turn on the taps to reduce oil prices, and hit Putin where it hurts.  (Though since Obama has seriously alienated the Saudis with his Syria policy and his dalliance with Iran, there is serious room to doubt whether the Saudis would be at all accommodating.)  Indeed, in 1986, the dramatic increase in oil production by the Saudis struck the USSR a mortal blow, and Putin’s Russia is almost as dependent on oil revenues as the Soviets.  (See Gaidar’s memoirs for a blow-by-blow account of how the collapse in oil prices gutted the USSR.  I’ve often wondered whether the Saudi action was directed against the USSR, rather than OPEC cheaters as was stated publicly, and done at the behest of the Reagan administration.)

There are some differences, though.  In ’86 KSA had about 7 million barrels of spare capacity, at a time when world consumption was on the order of 60 million barrels.  By producing to the max, the Saudis drove the price from around $23/bbl in December, 1985 to under $10/bbl in mid-1986, about a 60 percent drop.  Now Saudi spare capacity is  around 2 million bpd, when world output is around 90 million bpd.  A 2+ percent increase in Saudi output would result in at most a 20 percent price decline.  (Note that other producers would cut back, so that world output would go up by less than 2 percent even if the Saudis produced to their capacity.) Certainly enough to hit Putin hard, but not enough to create the existential crisis that the Soviets faced in the 80s.  But every little bit helps.

Insofar as gas is concerned, the Europeans could cushion the blow of sharply reducing consumption of Russian gas by increasing use of coal, which is in abundant supply in the US because the shale gas boom has displaced large quantities of coal in electricity generation.  But I doubt Europe has the stomach for that, and it could not get along without Russian gas altogether.

This leaves one last thing: crying havoc, and letting loose the accountants of war, a policy I advocated in August, 2008.  There is nothing that would make Putin and his coterie of thieves and thugs freak out more than putting their billions in loot stashed in the West at risk.

The fall of the Yanukovych regime provides a perfect cover for such an operation.  An aggressive search for the boodle of Yanukovych and his spawn would no doubt serendipitously uncover other illicit loot from the FSU: after all, a Hermitage Capital investigation traced connections between Yanukovych-linked companies and the fraud that the martyred Sergei Magnitsky uncovered.

This suggests a potentially fruitful asymmetric attack on Putin.  Loudly and publicly announce a thorough investigation of Yanukovych monies in the West.  Through back channels, tell Putin that unless he backs off-way off, like back to Rostov-on-Don off-that any dirty Russian money (and is there any other kind in Western banks-hell, even Putin pretty much agrees with this) that just so happens to be discovered during the investigation of Yanukovych will go to covering the US national debt.  Then go ahead and investigate anyways, and keep track of the moneys uncovered, for potential use at a later date.

Alas, even though this is a bloodless alternative (though it would drain the blood from Putin’s already pale, Botox-injected face), I seriously doubt Obama has the stomach for it.  In part because he knows Putin would lose his sh*t, and he doesn’t want to deal with that.

But here’s the thing.  There’s really not much reason to be intimated by Putin’s bluster–outside the FSU, anyways.  Russia has economic feet of clay.  Militarily it is a pretend power, fit to intimidate other decrepit post-Soviet militaries in smaller states on its borders, but sadly outmatched against a real power.  So call his bluff. Guarantee full employment for forensic accountants.

Then buy ear protection to guard against the shrieks emanating from points east and north, grab some popcorn, and sit back and enjoy the show.

The world petroleum market is undergoing substantial organizational changes, with private oil companies become progressively less vertically integrated and increasingly focused on the upstream.  The latest indicator of this trend is that Chevron is investigating the possibility of divesting its midstream operation.  This follows hard on the heels of the sale of Shell’s midstream and downstream operations in Australia to Vitol (bonus SWP quotes in the linked Reuters article).

This represents an interesting case study in transactions cost/Coasian economics.  In particular, the development of vibrant spot and forward markets for crude oil and petroleum products, and the growth and development of specialized trading firms (like Vitol, Trafigura, and Glencore) have reduced the costs of transacting on the market via the price system relative to the costs of conducting transactions within integrated firms.  Given the existence of thick, liquid, and active spot markets, and the development of logistical expertise by trading firms, assets at a particular stage of the value chain are less subject to holdup by owners of assets at adjacent links of the chain.  For instance, the existence of highly competitive spot markets for crude means that a refinery is  not locked into a small number of upstream suppliers, and thus need not be integrated with a source of crude supply to avoid contractual hazards.  The existence of active product markets has a similar effect.

It is interesting to note that much of the recent disintegration is occurring in smaller markets, and emerging markets, where contracting hazards have historically been particularly acute.  But this is precisely where the trading firms (notably Trafigura and Vitol) have stepped in and acquired assets from oil majors.

This evolution allows the majors to free up capital that they can employ in higher returning-and massively expensive-upstream exploration, development, and production activities.

I said that this was an illustration of transactions cost/Coasian economics in action.  As in most things economic, Adam Smith should really get the credit.  He noted that the division of labor (i.e., specialization) is limited by the extent of the market: Stigler used this insight to explain vertical integration.  The past thirty years have seen the development of a very extensive and vibrant market for oil and refined products (with Marc Rich deserving much of the credit for starting the process).  This spot market facilitates specialization, with the petroleum markets being increasingly characterized by firms that specialize in upstream, midstream, or downstream activities.

Interestingly, this development creates political and regulatory battles, as specialized firms at different segments of the value chain use political and regulatory means to capture a bigger share of the value of a barrel (pace the new battle over US crude oil exports).

Markets in action are a beautiful thing to behold.  Politics not so much.

Russell Gold has an  interesting piece about Bakken crude, specifically, its highly volatile nature.  This volatility makes it particularly dangerous to transport, especially by rail: due to its volatility, it is prone to explode in the event of a derailment or collision.

Further illustration, as if any were needed, that oil is not all alike.  Crude is a mixture of various hydrocarbons (and impurities), and different crudes are different mixtures.  Some are very light-almost like gasoline.  Some are very heavy-almost like asphalt. Different crudes present different challenges to refine-and different dangers to produce, transport, store, and refine.

My prediction is that this will result in some technical innovation that will make crude more amenable to transportation.  Maybe some sort of processing at the rail terminals.

This also brings to mind (mine, anyways) a historical episode.  In mid-1944, the Imperial Japanese Navy was tethered to bases in Indonesia, due to the ravaging of its tanker fleet by American submarines: fuel was available in Indonesia.

And a very special kind of fuel.  Crude produced on Tarakan Island was sufficiently light that it could be burned in ship boilers without refining.  One problem was that the crude was also sour (i.e., had a high sulphur content) and this corroded boiler tubes.

But the bigger problem was that it was very volatile, due to the large quantity of naphtha in the Tarakan crude.  This proved to be deadly to the IJN carriers Taiho and Shokaku (a veteran of Pearl Harbor) during the decisive Battle of the Philippine Sea (waged during the US invasion of Saipan).  When these ships were torpedoed by American submarines, the highly volatile fuel (and the vapors from aviation fuel leaking from ruptured tanks) eventually ignited, turning the ships into huge infernos.  The fuel eventually exploded, obliterating the huge carriers with massive losses of life. (Poor damage control on Taiho contributed to its destruction.)

Oil is not to be trifled with.  Which makes it all the more amazing how much is transported, stored, and consumed without incident.  Yes, Bakken presents challenges, but I am sure that economic imperatives (liability, the desire to avoid seeing valuable oil go up in flames, and yes, regulation) will result in adequate precautions and technical innovations that will substantially reduce the risks.  Desperation made the Japanese carriers fatal run risks with the oil they burned: we are not so desperate.