Streetwise Professor

If you’ve been waiting your entire life to witness the pure, un-adulturated, distilled essence of FUBAR, your dreams have been answered: for behold Cyprus!

For in one fell swoop, the with their monster mash of a bailout-bail-in of Cyprus, the Eurotards have succeeded in: gutting the rule of law and due process; riding roughshod over democratic institutions; increasing the risk of a catastrophic bank run in the event any Eurozone country (e.g., Spain) is believed to need to seek assistance; and sparking a huge diplomatic row with Russia.  Well played! Well played, indeed!

For those dwelling under a rock: as part of a 10 billion euro bailout for Cyprus, the Euros (meaning primarily Germany) required the imposition of a tax on deposits in Cypriot banks: a 6.75 percent tax on deposits below 100,000 euros, and 9.99 percent on deposits above 100K euros.

The bail-in essentially guts deposit insurance, which allegedly protects deposits below 100K.  A run on Cypriot banks is almost inevitable, because who is to say that this haircut is the last?  What’s worse, depositors in other peripheral banks have to take seriously the prospect that they will be similarly expropriated, in the event that their banks and/or sovereigns (to the extent this distinction has any meaning) require a Eurozone bailout.  This makes them much more likely to run at the first hint of trouble.  And of course, these things can be self-fulfilling.  If, say, Spanish depositors become more worried about the financial condition of the country’s banks, fearing having some of their deposits confiscated they might start to pull their funds from the banks; in the event, unable to fund themselves, the banks-and the Spanish government-may be forced to throw themselves to the tender mercies of the Germans, et al, leading to the imposition of the dreaded deposit tax.

The dynamics in these situations are always complicated, and highly dependent on beliefs, but it cannot be gainsaid that the actions in Cyprus increase appreciably the odds of a destabilizing run somewhere in the Eurozone, especially on the periphery.  Therefore, it is worthwhile to keep an eye on deposits at peripheral banks for any evidence of the beginnings of a run.  Relatedly, keep an eye on Target2 balances; an uptick in German Target2 assets could indicate attempts by peripheral depositors to move their funds to core banks.

The best-only?-hope of avoiding such an outcome is that Spaniards, Greeks, Italians, etc., believe that Cyprus is truly an exceptional, one-off case as the Eurocrats claim.  Which leads to the question: what differentiates Cyprus to such an extent that events in Cyprus do not cause depositors in Spain, etc., to update their beliefs regarding the probability they will be similarly expropriated in the event of a bailout of their countries’ banks?

There is one obvious answer: Russia.  Or, more properly, Russian money.

Cyprus has been the most popular destination for Russian funds leaving the country, and most notably dirty money: much of the money stolen in the Hermitage/Magnitsky fraud, for instance, went to Cyprus initially.  Germany’s intelligence service, the BND, said in a leaked report that a Euro bailout of Cypriot banks would largely benefit Russian depositors whose money has dubious origins.

This became a huge political issue in Germany.  The Social Democrats made a bailout of Cypriot banks political poison for Merkel: No bailout of Russian thieves!  She is ramping up for an election campaign, and in no way could be seen as bailing out dirty Russian money.

Supposedly she (and the IMF) wanted to force uninsured depositors (including many of the Russian depositors) to bear the entire burden of the bail-in, but Cyprus’s government refused.  Hence sharing the pain with smaller depositors.  But that has unleashed a furious reaction in Cyprus, and it is likely that the deal will be redone so as to put more of the burden on the uninsured (read-Russian) deposits and less on the insured deposits.

Which will only infuriate the Russians more.  And they are already plenty furious.  Putin just about lost his sh*t today, calling the original deal “unjust, unprofessional, and dangerous.”  And that’s before any adjustment of the deal to the further detriment of Russian depositors.

Any initial schadenfreud should be stifled: yes, the Russians are the masters of unjust expropriation, but two wrongs don’t make a right.  If some Russian money in Cyprus is dirty, being laundered, etc., the right way to handle it is to investigate and provide protections of due process to ensure that the guilty are identified and punished, and the innocent are spared: the Eurotard approach is Red Queen justice: “Sentence first! Trial later!”  The innocent are swept up with the guilty.  This is why the Euro approach guts the rule of law, with all of the pernicious effects that inevitably accompany such actions.

In some respects, Putin’s reaction is a surprise.  Given his declamations against tax evasion and the off-shoring of Russian money, there are some benefits to closing down an offshore bolt-hole for Russian money that Putin would prefer to remain in Russia.  But the unilateral Euro action no doubt rankles deeply, and no doubt strikes very close to home for Putin and some of his cronies.

It is very interesting to note that Russian stocks and the ruble took a far bigger hit from the Cyprus news than did Eurozone stocks.  The loss (about 2 percent on the major Russian indices, MICEX and RTS, and a .7 percent decline in the ruble, as compared to less than 1 pct declines in European stocks) cannot be explained by the direct effect of the expropriation.  Estimates are that there are about 30 billion euros in Russian deposits in Cyprus: 10 percent of that is only 3 billion euros, far less than the decline in Russian market capitalization.  Meaning that there is some indirect channel by which the expropriation is hitting Russian corporations: I am still trying to think through what that channel might be, but haven’t arrived at any opinions yet.

Whatever the reason, the market reaction demonstrates just how important the Cyprus issue is to Russian interests.  It will further stoke Russian paranoia-an amazing accomplishment.  It could cause a major diplomatic fallout between Germany and Russia, which would have substantial geopolitical implications.

All in all, it is hard to imagine how the Eurocrats could have played this any worse.  They didn’t really solve Cyprus’s debt problem.  They made it all the harder to deal with debt and banking problems outside of Cyprus.  They committed a major foreign policy blunder.  A truly amazing trifecta.

One final thought.  This points out the absurdity of the Euro project.  If tiny Cyprus is too big to fail, if the effects of its default would be so horrible that the Euro mandarins feel it necessary to take such a desperate and dangerous measure to prevent it, how can the Euro be anything but an absurdity?

Sorry about the silence, folks.  I was in Geneva doing my annual teaching in the University of Geneva’s Masters program in International Trading, Commodity Finance, and Shipping.  It is a very unique program, and a joy to teach in.  I also spoke at the annual Trading Forum sponsored by the Geneva Trading and Shipping Association (which also sponsors the Masters program).  I spoke about Frankendodd, which is somewhat ironic given that Mary Shelley wrote Frankenstein on the shores of Lac Leman a few miles from Geneva.

Some quick catch up.

First, Bloomberg is threatening to sue the CFTC for discriminating in favor of futures and against swaps.  Bloomberg plans to launch a SEF, and (rightly) believes that the discrimination regarding the margin requirements will seriously impair the prospects for its success.

At the annual FIA gathering in Boca, Gary Gensler doubled down in his support for the discrimination (a Risk Magazine link, so a subscription is required):

“Under clearing rules finalised in 2011, swaps executed on a designated contract market or a Sef have the same margin requirement – one day for energy, metals and agriculture, which is where we as a market have been for years. Interest rate swaps have been cleared for nearly 10 years on LCH.Clearnet. They have used a practice for many years around five-day minimum margining,” Gensler told Risk, after his prepared remarks yesterday at the Futures Industry Association annual conference in Florida.

How’s that for an answer lacking any intellectual content or analysis?  LCH’s done it that way in interest rates for many years, so everybody should do that for everything going forward.

Got it.  Why think when you can merely defer to precedent, regardless of how relevant that precedent is?

Someone is thinking, and echoes my analysis of the inanity of treating economically equivalent instruments differently just because one is called a “future” (good!) and the other a “swap” (bad! bad! bad!):

“If there are two products that are equally standardised, that take the same time to liquidate, that have the same risk, volatility and liquidity characteristics, then both of them should be subject to the same margin requirement. Collateral should be determined on the characteristics of the product in question, not the wrapper,” said Sunil Hirani, chief executive of fledgling interest rate swap and futures exchange TrueEx, speaking on the sidelines of the conference.

“If a contract takes five days to liquidate then it should be subject to five-day value-at-risk, and a one-day liquidation product should be subject to one-day VAR. If a futures contract has worse risk, liquidity and time-to-liquidation characteristics than a swap, but then receives a more favourable margin treatment because it’s in a futures wrapper, that is an injustice,” he added.

My only quibble is that it’s not an injustice, it’s a recipe for regulatory arbitrage and potentially for systemic risk.

Speaking of SEFs, Scott O’Malia told Risk that progress on writing the SEF rules-which had been expected any day-is slow.  Tiresomely, this also bears the fingerprints of Gensler’s meddling hand:

Nonetheless, at a panel discussion on Sefs held earlier in the day, O’Malia recited the Dodd-Frank definition of a Sef and observed pointedly that “the word five does not appear anywhere in there” – an allusion to the controversial proposal that any request for quote (RFQ) via a Sef must go to a minimum of five dealers.

“[CFTC chairman] Gary Gensler’s original position was that he did not want Sefs to include RFQ capability at all,” says one chief executive of a trading platform that plans to register as a Sef. “His initial hope was to restrict all these new venues to a central limit order book model, but when it became clear that an order book would only work for the most liquid swap contracts, he conceded the need to permit RFQ as an execution method, but included the stipulation that quotes must be sought from a minimum of five market-makers.”

And some dealers claim this is now the major impasse, with Gensler said to be refusing to drop the so-called RFQ5 provision from the final language or bring it into line with corresponding Securities and Exchange Commission rules for securities-based Sefs, which state that an RFQ can be sent to a single dealer.

So again, Gensler wants to dictate market structure: every SEF has to have a CLOB foot.  One size fits all.  No appreciation whatsoever for the fact that there is a diversity of market participants and interests that may well be served by a diversity of execution mechanisms.  No appreciation for the fact that the supposed beneficiaries of Gensler’s would-be fiat might actually know their own interests better than he does.  No appreciation for the fact that the discovery process of competition can result in the creation of a set of SEFs that best matches the diverse needs of market users, and that this competition may spur innovation that would result in the creation of an as yet undreamed of trading mechanism that meets market users’ needs far better than a CLOB.

Keeping this Gary Knows Best attitude in mind, be afraid, be very afraid when you read this story of about the next potential target of CFTC inquiries: price setting mechanisms. Taking inspiration from the Li(e)bor issue, the Commission is now (informally) discussing the possibility of investigating other benchmarks, notably the London gold and silver fixes:

“The idea that pervasive manipulation, or attempted manipulation [of interest rates], is so widespread should make us all query the veracity of the other key marks,” said CFTC Commissioner Bart Chilton at a Feb. 26 roundtable in Washington on financial benchmarks. “What about energy, swaps, the gold and silver fixes in London and the whole litany of ‘bors’?” he said, referring to Libor, Euribor and other benchmarks.

What’s rather disturbing is the linking of the gold and silver fixes and “bors”.  These things are very different.  The main problem with Li(e)bor, etc., is that they are not set on the basis of transactions: on this I agree with Gensler, having been making this point in an interest rate and commodity context for going onto 20 years.  (In my 1992 book Grain Futures Markets: An Economic Appraisal, I criticized proposals for cash settled grain contracts due to the lack of cash transactions on which to base an index.)

In contrast, the LBMA fixes are centralized auction mechanisms (Note to Gar: nearly a CLOB!)  Indeed, they are textbook examples of a Walrasian auction.  An initial price is mooted, and the participants indicate the amount they want to purchase or sell at that price: the quantity announced by each participating bank includes customer bids and offers, so buying and selling interest reflects more than just the proprietary trades of the fixing banks.  If at the initial price there are more buys (sells) than sells (buys), the price is increased (decreased), and each fixing participant again indicates its trading interest at the new price.  The process continues until buys equal sells, i.e., until the market clears.

Crucially, participants in the auction who are buyers (sellers) at the clearing price take (make) delivery of metal in an amount equal to their bid (offer) quantity at that price.  That is, the clearing price results in actual trades.  This is miles different than Li(e)bor.

This is not to say that a Walrasian auction cannot be manipulated: for instance, a company with a large long derivatives position that has a payoff tied to the fixing price might want to put in large buy orders in the fix to drive up the clearing price in order to impact favorably the payoff of the derivative.  Here the relevant issue would be the impact of orders on the clearing price.  That’s a totally different issue than in Li(e)bor, but I’m quite concerned that CFTC views all benchmarks as indistinguishable pieces in a mass.

And Gensler’s analysis-free treatment of futurization and SEFs only fuels those concerns. Good policy needs to be predicated on good analysis, not the prejudices and suspicion of the policymaker.  Gary Says So ain’t good enough, even for government work.  But too often that’s what we are getting.  We’ve seen it with futurization and SEFs, which raises legitimate concerns that the same will occur with benchmarks.  The confabulation of LBMA fixes with ‘bors only heightens those concerns.

A side note (added later): The suggestion that the CFTC can examine the London fixes betrays incredible hubris.  How could the US CFTC possibly have any jurisdiction over a UK entity-the LBMA-or the conduct of banks, only one of which (HSBC USA) is a US entity?  Especially given that as far as I am aware there is no CFTC regulated derivatives contract tied to the London gold or silver fixes.  But Gensler is all about extraterritoriality, so don’t put it past him to try.  I hope he tries, actually.  The Brits will go totally ballistic if he does.  Perhaps that’s exactly what’s needed to constrain GiGi’s imperial ambitions.

One other thing.  I didn’t mention anything about clearing, but Gensler’s analysis-free approach has been particularly prominent there.  To say that his “analysis” of clearing over the past 4 years has epitomized a comic book approach to the issue is an insult to the intellectual rigor of comic books.

John Kemp pixeled a rather lame response to my criticism of his earlier piece on “Broken Brent.”  I say lame because he did not even attempt to address any of the analysis I laid out.  Specifically, Kemp originally pointed to the dramatic drop in correlations between spot and forward prices and the different behavior of the curve in 2008 vs. 2012-2013 as evidence that fundamentals were somehow no longer driving oil prices.  I pointed out that that a fundamentals-based model would predict exactly such a pattern due to the pronounced backwardation in Brent and the substantial decline in macro volatility; I further pointed out that I had presented theoretical models that made this prediction and empirical evidence supporting it going back to the early-to-mid-1990s.  That’s what we call science.

Kemp’s response?  <Crickets.>

The most plausible explanation for his failure to rebut my analysis is that he can’t.  So instead he doubles down on “the hedge funds done it.”  Although he does it in a much more circumspect, passive way the second time around:

In a recent column, I suggested most of the short-term movements in Brent (and WTI) prices since mid-2010 could be traced to changes in money managers’ positions rather than fundamentals.

Read his original piece, and you’ll see that he did more than “suggest.” Accuse is more like it.

Kemp’s evidence consists of a few graphs depicting managed money futures positions and prices.  Point 1: eyeballs are not reliable evidence. Point 2: reliable evidence would involve some rigorous statistical analysis, which Kemp does not provide.  Point 3: said statistical analysis should attempt to control for other relevant factors, notably fundamentals.

But Kemp breezily dismisses the possibility that fundamentals could explain price movements in recent months.  After all, his original post is titled “static fundamentals”, and in that article and his response to me he asserts-and merely asserts-that fundamentals cannot explain price movements.  Since he does not even attempt to control for any fundamentals-related variable, Kemp’s analysis is plagued by omitted variables bias.  And that’s being charitable, because that phrase is usually employed to criticize statistical/econometric analyses, rather than gazes at graphs.

Sorry, John, but that doesn’t cut it.  In a commodity characterized by extremely inelastic supply and demand, such as oil, small fluctuations in supply and demand fundamentals can cause appreciable price movements.  Indeed, in a low macro volatility environment, fundamentals-based models imply that price movements are driven by highly technical, transient supply and demand shocks, and that moreover, these shocks cause substantial volatility in the shape of the forward curve.  That is, they cause low correlations between spot and futures prices.

In such an environment, seemingly minor factors such as the shut down of a refinery or regulatory perversities (such as the impact of RIN credits) drive movements in prices and the slope of the curve.  People who understand the fine structure of energy markets-people like Phil Verleger-realize this. Phil’s 18 February “Notes at the Margin” (which he kindly sent to me) provides a very detailed analysis of how low gasoline stocks and the closure of a Hess refinery are combining to increase gasoline cracks, which in turn are causing European refineries to buy and process Brent crude for sale to the US gasoline markets, which is in turn supporting Brent prices and backs.  As Phil characterizes it, the tight US East Coast gasoline market tail is wagging the Brent crude dog.  Fundamentals 101.

Phil analyzes these things carefully.  John couldn’t be bothered.  Instead, he squints at a few charts of COT data and prices, and declares fundamentals don’t matter.  If he could show that after correcting for the kinds of factors Phil Verleger analyzes carefully week after week that managed money position movements were associated with price changes, he would have established that a necessary condition for speculative price impact would hold: merely a necessary condition, but not a sufficient condition, because it could well be the case that the fundamentals were driving the managed money trades.  (To his credit, Kemp recognizes this possibility in his original article, though he dismisses it too readily.)

In brief, John Kemp’s attempt to show that hedge fund trading is causing movements in Brent crude prices and that fundamentals do not is plagued by numerous flaws.  Methodologically, graph gazing is the start of an analysis, not the culmination.  Furthermore, fundamentals-based models explain many of the phenomena Kemp finds anomalous.  What’s more, a micro-level analysis of supply and demand factors in the oil and product markets can account for many of the price movements that mystify Kemp.  When he confronts these issues head on, I’ll take him more seriously.

Climateer Investing weighs in on Kemp-Pirrong, and wonders why I felt obliged to go into smack down mode.  The answer is simple.  There are too many regulators and legislators and rabble-rousers (e.g., Oxfam)  who are more than willing to seize upon any claim that evil speculators are distorting markets in order to justify interference, in the form of position limits or transaction taxes or just general harassment of those engaged in legitimate and beneficial activities: yes, speculation is a legitimate and beneficial activity.  I have written and lectured extensively on the subject, and understand that speculation can, in exceptional circumstances, distort markets, but that such distortions leave distinctive tracks in quantities (e.g., inventories).  If you believe speculation has distorted markets, provide evidence that those tracks indeed exist.  Superficial examinations not grounded in well-established theoretical and empirical work don’t cut it, but feed prejudices that in turn too often lead to wrongheaded and destructive interventions into markets that cause real distortions (e.g., the rather cowardly decision of some European banks to exit the ag markets because of the propaganda campaigns waged by Oxfam and others).  When people writing for reputable sources like Reuters lazily encourage these prejudices, I will respond.  And being a Chicago guy, from a school where econ seminars are the academic equivalent of the MMA or UFC, my responses tend to be rather blunt and uncompromising.  If you can’t take it, don’t get in the ring.

And as to Climateer’s claim that the fall in oil prices from the $140s in July 08 to the $30s in early ’09 is some sort of “gotcha!” QED of the impact of speculation.  Please.  If you want me to take you seriously, you have to do a lot better than that.  A major adverse macro shock that causes the most severe, protracted economic contraction in decades following a period of robust demand (and again I commend Phil Verleger’s analysis of the summer of 2008 as the go-to source to understand what drove prices in that period) will cause a precipitous drop in the price of an inelastically supplied commodity.  Every time.  It would be anomalous if they didn’t.

John Kemp of Reuters-accompanied by cheerleading by Izabella Kaminska at FT Alphaville–is going on about the “disconnect” between nearby and deferred Brent.  He blames-wait for it-hedge funds.  Natch.

The Brent market is currently in a steep backwardation.  I demonstrated empirically almost 20 years ago that backwardation is associated with low correlations between spot and futures prices for oil and a variety of other commodities.  Indeed, my 1994 criticism of the Metallgesellschaft 1992-1993 “hedging” strategy-which led to several confrontations with Merton Miller-was based on the fact that MG’s “hedge” of long the nearby against distant deferred short positions was in fact risk increasing due to the fact that MG implemented this strategy during a backwardation, and this reduced substantially correlations thereby making the MG position very risky.  My 2011 book provides a robust model that predicts exactly this result.

The intuition is quite straightforward-as I’ve been teaching for about 20 years too.  Inventory is what connects spot and futures prices.  When inventories are large, the market is in contango, and spot and futures prices move together: cash-and-carry arbitrage connects these prices.  In contrast, when inventories are low, the market is in backwardation, cash-and-carry arbitrage doesn’t link the spot and the futures, and the correlation between these prices can go very low.  Hence the association between contango and high correlations.

Note: hedge funds, speculation, yadda yadda yadda have nothing to do with this.

Kemp does note that there is physical tightness that does explain the backwardation:

Overlaying all these broader factors are continuing problems with production of the four North Sea crude streams (Brent, Forties, Oseberg and Ekofisk) that physically underpin the Brent futures prices. BFOE crudes remain in short supply, keeping the market in a steep backwardation, with futures prices tending to rise sharply in the run up to contract expiry.

But then he discards this fundamental fact, and mounts his favorite hobby horse of bashing hedge funds and speculation.

Note even in this paragraph there is a telling piece of information that contradicts his view: “with futures prices tending to rise sharply in the run up to contract expiry.”  Uhm, that’s exactly when hedgies and other speculators are liquidating-selling-their nearby contracts and rolling them into the deferred months.  This should put downward pressure on nearby prices, if the speculators were really  in command. Completely inconsistent with his assertion that hedge funds are driving the disconnect between spot and futures.

Kemp also makes a comparison to spot price and curve movements in 2008 to more recent movements.  But as I also show in my book, to explain commodity price dynamics you need multiple shocks of differing persistence.  Curve shape is driven mainly by transitory shocks: that’s what inventory is used to smooth out.  The level of the curve is largely driven by persistent, business-cycle type shocks.  This means that conditioning on price levels alone is insufficient to make an apples-to-apples comparison.  The 2007-2008 boom was driven more by long run, secular factors-namely the Asian/Chinese growth boom.  This resulted in a rise in the price level and only a modest increase in backwardation.  That is completely different from current conditions-hence the different behavior.

Similarly, the differences between high correlations pre-2010 and low correlations now are readily explicable.  The market was much more abundantly supplied in 2009-2010 due to the severe economic contraction following the financial crisis, and as a result, the market was in contango most of that time-at times in a “supercontango”.  Again, one would expect this to be associated with high spot-futures correlations.

Moreover, there is a big difference in the composition of shocks, and the magnitude of these shocks that also explains the observed declines in correlations.  The 2009-2011 period was dominated by macro uncertainty driven by the financial crisis and then the Eurozone crisis.  These shocks tend to be persistent, affecting both current and expected future economic conditions in the same way, thereby contributing to high correlations between points on the curve; moreover, they tend to affect all commodities and asset classes similarly, leading to high correlations across commodities and asset classes.

At that time, macro volatility-as measured by the VIX-was high.   In early ’09, VIX was in the 30-50 percent range, and remained above 20 percent for most of 2010-2011, with spikes up to 35-40 percent.  Now VIX is tame, with levels in the low-teens, just like during the period of the “Great Moderation.”  High macro volatility tends to lead to high correlations along the curve and across commodities and between commodities and equities: common shocks dominate, especially when they are big.  The decline in macro volatility means that commodity-specific, relatively transient shocks tend to dominate: this tends to depress correlations along curves and across commodities, and between commodities and equities.  These are exactly the patterns observed in the past months.

That said, there are reasons to suspect the backwardation and the decline in correlations might be overdone, but not because of the malign influence of hedge funds.  Specifically, given the declining Brent supply base, it is reasonable to ask whether the backwardation is excessive.  At present, Forties is cheapest-t0-deliver, and this represents only about 350kbd of production.  Overall BFOE production is only about 1mmbpd.  Given the immense open interest in Brent futures and OTC derivatives, it is more that possible that large players are exercising market power by taking delivery of too much physical oil, thereby exacerbating the backwardation (i.e., creating an artificial scarcity).

If you want to identify who might be doing that, look at who is taking the physical cargoes.  Those parties would be the squeezers.  If hedge funds are the culprits, they should be taking a lot of physical supply.  Kemp certainly doesn’t provide any evidence of this, and his piece suggests these players are just playing with paper barrels, not wet ones: that’s my understanding too.  Historically, the Brent market has been the scene of many squeezes, but the squeezers have tended to be trading companies (e.g., Arcadia) or perhaps supermajors.

Brent was a squeezers paradise in the 1990s due to declining physical volumes and growing paper volumes.  Platts’s addition of Forties, Ekofisk and Oseberg to the delivery slate increased supply sufficiently to mitigate the manipulation problems.  But the decline in production has continued inexorably, and Brent is increasingly vulnerable to squeezes.  Which is why Platts and Shell have competing plans to tweak the pricing mechanism, namely by providing premiums for OE (Platts) or BOE (Shell), thereby reducing the delivery pressure on the cheapest-to-deliver Forties.

Squeeze-driven backwardation also tends to reduce spot-forward correlations.  The spot price is driven by squeeze-related technicals, the forward price by longer run fundamentals.  Squeezes also distort the inventory holding decision, and cause a breakdown in the cash-and-carry arb mechanism.  As I show in another book (and many articles).

So Brent may indeed be broken, but hedge funds haven’t broken it.  It is a classic problem in derivatives markets: a burgeoning derivatives market balancing on top of a declining deliverable supply.  I often analogize this to an inverted pyramid: and in Brent, the base of the pyramid (the paper market) is growing while its point (the physical market) is getting sharper.

Fixing Brent requires enhancing deliverable supply.  Not an easy thing to do.

Again contrast Brent and WTI.  Brent boosters have constantly bashed the WTI disconnect.  But this can be fixed by investments in infrastructure, which are being made, though not as fast as expected or as needed.  But building infrastructure is a helluva lot easier than building  a new Buzzard. Trust me on this.

So in the medium term, I expect Brent will get broker, and WTI will get better, leading to a shift of much futures and index trading activity (including hedge fund trades) back to WTI, which will no doubt lead John Kemp to saddle up his hobby horse and ride west into the Oklahoma sunset.

I laughed out loud when I read this paragraph from a Risk Magazine article about futurisation in the energy markets:

Top CFTC officials [GiGi? Is that you?] as well as members of Congress who supported Dodd-Frank [that’s Frankendodd around here, buddy] have repeatedly said the law was not aimed at physical end users of derivatives.  But if the the flight towards futures causes liquidity elsewhere in the market to dry up, end-users might have no choice but to fall in line.

Look: Elvis Costello’s “My aim is true” is definitely not the theme song of regulators and legislators in the US, or anywhere for that matter.  A 16 year old, hopped up, Afghan jihadi sprayin’ and prayin’ with his AK on full auto is more discriminating in his targeting than most regulators, and regulations.  Unintended consequences-AKA collateral damage-are the rule, rather than the exception with regulations.  This goes N-fold for monstrosities like Frankendodd.

Frankendodd is just starting its rampage.  The energy derivatives markets-and end-users in them-are only the first victims.

So when a regulator or legislator says that a particular reg or law isn’t aimed at you, don’t take comfort: take cover; there will be incoming.   We’re not talking Sergeant York or Annie Oakley behind the trigger here. More like Blind Lemon Jefferson.

Gazprom has announced that it is entering into exclusive negotiations with Levant LNG to secure the rights to market 100 percent of the gas produced by the Tamar floating LNG plant:

OAO Gazprom (GAZP), the world’s biggest natural gas producer, is seeking exclusive rights to export liquefied natural gas produced from fields off Israel’s Mediterranean coast.

Gazprom Marketing & Trading signed a heads of agreement with Levant LNG Marketing Corp., outlining the terms of a 20- year sales deal from the Tamar floating LNG plant, the unit said today in an e-mailed statement.

Levant and Gazprom’s marketing unit will hold exclusive talks on LNG sales for six months, according to a separate statement to the Tel Aviv bourse today. Sales may amount to 3 million tons of LNG a year, linked to Brent crude prices, according to the statement. That equals the plant’s total planned output volume.

My first reaction is that I cannot believe the Israelis will be so stupid as to lock themselves into Gazprom on an LNG project.  Why not?

Most importantly, Gazprom has little interest in seeing gas from the Mediterranean come onto market, and hence has an incentive to throw roadblocks in way of the project.  Interestingly, the announcement indicates that Gazprom plans to sell the gas in Asia, even though eastern Med gas is perfectly positioned to sell into Europe-which is probably precisely the reason that Gazprom wants to send the gas east rather than north and west.  But even if those tons of Israeli LNG don’t go to Europe, they would displace other gas that would otherwise go to Asia, and which could show up on European shores.  Thus, Gazprom still has an incentive to delay the gas coming on line any way that it can.  Yes, as a marketer, Gazprom would have less ability to do that than would the project developer, but it could still throw up obstacles.  If the Israelis do deal with Gazprom, they should be damned sure that the  contract is written very tightly.  And it would not be wise to give Gazprom the exclusive marketing rights, because that would maximize the Russian’s leverage.

But my second reaction is that the Russians may be signaling that they will overpay.  I base this on one detail in the announcement:  the price in the deal will be tied to the Brent crude oil price.  It is ironic that this announcement came out on the same day that the FT ran an article detailing how Japan-which is a major LNG buyer and which will purchase substantially more in the future as it moves away from nuclear power-is seriously considering ditching oil linked contracts for contracts tied to Henry Hub gas prices.

A flurry of projects has now emerged to harness the plentiful supplies of cheap shale gas by selling it on to international markets as LNG. And the exporters are pricing their gas off Henry Hub, the US natural gas benchmark, rather than off Brent or WTI. Henry Hub gas is now selling for about $3 to $4 per million British thermal units, less than a quarter of the price LNG cargoes are sold for in Asia. Japanese, Korean and Chinese buyers have, understandably, been flocking to the US in search of deals.

As a consequence, says Professor Jonathan Stern, head of gas research at the Oxford Institute for Energy Studies, Japanese utilities are increasingly reluctant to commit to oil-indexed LNG.

“They recognise how dangerous it is to sign up to any contracts on the old formula,” he says. “They can see the degree of commercial exposure, which is huge.”

What has spurred the Japanese into action is the way that rising LNG prices have stoked the country’s mounting trade deficit and exposed power utilities to big financial losses. Not only is LNG becoming more expensive, Japan has also been importing more of it: with most of the country’s nuclear reactors shut down in the wake of the 2011 Fukushima disaster, gas is filling the gap.

. . . .

Other Japanese gas importers, including Tokyo Gas and Osaka Gas, are also trying to move away from oil-linked prices, even for gas not produced in the US. Kansai Electric Power, for example, signed an innovative long-term agreement where the LNG it buys from BP, sourced from various parts of the world, is linked to daily Henry Hub settlements. Kepco is hoping for a 30 per cent reduction in LNG import costs.

So if it did an oil-linked deal with Levant LNG anticipating selling to Asia on the same terms, Gazprom will face increasing difficulty in doing so.  It therefore runs the risk of being effectively short oil (i.e., being hurt by rising oil prices) and long North American gas (hurt by falling gas prices).

But maybe this is the attraction of the deal to the Israelis.  If they anticipate a widening spread between oil and gas prices, and the Russians are willing to pay them the oil price when other marketers, anticipating that the market will soon transition to being priced off of gas (especially North American gas) will only be willing to do deals based on the gas curve.

So although the potential exposure to Gazprom opportunism would suggest that the Israelis would be suckers to enter into an exclusive deal with the Russian firm, Gazprom’s increasingly frantic attempts to defend the oil link may be leading the firm to overpay.  So maybe the Israelis are thinking that Gazprom is the sucker.

The pricing mechanism in gas is in a state of transition.  Moreover, these transitions tend to be very abrupt and “tippy.”  Once the market starts to shift from one benchmark to another, the move is self-reinforcing: there is a positive feedback effect as the liquidity in the new benchmark increases, attracting more trade, which increases liquidity, and so on.  The tipping process is well underway in Europe, and if Japan truly does move to gas based pricing and away from its historic commitment to oil linkage, that would likely start the snowball rolling downhill in Asia too.

Just look at what has happened in iron ore.  In a period of about two years, the industry has moved from annual negotiated contracts to spot price indexed deals between miners and steelmakers.

The economic case for gas linkage is compelling.  Gas prices reflect, well, gas market supply and demand fundamentals.  Oil prices, not so much.  The potential for misalignment of prices and values, which is so evident in European gas markets in particular, is much greater with oil indexing than gas indexing.  It is this misalignment that leads to misallocation of resources, and to disputes between buyers and sellers.   This provides a natural impetus towards the move to gas indexing.

But Gazprom is wedded to oil linkages.  Its commitment is likely what makes it willing to offer such a deal to the Israelis, and it is at least plausible that the Israelis see the writing on the wall that oil linkage is dying, and are calculating if Gazprom wants to be the sucker and lock itself into this obsolete mechanism, why should they say no?

I am adding a new entry to my list of phrases that put me on guard that someone is trying to con me: “balanced approach.”  Obama is always blathering about balanced approaches to fiscal matters.  And in today’s WSJ, Dow Chemical CEO Andrew Liveris pleads for a “balanced approach to shale gas exports.”

To say that “balanced” is highly subjective is the understatement of the century.  In Obamaland, “balanced approaches” mean large tax increases now, and hazy promises of spending cuts in some distant future.  In Leveris’s oped, “balanced” means imposing restrictions on exports of natural gas to lower the cost of his most important input.  Funny, ain’t it, that things seem to tip the way of those advocating “balanced approaches”?  In other words, if it helps me, it’s fair and balanced!

Liveris couches this as a means of stimulating employment in US manufacturing and increasing GDP:

Moving manufacturing facilities back to the U.S. from abroad—the trend known as “reshoring”—could create up to five million American jobs over the next seven years, according to the Boston Consulting Group. This figure is so high partly because in the chemical industry jobs created by investing in domestic manufacturing are eight times more beneficial to gross domestic product than are simple gas exports, as documented by the American Chemistry Council.

To which I reply: Bull.  National income is maximized when goods are allowed to flow to their highest value use.  If domestic gas prices are $3/mmBTU and foreign prices (net of transportation, etc.) are $4, that means that at the margin 1 mmBTU of gas consumed in the US-including by Dow-generates $3 of value, and if consumed overseas it generates $4.  Letting that mmBTU go overseas therefore generates $1 of value-of income.  No BCG or American Chemical Council mumbo jumbo can change that simple fact.  And I’m sure that the ACC is totally objective.  Totally.

Leveris pleads that all he wants is a rule-based system:

The truth is that every firm in every sector benefits from exports and rules-based free trade. But what are the rules for exports of liquefied natural gas? Who sets them? Oil and gas companies, states, Japanese government agencies? Or are they part of rules-based free-trade agreements that the U.S. government has negotiated so as not to disadvantage domestic consumers, manufacturers and workers?

Here’s a balanced rule for you, Mr. Leveris: Producers can sell to whomever offers them the highest price.  Short. Simple. Easy to understand.  No bureaucrats required.  And to show what a broad minded guy I am, I propose that the rule be applied to Dow.

But Leveris wants to insert bureaucrats into the process:

The Department of Energy has already received applications for the export of half the gas consumed in the U.S. today. Under a 1938 law, the department must determine if those applications for exports are in the national interest (taking into account all segments of society).

Several manufacturers, including Dow, are calling for faithfulness to current law. We are concerned that hasty government action, coupled with growing domestic and international demands for natural gas, will trigger a severe supply pinch that will send the U.S. back to the days of higher and more volatile domestic natural-gas prices.

Ah.  “The national interest.”  That’s the ticket.

The 1938 law inserts a government bureaucracy that can distribute rents among rent seeking supplicants-such as firms like D0w-based on political calculations.  Resources are wasted in the influence process: e.g., chemical companies and energy companies engage in an influence arms race employing lobbyists and other resources to importune the bureaucrats.  More resources are wasted as this process inevitably leads to inefficient outcomes.  The uncertainty generated by the vagaries of this process also serves to damp investment.

So here is my balanced proposal: scrap the 1938 law.

Everywhere you look you see that energy is highly politicized.  Politicians and bureaucrats exert a huge influence over the allocation of energy resources.  Look at Keystone XL.  Look at cockamamie subsidies for solar and wind.  I could go on and on.  These interventions destroy huge amounts of value.

Balance is a relevant concept here, because politicians and bureaucrats balance competing political interests when choosing policies that divide up the pie.  But that “balanced” process destroys wealth.

We need less politicized energy market.  Allowing free export of US natural gas-and oil-should be a no brainer if your object is-as Mr. Leveris claims his is-to maximize national income.  But that’s not his real objective.  His real aim is to maximize Dow’s income, to redirect wealth from the shareholders of E&P firms to his shareholders.

Leveris’s piece is a gaseous plea for mercantilism, though of a rather apostate form since traditional mercantilism advocates the maximization of exports.  But the essence of mercantilism is government control and manipulation of trade.  And moreover, one staple of mercantilist thought is that domestic raw materials should only be used in domestic manufacture because manufactured goods are more valuable than raw materials.  Leveris repeats this long discredited fallacy in his oped.  Proving that few things live longer than bad arguments.

Sadly, it is likely that the chemical industry, and other energy consuming industries, will exert some influence and succeed in restricting the exports of natural gas.  That’s the way things work, alas.  But don’t buy the bilge that these restrictions are part of a “balanced approach” that advances (ill-defined) “national interest.”  Instead, they are inherently unbalanced and advance very specific economic interests.

And one last word of advice: when anyone says they are only advocating a “balanced approach”, grab your wallet and call bull.

Gensler and Chilton are taking up the cudgels again for position limits-this in spite of the spanking from Judge Wilkens last year.

Chilton, as usual, is most outspoken on this issue:

Today, energy costs for most families have risen more than 20 percent since 2001. This hurts not only American households, but also American business—like many of your businesses—that rely on energy. According to the Energy Information Administration (EIA), nearly nine percent of our economy or $1.4 trillion is spent on energy annually. Imagine if that figure dropped by just ten percent—$140 billion freed up for investment and economic growth.

So that’s why I continue to lead the charge for position limits—to help keep the markets working for you. The efforts to stop position limits will ultimately fail. Congress told us in no uncertain terms to get it done, and I intend to see that we do that, before more families and businesses go into the “red” column on their balance sheets.

First of all, 20 percent in 13 years is less than 2 percent per year-that is, less than the rate of inflation: the CPI is up almost 30 percent over those 20 years, meaning that the real price of energy has fallen.   I say again: the real price of energy-per Chilton’s own numbers-have fallen.

I also note Chilton’s continued focus on the rise in oil prices, and his complete refusal to acknowledge the collapse of natural gas prices precisely during the period in which his Massive Passive bogeymen have allegedly driven commodity prices generally, and energy prices particularly, far above what they “should” be.   If “speculation” by “massive passives” (or whoever) can cause prices to become completely unhinged from fundamentals, why has natural gas moved in the exact opposite direction from oil?

Chilton’s egregious errors of omission and commission must be caused either by a lack of intellectual capacity, or a lack of intellectual honesty.  I really see no other alternative.

Obama and his acolytes flatter themselves as sophisticates, reality-based devotees of science.  They look to Europe for inspiration.  If only they would actually pay attention to the reality of Europe, as opposed to their fantasy vision.

Obama brought his supporters to paroxysms of joy-near orgasms, in fact-with his call in the SOTU speech for action on “climate change.”  Action that he said he would take if Congress does not-the Constitution be damned.

Would that he actually look to what his Euroheroes are actually doing  Which is to realize that their alternative energy initiatives have proved to be very expensive unicorn hunts.  Both Germany and Spain have realized that alt-energy is outrageously expensive and inadequate to achieve any meaningful impact on climate:

More than a decade ago, Germany and Spain created similar laws to aggressively promote the adoption of renewable energy. The two countries were again marching in step on Thursday—this time to fix a web of subsidies and compensations they created for green energy that had the unintended effect of driving up household electricity bills.

. . . .

Fearing a voter backlash from anger over the lopsided financing of green energy, Ms. Merkel’s government on Thursday proposed putting a cap on the green-energy surcharge until the end of 2014 and then restricting any rise in the surcharge after that to no more than 2.5% a year. The government also plans to tighten exemptions, which would force more companies to pay, and achieve a cut in green subsidies of €1.8 billion ($2.42 billion). The plan is a quick fix pending comprehensive reform after the election, government officials said.

. . . .

The Spanish parliament took a similar step on Thursday, passing a law that aims to curb rising household electricity costs by cutting aid to the renewable-energy industry.

Renewable-energy producers “are going to receive less revenue, but these measures are better for consumers” said Energy Minister José Manuel Soria.

In other words, Germany and Spain are retreating posthaste from their former grandiose commitments to green energy.

But despite this rather flagrant example of the economic bankruptcy of subsidies for renewables, Obama is intent on playing the David Farragut of greendoggles: Damn the reality! Full speed ahead!

It’s bad enough that Obama ignores what is going on in Euroland.  He should have plenty of examples closer to hand.  Like Solyndra. (Do you really need links?  Seriously?)  Like Tesla (ditto). Compact Power. LG Chem: read it and weep.  You’d  get more satisfaction out of taking $175mm in $100 bills and setting them alight.

But we are likely to be subjected to yet more of these monstrosities, because there is nothing that the reality-based community likes to do more than deny reality.  Especially when it stares them in the face.

Not only are we almost certain to chase green unicorns, we may well deny ourselves of very real energy sources.  This weekend saw protests against the Keystone XL pipeline, and I would say that the odds are better than even that he delays or kills it: the cabal of enviros and Warren Buffett will be pretty hard for Obama to oppose.  (The calculations of my earlier post imply that Keystone XL-which will last for decades-will pay for itself in less than 600 days-and that’s conservative because a good fraction of the $20mm/day in surplus generated by Cushing-Gulf pipelines is attributable to the oil that Keystone XL could transport.)  In contrast we’ll be paying for greendoggles for many multiples of 600 days.

It is quite instructive to view the contrast between the European’s concession to reality, and Obama’s denial thereof.  Just when the Euros are beginning to concede that green unicorns may not exist, Obama is hell bent on chasing them.

God help us.

Rosneft is scrambling to finance its acquisition of TNK-BP.  The means it is resorting to speak volumes about the gulf between its aspirations to be a supermajor and reality, and also about the risks that lenders perceive in dealing with Russia (and perhaps Rosneft specifically).

Rosneft is raising $10 billion through an oil pre-pay deal with Vitol and Glencore.  Rosneft agreed to sell the oil forward, with deliveries starting this year, and Vitol and Glencore used those contracts as collateral for loans for $10 billion.  The money goes from the banks, through Vitol and Glencore, and then on to Rosneft which will use it to pay AAR and BP.  The use of oil to secure the Rosneft-Vitol/Glencore deal is interesting.   Rosneft cannot borrow the money on its own promise to repay: it did borrow $15 billion from banks on that basis, but individual banks were not willing to take more than $1 billion in exposure to the Russian company: that limited appetite for Rosneft credit risk (which given its asset base is driven by political and legal risk) is quite telling.

Rosneft has to use prepays-a kind of financing usually extended to less creditworthy commodity traders, producers, or processors-to get additional funds.  Big commodity houses like Vitol and Glencore frequently use prepays and offtake agreements to provide funding to smaller producers and refiners.  It’s not the way real supermajors secure credit.

Oil is particularly useful as collateral, because if Rosneft tries to renege on its commitment to the Swiss houses (as it might be tempted to do if oil prices spike well above the agreed price), it will have a difficult time selling the oil as anything it tries to sell would be subject to seizure.  It’s a lot easier to seize oil in tankers or in storage facilities in Rotterdam to collect on a debt than it would be to try to seize a refinery in Russia.

Rosneft is also going back to the China well.  It has approached CNPC for $25-$30 billion dollars, again backed by sales of oil at fixed prices.  It originally denied it was in talks with CNPC, but this appears to be a “meaning of is” thing.  It might not have been in talks right at the instant that the Reuters reporter called them last week, but today Igor Sechin is in Beijing talking to the Chinese about a deal.  That’s not the kind of thing that is stitched up over a weekend.

This is a reprise of a $25 billion loan from CNPC and the China Development Bank to Rosneft and Transneft to fund construction of a pipeline extension to China negotiated at the depths of the crisis in 2009.  As I predicted at the time, that deal soon unleashed conflict between the Chinese and the Russians over the price of the oil that the Russians sold to secure the loan, and the transportation cost. The battle raged for several years, until the Russians agreed to sell the oil at a $1.50/bbl discount to the price they charged other customers buying off the ESPO pipeline.

Again, doing a large loan secured by oil, especially with a counterparty with whom the Russians have had numerous pricing disputes (they still haven’t negotiated a price in a gas deal that was first inked in 2006), is hardly the mark of a supermajor.

I fully expect that any new deal with China will spark future price disputes.

The quite evident limits on Rosneft’s borrowing capacity will constrain its ambitions to expand production in Russia, especially in offshore projects in the Arctic.  Hence, it will be very reliant on JVs with companies like Exxon who will no doubt drive very hard bargains.

The means that Rosneft must resort to in order to finance its purchase of TNK-BP says a lot.  It can’t borrow agains the assets it is acquiring, or its other assets.  Beyond the $15 billion syndicated loan, the only thing that lenders feel comfortable lending against is the oil that Rosneft must sell.  That’s the way middling-to-marginal commodity firms get funding, not supermajors.